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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K



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|x | Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended June 30, 2004 or
|- | -------------------------------------------------------------------------------------------------------------------------------



| ̈ | Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from
 to .
|- | -----------------------------------------------------------------------------------------------------------------------------



Commission file number: 001-31265



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AVATECH SOLUTIONS, INC.

(Exact name of registrant as specified in its
charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|DELAWARE                                                       |  | 84-1035353                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|10715 Red Run Blvd, Suite 101, Owings Mills, Maryland          |  | 21117                               
|(Address of principal executive offices)                       |  | (Zip Code)                          



Registrants
telephone number, including area code (410) 581-8080



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Securities registered pursuant to Section 12(b) of the Act:



|               |  |                                          
|-------------- |  | -----------------------------------------
|Title of Class |  | Name of Each Exchange on Which Registered
|None           |  | None                                     



Securities
registered pursuant to Section 12(g) of the Act:



|              
|--------------
|Title of Class

Common Stock, $.01 par value



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



Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statement incorporated by
reference in Part III of this Form 10-K or any amendment to this Form 10-K.



Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.    Yes ̈No  x



The aggregate market value of the voting stock held by non-affiliates of the registrant as of September 24, 2004 was $4,909,492.



The number of shares of common stock outstanding as of September 24, 2004 was
9,626,455.



DOCUMENTS INCORPORATED BY REFERENCE



To the extent specified, Part III of this Form 10-K incorporates information
by reference to the Registrants definitive proxy statement for its 2004 Annual Meeting of Shareholders (to be filed).



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TABLE OF CONTENTS



|         |  |          |  |                                                                                                              |  |   
|-------- |  | -------- |  | ------------------------------------------------------------------------------------------------------------ |  | --
|         |  |         
|PART I   |  |          |  | 2                                                                                                           
|         |  |          | 
|         |  | ITEM 1.  |  | Business                                                                                                     |  | 2 
|         |  |          | 
|         |  | ITEM 2.  |  | Properties                                                                                                   |  | 7 
|         |  |          | 
|         |  | ITEM 3.  |  | Legal Proceedings                                                                                            |  | 7 
|         |  |          | 
|         |  | ITEM 4.  |  | Submission of Matters to a Vote of Security Holders                                                          |  | 8 
|         |  |          | 
|         |  |          |  | Executive Officers                                                                                           |  | 8 
|         |  |         
|PART II  |  |          |  | 10                                                                                                          
|         |  |          | 
|         |  | ITEM 5.  |  | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |  | 10
|         |  |          | 
|         |  | ITEM 6.  |  | Selected Financial Data                                                                                      |  | 11
|         |  |          | 
|         |  | ITEM 7.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                        |  | 12
|         |  |          | 
|         |  | ITEM 7A. |  | Quantitative and Qualitative Disclosures about Market Risk                                                   |  | 24
|         |  |          | 
|         |  | ITEM 8.  |  | Financial Statements and Supplementary Data                                                                  |  | 25
|         |  |          | 
|         |  | ITEM 9.  |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosures                        |  | 25
|         |  |          | 
|         |  | ITEM 9A. |  | Controls and Procedures                                                                                      |  | 25
|         |  |          | 
|         |  | ITEM 9B. |  | Other Information                                                                                            |  | 25
|         |  |         
|PART III |  |          |  | 26                                                                                                          
|         |  |          | 
|         |  | ITEM 10. |  | Directors and Executive Officers of the Registrant                                                           |  | 26
|         |  |          | 
|         |  | ITEM 11. |  | Executive Compensation                                                                                       |  | 26
|         |  |          | 
|         |  | ITEM 12. |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters               |  | 26
|         |  |          | 
|         |  | ITEM 13. |  | Certain Relationships and Related Transactions                                                               |  | 26
|         |  |          | 
|         |  | ITEM 14. |  | Principal Accountant Fees and Services                                                                       |  | 26
|         |  |         
|PART IV  |  |          |  | 27                                                                                                          
|         |  |          | 
|         |  | ITEM 15. |  | Exhibits and Financial Statement Schedules                                                                   |  | 27



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##### Table of Contents

PART I

ITEM 1. BUSINESS



Background



Avatech Solutions, Inc. was formed as a Delaware
corporation on September 9, 1996. During fiscal years 1997 through 1999, we consummated business combinations with ten companies that provided design automation software, training, technical support, and professional services to corporations,
government agencies, and educational institutions throughout the United States.



In November 2002, Avatech Solutions completed a merger with PlanetCAD, Inc and became a wholly owned subsidiary of PlanetCAD, Inc., after which PlanetCAD changed its name to Avatech Solutions, Inc. and Avatech changed
its name to Avatech Solutions Subsidiary, Inc. As a result of the merger, PlanetCADs shareholders retained twenty-five percent of the surviving company and, in exchange for all of the common stock of Avatech Solutions, Inc., Avatechs
shareholders were issued registered shares constituting seventy-five percent of the surviving companys outstanding common stock. Avatech was deemed to have acquired PlanetCAD because Avatechs shareholders received the majority of the
common stock of the post-merger company. In November 2002, Avatech Solutions, Inc. began trading on the OTC Bulletin Board under the symbol AVSO.OB.



In the fourth quarter of our fiscal year ended June 30, 2003 and the first quarter of fiscal year 2004, we restructured the business to eliminate certain
unprofitable operating segments, including the acquired PlanetCAD operations and four reseller locations.



General



We are a
leader in design and engineering technology solutions with expertise in CAD software, data management and process optimization for the manufacturing, engineering, building design and facilities management industries. We specialize in software
resale, integration, standards development and deployment, education and technical support, aimed at improving design and documentation efficiencies and the seamless integration of workflow processes. Our sales are to corporations, government
agencies, and educational institutions worldwide.



We
differentiate ourselves from traditional product resellers through our wide range of value-added services, consisting primarily of training, technical support, and professional services. We also provide software customization, data migration,
computer aided design standards consulting, process workflow analysis, and implementation assistance for complex design environments. Our strategic focus is to respond to our customers requests for interoperability and provide solutions that
address broad, enterprise-wide initiatives.



Our national sales
and service delivery network consists of approximately 133 personnel operating out of sixteen business offices across the country. Our sales database has over 180,000 point-of-contact names collected over a fifteen-year time span and an active
customer list of approximately 18,000 private firms and federal, state, and local agencies.



Our product sales are cyclic, and increase when the developer of a specific software product offers a new version, promotions or discontinues support of an older product.



As is common among software resellers, we purchase our products from our
suppliers with a combination of cash and credit extended by the supplier. We do not carry significant inventory, and generally place an order with the supplier only after receiving a firm commitment from our customer. Except in unusual situations,
we do not allow our customers to return merchandise, and do not offer extended payment terms to our customers.



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Products



Substantially all of our business consists of the sale of prepackaged software and associated services to customers in the United States. Our sales are
focused on three major product categories and associated value-added services.



Design Automation. More than 90% of our total revenue arises from the resale of design software developed by Autodesk, Inc. (Autodesk) for the building design and land development, manufacturing, utilities, and
telecommunications industries, and the delivery of related services from the sales of these products. These product sales are primarily packaged software programs installed on a user workstation, on a local area network server, or in a hosted
environment. The programs perform and support a wide variety of functions related to design, drafting, manufacturing, workflow automation, and document management activities.



In addition to our Autodesk offerings, we also provide other solutions to our design automation customers, such as
electronic document management software from Cyco Software, Inc., which provides methodical and organized processes to store, retrieve, manage, and version design files, drawings, and related documents such as customer correspondence, inventory
lists, digital images, and other items. We offer Proof Positive, a quality assurance solution for mechanical design, which we also develop and support. In addition, we offer ongoing support for legacy products such as STONErule® for CATIA, a design automation toolkit. These products are based on client/server
architecture, and are scalable from a departmental solution to a division level infrastructure system.



We provide a variety of services along with our design automation software sales, to assist our customers in maximizing the benefits from these software
applications. These services include training, technical support, and professional services.



We offer training courses in over thirty different subjects related to various software solutions offered at nineteen training facilities and through mobile labs that we can send to a customer site or other off-site
facilities. We have 17 employees who serve as class instructors and have formal training or successful industry experience in the topics they are teaching. We can also provide training services that are highly tailored to meet the needs of a
particular customer, including company-specific operational topics, customized product usage, and other general technology or process training. As part of our training offering, we have developed and deployed an Internet based assessment tool that
allows our clients to test their employees knowledge and ability to use the software tools. We can write custom questions to focus the assessment on the specific tasks of a particular client, or can make the assessment broader to help identify
the productivity issues within a company. Following the assessment and using reports, we are able to create a custom curriculum and learning environment to directly address the clients needs. This tool is also being integrated into our
standard training classes to ensure customer satisfaction, to identify areas where our training offerings or instructors may need improvement and/or to identify opportunities for additional offerings. Our instructors must pass annual subject-matter
exams required by Autodesk and other software providers to retain their product-based teaching certifications.



We provide end-user and corporate technical support services through our National Support Center (NSC) located in Omaha, Nebraska. A staff of five
full-time product and technology consultants assists customers calling with questions about product features, functions, usability issues, and configurations. The NSC offers services through multiple access levels including prepaid services, actual
elapsed time, and annual support contracts. Customers can communicate with the NSC through e-mail, telephone, and fax channels. Standard NSC support services are offered on a 12-hour by 5-day basis, with premium pricing for extended coverage hours.



Our professional services include project-focused offerings
such as software customization, data migration, computer aided design standards consulting, supplemental staffing for design work, drawing digitization, and symbol library development. We have two project managers and four industry specialists who
provide professional services to our design automation customers. We also provide technology interoperability, engineering collaboration, and workflow improvement solutions with design automation and manufacturing organizations.



Product Lifecycle Management. In July of 2003, we entered into an
Authorized Reseller Agreement with Dassault Systèmes of France, a world leader in product lifecycle management (PLM) solutions, with more than 65,000 customers in 80 countries. This agreement makes us a Dassault Systèmes Business
Partner and authorizes us



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to sell Dassaults SmarTeam PLM solution throughout North America. PLM software solutions are expected to be a
significant new tool for manufacturers in multiple vertical industries over the next decade, and this agreement positions us to provide unique cost-effective PLM solutions designed to help companies optimize business processes, shorten the
time-to-market, increase innovation, and reduce costs.



We
market PLM solutions to our existing and new small and medium-sized business customers through a team of dedicated salespeople. As of June 30, 2004 we have four dedicated sales people and five dedicated technical specialists involved in marketing
and supporting sales of PLM product and associated services.



Facilities Management. In May 2003, we entered into an Authorized Reseller Agreement with Archibus, Inc. of Boston, MA, a world leader in facilities and infrastructure management products, with more than 100,000 enterprise users, and
one million web users worldwide. This Agreement authorizes us sell Archibuss FM solution throughout the United States. Its flagship product, ARCHIBUS/FM, is a powerful suite of integrated applications that creates a single, comprehensive
repository of information on an organizations people, places, processes, and physical assets. Physical assets, such as real estate, buildings, equipment, materials, and furniture make up a significant percentage of an organizations total
asset value. These assets are used by many different business units, departments, and individuals, and must be accurately managed in order to extend asset life cycles and keep operating costs at a minimum.



Total Infrastructure and Facilities Management (TIFM) solutions enable
organizations to make informed strategic and business decisions that optimize return on investment, lower asset life cycle costs, and increase enterprise-wide productivity and profitability. Organizations of all sizes, spanning the financial,
educational, governmental, healthcare, and manufacturing industries, use TIFM to deliver timely, relevant facilities information as part of their strategic business plans.



Geographic Information Systems (GIS) software permits users to link together disparate data files (maps, aerial photos, tax
records, marketing data, etc.) and provide the user with a unified image and knowledge base of a specific geographic location or building location. When integrated with Internet browsers and document management tools into a facilities management
solution, users gain substantial knowledge about their buildings, their neighborhoods, and their documents, providing increased effectiveness and cost containment.



New technology based on powerful desktop computer hardware has enabled software developers to offer products that are easier
to use and less expensive than the previous applications, thus expanding the volume of purchases, installation, and level of usage from the traditional civil engineering, utilities, public works, and transportation logistics markets and into the
emergency services and Homeland Security segments.



In the
fourth quarter of our fiscal year ended June 30, 2003, we began to sell, customize, and implement facilities management solutions through our three dedicated salespeople, two dedicated technical specialists and a network of strategic partners. We
also provide GIS database development services to facilities management customers, both through our own employees and our strategic partners.



Markets



Design Automation. In the design automation market, we focus on providing enterprise solutions to small- and medium-sized businesses with under one billion dollars of annual revenue, primarily in the
architecture, engineering, and construction (AEC) market and the mechanical design and manufacturing (MDM) market. The AEC market is comprised of design services focused on the construction of large physical assets such as buildings, roads,
factories, utility companies, and commercial infrastructure projects. The MDM market is primarily focused on the design, tooling, assembly, and testing of instruments, electronic devices, machines, mechanical devices, and power-driven equipment. We
also sell prepackaged design automation software to small companies with less than fifty million dollars of annual revenue on an order-fulfillment basis through our call center in Tampa, Florida.



While several local and regional competitors exist in the various geographic
territories where we conduct business, we have a competitive advantage in terms of geographic reach, comprehensive training and support, and the provision of other products and services. We are one of the largest commercial Autodesk resellers in the
United



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States. Two national competitors that could be compared to us in scale, size, geographical reach, and target markets for
the resale of Autodesk products are INCAT International, Inc. (INCAT) and RAND A Technology Corporation (RAND).



INCAT is a systems integrator for design automation products. They have thirty offices in nine countries with worldwide headquarters in the United Kingdom
and fifteen offices in the United States. They have approximately eight hundred employees worldwide, with approximately sixty-five percent in consulting, design engineering and technical support. While INCAT is larger than Avatech, we estimate that
the Autodesk portion of its business is less than our Autodesk business.



RAND is the largest computer-aided design and engineering technology company worldwide. It also has been selling Dassaults SmarTeam PLM solution in North America for approximately two years. However, we estimate
that its North American Autodesk-related business is less than ours. It has twelve U.S. offices in the Midwest, Northwest and Florida. RAND operates 104 offices located in twenty-seven countries with its corporate headquarters in Canada.



Product Lifecycle Management. We recently have begun to provide
Dassaults SmarTeam products, which are rapidly implemented, scalable, tailored and uniquely cost-effective PLM solutions designed to offer streamlined data management, improved workflow, and comprehensive collaboration to help companies
optimize business processes, shorten the time-to-market, increase innovation, and reduce costs. We provide these solutions as part of an enterprise solution for existing and new small- and medium-sized business customers. According to AMR Research,
the PLM software market was two billion dollars in 2001 and will grow to nearly eight billion dollars by 2006.



Prior to our arrangement, Dassaults SmarTeam products were generally marketed in the United States exclusively through IBM and on every other
continent through leading resellers.



We believe that PLM
software and services represents a significant opportunity for future growth. Our arrangement with Dassault not only provides us with a potentially significant new product line, but also allows us to expand our higher margin service revenues and
significantly increases the average size of sales transactions. PLM software greatly enhances manufacturing efficiencies and permits manufacturers to manage products through their active lifecycles. We believe that our arrangement with Dassault
provides us with important product diversity consistent with our new strategy of increased investment of people, diversification of product and service offerings.



Facilities Management. We provide facilities management solutions to organizations of all sizes, spanning the
financial, educational, governmental, healthcare, and manufacturing industries. Our major competitors in facilities management products are CFI, BRG  Business Resource Group, and DB Associates. CFI is a privately held company based in
Southfield, MI. It provides mainly ARCHIBUS/FM products, as well as consulting services and outsourced staffing, but they are no longer an Autodesk distribution partner. BRG  Business Resource Group (BRG) is a privately held
company based in San Jose, CA, whose primary business is the resale of commercial furniture systems. BRG focuses on the ARCHIBUS/FM product line and provides consulting and implementation services and outsourced staffing. DB Associates, parent
company of the wholly owned subsidiary, Facilities Resources, Inc. (FRI), focuses primarily on furniture management and warehousing services. We believe FRI is the largest ARCHIBUS/FM partner by volume. We believe that our larger
employee pool and well-developed customer base give us advantages over these competitors and will contribute to future growth in this market.



Arrangements with Principal Suppliers



Our revenues are primarily derived from the resale of vendor software products and services. These resales are made pursuant to channel sales agreements
whereby we are granted authority to purchase and resell the vendor products and services. Under these agreements, we either resell software directly to our customers or act as a sales agent for various vendors and receive commissions for our sales
efforts.



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We are required to enter into an annual Authorized Channel Partner Agreement with Autodesk, Inc. whereby
Autodesk appoints us as a non-exclusive partner to market, distribute, and support Autodesk software products. Collectively with our subsidiaries, we must achieve a yearly minimum revenue in the amount of $300,000 from the sale of Autodesks
software products in order to be eligible to purchase such products directly from Autodesk. This agreement authorizes us to sell certain software products to certain customers in specific geographic areas of the United States. There are no clauses
in this agreement that limit or restrict the services that we can offer to customers.



We have also entered into an Authorized Reseller Agreement with Dassault Systèmes whereby we market and distribute Dassaults SmarTeam PLM products in the United States. In connection with this July 2003
arrangement, Dassault provided us with certain financial assistance, including funds to create a dedicated PLM sales force and related marketing efforts.



Customers



We market our products to private companies, public corporations, government agencies, and educational institutions throughout the United States. In the
fiscal year ended June 30, 2004, the revenues generated by our top ten customers represented approximately five percent of consolidated revenues, and no single customer accounted for ten percent or more of our consolidated revenues.



Intellectual Property



We regard our technology and other proprietary rights as essential to our business. We rely on copyright, trade secret,
confidentiality procedures, contract provisions, and trademark law to protect our technology and intellectual property. We have also entered into confidentiality agreements with our consultants and corporate partners and intend to control access to,
and distribution of our products, documentation, and other proprietary information.



We own several federally registered trademarks, including AVATECH SOLUTIONS, and AVANEWS, and have a number of trademark applications pending. We have no patents or patent applications pending.
We acquired a number of other trademarks as a result of our merger with PlanetCAD.



This Annual Report contains trademarks and trade names of Avatech Solutions, Inc. and its affiliates as well as those of other companies. All trademarks and trade names appearing in this report are the property of
their respective holders.



Employees



At June 30, 2004, we had approximately 131 full time employees and two part
time employees located in sixteen offices throughout the United States. Many of our current employees formerly were employees of the companies that we acquired. Approximately 37 are located in Maryland, where we have our corporate headquarters, as
well as one sales and one training location. Maryland is also the location of our centralized accounting, order processing, and marketing functions. Approximately 50 of our employees are engaged in sales and marketing activities and approximately 46
employees are engaged in service fulfillment.



Our future
success depends in significant part upon the continued services of our key sales, technical, and senior management personnel and our ability to attract and retain highly qualified sales, technical, and managerial personnel. None of our employees are
represented by collective bargaining agreements, and we have never experienced a work stoppage. We believe our employee relations are good.



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Available Information



Our Internet website is www.avatechsolutions.com. We make available free of charge on our website our annual reports on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after we electronically file with or furnish such materials to the SEC.



Our executive offices are located at 10715 Red Run Blvd, Suite 101, Owings Mills, Maryland 21117 and our telephone number is
(410) 581-8080.



ITEM 2. PROPERTIES



Our corporate offices are located in Owings Mills, Maryland where we lease approximately 13,430 square feet of office space, pursuant to a lease which expires on July 21, 2011. These facilities house our executive and primary administrative
offices as well as accounting, order processing operations, IT, sales, and marketing. We also lease office space at the following locations:



|                          |  |                |  |               
|------------------------- |  | -------------- |  | --------------
|Location                  |  | Square Footage |  | Term          
|ColoradoEnglewood        |  | 7,250          |  | 12/31/2008    
|ColoradoBoulder *        |  | 3,720          |  | 11/1/2007     
|ConnecticutMeriden       |  | 2,679          |  | 12/31/2008    
|FloridaTampa             |  | 4,103          |  | 03/31/2009    
|Illinois  Westchester    |  | 150            |  | month to month
|IowaCedar Rapids         |  | 2,525          |  | 05/20/2006    
|IowaDes Moines           |  | 3,027          |  | 07/31/2011    
|KentuckyGeorgetown       |  | 950            |  | 01/31/2005    
|MinnesotaSt. Paul        |  | 2,782          |  | 03/31/2007    
|NebraskaOmaha            |  | 6,242          |  | 12/31/2007    
|New JerseyEast Brunswick |  | 2,000          |  | 09/30/2004    
|TexasAustin              |  | 2,125          |  | 10/31/2004    
|TexasIrving              |  | 3,416          |  | 01/31/2008    
|VirginiaAlexandria       |  | 280            |  | 10/14/2004    
|VirginiaRichmond         |  | 2,250          |  | 03/31/2006    
|VirginiaVirginia Beach   |  | 5,887          |  | 12/31/2004    

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|* | We no longer maintain offices in this location, however, our lease has not yet expired.
|- | ---------------------------------------------------------------------------------------



Not listed are leases for space that we have vacated if the sublessees payments to us defray, in whole or in
substantial part, our lease payment obligations.



The
commercial real estate market is volatile and unpredictable in terms of available space, rental fees, and occupancy rates and preferred locations. We cannot be certain that additional space will be available when we require it, or that it will be
affordable or in a preferred location.



ITEM 3.LEGAL PROCEEDINGS



From time to time, we are involved in legal matters or named as a defendant in legal actions arising from normal operations, or are presented with claims for damages arising out of our actions. Management believes that these matters will
not have a material adverse effect on our financial statements.



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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS



A Special Meeting of Shareholders was held on June 4, 2004. Of the 12,075,703 shares entitled to vote at the meeting, 8,001,203 voted. The following
matters were voted on at the meeting:



|                                                                                                                                                                                                                |  |                  |  |         |  |          |  |                   |  |          
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- |  | ------- |  | -------- |  | ----------------- |  | ---------
|                                                                                                                                                                                                                |  | Number of Votes:
|Proposal:                                                                                                                                                                                                       |  | In Favor         |  | Against |  | Withheld |  | Broker Non-Voting |  | Abstained
|To increase the number of shares authorized for issuance under our Employee Stock Purchase Plan from 450,000 to 1,000,000.                                                                                      |  | 7,611,028        |  | 369,290 |  |         |  |                  |  | 20,885   
|To amend our certificate of incorporation to increase the number of shares of authorized capital stock to 100,000,000, comprised of 80,000,000 shares of common stock and 20,000,000 shares of
preferred stock. |  | 7,893,583        |  | 106,801 |  |         |  |                  |  | 819      



EXECUTIVE OFFICERS



Set
forth below is information, as of June 30, 2004, with respect to the individuals who serve as our executive officers.



|                       |  |     |  |                                             
|---------------------- |  | --- |  | --------------------------------------------
|Name                   |  | Age |  | Position                                    
|Donald Scotty Walsh  |  | 68  |  | Chief Executive Officer                     
|Beth O. MacLaughlin    |  | 53  |  | Interim Chief Financial Officer             
|W. Scott Harris        |  | 42  |  | President and Chief Operating Officer       
|Christopher D. Olander |  | 55  |  | Executive Vice President and General Counsel



DONALD R. WALSH.
Before joining Avatech as its CEO in December 2002, Mr. Walsh was the Executive Vice President of Business & Network Systems Sales for InterVoice-Brite, Inc., a global leader in the call automation industry, a position he held since August 1999.
From August 1990 until the 1999 merger of Brite Voice Systems, Inc. with InterVoice, Inc., Mr. Walsh served in a number of management roles including the Executive Vice President of Worldwide Sales for the Brite Voice Systems. Before joining Brite
Voice Systems, Mr. Walsh served as President of PSC Information Services, a division of a Philadelphia suburban corporation that provides data processing products and services. Mr. Walshs experience also includes 23 years of experience with
IBM.



BETH O. MACLAUGHLIN. Ms. MacLaughlin joined Avatech in
1998 as its Controller and was appointed Vice President-Finance, Controller and Interim Chief Financial Officer in August 2003. Prior to joining Avatech in 1998, she served as director of Finance for NRL & Associates, a manufacturing firm, and
held responsibilities as a staff accountant for two public accounting firms. She was adjunct professor of accounting at Catonsville Community College and an accounting instructor at Anne Arundel Community College during the period 1995 through 2001.
She is a certified public accountant and holds a B.S. in Accounting from the University of Baltimore, where she graduated with cum laude honors in 1994.



W. SCOTT HARRIS. Mr. Harris joined Avatech on June 1, 2004 after serving as president and COO of Washington Cable Supply, Inc., from May 2003 through May
2004, where he was responsible for all aspects of the companys operations. Mr. Harris served as Chief Operating Officer of Adaptave Trade, Inc. from December 2000 to January 2002, and as Chief Operating Officer of Guestech L.L.C. from June
1999 through September 2000. At various times during 2000 through 2003, Mr. Harris provided strategic consulting services through Scottswood Consulting, at which he served as a principal, primarily to early stage services, software and hardware
technology companies, helping them to become profitable entities and adding value for investors. As General Manager and COO of The Harris Group, Mr. Harris developed and executed a five-year business plan that led to the sale of the company to Bell
& Howell, where he continued as the Vice President, Software Operations & Business Development for a $400 million division. He held a long distinguished career at IBM. Mr. Harris holds a BS in Information Systems Management from Tulane
University.



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CHRISTOPHER D. OLANDER. During his thirty-year career, Mr. Olander has concentrated on technology
start-ups, corporate finance, securities regulation, merger and acquisition transactions, and complex banking transactions. He has a unique combination of law and business experience; he has represented companies, investment banks, merchant banks,
venture capital funds and trustees in securities transactions totaling in excess of $30 billion. Before joining Avatech, Mr. Olander was of counsel at Neuberger Quinn Gielen Rubin & Gibber from October 2002 through June 2004, President and CEO
of Phone Genie Technology, Inc. from July 2001 through October 2002, Executive Vice President and Chief Internet Strategist at QUADS Financial Group, Inc. from February 2000 through July 2001, and President and CEO of ExpertDriven, Inc. from June
1999 to February 2000. He was managing partner at Shapiro and Olander from 1977 to 1999. Mr. Olander is a 1970 graduate of The Johns Hopkins University, and a 1973 graduate, with honors, of the University of Maryland School of Law.



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PART II



ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES



Market Price Data



Prior to our merger with PlanetCAD, PlanetCADs common stock was listed on the American Stock Exchange under the symbol PCD. Since the
date of the merger, our common stock has been trading on the OTC Bulletin Board under the symbol AVSO.OB. The following table indicates the high and low sales prices per share, rounded to the nearest whole cent, reported by the American
Stock Exchange, for the periods indicated prior to November 20, 2002 and as available through the OTC market for the periods indicated since that date. The OTC quotations represent prices between dealers and do not reflect the retailer markups,
markdowns or commissions, and may not represent actual transactions. All prices shown have been restated to reflect the two-for-one stock dividend which was distributed on October 1, 2003 for shareholders of record at September 15, 2003 as well as
the one-for-twenty reverse stock split that occurred on October 22, 2002.



|                                |  |      |      |     |   |     
|------------------------------- |  | ---- | ---- | --- | - | ----
|Period                          |  | High |      | Low
|Fiscal Year Ended June 30, 2003 |  |      |      |     |   |     
|First Quarter                   |  | $    | 2.87 |     | $ | 1.60
|Second Quarter                  |  |      | 2.00 |     |   | 0.17
|Third Quarter                   |  |      | 0.68 |     |   | 0.34
|Fourth Quarter                  |  |      | 0.43 |     |   | 0.15
|                                |  |     
|Fiscal Year Ended June 30, 2004 |  |      |      |     |   |     
|First Quarter                   |  | $    | 0.34 |     | $ | 0.10
|Second Quarter                  |  |      | 1.00 |     |   | 0.17
|Third Quarter                   |  |      | 0.51 |     |   | 0.21
|Fourth Quarter                  |  |      | 1.01 |     |   | 0.37



Recent Closing Prices



On September 24, 2004, the last closing price for
our common stock on the OTC Bulletin Board, as reported by Reuters, was $0.51.



Dividend Information



We have never paid cash
dividends on our common stock and we anticipate that we will continue to retain any earnings for the foreseeable future for use in the expansion and operation of our business.



Our Series D Convertible Preferred Stock is eligible for 10% annual, cumulative dividends, payable quarterly, when and as
declared by the Board of Directors. These dividends have priority over any declaration or payment of any dividend or other distribution on our Common Stock and all other currently outstanding shares of our equity securities. For the year ended June
30, 2004, dividends totaling $56,305 were paid to preferred shareholders.



Number of Stockholders



As of September
24, 2004, there were 258 holders of record of our common stock and 16 holders of our Series D Convertible Preferred Stock.



Recent Sales of Unregistered Securities



On April 21, 2004, our Board of Directors authorized the issuance of warrants to purchase 51,838 shares of our common stock to Mr. Hindman, with an
exercise price of $0.45 per share, expiring on March 31, 2009, in consideration for his agreement on April 1, 2004 to extend the due date of loans made to the company from July 1, 2004 to July 1, 2005.



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##### Table of Contents

ITEM 6. SELECTED FINANCIAL DATA



The following selected historical annual consolidated financial data is derived from our audited financial statements as of and for the five years ended June 30, 2004. The following consolidated financial data should be read in conjunction
with Managements Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and related notes included elsewhere in this Report.



|                                                                         |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|------------------------------------------------------------------------ |  | ------------------- | ---------- | - | ---- | - | ---------- | ------- |  | - | ---------- | - |  | ------- | ---------- | - |  | - | ---------- | -
|                                                                         |  | Year ended June 30, |           
|                                                                         |  | 2000                |            |   | 2001 |   |            | 2002(2) |  |   | 2003(1)    |   |  | 2004(1) |           
|Statement of Operations Data:                                            |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Revenue:                                                                 |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Product sales                                                            |  | $                   | 18,925,782 |   |      | $ | 18,329,676 |         |  | $ | 16,619,444 |   |  | $       | 12,369,846 |   |  | $ | 17,710,150 |  
|Service revenues                                                         |  |                     | 6,695,797  |   |      |   | 5,401,091  |         |  |   | 5,775,045  |   |  |         | 5,931,623  |   |  |   | 5,470,360  |  
|Commission revenue                                                       |  |                     | 2,654,829  |   |      |   | 3,767,634  |         |  |   | 4,245,987  |   |  |         | 4,199,465  |   |  |   | 4,769,984  |  
|                                                                         |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Total revenue                                                            |  |                     | 28,276,408 |   |      |   | 27,498,401 |         |  |   | 26,640,476 |   |  |         | 22,500,934 |   |  |   | 27,950,494 |  
|                                                                         |  |                     |            |   |     
|Cost of revenue:                                                         |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Cost of product sales                                                    |  |                     | 13,512,719 |   |      |   | 12,643,511 |         |  |   | 11,071,083 |   |  |         | 8,776,509  |   |  |   | 12,647,646 |  
|Cost of service revenue                                                  |  |                     | 4,126,119  |   |      |   | 3,415,718  |         |  |   | 3,365,110  |   |  |         | 3,766,904  |   |  |   | 4,086,069  |  
|                                                                         |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Total cost of revenue                                                    |  |                     | 17,638,838 |   |      |   | 16,059,229 |         |  |   | 14,436,193 |   |  |         | 12,543,413 |   |  |   | 16,733,715 |  
|                                                                         |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Gross margin                                                             |  |                     | 10,637,570 |   |      |   | 11,439,172 |         |  |   | 12,204,283 |   |  |         | 9,957,521  |   |  |   | 11,216,779 |  
|                                                                         |  |                     |            |   |     
|Other operating expenses:                                                |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Selling, general and administrative                                      |  |                     | 11,375,249 |   |      |   | 10,367,454 |         |  |   | 11,720,443 |   |  |         | 12,201,380 |   |  |   | 11,073,123 |  
|Depreciation and amortization                                            |  |                     | 573,884    |   |      |   | 572,430    |         |  |   | 503,248    |   |  |         | 411,612    |   |  |   | 330,926    |  
|Impairment loss                                                          |  |                     |           |   |      |   |           |         |  |   | 284,766    |   |  |         |           |   |  |   |           |  
|                                                                         |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Total other operating expenses                                           |  |                     | 11,949,133 |   |      |   | 10,939,884 |         |  |   | 12,508,457 |   |  |         | 12,612,992 |   |  |   | 11,404,049 |  
|                                                                         |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Operating income (loss)                                                  |  |                     | (1,311,563 | ) |      |   | 499,288    |         |  |   | (304,174   | ) |  |         | (2,655,471 | ) |  |   | (187,269   | )
|                                                                         |  |                     |            |   |     
|Other non-operating income/(expense):                                    |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Gain on the extinguishment of debt                                       |  |                     |           |   |      |   |           |         |  |   |           |   |  |         | 1,960,646  |   |  |   |           |  
|Interest and other income (expense)                                      |  |                     | (50,420    | ) |      |   | 60,251     |         |  |   | 48,171     |   |  |         | 15,642     |   |  |   | 38,570     |  
|Minority interest                                                        |  |                     |           |   |      |   |           |         |  |   |           |   |  |         | (94,140    | ) |  |   | (152,500   | )
|Interest expense                                                         |  |                     | (619,506   | ) |      |   | (553,180   | )       |  |   | (487,230   | ) |  |         | (290,373   | ) |  |   | (351,987   | )
|                                                                         |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|                                                                         |  |                     | (669,926   | ) |      |   | (492,929   | )       |  |   | (439,059   | ) |  |         | 1,591,775  |   |  |   | (465,917   | )
|                                                                         |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Income (loss) from continuing operations                                 |  |                     | (1,981,489 | ) |      |   | 6,359      |         |  |   | (743,233   | ) |  |         | (1,063,696 | ) |  |   | (653,186   | )
|Income tax expense (benefit)                                             |  |                     |           |   |      |   | 7,426      |         |  |   | (297,651   | ) |  |         | 408,072    |   |  |   | 29,898     |  
|                                                                         |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Loss from continuing operations                                          |  | $                   | (1,981,489 | ) |      | $ | (1,067     | )       |  | $ | (445,582   | ) |  | $       | (1,471,768 | ) |  | $ | (683,084   | )
|                                                                         |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Loss from continuing operations per common share  basic and diluted     |  | $                   | (0.29      | ) |      | $ | (0.00      | )       |  | $ | (0.07      | ) |  | $       | (0.18      | ) |  | $ | (0.08      | )
|                                                                         |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Weighted average number of common shares outstanding  basic and diluted |  |                     | 6,754,200  |   |      |   | 6,662,568  |         |  |   | 6,674,979  |   |  |         | 8,028,030  |   |  |   | 9,341,785  |  
|                                                                         |  |                     |            |   |      |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  



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##### Table of Contents

|                            |  |                    |            |   |      |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|--------------------------- |  | ------------------ | ---------- | - | ---- | - | ---------- | ---- |  | - | ---------- | - |  | ---- | ---------- | - |  | - | ---------- | -
|                            |  | Year ended June 30 |           
|                            |  | 2000               |            |   | 2001 |   |            | 2002 |  |   | 2003       |   |  | 2004 |           
|Balance Sheet Data:         |  |                    |            |   |      |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Cash and cash equivalents   |  | $                  | 423,307    |   |      | $ | 309,621    |      |  | $ | 222,562    |   |  | $    | 540,384    |   |  | $ | 689,995    |  
|Working capital             |  |                    | (1,257,780 | ) |      |   | (3,927,450 | )    |  |   | (1,615,747 | ) |  |      | (3,821,523 | ) |  |   | (2,979,229 | )
|Total assets                |  |                    | 7,920,247  |   |      |   | 8,377,015  |      |  |   | 7,108,413  |   |  |      | 5,271,967  |   |  |   | 6,566,619  |  
|Total debt                  |  |                    | 5,750,883  |   |      |   | 6,480,880  |      |  |   | 5,980,013  |   |  |      | 2,851,212  |   |  |   | 4,217,655  |  
|Total stockholders deficit |  | $                  | (3,427,041 | ) |      | $ | (3,424,838 | )    |  | $ | (3,737,862 | ) |  | $    | (5,974,197 | ) |  | $ | (6,388,962 | )

---

|(1) | In 2003 and 2004, we decided to discontinue the operations of PlanetCAD Inc. and close four additional offices located in California, New York, Michigan and Ohio. The results of
operations of these operations are treated as discontinued operations and reported as a separate component of operating results in our consolidated statement of operations for all periods presented. A more detailed description of this transaction is
provided in Note 4 of the Consolidated Financial Statements.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | As of July 1, 2002, we adopted Statements of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (Statement 142). As a result goodwill
and other intangible assets deemed to have indefinite lives are no longer amortized, but are subject to annual impairment tests. As a result of testing goodwill for impairment upon the adoption of Statement 142, we recorded a non-cash impairment
charge of $520,000, which is included as a cumulative effect of a change in accounting principle in the 2003 statement of operations. A more detailed description of this transaction is provided in Note 1 of the Consolidated Financial Statements.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



THE FOLLOWING DISCUSSION AND ANALYSIS OF THE FINANCIAL CONDITION AND RESULTS OF OPERATIONS SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND
THE RELATED NOTES THERETO INCLUDED ELSEWHERE IN THIS REPORT.



Certain statements set forth below constitute forward-looking statements. Such forward-looking statements involve known and unknown risk, uncertainties and other factors including, but not limited to, those discussed in our
annual and quarterly reports, that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements implied by such forward-looking statements. These forward-looking statements
may generally be identified by the use of the words may, will, believe, should, expect, anticipate, estimate, and similar expressions. Given these uncertainties,
investors and prospective investors are cautioned not to place undue reliance on such forward-looking statements. We disclaim any obligation to update information contained in any forward-looking statement.



Overview



We are a leading provider of design automation and data management solutions for the manufacturing, building design,
engineering, and total infrastructure and facilities management markets. We specialize in technical support, training, and consulting aimed at improving design and documentation efficiencies and the seamless integration of workflow processes. These
technology solutions enable our customers to enhance productivity, profitability, and competitive position. We are one of the largest Autodesk software integrators worldwide and a leading provider of engineering document management solutions.



During the fall of 2003, we revised our growth strategy and
began to focus on new ways of expanding our people resources, product offerings, and geographic footprint. We are accomplishing this strategy by:



| |  | restructuring our company to focus on three product groups: Design Automation (DA), Facility and Asset Management (F/AM), and Product Lifecycle Management (PLM);
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | employing highly qualified professionals in specialized areas;
| | - | --------------------------------------------------------------



| |  | expanding our product offerings to include SmarTeam PLM software, various F/AM software packages, and new, internally-developed proprietary software to support our PLM solutions;
and
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | focusing on solutions and services selling.
| | - | -------------------------------------------



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##### Table of Contents

This revised growth strategy was intended to match our product and service offerings more precisely with the needs of our
customers. In July 2003, we entered into an Authorized Reseller Agreement with Dassault Systèmes Corp., an international developer and distributor of PLM application software and services, whereby we will market and distribute Dassaults
SmarTeam PLM products in the United States. In connection with this agreement, Dassault provided us with certain financial assistance to create a dedicated PLM sales force and to conduct related marketing efforts. We plan to continue implementing
this strategy by expanding geographically through targeted mergers and acquisitions, opening new locations, and expanding international product distribution relationships.



Beginning in June 2003 and continuing through the second quarter of the fiscal year ended June 30, 2004, we instituted a
number of cost containment measures to align our selling, general and administrative expenses with our revenue levels. We accomplished this plan by:



| |  | closing five underperforming offices;
| | - | -------------------------------------



| |  | terminating approximately 30 employees in June 2003; and
| | - | --------------------------------------------------------



| |  | reducing our professional fees, telephone, supplies, marketing, and travel expenses.
| | - | ------------------------------------------------------------------------------------



As a result, we reduced selling, general and administrative expenses related to underperforming offices. In accordance with Statement of
Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-lived Assets, the results of operations of these operating units are treated as discontinued operations, and reported as a separate
component of operating results in our consolidated statements of operations.



We considered these expense reduction measures necessary to help reduce operating losses arising from the prolonged impact of economic recession on the software industry and also to help us carry out our revised
strategy. Our consolidated financial statements consistently present these operations as discontinued operations. Unless otherwise indicated, all amounts included in this Discussion and Analysis of Financial Condition and Results of Operations are
from continuing operations.



Product Sales. Our product
sales consist primarily of the resale of packaged design software, including:



| |  | Autodesk design automation software for mechanical, architectural and civil engineering sectors and the Discreet product line for animation;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------



| |  | Archibus facilities management software for space planning, strategic planning, and lease/property administration;
| | - | ------------------------------------------------------------------------------------------------------------------



| |  | Cyco engineering data management solutions using Meridian software; and
| | - | -----------------------------------------------------------------------



| |  | Dassaults SmarTeam PLM software.
| | - | ---------------------------------



We also offer Autodesks subscription programs, which entitle subscribers to receive software upgrades, web support and eLearning lessons directly from Autodesk.
Because we do not participate in the delivery of these subscription products or the web support and eLearning lesson benefits, we record the margin (the difference between the revenue and cost of the product) from the sale of Autodesk software
subscriptions as commission revenue. Approximately 92% of our total product revenue is related to the resale of Autodesk products.



Service Revenue. We provide services in the form of training, consulting services, professional services, and technical support to our design
automation, PLM, and F/AM customers. We also offer our customers an assessment tool to analyze the ability and knowledge of current and potential employees in computer aided design.



We employ a technical staff of approximately 52 personnel associated with these types of services. In the third quarter of
fiscal 2004, we revised our sales commission plan to focus on increasing service sales and higher service margins. Because we replaced approximately 50% of our applications engineers during the third and fourth quarters of fiscal 2004, and it takes
three to four months for these personnel to complete their training and become billable at acceptable levels, we have not yet determined the success of our new commission structure.



Commission Revenue. We generate commission revenue from the resale of Autodesk software to various customers, a
number of which Autodesk considers major accounts. Autodesk designates these customers as major accounts based on specific criteria, primarily sales volume, and typically gives these customers volume discounts. We are responsible for
managing and reselling Autodesk products to a number of these major account customers; however, software products are shipped directly from Autodesk to the customers. We receive commissions upon shipment of the products from Autodesk to the customer
based on the product sales price.



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##### Table of Contents

Cost of Product Sales. Our cost of product sales consists of the cost of purchasing products from
software suppliers or hardware manufacturers. We also include the associated shipping and handling costs in cost of product sales.



Cost of Service Revenue. Cost of service revenue includes the direct costs associated with the implementation of software and hardware solutions as
well as training, support services, and professional services. These costs consist primarily of compensation, benefits, travel, and the costs of third-party contractors engaged by us. Our cost of service revenue does not include an allocation of
overhead costs.



Selling, General and Administrative
Expenses. Selling, general and administrative expenses consist primarily of compensation and other expenses associated with management, finance, human resources, and information systems. We also include advertising and public relations expenses
and expenses for facilities, such as rent and utilities, in selling, general and administrative expenses.



Depreciation and Amortization Expenses. Depreciation and amortization expenses represent the period costs associated with our investment in
property and equipment, consisting principally of computer equipment, software, furniture and fixtures, and leasehold improvements. We compute depreciation and amortization expenses using the straight-line method. We lease all of our facilities and
depreciate leasehold improvements over the lesser of the lease term or the estimated useful life of the asset.



Interest Expense. Interest expense consists primarily of interest on our revolving line-of-credit and subordinated debt, which we incurred to fund
operations over the past three years.



Critical Accounting Policies



General. Our consolidated financial statements are
impacted by the accounting policies used and the estimates and assumptions made by management during their preparation. Critical accounting policies and estimates that impact the consolidated financial statements are those that relate to software
revenue recognition and estimates of bad debts. We discuss all of these critical accounting policies with our Audit Committee on a periodic basis. Presented below is a description of the accounting policies that are most critical to an understanding
of our consolidated financial statements.



Software Revenue
Recognition. We derive most of our revenue from the resale of packaged software products. Our product sales may also include hardware that we may purchase for the convenience of our customers. Historically, we have not experienced significant
customer returns. We earn service revenue from training and other professional services, which often are related to the products that we sell but are not essential to the functionality of the software. We offer annual support contracts to our
customers for the software products that we sell, or we offer maintenance and support services under hourly billing arrangements.



We recognize revenue from software arrangements in accordance with the provisions of AICPA Statement of Position No. 97-2, Software Revenue
Recognition, as amended by SOP No. 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions. Prior to recognizing any revenue under these arrangements, (1) persuasive evidence of an arrangement
must exist, (2) delivery of the software or service must have occurred, (3) all fees must be assessed as fixed or determinable, and (4) all fees must be probable of collection. We determine whether criteria (3) and (4) have been satisfied based on
our judgment regarding the fixed nature of the fee charged for services rendered and products delivered and the collectibility of such fee. Revenue recognized in a reporting period could be adversely affected if future changes in conditions related
to a transaction cause us to determine these criteria are not met. In the past, we have not needed to adjust our reported revenue due to changes in conditions, and we continue to evaluate current conditions that may affect the nature and timing of
our revenue recognition.



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##### Table of Contents

Our customer arrangements can involve the sale of one or more elements. When this occurs, we allocate
revenue to each element if we can determine reliably the relative fair value of each element. We limit the assessment of fair value to the price that we charge when the element is sold separately. If the fair value of each element in a multiple
element arrangement cannot be reliably determined, and if the fair value of any undelivered element cannot also be reliably determined, all revenue under the arrangement is deferred until such time as the only remaining undelivered element is
maintenance, or in the absence of maintenance, implementation services, upon which time revenue is recognized over the remaining maintenance or service period. We have established the fair value of the product and service elements within the design
automation software arrangements that we sell. However, we do not have sufficient vendor-specific evidence of the fair value of the maintenance programs and services we offer in tandem with our newer PLM products, and accordingly, we recognize
revenue associated with these arrangements over the maintenance or service period in accordance with our stated accounting policy. Revenue that is deferred and recognized over a maintenance or service period is recognized in proportion to the
services delivered, or ratably if no better measure of performance can be determined.



The timing of the revenue that we recognize in future periods from our multiple element arrangements with customers will be dependent upon our ability to establish or continue to have vendor-specific evidence of the
fair value of each of the elements in these types of arrangements. In the near term, we expect the number of PLM solutions that we sell to increase, thereby increasing our deferred revenue.



Bad Debts. We maintain an allowance for doubtful accounts for
estimated losses which may result from the inability of our customers to pay for purchased products and services or for disputes that affect our ability to fully collect our accounts receivable. We estimate this allowance by reviewing the status of
our past-due accounts and record general reserves based on our historical bad debt expense. Our actual experience has not varied significantly from our estimates; however, if the financial condition of our customers were to deteriorate, resulting in
their inability to pay for products or services, we may need to record additional allowances in future periods. To mitigate this risk, we perform ongoing credit evaluations of our customers.



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##### Table of Contents

Years Ended June 30, 2002, 2003, and 2004



The following table sets forth the percentages of total revenue represented by selected items reflected in our audited
Consolidated Statements of Operations included elsewhere in this report. The year-to-year comparisons of financial results are not necessarily indicative of future results.



|                                                                                                                             |  |                     |    |  |       |    |  |       |   
|---------------------------------------------------------------------------------------------------------------------------- |  | ------------------- | -- |  | ----- | -- |  | ----- | --
|                                                                                                                             |  | Year ended June 30, |   
|                                                                                                                             |  | 2002                |    |  | 2003  |    |  | 2004  |   
|Revenue:                                                                                                                     |  |                     |    |  |       |    |  |       |   
|Product sales                                                                                                                |  | 62.4                | %  |  | 55.0  | %  |  | 63.4  | % 
|Service revenue                                                                                                              |  | 21.7                | %  |  | 26.4  | %  |  | 19.6  | % 
|Commission revenue                                                                                                           |  | 15.9                | %  |  | 18.6  | %  |  | 17.0  | % 
|                                                                                                                             |  |                     |    |  |       |    |  |       |   
|Total revenue                                                                                                                |  | 100.0               | %  |  | 100.0 | %  |  | 100.0 | % 
|Cost of Revenue:                                                                                                             |  |                     |    |  |       |    |  |       |   
|Cost of product sales                                                                                                        |  | 41.6                | %  |  | 39.0  | %  |  | 45.3  | % 
|Cost of service revenue                                                                                                      |  | 12.6                | %  |  | 16.7  | %  |  | 14.6  | % 
|                                                                                                                             |  |                     |    |  |       |    |  |       |   
|Total Cost of Revenue                                                                                                        |  | 54.2                | %  |  | 55.7  | %  |  | 59.9  | % 
|                                                                                                                             |  |                     |    |  |       |    |  |       |   
|Gross Margin                                                                                                                 |  | 45.8                | %  |  | 44.3  | %  |  | 40.1  | % 
|                                                                                                                             |  |                     |   
|Other Operating Expenses:                                                                                                    |  |                     |    |  |       |    |  |       |   
|Selling, general and administrative                                                                                          |  | 44.0                | %  |  | 54.3  | %  |  | 39.6  | % 
|Depreciation and amortization                                                                                                |  | 1.9                 | %  |  | 1.8   | %  |  | 1.2   | % 
|Impairment loss                                                                                                              |  | 1.1                 | %  |  |      |    |  |      |   
|                                                                                                                             |  |                     |    |  |       |    |  |       |   
|Total other operating expenses                                                                                               |  | 47.0                | %  |  | 56.1  | %  |  | 40.8  | % 
|                                                                                                                             |  |                     |    |  |       |    |  |       |   
|Operating loss                                                                                                               |  | (1.2                | )% |  | (11.8 | )% |  | (0.7  | )%
|Other non-operating income (expense):                                                                                        |  |                     |    |  |       |    |  |       |   
|Gain on the extinguishment of debt                                                                                           |  |                    |    |  | 8.7   | %  |  | 0.0   | % 
|Interest and other income                                                                                                    |  | 0.2                 | %  |  | 0.1   | %  |  | 0.1   | % 
|Minority interest                                                                                                            |  | 0.0                 | %  |  | (0.4  | )% |  | (0.5  | )%
|Interest expense                                                                                                             |  | (1.8                | )% |  | (1.3  | )% |  | (1.3  | )%
|                                                                                                                             |  |                     |    |  |       |    |  |       |   
|Total other non-operating income (expense)                                                                                   |  | (1.6                | )% |  | 7.1   | %  |  | (1.7  | )%
|                                                                                                                             |  |                     |    |  |       |    |  |       |   
|Loss from continuing operations before income taxes and cumulative effect of change in accounting principle                  |  | (2.8                | )% |  | (4.7  | )% |  | (2.4  | )%
|Income tax expense (benefit)                                                                                                 |  | (1.1                | )% |  | 1.8   | %  |  | 0.1   | % 
|                                                                                                                             |  |                     |    |  |       |    |  |       |   
|Loss from continuing operations before cumulative effect of change in accounting principle                                   |  | (1.7                | )% |  | (6.5  | )% |  | (2.5  | )%
|                                                                                                                             |  |                     |   
|Income (loss) from continuing operations of discontinued operating segments (including loss on disposal of $354,000 in 2003) |  | 0.7                 | %  |  | (8.3  | )% |  | (0.8  | )%
|                                                                                                                             |  |                     |    |  |       |    |  |       |   
|Loss before cumulative effect of change in accounting principle                                                              |  | (0.9                | )% |  | (14.8 | )% |  | (3.3  | )%
|Cumulative effect of change in accounting for goodwill                                                                       |  |                    |    |  | (2.3  | )% |  |      |   
|                                                                                                                             |  |                     |    |  |       |    |  |       |   
|Net loss                                                                                                                     |  | (0.9                | )% |  | (17.1 | )% |  | (3.3  | )%
|                                                                                                                             |  |                     |    |  |       |    |  |       |   



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##### Table of Contents

Year Ended June 30, 2003 Compared to Year Ended June 30, 2004



Revenue



|                   |  |                     |            |      |   |            |  |      |   
|------------------ |  | ------------------- | ---------- | ---- | - | ---------- |  | ---- | --
|                   |  | Year ended June 30, |           
|                   |  | 2003                |            | 2004 |   | % change   | 
|Revenue:           |  |                     |            |      |   |            |  |      |   
|Product sales      |  | $                   | 12,369,846 |      | $ | 17,710,150 |  | 43.2 | % 
|Service revenue    |  |                     | 5,931,623  |      |   | 5,470,360  |  | (7.8 | )%
|Commission revenue |  |                     | 4,199,465  |      |   | 4,769,984  |  | 13.6 | % 
|                   |  |                     |            |      |   |            |  |      |   
|Total Revenue:     |  | $                   | 22,500,934 |      | $ | 27,950,494 |  | 24.2 | % 
|                   |  |                     |            |      |   |            |  |      |   



Total Revenue.
Total revenue for our fiscal year ended June 30, 2004 was $28.0 million, compared to $22.5 million in fiscal 2003, an increase of $5.5 million. Our total revenue includes product sales, service revenue, and commission revenue.



For fiscal 2004, revenue in two categoriesproduct sales and commission
revenueincreased due to a positive general economic turnaround, Autodesks new product releases and promotional activities, and demand caused by customers upgrading their software. During fiscal 2004, we began to offer PLM and F/AM
software products from Dassault and Archibus. Also, during October 2003, we reduced prices when Autodesk reduced the price we pay for products by 20% under a short-term promotional program, which increased our volume of units delivered.



Product Sales. Product sales for fiscal 2004 were $17.7 million,
compared to $12.4 million in fiscal 2003, increasing $5.3 million. The increase was due to an improving economy, Autodesks reduction in major accounts, many of whom then started purchasing from us, and increased commercial customer
product and service sales from our new product groups, PLM and F/AM.



Service Revenue. Service revenue for fiscal 2004 was $5.5 million, compared to $5.9 million in fiscal 2003, decreasing $461,000. This decrease in service revenue is the result of the market focusing on product upgrades from
discontinued products and a reduction in the number of our service employees dedicated to service activities. We also experienced an unusually high rate of turnover in service professionals, replacing approximately one-half of our application
engineers during fiscal 2004. Although some employee turnover is normal, the higher turnover rate during fiscal 2004 occurred because we terminated underperforming service employees and hired better qualified personnel. However, it generally takes
three to four months for new service personnel to complete their training, and we were not able to fill vacancies in time to prevent the decrease in service revenue. We have reestablished our professional service group with highly qualified
personnel, and we expect all of our new service professionals to be fully trained by October 2004.



Commission Revenue. Commission revenue for fiscal 2004 was $4.8 million, compared to $4.2 million in fiscal 2003, increasing $571,000. The increase
in commission revenue was a result of two factors: an increase in net subscription revenue of approximately $952,000, primarily due to the industry-wide increase in sales volume related to the associated software products; and a decrease of
approximately $381,000 in commission revenue from Autodesk major accounts due to Autodesks new, more restrictive criteria for major accounts, which reduced the number of customers who qualified for major account discounts. Because many of
these customers continued to purchase Autodesk software and related services from us, some of the revenue from these customers that we recognized as commission revenue during fiscal 2003 was included in our product sales and service revenue during
fiscal 2004.



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##### Table of Contents

Cost of Revenue and Expenses



|                        |  |                     |            |      |   |            |  |      |  
|----------------------- |  | ------------------- | ---------- | ---- | - | ---------- |  | ---- | -
|                        |  | Year ended June 30, |           
|                        |  | 2003                |            | 2004 |   | % change   | 
|Cost of revenue:        |  |                     |            |      |   |            |  |      |  
|Cost of product sales   |  | $                   | 8,776,509  |      | $ | 12,647,646 |  | 44.1 | %
|Cost of service revenue |  |                     | 3,766,904  |      |   | 4,086,069  |  | 8.5  | %
|                        |  |                     |            |      |   |            |  |      |  
|Total cost of revenue   |  | $                   | 12,543,413 |      | $ | 16,733,715 |  | 33.4 | %
|                        |  |                     |            |      |   |            |  |      |  
|Gross margin            |  | $                   | 9,957,521  |      | $ | 11,216,779 |  | 12.6 | %
|                        |  |                     |            |      |   |            |  |      |  



Cost of Product
Sales. Cost of product sales for fiscal 2004 was $12.6 million, compared to $8.8 million for fiscal 2003, increasing $3.9 million. This increase was primarily due to increased sales volume. Cost of product sales as a percentage of related
revenue for fiscal 2004 also increased slightly to 71.4% from 71.0% in the same period in fiscal 2003.



Cost of service revenue. Cost of service revenue for fiscal 2004 was $4.1 million, compared to $3.8 million for fiscal 2003, increasing $319,000.
Cost of service revenue as a percentage of related revenue for fiscal 2004 increased to 74.7% from 63.5% in the same period in fiscal 2003. We attribute this increase in cost of service revenue as a percentage of revenue primarily to our need to
subcontract certain work to third party providers in our PLM and F/AM service businesses until our own service organization is fully staffed and trained. During 2004, we were engaged to perform professional services as part of a few large F/AM
software implementation projects. In order to provide the appropriate expertise and service the projects, we subcontracted some of this work to third party providers, which resulted in an increase the cost of service revenue.



Gross margin. We calculate gross margin percentage as the quotient
obtained by dividing costs by the related revenue. Overall, the gross margin percentage decreased to 40.1% for fiscal 2004, compared to 44.3% in fiscal 2003, primarily due the combination of the increase cost of service revenue and an overall
decrease in service revenue. We currently are focused on developing our PLM and F/AM markets for products and related services, and until such time as we generate significant revenue from these new product and service offerings, our margins will be
affected by our investment in a professional, well-trained service staff. We ultimately expect our service revenue from F/AM and PLM to increase and for our margins to return to historical levels.



Other Operating Expenses



|                                    |  |                     |            |      |   |            |  |       |   
|----------------------------------- |  | ------------------- | ---------- | ---- | - | ---------- |  | ----- | --
|                                    |  | Year ended June 30, |           
|                                    |  | 2003                |            | 2004 |   | % change   | 
|Other operating expenses:           |  |                     |            |      |   |            |  |       |   
|Selling, general and administrative |  | $                   | 12,201,380 |      | $ | 11,073,122 |  | (9.2  | )%
|Depreciation and amortization       |  |                     | 411,612    |      |   | 330,926    |  | (19.6 | )%
|                                    |  |                     |            |      |   |            |  |       |   
|Total other operating expenses      |  | $                   | 12,612,992 |      | $ | 11,404,048 |  | (9.6  | )%
|                                    |  |                     |            |      |   |            |  |       |   



Selling, General
and Administrative. Selling, general and administrative expenses for fiscal 2004 were $11.1 million, compared to $12.2 million during the fiscal year ended June 30, 2003, decreasing $1.1 million. Selling, general and administrative expenses as a
percent of total revenue were 39.6% during fiscal 2004, and 54.2% during the same period in fiscal 2003. This decrease in selling, general and administrative expenses was principally due to a combination of elements: a $297,000 increase in marketing
cooperative credits from Autodesk due to increased sales volume, reimbursement of $1.2 million of our PLM marketing expenses by Dassault, and our company-wide focus on controlling expenses.



Depreciation and Amortization. Depreciation and amortization expenses
for fiscal 2004 were $331,000, compared to $412,000 for fiscal 2003, decreasing $81,000. Depreciation and amortization expenses of property and equipment decreased as a result of an increase in the number of fully depreciated assets compared to the
prior period.



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##### Table of Contents

Other Non-operating Income (Expense).



|                                           |  |                     |           |   |      |   |          |          |  |       |  
|------------------------------------------ |  | ------------------- | --------- | - | ---- | - | -------- | -------- |  | ----- | -
|                                           |  | Year ended June 30, |          
|                                           |  | 2003                |           |   | 2004 |   |          | % change | 
|Other non-operating income (expense):      |  |                     |           |   |      |   |          |          |  |       |  
|Gain on the extinguishment of debt         |  | $                   | 1,960,646 |   |      |   |         |          |  |      |  
|Minority interest                          |  |                     | (94,140   | ) |      |   | (152,500 | )        |  | 62.0  | %
|Interest and other income                  |  |                     | 15,642    |   |      |   | 38,570   |          |  | 146.6 | %
|Interest expense                           |  |                     | (290,373  | ) |      |   | (351,987 | )        |  | 21.2  | %
|                                           |  |                     |           |   |      |   |          |          |  |       |  
|Total other non-operating income (expense) |  | $                   | 1,591,775 |   |      | $ | (465,917 | )        |  |      |  
|                                           |  |                     |           |   |      |   |          |          |  |       |  



Other non-operating
income (expense) was ($466,000) and $1.6 million in fiscal 2004 and fiscal 2003, respectively. The significant increase in other income during the 2003 fiscal year relates to a gain recorded from the extinguishment of our debt. In January 1999, we
borrowed $3.0 million from a significant supplier. In August 2002, we executed an agreement to extinguish the debt for a cash payment of $1.0 million, resulting in a $2.0 million gain on the extinguishment of debt. The minority interest represents
dividends paid on shares of preferred stock issued by one of our subsidiaries.



Income Tax Expense



|                   |  |                     |         |      |   |          |  |       |   
|------------------ |  | ------------------- | ------- | ---- | - | -------- |  | ----- | --
|                   |  | Year ended June 30, |        
|                   |  | 2003                |         | 2004 |   | % change | 
|Income tax expense |  | $                   | 408,072 |      | $ | 29,898   |  | (92.7 | )%
|                   |  |                     |         |      |   |          |  |       |   



Income tax expense was
$30,000 and $408,000 in fiscal 2004 and fiscal 2003, respectively. In August 2002, we realized a $2.0 million taxable gain from the extinguishment of certain debt, which resulted in our recording a net deferred tax asset of $373,000 at June 30,
2002. In 2003, we recorded deferred income tax expense of $373,000 related to the estimated reduction in deferred tax assets in 2003. Our tax expense in fiscal 2004 relates solely to state and local income taxes. Because we have significant net
operating loss carryforwards, we do not expect to pay federal income taxes for the foreseeable future.



Cumulative Effect of Change in Accounting Principle



|                                                       |  |                     |          |   |      |   |          |  
|------------------------------------------------------ |  | ------------------- | -------- | - | ---- | - | -------- | -
|                                                       |  | Year ended June 30,
|                                                       |  | 2003                |          |   | 2004 |   | % change
|Cumulative effect of change in accounting for goodwill |  | $                   | (520,000 | ) |      |  |          | 
|                                                       |  |                     |          |   |      |   |          |  



As of July 1, 2002, we
adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (Statement 142). As a result of adopting Statement 142 and performing the required transitional impairment tests, we recorded a
non-cash charge of $520,000, which is included in cumulative effect of change in accounting principle in the 2003 consolidated statement of operations. The impairment charge relates solely to Avatech of Michigan, a business unit that ceased
operations in June 2003.



Year Ended June 30, 2002 Compared to Year Ended
June 30, 2003



Revenue



|                   |  |                     |            |      |   |            |  |       |   
|------------------ |  | ------------------- | ---------- | ---- | - | ---------- |  | ----- | --
|                   |  | Year ended June 30, |           
|                   |  | 2002                |            | 2003 |   | % change   | 
|Revenue:           |  |                     |            |      |   |            |  |       |   
|Product sales      |  | $                   | 16,619,444 |      | $ | 12,369,846 |  | (25.6 | )%
|Service revenue    |  |                     | 5,775,045  |      |   | 5,931,623  |  | 2.7   | % 
|Commission revenue |  |                     | 4,245,987  |      |   | 4,199,465  |  | (1.1  | )%
|                   |  |                     |            |      |   |            |  |       |   
|Total Revenue:     |  | $                   | 26,640,476 |      | $ | 22,500,934 |  | (15.5 | )%
|                   |  |                     |            |      |   |            |  |       |   



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##### Table of Contents

Total revenue for our fiscal year ended June 30, 2003 was $22.5 million, compared to $26.6 million for
fiscal 2002, decreasing $4.2 million. For fiscal 2003, revenue in two of three categoriesproduct sales and commission revenuedecreased as a result of the weak economic conditions and a restructuring of Autodesks major account
programs. Product sales in fiscal 2003 were $12.4 million compared to $16.6 million in fiscal 2002, a decrease of $4.2 million. We attribute this fluctuation in product sales to weak economic conditions, causing customers to defer purchasing
software products as well as the timing and customer acceptance of product upgrades. During the fiscal year ended June 30, 2003, Autodesk reduced the number of customers designated as major accounts by changing the specific criteria for granting
volume discounts, reducing our customer base for commission revenue. As a result, commission revenue for fiscal 2003 decreased by 1%, or $47,000.



During fiscal 2003, we continued to realign our sales organization and focus on being a full solution service provider for our customers, increasing our
professional and technical support service contracts over the prior period. As a result, our service revenue increased $157,000 in fiscal 2003 to $5.9 million from $5.7 million in fiscal 2002. Our training service revenue increased due to an
increase in the number of training seminars held at Avatech sites also were engaged to perform professional services as part of a few large facilities management software implementation projects initiated in 2003.



Cost of Revenues and Expenses



|                        |  |                     |            |      |   |            |  |       |   
|----------------------- |  | ------------------- | ---------- | ---- | - | ---------- |  | ----- | --
|                        |  | Year ended June 30, |           
|                        |  | 2002                |            | 2003 |   | % change   | 
|Cost of revenue:        |  |                     |            |      |   |            |  |       |   
|Cost of product sales   |  | $                   | 11,071,083 |      | $ | 8,776,509  |  | (20.7 | )%
|Cost of service revenue |  |                     | 3,365,110  |      |   | 3,766,904  |  | 11.9  | % 
|                        |  |                     |            |      |   |            |  |       |   
|Total cost of revenue   |  | $                   | 14,436,193 |      | $ | 12,543,413 |  | (13.1 | )%
|                        |  |                     |            |      |   |            |  |       |   
|Gross margin            |  | $                   | 12,204,283 |      | $ | 9,957,521  |  | (18.4 | )%
|                        |  |                     |            |      |   |            |  |       |   



Cost of Product
Sales. Cost of product sales for fiscal 2003 were $8.8 million, compared to $11.1 for fiscal 2002, decreasing $2.3 million. We attribute this increase in cost of product sales to Autodesks restructuring of its marketing cooperative
program, which increased the price we pay for Autodesk products by approximately 5%, while increasing the payments we receive from Autodesk for advertising expenses. These new credits are offset against our marketing expenses (included in selling,
general and administrative expenses) rather than our cost of product sales.



Cost of Service Revenue.Cost of service revenue for fiscal 2003 was $3.8 million, compared to $3.4 million in fiscal 2002, increasing $402,000. We attribute this increase in cost of service revenue
primarily to our need to subcontract certain work to third party providers. During 2003, we were engaged to perform professional services as part of a few large facilities management software implementation projects. In order to provide the
appropriate expertise and service the projects, we subcontracted some of this work to third party providers, which resulted in an increase in related the cost of service revenues.



Gross Margin Percentage. Overall, the gross margin percentage decreased to 44.3% for fiscal 2003 from 45.8% in fiscal
2002, primarily due to increased costs resulting from Autodesks restructuring of its marketing cooperative program, and increased outsourcing of service contracts. Cost of product sales as a percentage of related revenues for fiscal 2003
increased to 71.0% from 66.6% in the same period in 2002 and cost of service revenue as a percentage of related revenues for fiscal 2003 increased to 63.5% from 58.3% in fiscal 2002.



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##### Table of Contents

Other Operating Expenses



|                                    |  |                     |            |      |   |            |  |       |   
|----------------------------------- |  | ------------------- | ---------- | ---- | - | ---------- |  | ----- | --
|                                    |  | Year ended June 30, |           
|                                    |  | 2002                |            | 2003 |   | % change   | 
|Other operating expenses:           |  |                     |            |      |   |            |  |       |   
|Selling, general and administrative |  | $                   | 11,720,443 |      | $ | 12,201,380 |  | 4.1   | % 
|Depreciation and amortization       |  |                     | 503,248    |      |   | 411,612    |  | (18.2 | )%
|Impairment loss                     |  |                     | 284,766    |      |   |           |  |      |   
|                                    |  |                     |            |      |   |            |  |       |   
|Total other operating expenses      |  | $                   | 12,508,457 |      | $ | 12,612,992 |  | 0.8   | % 
|                                    |  |                     |            |      |   |            |  |       |   



Selling, General
and Administrative. Selling, general and administrative expenses for fiscal 2003 were $12.2 million, compared to $11.7 million for fiscal 2002, increasing $481,000. Selling, general and administrative expenses as a percent of total revenues for
fiscal 2003 increased to 54.2% from 44.0% in fiscal 2002. We attribute the increase in selling, general and administrative expenses to the fixed cost required to support a nationwide network of offices, and to the PlanetCAD merger on November 19,
2002. After this reverse merger, our professional services costs increased by $370,000 and insurance expenses increased by $172,000 due to the cost of being a public company.



Depreciation and Amortization. Depreciation and amortization expenses for fiscal 2003 were $412,000, compared to
$503,000 during fiscal 2002, decreasing $92,000. Depreciation and amortization expenses for property and equipment decreased as a result of reduced capital expenditures for computer equipment and software and an increase in the number of fully
depreciated assets compared to the prior period. For the year ended June 30, 2002, we recorded an impairment charge of $285,000 for the write-down of unamortized goodwill to its estimated fair value. We recorded this impairment charge in the third
quarter of 2002 after determining that sales at one subsidiary were unlikely to reach previously projected levels. We evaluated the goodwill for impairment by comparing our best estimate of undiscounted future cash flows with the carrying value of
goodwill. As the carrying value of goodwill exceeded the estimate of undiscounted future cash flows, a discounted cash flow analysis was performed to estimate the fair value of the goodwill.



Other Non-operating Income (Expense)



|                                      |  |                     |          |   |      |   |           |          |  |       |   
|------------------------------------- |  | ------------------- | -------- | - | ---- | - | --------- | -------- |  | ----- | --
|                                      |  | Year ended June 30, |         
|                                      |  | 2002                |          |   | 2003 |   |           | % change | 
|Other non-operating income (expense): |  |                     |          |   |      |   |           |          |  |       |   
|Gain on the extinguishment of debt    |  |                     |         |   |      | $ | 1,960,646 |          |  |      |   
|Minority interest                     |  |                     |         |   |      |   | (94,140   | )        |  |      |   
|Interest and other income             |  |                     | 48,171   |   |      |   | 15,642    |          |  | (67.5 | )%
|Interest expense                      |  |                     | (487,230 | ) |      |   | (290,373  | )        |  | (40.4 | )%
|                                      |  |                     |          |   |      |   |           |          |  |       |   
|Total non-operating income (expense)  |  | $                   | (439,059 | ) |      | $ | 1,591,775 |          |  |      |   
|                                      |  |                     |          |   |      |   |           |          |  |       |   



Other non-operating
income (expense) was ($439,800) and $1.6 million in fiscal 2002 and fiscal 2003, respectively. The significant increase in other income during the 2003 fiscal year relates to a gain recorded from the extinguishment of our debt. In January 1999, we
borrowed $3.0 million from a significant supplier. In August 2002, we executed an agreement to extinguish the debt for a cash payment of $1.0 million resulting in a $2.0 million gain on the extinguishment of debt. The extinguishment of debt also
contributed to the $197,000 reduction in interest expense in fiscal 2003 compared to fiscal 2002. The minority interest represents dividends paid during fiscal 2003 on shares of preferred stock issued by one of our subsidiaries.



Income Tax Expense (Benefit)





|                             |  |                     |          |   |      |   |          |  |  
|---------------------------- |  | ------------------- | -------- | - | ---- | - | -------- |  | -
|                             |  | Year ended June 30,
|                             |  | 2002                |          |   | 2003 |   | % change
|Income tax expense (benefit) |  | $                   | (297,651 | ) |      | $ | 408,072  |  | 
|                             |  |                     |          |   |      |   |          |  |  



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##### Table of Contents

Income tax expense (benefit) was ($298,000) and $408,000 in fiscal 2002 and fiscal 2003, respectively. In
August 2002, we realized a $2.0 million taxable gain from the extinguishment of certain debt, which resulted in us recording a net deferred tax asset of $373,000 at June 30, 2002. In fiscal 2003, we recorded deferred income tax expense of $373,000
related to the estimated reduction in deferred tax assets in fiscal 2003. This increase in deferred income tax expense, coupled with certain state tax expenses, resulted in the additional income tax expense for fiscal 2003. We have significant net
operating loss carryforwards, which are available to reduce future taxable income.



Cumulative Effect of Change in Accounting Principle



|                                                       |  |                     |  |      |          |   |          |  
|------------------------------------------------------ |  | ------------------- |  | ---- | -------- | - | -------- | -
|                                                       |  | Year ended June 30,
|                                                       |  | 2002                |  | 2003 |          |   | % change
|Cumulative effect of change in accounting for goodwill |  |                    |  | $    | (520,000 | ) |          | 
|                                                       |  |                     |  |      |          |   |          |  



As of July 1, 2002, we
adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (Statement 142). As a result of adopting Statement 142 and performing the required transitional impairment tests, we recorded a
non-cash charge of $520,000, which is included in cumulative effect of change in accounting principle in the 2003 consolidated statement of operations. The impairment charge relates solely to Avatech of Michigan, a business unit that ceased
operations in June 2003.



Liquidity and Capital Resources



Historically, we have financed our operations and met our capital
expenditure requirements primarily through cash flows provided by operations, borrowings under short-term and long-term debt arrangements, and sales of preferred stock.



During fiscal 2004, we used $1.2 million of cash in operations, primarily as a result of our loss before non-cash charges of
$300,000 and working capital needs of $0.9 million. Our working capital needs increased principally as a result of increases in accounts receivable caused by higher revenue. During fiscal 2004, our revenue increased about $5.5 million to $28.0
million compared to $22.5 million in fiscal 2003, which led to a corresponding increase in our gross accounts receivable balance of about $700,000 between June 30, 2003 and June 30, 2004. We financed these operating cash requirements through
borrowings of $1.5 million from a software vendor, and the net cash proceeds of $330,000 from the sale of preferred stock and stock purchase warrants. We purchase over 90% of the products we sell from Autodesk, which provides us with the ability to
purchase up to $3.0 million of inventory under 60 to 90 day payment terms. Historically, we have been able to manage our average days sales outstanding in a range from 40 to 50 days. Our customary collection terms range from 30 to 60 days for all of
our customers.



Our investing activities consist principally of
investments in computer and office equipment. Our capital expenditures for fiscal 2004 were approximately $332,000, compared to $273,000 for the same period in 2003. If funds from operations are sufficient, or if additional investment capital
becomes available, we intend to make a significant investment in our infrastructure during fiscal 2005. If neither occurs, these capital expenditures will be deferred.



Our line of credit with a bank allows us to borrow up to $2.0 million (temporarily increased to $2.5 million through October
31, 2004), limited to 85% of eligible accounts receivable. At June 30, 2004, our outstanding balance under this line-of-credit totaled $1.6 million. The line-of-credit expires in September 2006 and is payable within 60 days of demand.



Prior to the merger with PlanetCAD, Inc. in November 2002, we had outstanding
$1.7 million of 10% subordinated notes. The notes were to mature on July 1, 2003 and interest was payable quarterly until maturity or prepayment. On November 19, 2002, with the completion of the merger with PlanetCAD, subordinated note holders
owning an aggregate of $1.5 million of subordinated notes exchanged their notes for preferred stock in our subsidiary. These shares will automatically convert to common stock no later than November 2004.



On July 22, 2003, we entered into a loan agreement with a software vendor to
borrow up to $1.5 million for working capital purposes. The loan was received in two payments, with the initial funding of $1.0 million occurring



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##### Table of Contents

on July 25, 2003 and the remaining $500,000 provided on February 5, 2004. The loan agreement requires repayment of
principal plus interest at 6% per annum in thirty-five equal quarterly installments beginning in January 2005. We must meet certain financial and non-financial covenants in connection with this agreement.



Additionally, we have outstanding borrowings of approximately $879,000 (net
of unamortized debt discount) at June 30, 2004 that are payable to a director and shareholder. On April 1, 2004, the maturity date of this borrowing was extended to July 1, 2005. Currently, we expect to be able to satisfy this outstanding debt as of
the maturity date.



Our outstanding debt totaled $4.2 million
at June 30, 2004, and we had a deficiency of working capital of $3.0 million. Our deficiency of working capital is in large part caused by the classification of our line of credit as a current liability due to its demand provisions. Despite the
existence of the 60-day demand provision on this line-of-credit, we do not believe it is likely that the bank will exercise the demand provisions of the agreement. In the event that the bank does so, we believe that other lenders would provide us
with a line of credit with similar terms, as long as our financial position and results of operations have not significantly declined.



Our existing outstanding indebtedness restricts our ability to, among other things, incur additional debt, repay certain other debt, pay dividends, and
make certain investments, mergers or acquisitions. In addition, we cannot declare dividends or incur additional debt without the written approval from our lenders, which significantly restricts our ability to raise additional capital. Our ability to
receive the necessary approvals is largely dependent upon our relationship with our lenders.



We believe that our working capital needs have stabilized, and we believe our near-term needs can be met from our available cash resources, cash flows from operations and our line of credit. Because of our reliance on
Autodesk to supply us with the products that we sell, and due to the concentration of our revenue from the sale of Autodesk products, we cannot readily predict our ability to generate sufficient cash from our operations to meet our obligations
beyond July 1, 2005. In the event that our operating results unexpectedly decline and we are unable to generate cash flows from our operations in the near term, then we may be unable to meet our existing obligations in the normal course of business
and expand our operations to allow for continued long-term improvement in operating results.



Below is a summary of our contractual obligations and commitments at June 30, 2004:



|                                  |  |                        |           |                 |   |             |  |             |           |                  |   |           |  |   |          
|--------------------------------- |  | ---------------------- | --------- | --------------- | - | ----------- |  | ----------- | --------- | ---------------- | - | --------- |  | - | ---------
|                                  |  | Payments due by period
|                                  |  | Total                  |           | Less than 1year |   | 1  3 years |  | 3  5 years |           | More than 5years
|Contractual Obligations           |  |                        |           |                 |   |             |  |             |           |                  |   |           |  |   |          
|Long-term debt and line of credit |  | $                      | 4,217,656 |                 | $ | 1,732,724   |  | $           | 1,337,056 |                  | $ | 321,466   |  | $ | 826,410  
|Operating leases                  |  |                        | 3,684,113 |                 |   | 773,290     |  |             | 1,414,461 |                  |   | 947,749   |  |   | 548,613  
|Other liabilities                 |  |                        | 494,649   |                 |   | 176,333     |  |             | 280,998   |                  |   | 37,318    |  |   |         
|                                  |  |                        |           |                 |   |             |  |             |           |                  |   |           |  |   |          
|Total obligations                 |  | $                      | 8,396,418 |                 | $ | 2,682,347   |  | $           | 3,032,515 |                  | $ | 1,306,533 |  | $ | 1,375,023
|                                  |  |                        |           |                 |   |             |  |             |           |                  |   |           |  |   |          



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##### Table of Contents

Quarterly Results of Operations



The following table sets forth unaudited quarterly financial information for each of the eight quarters in the two years
ended June 30, 2004. Management believes that this information has been prepared on the same basis as the audited consolidated financial statements appearing elsewhere in this Report and, in managements opinion, this information includes all
adjustments, consisting only of normal recurring adjustments, necessary to fairly present the unaudited quarterly operating results when read in conjunction with our audited consolidated financial statements and the notes thereto appearing elsewhere
in this Report. These operating results are not necessarily indicative of results for any future period.



|                                   |  |                    |           |   |               |   |           |               |  |   |               |   |  |                |            |   |               |   |           |               |  |               |           |   |  |   |            |  |   |           |  
|---------------------------------- |  | ------------------ | --------- | - | ------------- | - | --------- | ------------- |  | - | ------------- | - |  | -------------- | ---------- | - | ------------- | - | --------- | ------------- |  | ------------- | --------- | - |  | - | ---------- |  | - | --------- | -
|                                   |  | Three Months Ended |          
|                                   |  | Sept. 30, 2002     |           |   | Dec. 31, 2002 |   |           | Mar. 31, 2003 |  |   | Jun. 30, 2003 |   |  | Sept. 30, 2003 |            |   | Dec. 31, 2003 |   |           | Mar. 31, 2004 |  | Jun. 30, 2004 |          
|Revenues                           |  | $                  | 5,333,639 |   |               | $ | 5,685,446 |               |  | $ | 6,068,433     |   |  | $              | 5,413,416  |   |               | $ | 5,866,312 |               |  | $             | 7,867,073 |   |  | $ | 7,836,045  |  | $ | 6,381,064 |  
|Cost of sales                      |  |                    | 2,896,625 |   |               |   | 3,051,614 |               |  |   | 3,146,816     |   |  |                | 3,448,358  |   |               |   | 3,541,026 |               |  |               | 4,980,595 |   |  |   | 4,385,298  |  |   | 3,826,796 |  
|Gross margin                       |  |                    | 2,437,014 |   |               |   | 2,633,832 |               |  |   | 2,921,617     |   |  |                | 1,965,058  |   |               |   | 2,325,286 |               |  |               | 2,886,478 |   |  |   | 3,450,747  |  |   | 2,554,268 |  
|Operating income (loss)            |  |                    | (565,892  | ) |               |   | (360,548  | )             |  |   | (360,911      | ) |  |                | (1,368,120 | ) |               |   | (244,861  | )             |  |               | 142,011   |   |  |   | 398,767    |  |   | (483,186  | )
|Net income (loss)                  |  |                    | 972,076   |   |               |   | (799,729  | )             |  |   | (758,790      | ) |  |                | (3,261,863 | ) |               |   | (503,476  | )             |  |               | 4,725     |   |  |   | 170,362    |  |   | (598,376  | )
|                                   |  |                    |           |   |               |   |           |              
|Earnings (loss) per share-basic    |  | $                  | 0.15      |   |               | $ | (0.11     | )             |  | $ | (0.08         | ) |  | $              | (0.41      | ) |               | $ | (0.04     | )             |  | $             | (0.00     | ) |  | $ | 0.02       |  | $ | (0.06     | )
|                                   |  |                    |           |   |               |   |           |               |  |   |               |   |  |                |            |   |               |   |           |               |  |               |           |   |  |   |            |  |   |           |  
|Earnings (loss) per share-diluted  |  | $                  | 0.15      |   |               | $ | (0.11     | )             |  | $ | (0.08         | ) |  | $              | (0.41      | ) |               | $ | (0.04     | )             |  | $             | (0.00     | ) |  | $ | 0.01       |  | $ | (0.06     | )
|                                   |  |                    |           |   |               |   |           |               |  |   |               |   |  |                |            |   |               |   |           |               |  |               |           |   |  |   |            |  |   |           |  
|Shares used in basic computation   |  |                    | 6,690,870 |   |               |   | 7,172,370 |               |  |   | 8,897,874     |   |  |                | 8,028,030  |   |               |   | 9,127,160 |               |  |               | 9,217,874 |   |  |   | 9,304,794  |  |   | 9,396,846 |  
|                                   |  |                    |           |   |               |   |           |               |  |   |               |   |  |                |            |   |               |   |           |               |  |               |           |   |  |   |            |  |   |           |  
|Shares used in diluted computation |  |                    | 6,690,870 |   |               |   | 7,172,370 |               |  |   | 8,897,874     |   |  |                | 8,028,030  |   |               |   | 9,127,160 |               |  |               | 9,217,874 |   |  |   | 12,377,537 |  |   | 9,396,846 |  
|                                   |  |                    |           |   |               |   |           |               |  |   |               |   |  |                |            |   |               |   |           |               |  |               |           |   |  |   |            |  |   |           |  



In the first quarter
of fiscal 2003, we recorded a $2.0 million gain from the extinguishment of our debt. See Note 6 to our consolidated financial statements. In addition, we also recorded a $520,000 charge in the first quarter of fiscal 2003 upon the adoption of a new
accounting standard for recording goodwill. See Note 1 to our consolidated financial statements.



Our operating results may vary significantly from quarter to quarter due to a variety of factors. One such significant factor is the potential fluctuation
in revenue due to seasonality of the business. Historically, we have experienced such seasonal fluctuations in revenue, with increased revenue in our second and third quarters, and lower revenue in our first and fourth quarters. These seasonal
fluctuations are often driven by our major suppliers new product releases and promotional campaigns.



|ITEM 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|-------- | ----------------------------------------------------------



We are exposed to market risk from changes in interest rates associated with our variable rate line-of-credit facility. At June 30, 2004, approximately
38% of our outstanding debt bore interest at variable rates. Accordingly, our earnings and cash flow are affected by changes in interest rates. Assuming the current level of borrowings at variable rates and assuming a 100 basis point change in the
2004 average interest rate under these borrowings, it is estimated that our 2004 interest expense and net income would have changed by less than $20,000. In the event of an adverse change in interest rates, management would likely take actions to
further mitigate our exposure. However, due to the uncertainty of the actions that would be taken and their possible effects, this analysis assumes no such actions. Further this analysis does not consider the effects of the change in the level of
overall economic activity that could exist in such an environment.



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##### Table of Contents

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



The financial statements and supplementary data required by this Item 8 are included in our Consolidated Financial Statements and set forth in the pages indicated in Item 15(a) of this Annual Report.



ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES



None.



ITEM 9A. CONTROLS AND PROCEDURES



The Companys management, with the participation of the Companys Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Companys disclosure controls and procedures
as of June 30, 2004. Based on that evaluation, the Companys Chief Executive Officer and Chief Financial Office concluded that the Companys disclosure controls and procedures were effective as of June 30, 2004. There were no material
changes in the Companys internal controls over financial reporting during the fourth quarter of fiscal year 2004.



ITEM 9B. OTHER INFORMATION



None.



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##### Table of Contents

PART III



ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT



The information with respect to the identity and business experience of the directors of the Company and their remuneration set forth in the section
captioned Election of Directors in the Companys definitive Proxy Statement to be filed pursuant to Regulation 14A and issued in conjunction with the 2004 Annual Meeting of Stockholders (the Proxy Statement) is
incorporated herein by reference. The information with respect to the identity and business experience of executive officers of the Company is set forth in Part I of this Form 10-K. The information with respect to the Companys Audit Committee
is incorporated herein by reference to the section captioned Committees and Meetings of the Board of Directors in the Proxy Statement. The information with respect to compliance with Section 16(a) of the Exchange Act is incorporated
herein by reference to the section captioned Compliance With Section 16(a) of the Exchange Act in the Proxy Statement. The information with respect to the Companys Code of Ethics is incorporated herein by reference to the section
captioned Code of Ethics in the Proxy Statement.



ITEM 11.EXECUTIVE COMPENSATION



The information required by this item is incorporated herein by reference to the sections captioned Compensation of Directors and Executive Compensation in the Proxy Statement.



ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENTAND RELATED STOCKHOLDER MATTERS



The information required by this item is incorporated herein by reference to the sections captioned Beneficial Ownership of Avatech Solutions,
Inc., Share Ownership of Management, and Securities Authorized for Issuance under Equity Compensation Plans in the Proxy Statement.



ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS



The information required by this item is incorporated herein by reference to the section captioned Relationships and Related Transactions in
the Proxy Statement.



ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES



The information required by this item is incorporated herein by reference to the section captioned Registered Public Accounting Firm in the Proxy Statement.



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##### Table of Contents

PART IV



ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES



1. Financial Statements



|                                                                                                   |  |     
|-------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                   |  | Page
|Report of Independent Registered Public Accounting Firm                                            |  | F-2 
|Consolidated Balance Sheets as of June 30, 2003 and 2004                                           |  | F-3 
|Consolidated Statements of Operations for the Years Ended June 30, 2002, 2003, and 2004            |  | F-5 
|Consolidated Statements of Stockholders Deficit for the Years Ended June 30, 2002, 2003, and 2004 |  | F-6 
|Consolidated Statements of Cash Flows for the Years Ended June 30, 2002, 2003, and 2004            |  | F-7 
|Notes to Consolidated Financial Statements                                                         |  | F-8 



2. Financial Statement Schedules:
Schedule II - Schedule of Valuation and Qualifying Accounts



Report of
Independent Registered Public Accounting Firm on Financial Statement Schedule



The Board of Directors and Stockholders

Avatech Solutions, Inc.



We have audited the consolidated financial statements of Avatech Solutions, Inc. as of June 30, 2003 and 2004 and for each
of the three years in the period ended June 30, 2004, and have issued our report thereon dated September 17, 2004 (included elsewhere in this Report). Our audits also included the financial statement schedule responsive to Item 15 of this Report.
This schedule is the responsibility of the Companys management. Our responsibility is to express an opinion based on our audits.



In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole,
present fairly in all material respects the information set forth therein.



/s/ Ernst & Young LLP




Baltimore, Maryland

September 17, 2004



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##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries Valuation and Qualifying Accounts



|                                            |  |                              |           |                             |   |                                    |  |           |                       |  |   |                         |      |  |   |          
|------------------------------------------- |  | ---------------------------- | --------- | --------------------------- | - | ---------------------------------- |  | --------- | --------------------- |  | - | ----------------------- | ---- |  | - | ---------
|                                            |  |                              |           | Additions                   |   |                                    |  |           |                       | 
|Description                                 |  | Balance atbeginning ofperiod |           | Charged tocosts andexpenses |   | Charged tootheraccounts  describe |  |           | Deductions  describe |  |   | Balance atend of period
|Year Ended June 30, 2004:                   |  |                              |           |                             |   |                                    |  |           |                       |  |   |                         |      |  |   |          
|Deducted from assets accounts:              |  |                              |           |                             |   |                                    |  |           |                       |  |   |                         |      |  |   |          
|Allowance for doubtful accounts             |  | $                            | 160,000   |                             | $ | 75,000                             |  |          |                       |  | $ | (135,000                | )(1) |  | $ | 100,000  
|Valuation allowance for deferred tax assets |  |                              | 3,072,391 |                             |   |                                   |  | 200,608   | (3)                   |  |   |                        |      |  |   | 3,272,999
|                                            |  |                              |           |                             |  
|Year Ended June 30, 2003:                   |  |                              |           |                             |   |                                    |  |           |                       |  |   |                         |      |  |   |          
|Deducted from assets accounts:              |  |                              |           |                             |   |                                    |  |           |                       |  |   |                         |      |  |   |          
|Allowance for doubtful accounts:            |  |                              | 112,000   |                             |   | 118,000                            |  | 53,000    | (2)                   |  |   | (123,000                | )(1) |  |   | 160,000  
|Valuation allowance for deferred tax assets |  |                              | 1,602,899 |                             |   |                                   |  | 1,469,492 | (4)                   |  |   |                        |      |  |   | 3,072,391
|                                            |  |                              |           |                             |  
|Year Ended June 30, 2002:                   |  |                              |           |                             |   |                                    |  |           |                       |  |   |                         |      |  |   |          
|Deducted from assets accounts:              |  |                              |           |                             |   |                                    |  |           |                       |  |   |                         |      |  |   |          
|Allowance for doubtful accounts:            |  |                              | 212,000   |                             |   | 76,000                             |  |          |                       |  |   | (176,000                | )(1) |  |   | 112,000  
|Valuation allowance for deferred tax assets |  |                              | 1,848,449 |                             |   |                                   |  |          |                       |  |   | (245,550                | )(5) |  |   | 1,602,899

---

|(1) | Uncollectible accounts written off, net of recoveries.
|--- | ------------------------------------------------------

|(2) | Allowance recorded upon acquisition.
|--- | ------------------------------------

|(3) | Increase in valuation allowance, net of temporary differences.
|--- | --------------------------------------------------------------

|(4) | Increase in valuation allowance, net of temporary differences and reversal of income tax benefit recorded in prior period.
|--- | --------------------------------------------------------------------------------------------------------------------------

|(5) | Income tax benefit recorded, net of temporary differences.
|--- | ----------------------------------------------------------



All other financial statement schedules are not required under the related instructions or are inapplicable and therefore have been omitted.



3. Exhibits required to be filed by Item 601 of Regulation S-K



|            |  |                                                                                                                        
|----------- |  | -----------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                                                 
|2.1         |  | Agreement and Plan of Mergera                                                                                          
|            | 
|3.1         |  | Restated Certificate of Incorporationb                                                                                 
|            | 
|3.2         |  | First Amendment to Restated Certificate of Incorporationb                                                              
|            | 
|3.3         |  | Reverse Split Amendment to Restated Certificate of Incorporationa                                                      
|            | 
|3.4         |  | Amendment of PlanetCADs Certificate of Incorporation to change the name of PlanetCAD, Inc. to Avatech Solutions, Inc.a
|            | 
|3.5         |  | Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Stockc                   
|            | 
|3.6         |  | Certificate of Designation, Preferences and Rights of Series B Convertible Preferred Stockd                            
|            | 
|3.7         |  | Certificate of Designation, Preferences and Rights of Series C Convertible Preferred Stocke                            
|            | 
|3.8         |  | Certificate of Amendment to Certificate of Designation of Series C Convertible Preferred Stockf                        



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##### Table of Contents

|      |  |                                                                                                                                                                                                                                                                                              
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|      | 
|3.9   |  | Certificate of Designation, Preferences and Rights of Series D Convertible Preferred Stockf                                                                                                                                                                                                  
|      | 
|3.10  |  | Certificate of Elimination of Series A Junior Participating Preferred Stockf                                                                                                                                                                                                                 
|      | 
|3.11  |  | Certificate of Elimination of Series C Convertible Preferred Stockf                                                                                                                                                                                                                          
|      | 
|3.12  |  | Certificate of Amendment to Certificate of Designation of Series D Convertible Preferred Stockf                                                                                                                                                                                              
|      | 
|3.13  |  | Certificate of Amendment to Amended and Restated Certificate of Incorporationk                                                                                                                                                                                                               
|      | 
|3.14  |  | By-Lawsb                                                                                                                                                                                                                                                                                     
|      | 
|10.01 |  | Autodesk Authorized Channel Partner Agreement by and among Avatech Solutions, Inc. and Autodesk, Inc. effective as of February 1, 2003e                                                                                                                                                      
|      | 
|10.02 |  | Autodesk Authorized Channel Partner Agreement by and among Avatech Solutions, Inc. and Autodesk, Inc. effective as of February 1, 2004f                                                                                                                                                      
|      | 
|10.03 |  | Loan Agreement by and between Avatech Solutions Subsidiary, Inc. and a Strategic Partner dated July 22, 2003, as amended (portions of this exhibit have been omitted and filed separately with
the U.S. Securities and Exchange Commission pursuant to a request for confidential treatment)g
|      | 
|10.04 |  | Security Agreement by and between Avatech Solutions Subsidiary, Inc. and a Strategic Partner dated July 22, 2003 (portions of this exhibit have been omitted and filed separately with the U.S.
Securities and Exchange Commission pursuant to a request for confidential treatment)g        
|      | 
|10.05 |  | Demand Promissory Note by and between Avatech Solutions Subsidiary, Inc. and Key Bank and Trust in the amount of $2,000,000 dated September 11, 2003g                                                                                                                                        
|      | 
|10.06 |  | Loan and Security Agreement by and between Avatech Solutions Subsidiary, Inc. and Key Bank and Trust dated September 11, 2003g                                                                                                                                                               
|      | 
|10.07 |  | Lease by and between Merritt-DM1, LLC and Avatech Solutions, Inc. effective June 1, 2004k                                                                                                                                                                                                    
|      | 
|10.08 |  | Form of Promissory Note, principal amount $500,000.00, issued by Avatech Solutions, Inc. in favor of W. James Hindman dated May 28, 2003g                                                                                                                                                    
|      | 
|10.09 |  | Warrants to purchase up to 32,400 shares of common stock issued by Avatech to W. James Hindman dated May 28, 2003g                                                                                                                                                                           
|      | 
|10.10 |  | Affidavit and Discharge of Indebtedness by W. James Hindmang                                                                                                                                                                                                                                 
|      | 
|10.11 |  | Form of 10% Subordinated Note with attached Warrant issued by Avatech Solutions, Inc. to certain note holders in connection with Avatech Solutions Subsidiary, Inc.s 1998 $2,600,000
Subordinated Debt Offering, dated January 1, 2004f                                                     
|      | 
|10.12 |  | Form of 12 % Subordinated Note issued by Avatech Solutions, Inc. to certain note holders in connection with Avatech Solutions Subsidiary, Inc.s 1998 $2,600,000 Subordinated Debt
Offering dated January 1, 2004f                                                                           
|      | 
|10.13 |  | Form of Purchase Agreement for Series D Convertible Preferred Stockf                                                                                                                                                                                                                         
|      | 
|10.14 |  | 2002 Stock Option Plana                                                                                                                                                                                                                                                                      
|      | 
|10.15 |  | Restricted Stock Award Plane                                                                                                                                                                                                                                                                 
|      | 
|10.16 |  | Avatech Solutions, Inc. Employee Stock Purchase Plani                                                                                                                                                                                                                                        
|      | 
|10.17 |  | Employment Agreement by and between Eric L. Pratt and Avatech Solutions, Inc. effective April 15, 2003h                                                                                                                                                                                      
|      | 
|10.18 |  | Employment Agreement by and between Scott N. Fischer and Avatech Solutions, Inc. dated as of March 17, 2003g                                                                                                                                                                                 
|      | 
|10.19 |  | Separation Agreement between Scott Fischer and Avatech Solutions, Inc. dated as of March 10, 2004j                                                                                                                                                                                           
|      | 
|10.20 |  | Employment Agreement by and between Donald R. Scotty Walsh and Avatech Solutions, Inc. dated July 1, 2003g                                                                                                                                                                                 



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##### Table of Contents

|      |  |                                                                                                                                           
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------
|      | 
|10.21 |  | Employment Agreement by and between Beth O. MacLaughlin and Avatech Solutions Subsidiary, Inc. dated as of August 7, 2003k                
|      | 
|10.22 |  | Employment Agreement by and between W. Scott Harris and Avatech Solutions Subsidiary, Inc. dated as of June 1, 2004k                      
|      | 
|10.23 |  | Employment Agreement by and between Christopher D. Olander and Avatech Solutions Subsidiary, Inc. dated June 18, 2004k                    
|      | 
|10.24 |  | Form of Promissory Note, principal amount $902,168.80, issued by Avatech Solutions, Inc. in favor of W. James Hindman dated April 1, 2004j
|      | 
|10.25 |  | Warrants to purchase up to 51,828 shares of common stock issued by Avatech to W. James Hindman dated April 1, 2004k                       
|      | 
|10.26 |  | Employment Agreement by and between Eric L. Pratt and Avatech Solutions Subsidiary, Inc. dated June 1, 2004.k                             
|      | 
|14.1  |  | Code of Business Conduct and Ethics*                                                                                                      
|      | 
|21.1  |  | Subsidiaries of the Registranti                                                                                                           
|      | 
|23.1  |  | Consent of Ernst & Young LLP *                                                                                                            
|      | 
|24.1  |  | Power of Attorney*                                                                                                                        
|      | 
|31.1  |  | Rule 15d-14(a) Certification of Chief Executive Officer*                                                                                  
|      | 
|31.2  |  | Rule 15d-14(a) Certification of Chief Financial Officer*                                                                                  
|      | 
|32.1  |  | Section 1350 Certifications*                                                                                                              

---

|* | Filed herewith
|- | --------------

|a. | Incorporated by reference to our Registration Statement on form S-4 filed on May 30, 2002, File No. 333-89386.
|-- | --------------------------------------------------------------------------------------------------------------

|b. | Incorporated by reference to our Registration Statement on form SB-2 filed on November 21, 2000, File No. 333-50426.
|-- | --------------------------------------------------------------------------------------------------------------------

|c. | Incorporated by reference to our Registration Statement on form 8-A filed on March 11, 2002, File No. 001-31265.
|-- | ----------------------------------------------------------------------------------------------------------------

|d. | Incorporated by reference to our Current Report on form 8-K, filed on May 28, 2002, File No. 001-31265.
|-- | -------------------------------------------------------------------------------------------------------

|e. | Incorporated by reference to our Amended Registration Statement on form S-1, filed on April 11, 2003, File No. 333-104035.
|-- | --------------------------------------------------------------------------------------------------------------------------

|f. | Incorporated by reference to our Quarterly Report on form 10-Q, filed on February 13, 2004, File No. 001-31265.
|-- | ---------------------------------------------------------------------------------------------------------------

|g. | Incorporated by reference to our Annual Report on form 10-K, filed on October 3, 2003, File No. 001-31265.
|-- | ----------------------------------------------------------------------------------------------------------

|h. | Incorporated by reference to our Amended Registration Statement on form S-1, filed on June 4, 2003, File No. 333-104035.
|-- | ------------------------------------------------------------------------------------------------------------------------

|i. | Incorporated by reference to our Definitive Proxy Statement on form 14A, filed on May 7, 2004, File No. 001-31265.
|-- | ------------------------------------------------------------------------------------------------------------------

|j. | Incorporated by reference to our Quarterly Report on form 10-Q, filed on May 17, 2004, File No. 001-31265.
|-- | ----------------------------------------------------------------------------------------------------------

|k. | Incorporated by reference to our Registration Statement on form S-1, filed on July 19, 2004, File No. 333-114230.
|-- | -----------------------------------------------------------------------------------------------------------------



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##### Table of Contents

SIGNATURES



Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereto duly authorized.



|                         |  |                         |  |                                                 
|------------------------ |  | ----------------------- |  | ------------------------------------------------
|                         |  | AVATECH SOLUTIONS, INC.
|                         |  |                        
|Date: September 28, 2004 |  | By:                     |  | /s/ Donald R. (Scotty) Walsh                    
|                         |  |                         |  | Donald R. (Scotty) Walsh Chief Executive
Officer



Pursuant to the
requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.



|    |  |                                                                                                 |  |     |  |                                                                                           
|--- |  | ----------------------------------------------------------------------------------------------- |  | --- |  | ------------------------------------------------------------------------------------------
|    |  |                                                                                                 | 
|By: |  | /s/ Edgar D. Aronson                                                                            |  | By: |  | /s/ Beth O. MacLaughlin                                                                   
|    |  | Edgar D. Aronson, Director September 28,
2004 By: Christopher D. Olander, Attorney-in-fact      |  |     |  | Beth O. MacLaughlin, Interim Chief Financial Officer September 28, 2004                   
|    |  |                                                                                                 | 
|By: |  | /s/ Garnett Y. Clark, Jr.                                                                       |  | By: |  | /s/ W. James Hindman                                                                      
|    |  | Garnett Y. Clark, Jr., Director September 28,
2004 By: Christopher D. Olander, Attorney-in-fact |  |     |  | W. James Hindman, Director September 28,
2004 By: Christopher D. Olander, Attorney-in-fact
|    |  |                                                                                                 | 
|By: |  | /s/ George Cox                                                                                  |  | By: |  | /s/ Robert Post                                                                           
|    |  | George Cox, Director September 28, 2004 By: Christopher D. Olander, Attorney-in-fact            |  |     |  | Robert Post, Director September 28, 2004
By: Christopher D. Olander, Attorney-in-fact     
|    |  |                                                                                                 | 
|By: |  | /s/ Eugene J. Fischer                                                                           |  | By: |  | /s/ Donald Scotty Walsh                                                                 
|    |  | Eugene J. Fischer, Director September 28,
2004 By: Christopher D. Olander, Attorney-in-fact     |  |     |  | Donald Scotty Walsh, Director September 28,
2004                                        



- 31 -



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##### Table of Contents

FINANCIAL STATEMENTS AND SCHEDULES



Avatech Solutions, Inc.



Index to
Consolidated Financial Statements



|                                                        |  |      
|------------------------------------------------------- |  | -----
|                                                        |  | Page 
|Report of Independent Registered Public Accounting Firm |  | F  2
|Consolidated Balance Sheets                             |  | F  3
|Consolidated Statements of Operations                   |  | F  5
|Consolidated Statements of Stockholders Deficit        |  | F  6
|Consolidated Statements of Cash Flows                   |  | F  7
|Notes to Consolidated Financial Statements              |  | F  8



F - 1



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##### Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors and Stockholders

Avatech Solutions, Inc.



We have audited the accompanying consolidated balance sheets of Avatech Solutions, Inc. and subsidiaries as of June 30, 2003 and 2004, and
the related consolidated statements of operations, stockholders deficit and cash flows for each of the three years in the period ended June 30, 2004. These financial statements are the responsibility of the Companys management. Our
responsibility is to express an opinion on these financial statements based on our audits.



We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.



In our opinion, the financial statements referred to above present fairly, in all material
respects, the consolidated financial position of Avatech Solutions, Inc. and subsidiaries at June 30, 2003 and 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended June 30, 2004,
in conformity with U.S. generally accepted accounting principles.



As discussed
in Note 1 to the financial statements, the Company changed its method of accounting for goodwill effective July 1, 2002.



/s/ Ernst & Young LLP



Baltimore, Maryland

September 17, 2004



F - 2



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##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Balance Sheets



|                                                                             |  |         |           |      |   |          
|---------------------------------------------------------------------------- |  | ------- | --------- | ---- | - | ---------
|                                                                             |  | June 30
|                                                                             |  | 2003    |           | 2004
|Assets                                                                       |  |         |           |      |   |          
|Current assets:                                                              |  |         |           |      |   |          
|Cash and cash equivalents                                                    |  | $       | 540,384   |      | $ | 689,995  
|Accounts receivable, less allowance of $160,000 in 2003 and $100,000 in 2004 |  |         | 3,239,224 |      |   | 3,906,724
|Other receivables                                                            |  |         | 153,899   |      |   | 366,475  
|Inventory                                                                    |  |         | 146,877   |      |   | 215,321  
|Prepaid expenses                                                             |  |         | 395,189   |      |   | 398,815  
|Other current assets                                                         |  |         | 94,258    |      |   | 70,775   
|                                                                             |  |         |           |      |   |          
|Total current assets                                                         |  |         | 4,569,831 |      |   | 5,648,105
|                                                                             |  |        
|Property and equipment:                                                      |  |         |           |      |   |          
|Computer software and equipment                                              |  |         | 2,925,159 |      |   | 2,396,593
|Office furniture and equipment                                               |  |         | 760,020   |      |   | 881,036  
|Leasehold improvements                                                       |  |         | 207,661   |      |   | 197,245  
|                                                                             |  |         |           |      |   |          
|                                                                             |  |         | 3,892,840 |      |   | 3,474,874
|Less accumulated depreciation and amortization                               |  |         | 3,255,361 |      |   | 2,921,705
|                                                                             |  |         |           |      |   |          
|                                                                             |  |         | 637,479   |      |   | 553,169  
|Goodwill                                                                     |  |         | 52,272    |      |   | 52,272   
|Other assets                                                                 |  |         | 12,385    |      |   | 313,073  
|                                                                             |  |         |           |      |   |          
|Total assets                                                                 |  | $       | 5,271,967 |      | $ | 6,566,619
|                                                                             |  |         |           |      |   |          



F - 3



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##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Balance Sheets (Continued)



|                                                                                                                                                                                                                                                              |  |         |            |   |      |   |             |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------- | ---------- | - | ---- | - | ----------- | -
|                                                                                                                                                                                                                                                              |  | June 30 |           
|                                                                                                                                                                                                                                                              |  | 2003    |            |   | 2004 |  
|Liabilities and stockholders deficit                                                                                                                                                                                                                         |  |         |            |   |      |   |             |  
|Current liabilities:                                                                                                                                                                                                                                          |  |         |            |   |      |   |             |  
|Accounts payable and accrued expenses                                                                                                                                                                                                                         |  | $       | 5,089,207  |   |      | $ | 5,257,848   |  
|Accrued compensation and related benefits                                                                                                                                                                                                                     |  |         | 354,555    |   |      |   | 347,020     |  
|Borrowings under line-of-credit                                                                                                                                                                                                                               |  |         | 1,634,709  |   |      |   | 1,640,180   |  
|Current portion of long-term debt                                                                                                                                                                                                                             |  |         | 250,000    |   |      |   | 92,544      |  
|Deferred revenue                                                                                                                                                                                                                                              |  |         | 736,963    |   |      |   | 956,636     |  
|Other current liabilities                                                                                                                                                                                                                                     |  |         | 325,920    |   |      |   | 333,106     |  
|                                                                                                                                                                                                                                                              |  |         |            |   |      |   |             |  
|Total current liabilities                                                                                                                                                                                                                                     |  |         | 8,391,354  |   |      |   | 8,627,334   |  
|                                                                                                                                                                                                                                                              |  |        
|Long-term debt                                                                                                                                                                                                                                                |  |         |           |   |      |   | 1,606,206   |  
|Note payable to related party                                                                                                                                                                                                                                 |  |         | 966,503    |   |      |   | 878,725     |  
|Other long-term liabilities                                                                                                                                                                                                                                   |  |         | 363,307    |   |      |   | 318,316     |  
|Commitments and contingencies                                                                                                                                                                                                                                 |  |         |           |   |      |   |            |  
|                                                                                                                                                                                                                                                              |  |        
|Minority interest                                                                                                                                                                                                                                             |  |         | 1,525,000  |   |      |   | 1,525,000   |  
|                                                                                                                                                                                                                                                              |  |        
|Stockholders deficit:                                                                                                                                                                                                                                        |  |         |            |   |      |   |             |  
|Series C Convertible Preferred Stock, $0.01 par value; 1,000,000 shares authorized; 172,008 shares issued and outstanding at June 30, 2003 and
-0- shares authorized, issued and outstanding at June 30, 2004                                                 |  |         | 1,720      |   |      |   |            |  
|Series D Convertible Preferred Stock, $0.01 par value; -0- shares authorized, issued and outstanding at June 30, 2003 and 1,297,537 shares
authorized, issued and outstanding at June 30, 2004; aggregate liquidation preference of $778,522 at June 30, 2004 |  |         |           |   |      |   | 12,975      |  
|Common stock, $0.01 par value; 80,000,000 shares authorized; issued and outstanding shares of 8,897,874 at June 30, 2003 and 9,460,380 at June
30, 2004                                                                                                       |  |         | 88,980     |   |      |   | 94,605      |  
|Additional paid-in capital                                                                                                                                                                                                                                    |  |         | 3,242,454  |   |      |   | 3,737,574   |  
|Accumulated deficit                                                                                                                                                                                                                                           |  |         | (9,307,351 | ) |      |   | (10,234,116 | )
|                                                                                                                                                                                                                                                              |  |         |            |   |      |   |             |  
|Total stockholders deficit                                                                                                                                                                                                                                   |  |         | (5,974,197 | ) |      |   | (6,388,962  | )
|                                                                                                                                                                                                                                                              |  |         |            |   |      |   |             |  
|Total liabilities and stockholders deficit                                                                                                                                                                                                                   |  | $       | 5,271,967  |   |      | $ | 6,566,619   |  
|                                                                                                                                                                                                                                                              |  |         |            |   |      |   |             |  



See accompanying notes.



F - 4



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##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Operations



|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ---------- | - | ---- | - | ---------- | ---- |  | - | ---------- | -
|                                                                                                                                |  | Year ended June 30 |           
|                                                                                                                                |  | 2002               |            |   | 2003 |   |            | 2004 | 
|Revenues:                                                                                                                       |  |                    |            |   |      |   |            |      |  |   |            |  
|Product sales                                                                                                                   |  | $                  | 16,619,444 |   |      | $ | 12,369,846 |      |  | $ | 17,710,150 |  
|Service revenue                                                                                                                 |  |                    | 5,775,045  |   |      |   | 5,931,623  |      |  |   | 5,470,360  |  
|Commission revenue                                                                                                              |  |                    | 4,245,987  |   |      |   | 4,199,465  |      |  |   | 4,769,984  |  
|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|                                                                                                                                |  |                    | 26,640,476 |   |      |   | 22,500,934 |      |  |   | 27,950,494 |  
|Cost of revenue:                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|Cost of product sales                                                                                                           |  |                    | 11,071,083 |   |      |   | 8,776,509  |      |  |   | 12,647,646 |  
|Cost of service revenue                                                                                                         |  |                    | 3,365,110  |   |      |   | 3,766,904  |      |  |   | 4,086,069  |  
|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|                                                                                                                                |  |                    | 14,436,193 |   |      |   | 12,543,413 |      |  |   | 16,733,715 |  
|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|Gross margin                                                                                                                    |  |                    | 12,204,283 |   |      |   | 9,957,521  |      |  |   | 11,216,779 |  
|                                                                                                                                |  |                    |           
|Other operating expenses:                                                                                                       |  |                    |            |   |      |   |            |      |  |   |            |  
|Selling, general and administrative                                                                                             |  |                    | 11,720,443 |   |      |   | 12,201,380 |      |  |   | 11,073,122 |  
|Depreciation and amortization                                                                                                   |  |                    | 503,248    |   |      |   | 411,612    |      |  |   | 330,926    |  
|Impairment loss                                                                                                                 |  |                    | 284,766    |   |      |   |           |      |  |   |           |  
|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|                                                                                                                                |  |                    | 12,508,457 |   |      |   | 12,612,992 |      |  |   | 11,404,048 |  
|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|Operating loss                                                                                                                  |  |                    | (304,174   | ) |      |   | (2,655,471 | )    |  |   | (187,269   | )
|                                                                                                                                |  |                    |           
|Other income (expense):                                                                                                         |  |                    |            |   |      |   |            |      |  |   |            |  
|Gain on the extinguishment of debt                                                                                              |  |                    |           |   |      |   | 1,960,646  |      |  |   |           |  
|Minority interest                                                                                                               |  |                    |           |   |      |   | (94,140    | )    |  |   | (152,500   | )
|Interest and other income                                                                                                       |  |                    | 48,171     |   |      |   | 15,642     |      |  |   | 38,570     |  
|Interest expense                                                                                                                |  |                    | (487,230   | ) |      |   | (290,373   | )    |  |   | (351,987   | )
|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|                                                                                                                                |  |                    | (439,059   | ) |      |   | 1,591,775  |      |  |   | (465,917   | )
|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|Loss from continuing operations before income taxes and cumulative effect of change in accounting principle                     |  |                    | (743,233   | ) |      |   | (1,063,696 | )    |  |   | (653,186   | )
|Income tax expense (benefit)                                                                                                    |  |                    | (297,651   | ) |      |   | 408,072    |      |  |   | 29,898     |  
|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|Loss from continuing operations before cumulative effect of change in accounting principle                                      |  |                    | (445,582   | ) |      |   | (1,471,768 | )    |  |   | (683,084   | )
|Income (loss) from operations of discontinued operating segments (including loss on disposal of $354,000 in 2003)               |  |                    | 198,087    |   |      |   | (1,856,538 | )    |  |   | (243,681   | )
|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|Loss before cumulative effect of change in accounting principle                                                                 |  |                    | (247,495   | ) |      |   | (3,328,306 | )    |  |   | (926,765   | )
|Cumulative effect of change in accounting for goodwill                                                                          |  |                    |           |   |      |   | (520,000   | )    |  |   |           |  
|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|Net loss                                                                                                                        |  | $                  | (247,495   | ) |      | $ | (3,848,306 | )    |  | $ | (926,765   | )
|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|Loss from continuing operations before cumulative effect of change in accounting principle per common share  basic and
diluted |  | $                  | (0.07      | ) |      | $ | (0.18      | )    |  | $ | (0.08      | )
|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  
|Loss per common share  basic and diluted                                                                                       |  | $                  | (0.04      | ) |      | $ | (0.48      | )    |  | $ | (0.11      | )
|                                                                                                                                |  |                    |            |   |      |   |            |      |  |   |            |  



See accompanying notes.



F - 5



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##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statement of Stockholders Deficit



|                                                                                             |  |                             |   |  |           |        |              |                 |           |           |   |                  |  |           |           |  |   |                          |   |  |                    |           |   |       |   |             |   |  |   |            |  
|-------------------------------------------------------------------------------------------- |  | --------------------------- | - |  | --------- | ------ | ------------ | --------------- | --------- | --------- | - | ---------------- |  | --------- | --------- |  | - | ------------------------ | - |  | ------------------ | --------- | - | ----- | - | ----------- | - |  | - | ---------- | -
|                                                                                             |  | Convertible Preferred Stock |   |  |           |        |              |                 |           |           |   |                  |  |           |           |  |  
|                                                                                             |  | Series C                    |   |  | Series D  |        | Common Stock |                 |           |           |   |                  |  |           |           |  |  
|                                                                                             |  | Numberof Shares             |   |  | Par Value |        |              | Number ofShares |           | Par Value |   | Number of Shares |  |           | Par Value |  |   | AdditionalPaid-InCapital |   |  | AccumulatedDeficit |           |   | Total |  
|Balance at July 1, 2001                                                                      |  |                            |   |  | $         |       |              |                 |          |           | $ |                 |  | 6,682,176 |           |  | $ | 66,822                   |   |  | $                  | 1,719,890 |   |       | $ | (5,211,550  | ) |  | $ | (3,424,838 | )
|Purchase of common stock from current and former employees                                   |  |                            |   |  |           |       |              |                 |          |           |   |                 |  | (20,166   | )         |  |   | (201                     | ) |  |                    | (65,328   | ) |       |   |            |   |  |   | (65,529    | )
|Net loss for fiscal year 2002                                                                |  |                            |   |  |           |       |              |                 |          |           |   |                 |  |          |           |  |   |                         |   |  |                    |          |   |       |   | (247,495    | ) |  |   | (247,495   | )
|                                                                                             |  |                             |   |  |           |        |              |                 |           |           |   |                  |  |           |           |  |   |                          |   |  |                    |           |   |       |   |             |   |  |   |            |  
|Balance at June 30, 2002                                                                     |  |                            |   |  |           |       |              |                 |          |           |   |                 |  | 6,662,010 |           |  |   | 66,621                   |   |  |                    | 1,654,562 |   |       |   | (5,459,045  | ) |  |   | (3,737,862 | )
|Issuance of shares of common stock to purchase PlanetCAD, Inc.                               |  |                            |   |  |           |       |              |                 |          |           |   |                 |  | 2,235,864 |           |  |   | 22,359                   |   |  |                    | 1,262,641 |   |       |   |            |   |  |   | 1,285,000  |  
|Issuance of warrants in conjunction with notes payable                                       |  |                            |   |  |           |       |              |                 |          |           |   |                 |  |          |           |  |   |                         |   |  |                    | 36,288    |   |       |   |            |   |  |   | 36,288     |  
|Issuance of Series C Convertible Preferred Stock for cash                                    |  | 172,008                     |   |  |           | 1,720  |              |                 |          |           |   |                 |  |          |           |  |   |                         |   |  |                    | 288,963   |   |       |   |            |   |  |   | 290,683    |  
|Net loss for fiscal year 2003                                                                |  |                            |   |  |           |       |              |                 |          |           |   |                 |  |          |           |  |   |                         |   |  |                    |          |   |       |   | (3,848,306  | ) |  |   | (3,848,306 | )
|                                                                                             |  |                             |   |  |           |        |              |                 |           |           |   |                  |  |           |           |  |   |                          |   |  |                    |           |   |       |   |             |   |  |   |            |  
|Balance at June 30, 2003                                                                     |  | 172,008                     |   |  |           | 1,720  |              |                 |          |           |   |                 |  | 8,897,874 |           |  |   | 88,980                   |   |  |                    | 3,242,454 |   |       |   | (9,307,351  | ) |  |   | (5,974,197 | )
|Issuance of common stock as compensation                                                     |  |                            |   |  |           |       |              |                 |          |           |   |                 |  | 562,506   |           |  |   | 5,625                    |   |  |                    | 96,446    |   |       |   |            |   |  |   | 102,071    |  
|Conversion of Series C Convertible Preferred Stock into Series D Convertible Preferred Stock |  | (172,008                    | ) |  |           | (1,720 | )            |                 | 484,487   |           |   | 4,845            |  |          |           |  |   |                         |   |  |                    | (3,125    | ) |       |   |            |   |  |   |           |  
|Issuance of Series D Convertible Preferred Stock and warrants to purchase common stock       |  |                            |   |  |           |       |              |                 | 813,050   |           |   | 8,130            |  |          |           |  |   |                         |   |  |                    | 419,945   |   |       |   |            |   |  |   | 428,075    |  
|Preferred stock dividends                                                                    |  |                            |   |  |           |       |              |                 |          |           |   |                 |  |          |           |  |   |                         |   |  |                    | (56,305   | ) |       |   |            |   |  |   | (56,305    | )
|Issuance of warrants to purchase common stock                                                |  |                            |   |  |           |       |              |                 |          |           |   |                 |  |          |           |  |   |                         |   |  |                    | 38,159    |   |       |   |            |   |  |   | 38,159     |  
|Net loss                                                                                     |  |                            |   |  |           |       |              |                 |          |           |   |                 |  |          |           |  |   |                         |   |  |                    |          |   |       |   | (926,765    | ) |  |   | (926,765   | )
|                                                                                             |  |                             |   |  |           |        |              |                 |           |           |   |                  |  |           |           |  |   |                          |   |  |                    |           |   |       |   |             |   |  |   |            |  
|Balance at June 30, 2004                                                                     |  |                            |   |  | $         |       |              |                 | 1,297,537 |           | $ | 12,975           |  | 9,460,380 |           |  | $ | 94,605                   |   |  | $                  | 3,737,574 |   |       | $ | (10,234,116 | ) |  | $ | (6,388,962 | )
|                                                                                             |  |                             |   |  |           |        |              |                 |           |           |   |                  |  |           |           |  |   |                          |   |  |                    |           |   |       |   |             |   |  |   |            |  



See accompanying notes.



F - 6



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##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Cash Flows



|                                                                                          |  |                    |             |   |      |   |             |      |  |   |             |  
|----------------------------------------------------------------------------------------- |  | ------------------ | ----------- | - | ---- | - | ----------- | ---- |  | - | ----------- | -
|                                                                                          |  | Year ended June 30 |            
|                                                                                          |  | 2002               |             |   | 2003 |   |             | 2004 | 
|Cash flows from operating activities                                                      |  |                    |             |   |      |   |             |      |  |   |             |  
|Net loss                                                                                  |  | $                  | (247,495    | ) |      | $ | (3,848,306  | )    |  | $ | (926,765    | )
|Adjustments to reconcile net loss to net cash provided by (used in) operating activities: |  |                    |             |   |      |   |             |      |  |   |             |  
|Provision for bad debts                                                                   |  |                    | 75,542      |   |      |   | 118,046     |      |  |   | 74,821      |  
|Gain on extinguishment of debt                                                            |  |                    |            |   |      |   | (1,960,646  | )    |  |   |            |  
|Depreciation and amortization                                                             |  |                    | 612,918     |   |      |   | 665,990     |      |  |   | 330,926     |  
|Deferred income taxes                                                                     |  |                    | (373,000    | ) |      |   | 373,000     |      |  |   |            |  
|Impairment loss                                                                           |  |                    | 285,374     |   |      |   | 256,864     |      |  |   |            |  
|Non-cash stock compensation expense                                                       |  |                    |            |   |      |   |            |      |  |   | 102,071     |  
|Cumulative effect of change in accounting principle                                       |  |                    |            |   |      |   | 520,000     |      |  |   |            |  
|Write-off of in-process research and development                                          |  |                    |            |   |      |   | 282,000     |      |  |   |            |  
|Loss on disposal of property and equipment                                                |  |                    | 7,575       |   |      |   | 116,862     |      |  |   | 62,785      |  
|Amortization of debt discount charged to interest expense                                 |  |                    | 3,844       |   |      |   | 6,325       |      |  |   | 37,633      |  
|Changes in operating assets and liabilities:                                              |  |                    |             |   |      |   |             |      |  |   |             |  
|Accounts receivable and other receivables                                                 |  |                    | 893,017     |   |      |   | 787,249     |      |  |   | (954,897    | )
|Inventory                                                                                 |  |                    | 106,647     |   |      |   | 209,136     |      |  |   | (68,444     | )
|Prepaid expenses and other current assets                                                 |  |                    | 190,804     |   |      |   | 235,997     |      |  |   | 19,857      |  
|Other assets                                                                              |  |                    |            |   |      |   |            |      |  |   | (256,782    | )
|Accounts payable and accrued expenses                                                     |  |                    | (240,179    | ) |      |   | 725,490     |      |  |   | 168,641     |  
|Accrued compensation and related benefits                                                 |  |                    | (69,862     | ) |      |   | 109,014     |      |  |   | (7,535      | )
|Deferred revenue                                                                          |  |                    | (144,405    | ) |      |   | (142,874    | )    |  |   | 219,673     |  
|Other current liabilities                                                                 |  |                    | (4,058      | ) |      |   | (10,000     | )    |  |   | (30,312     | )
|                                                                                          |  |                    |             |   |      |   |             |      |  |   |             |  
|Net cash provided by (used in) operating activities                                       |  |                    | 1,096,722   |   |      |   | (1,555,853  | )    |  |   | (1,228,328  | )
|                                                                                          |  |                    |            
|Cash flows from investing activities                                                      |  |                    |             |   |      |   |             |      |  |   |             |  
|Purchase of property and equipment                                                        |  |                    | (258,944    | ) |      |   | (273,088    | )    |  |   | (332,564    | )
|Proceeds from sale of property and equipment                                              |  |                    | 10,584      |   |      |   | 7,325       |      |  |   | 46,177      |  
|Proceeds from sale of available-for-sale securities                                       |  |                    |            |   |      |   | 625,000     |      |  |   |            |  
|Acquisition costs related to PlanetCAD merger                                             |  |                    | (302,228    | ) |      |   | (612,782    | )    |  |   |            |  
|Cash received from PlanetCAD merger                                                       |  |                    |            |   |      |   | 995,425     |      |  |   |            |  
|                                                                                          |  |                    |             |   |      |   |             |      |  |   |             |  
|Net cash provided by (used in) investing activities                                       |  |                    | (550,588    | ) |      |   | 741,880     |      |  |   | (286,387    | )
|                                                                                          |  |                    |            
|Cash flows from financing activities                                                      |  |                    |             |   |      |   |             |      |  |   |             |  
|Proceeds from borrowings under line-of-credit                                             |  |                    | 31,166,171  |   |      |   | 29,490,344  |      |  |   | 31,964,775  |  
|Repayments of borrowings under line-of-credit                                             |  |                    | (31,660,182 | ) |      |   | (29,278,536 | )    |  |   | (31,953,574 | )
|Proceeds from issuance of long-term debt                                                  |  |                    |            |   |      |   | 175,000     |      |  |   | 1,500,000   |  
|Proceeds from issuance of notes payable to related parties                                |  |                    |            |   |      |   | 1,500,000   |      |  |   |            |  
|Repayments of long-term debt                                                              |  |                    |            |   |      |   | (1,000,000  | )    |  |   | (51,250     | )
|Proceeds from issuance of preferred stock                                                 |  |                    |            |   |      |   | 290,683     |      |  |   | 330,244     |  
|Dividends paid to preferred shareholders                                                  |  |                    |            |   |      |   |            |      |  |   | (56,305     | )
|Repurchase of common stock                                                                |  |                    | (65,529     | ) |      |   |            |      |  |   |            |  
|Change in other assets related to financing costs                                         |  |                    | (73,653     | ) |      |   | (45,696     | )    |  |   | (62,071     | )
|Change in other current liabilities related to financing                                  |  |                    |            |   |      |   |            |      |  |   | 37,498      |  
|Change in other long-term liabilities                                                     |  |                    |            |   |      |   |            |      |  |   | (44,991     | )
|                                                                                          |  |                    |             |   |      |   |             |      |  |   |             |  
|Net cash provided by (used in) financing activities                                       |  |                    | (633,193    | ) |      |   | 1,131,795   |      |  |   | 1,664,326   |  
|                                                                                          |  |                    |             |   |      |   |             |      |  |   |             |  
|Net increase (decrease) in cash and cash equivalents                                      |  |                    | (87,059     | ) |      |   | 317,822     |      |  |   | 149,611     |  
|Cash and cash equivalentsbeginning of year                                               |  |                    | 309,621     |   |      |   | 222,562     |      |  |   | 540,384     |  
|                                                                                          |  |                    |             |   |      |   |             |      |  |   |             |  
|Cash and cash equivalentsend of year                                                     |  | $                  | 222,562     |   |      | $ | 540,384     |      |  | $ | 689,995     |  
|                                                                                          |  |                    |             |   |      |   |             |      |  |   |             |  



See accompanying notes.



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##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements



1. Summary of Significant Accounting Policies



Nature of Business and Basis of Presentation



Avatech Solutions, Inc. provides design automation software, hardware, training, technical
support and professional services to corporations, government agencies and educational institutions throughout the United States.



The consolidated financial statements include the accounts of Avatech Solutions, Inc. and its majority-owned subsidiaries (the Company or Avatech). One of the
Companys subsidiaries has issued and outstanding preferred stock, which is accounted for as minority interest. All intercompany accounts and transactions between the Company and its consolidated affiliated companies have been eliminated in
consolidation.



Use of Estimates



The preparation of financial statements in conformity with accounting principles generally
accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.



Cash and Cash Equivalents



The Company considers all highly liquid investments with a maturity of three months or less
when purchased to be cash equivalents.



Inventory



Inventory, consisting of computer software and hardware, is stated at the lower of first-in,
first-out cost, or market.



Property and Equipment



Property and equipment is stated at cost. Depreciation for computer software and equipment
and office furniture and equipment is provided for by the straight-line method over estimated useful lives ranging from three to seven years. Leasehold improvements are amortized over the lesser of the lease term or the useful life of the asset
using the straight-line method.



Impairment of Long-Lived Assets Excluding
Goodwill



Long-lived assets, excluding goodwill, are reviewed for
impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or group of assets may not be fully recoverable. These events or changes in circumstances may include a significant deterioration of operating
results, changes in business plans, or changes in anticipated future cash flows. If an impairment indicator is present, the Company evaluates recoverability by a comparison of the carrying amount of the assets to future undiscounted net cash flows
expected to be generated by the assets. Assets are grouped at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows generated by other asset groups. If the assets are impaired, the impairment
recognized is measured by the amount by which the carrying amount exceeds the fair value of the assets. Fair value is generally determined by estimates of discounted cash flows. The discount rate used in any estimate of discounted cash flows would
be the rate required for a similar investment of like risk.



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##### Table of Contents

1. Summary of Significant Accounting Policies (continued)



Goodwill and Accounting Change



Goodwill is the excess of the purchase price paid over the fair value of the identifiable
net assets acquired in purchase business combinations. Prior to July 1, 2002, goodwill was amortized on a straight-line basis over 15 to 20 years. As of July 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets (Statement 142). Under Statement 142, goodwill and other intangible assets deemed to have indefinite lives are no longer amortized, but are subject to annual impairment tests. Impairment is the
condition that exists when the carrying amount of goodwill exceeds its implied fair value. The implied fair value of goodwill is the amount determined by deducting the estimated fair value of all tangible and identifiable intangible net assets of
the reporting unit to which goodwill has been allocated from the estimated fair value of the reporting unit. If the recorded value of goodwill exceeds its implied value, an impairment charge is recorded for the excess.



The changes in the carrying amount of goodwill for the years ended June 30, 2003 and 2004 are
as follows:



|                                                          |  |   |          |  
|--------------------------------------------------------- |  | - | -------- | -
|Balance at July 1, 2002                                   |  | $ | 752,920  |  
|Changes in goodwill during 2003:                          |  |   |          |  
|Cumulative effect of a change in accounting principle     |  |   | (520,000 | )
|Goodwill impairment of Avatech of Michigan disposal group |  |   | (180,648 | )
|                                                          |  |   |          |  
|Balance at June 30, 2003                                  |  |   | 52,272   |  
|Changes in goodwill during 2004:                          |  |   |         |  
|                                                          |  |   |          |  
|Balance at June 30, 2004                                  |  | $ | 52,272   |  
|                                                          |  |   |          |  



As a result of testing goodwill for
impairment upon the adoption of Statement 142 as of July 1, 2002, the Company recorded a non-cash impairment charge of $520,000, which is included as a cumulative effect of a change in accounting principle in the consolidated statements of
operations. The impairment charge relates solely to Avatech of Michigan, a business unit, which ceased operations in June 2003.



If goodwill was not amortized in 2002, consolidated net loss would have been $73,000 lower, or $(174,495), and loss per common share would have been $0.01 per share
lower, or $(0.03) per share.



Stock Options and Stock Granted to Employees



The Company records compensation expense for all stock-based compensation
plans using the intrinsic value method prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25). Under APB No. 25, compensation expense is recorded ratably over the vesting period to the extent that
the fair value of the underlying stock on the date of grant exceeds the exercise or acquisition price of the stock or stock-based award. Financial Accounting Standards Board Statement No. 123, Accounting for Stock Based Compensation,
(Statement 123) encourages companies to recognize expense for stock-based awards based on their estimated fair value on the date of grant. Statement 123 requires the disclosure of pro forma income and earnings per share data in the notes
to the financial statements if the fair value method is not adopted.



F - 9



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##### Table of Contents

1. Summary of Significant Accounting Policies (continued)



The following table illustrates the effect on net loss and loss per share as if the Company
had applied the fair value recognition provisions of Statement 123 to stock-based employee compensation:



|                                                                                                                                   |  |                    |          |   |      |   |            |      |  |   |            |  
|---------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | -------- | - | ---- | - | ---------- | ---- |  | - | ---------- | -
|                                                                                                                                   |  | Year ended June 30 |         
|                                                                                                                                   |  | 2002               |          |   | 2003 |   |            | 2004 | 
|Net loss as reported                                                                                                               |  | $                  | (247,495 | ) |      | $ | (3,848,306 | )    |  | $ | (926,765   | )
|Add: Stock-based employee compensation cost included in net loss, net of income taxes                                              |  |                    |         |   |      |   |           |      |  |   | 102,071    |  
|Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of income
taxes |  |                    | (116,362 | ) |      |   | (191,855   | )    |  |   | (253,450   | )
|                                                                                                                                   |  |                    |          |   |      |   |            |      |  |   |            |  
|Pro forma net loss                                                                                                                 |  |                    | (363,857 | ) |      |   | (4,040,161 | )    |  |   | (1,078,144 | )
|Less: Preferred stock dividends                                                                                                    |  |                    |         |   |      |   |           |      |  |   | (56,305    | )
|                                                                                                                                   |  |                    |          |   |      |   |            |      |  |   |            |  
|Pro forma net loss attributable to common shareholders                                                                             |  | $                  | (363,857 | ) |      | $ | (4,040,161 | )    |  | $ | (1,134,449 | )
|                                                                                                                                   |  |                    |          |   |      |   |            |      |  |   |            |  
|Loss per common share:                                                                                                             |  |                    |          |   |      |   |            |      |  |   |            |  
|Basic and diluted  as reported                                                                                                    |  | $                  | (0.04    | ) |      | $ | (0.48      | )    |  | $ | (0.11      | )
|                                                                                                                                   |  |                    |          |   |      |   |            |      |  |   |            |  
|Basic and diluted  pro forma                                                                                                      |  | $                  | (0.05    | ) |      | $ | (0.50      | )    |  | $ | (0.12      | )
|                                                                                                                                   |  |                    |          |   |      |   |            |      |  |   |            |  



To determine the pro forma data as
required by Statement 123, the Company used stock option pricing models to measure the fair value of stock options as of the date of grant. For all stock options granted prior to November 19, 2002, the date the Companys common stock became
publicly traded and had a readily determinable market value, the Company used the minimum value method to calculate pro forma stock compensation expense. For all stock options grated after this date, the Company used the Black-Scholes option pricing
model.



The minimum value method calculates the fair value of options as the
excess of the estimated fair value of the underlying stock at the date of grant over the present value of both the exercise price and the expected dividend payments, each discounted at the risk-free rate, over the expected life of the option. The
Black-Scholes option pricing model was developed for estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions,
including the expected stock price volatility. Because the Companys stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair
value estimate, in managements opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock-based awards. The following are the assumptions made in computing the fair value of stock-based
awards:



|                                               |  |                    |         |    |      |   |         |      |  |   |         |  
|---------------------------------------------- |  | ------------------ | ------- | -- | ---- | - | ------- | ---- |  | - | ------- | -
|                                               |  | Year ended June 30 |        
|                                               |  | 2002               |         |    | 2003 |   |         | 2004 | 
|Average risk-free interest rate                |  |                    | 4.48    | %  |      |   | 3.03    | %    |  |   | 3.28    | %
|Dividend yield                                 |  |                    | 0       | %  |      |   | 0       | %    |  |   | 0       | %
|Expected life                                  |  |                    | 5 years |    |      |   | 5 years |      |  |   | 5 years |  
|Expected volatility                            |  |                    | (       | *) |      |   | 1.95    |      |  |   | 2.58    |  
|Weighted average fair value of granted options |  | $                  | 1.77    |    |      | $ | 0.86    |      |  | $ | 0.52    |  

---

|(*)    Assumption | is not applicable under the minimum value method.
|----------------- | -------------------------------------------------



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##### Table of Contents

1. Summary of Significant Accounting Policies (continued)



Revenue Recognition and Accounts Receivable



Software products are sometimes sold in an arrangement that includes implementation services
or maintenance services. Maintenance services are limited to help desk support and training. The Company allocates the total arrangement fee among each element based on vendor-specific objective evidence of the relative fair value of each of the
elements. The Company limits its assessment of fair value of each element to the price charged when the same element is sold separately. If the fair value of each element in a multiple element arrangement cannot be reliably determined, and if the
fair value of any undelivered element cannot also be reliably determined, all revenue under the arrangement is deferred until such time as the only remaining undelivered element is maintenance, or in the absence of maintenance, implementation
services, upon which time revenue is recognized over the remaining maintenance or service period. Revenue that is deferred and recognized over a maintenance or service period is recognized in proportion to the services delivered, or ratably if no
better measure of performance can be determined.



Revenues for software product
sales are recognized as revenue when four criteria are met. These four criteria are (i) a signed purchase order has been obtained (ii) delivery of the software has occurred (iii) the fee is fixed or determinable and (iv) the fee is probable of
collection. Software product sales billed and not recognized as revenue are included in deferred revenue. The Company generally does not require collateral for accounts receivable. The Company provides a 30-day return policy to its customers. The
Company has historically not experienced significant returns, and accordingly, allowances for returned products are not recorded.



Maintenance services are sold for stated periods or for stated numbers of hours. Revenues are recognized ratably over the service period for arrangements to provide
maintenance over a stated period. Revenues for maintenance delivered on an hourly basis are recognized as the services are delivered. Revenues from implementation and training services are recognized as the services are provided. Advance payments
for these services are deferred and recognized in the periods when the services are performed.



The Company also receives commissions from vendors for transactions in which the Company essentially acts as an agent for the vendor. In these transactions, the Company does not take title to the product, have
responsibility for the delivery of any services, or have risk of loss for collection. These commissions are recorded as revenue when earned.



Deferred Costs



The Company records as deferred costs any incremental direct costs associated with revenue that has been deferred in accordance with the Companys revenue recognition policy. Deferred costs principally consist of
product costs, and are classified in other assets in the accompanying balance sheets. These costs are subsequently recognized in earnings in the same proportion as the related revenue recognized.



Allowance for Doubtful Accounts



The Company uses estimates to determine the amount of the allowance for doubtful accounts
necessary to reduce accounts receivable to its expected net realizable value. The Company estimates the amount of the required allowance by reviewing the status of past-due receivables and analyzing historical bad debt trends. Actual collection
experience has not varied significantly from estimates, due primarily to credit policies, collection experience, and a lack of concentration of accounts receivable. The Company charges-off receivables deemed to be uncollectible to the allowance for
doubtful accounts. Accounts receivable balances are not collateralized.



Cost of Product Sales



Cost of product sales includes the
costs of purchasing software and hardware from suppliers and the associated shipping and handling costs.



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##### Table of Contents

Cost of Service Revenue



Cost of service revenue consists primarily of direct employee compensation and related benefits, the cost of subcontracted services and direct expenses billable to
customers. Cost of service revenue does not include an allocation of overhead costs.



Warranty Costs



The Company does not
provide for warranty costs for its products as such costs are incurred by the manufacturer of the products.



Advertising Costs



Costs incurred for
producing and communicating advertisements are expensed as incurred and included in selling, general and administrative expenses in the accompanying statements of operations. Advertising expenses approximated $549,000, $780,000 and $813,000 for
years ended June 30, 2002, 2003 and 2004, respectively.



Business Segment
Reporting



The Companys operating segments are established based on
geographical areas managed by location managers and for which discrete financial information is prepared and reviewed by the Companys chief operating decision maker. These segments are aggregated for segment reporting purposes into one
reporting segment because the operating segments have similar economic characteristics and generate revenues from sales of similar products and services to similar types of customers.



Income Taxes



The Company uses the liability method to account for income taxes. Income tax expense includes income taxes currently payable and deferred taxes arising from temporary
differences between financial reporting and income tax bases of assets and liabilities. Deferred income taxes are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.



Stock Split



The Companys board of directors authorized a three-for-one stock split in the form of a stock dividend to be distributed to
stockholders of record on September 15, 2003. All share and per share data included in the consolidated financial statements have been restated to reflect the split.



2. Supplemental Disclosure of Cash Flow Information



The Company paid interest of approximately $416,000, $282,000 and $235,000 in 2002, 2003 and 2004, respectively.



The following significant non-cash investing and financing activities occurred in 2003 and
2004:



In 2003, the Company entered into a business combination with
PlanetCAD, Inc., whereby assets totaling $2.9 million were acquired and liabilities totaling $0.95 million were assumed in exchange for common stock. Also in 2003, holders of $1.5 million of subordinated debt converted the debt into preferred stock
in one of the Companys wholly-owned subsidiaries.



In 2004, the Company
issued Series D Preferred Stock valued at $98,000 to reduce the balance of a related party note payable.



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##### Table of Contents

3. Merger with PlanetCAD Inc.



On November 19, 2002, the Company consummated a merger with PlanetCAD Inc., whereby shareholders of the Company exchanged their shares of
the Companys common stock for common stock of PlanetCAD. Upon completion of the merger, the shareholders of the Company owned 75% of the outstanding common stock of PlanetCAD. PlanetCAD develops, markets, and supports cycle time reduction
software solutions that integrate engineering processes and data for the manufacturing supply chain. In connection with the merger, options and warrants to purchase the common stock of the Company were converted into options and warrants to acquire
common stock of the post-merger entity based on the merger exchange ratio.



For
accounting purposes, the Company was deemed to have acquired PlanetCAD, as its shareholders own a majority of the outstanding common stock of the surviving entity. Upon the completion of the merger, the Company had 8,897,874 shares of outstanding
common stock, 6,662,010 of which were issued to shareholders of Avatech upon the closing date. The results of operations of PlanetCAD are included in the accompanying 2003 statement of operations since November 1, 2002, or the effective date of the
merger. The purchase method of accounting was used to record the acquisition, and the cost of acquiring PlanetCAD of $2.2 million, including estimated acquisition costs of $1.0 million, was assigned to acquired assets and liabilities based on their
estimated fair value, as determined by an independent appraisal.



The purchase
price allocation to acquired assets and liabilities at the acquisition date is summarized below:



|                                                                                                       |  |   |          
|------------------------------------------------------------------------------------------------------ |  | - | ---------
|Assets                                                                                                 |  |   |          
|Cash                                                                                                   |  | $ | 995,000  
|Accounts receivable                                                                                    |  |   | 120,000  
|Investments                                                                                            |  |   | 625,000  
|Prepaid expenses and other current assets                                                              |  |   | 611,000  
|Property and equipment                                                                                 |  |   | 337,000  
|Acquired technology and other amortizable intangible assets                                            |  |   | 216,000  
|                                                                                                       |  |   |          
|Total assets                                                                                           |  | $ | 2,904,000
|                                                                                                       |  |   |          
|Liabilities                                                                                            |  |   |          
|Accounts payable and accrued expenses                                                                  |  |   | 720,000  
|Deferred revenue                                                                                       |  |   | 229,000  
|                                                                                                       |  |   |          
|Total liabilities                                                                                      |  | $ | 949,000  
|                                                                                                       |  |   |          
|Cost of net assets acquired, excluding acquired in-process research and development assets of $282,000 |  | $ | 1,955,000
|                                                                                                       |  |   |          



The value allocated to projects
identified as in-process research and development of PlanetCAD products was charged to expense immediately following the completion of the merger and is included in the loss from operations of discontinued operating segments in the accompanying 2003
statement of operations. This write-off was necessary because the acquired in-process research and development had not yet reached technological feasibility and has no future alternative uses, and the related products under development may not
achieve commercial viability. The value of acquired technology was determined by taking into account risks related to the characteristics and applications of the developed technology, existing and future markets and assessments of the stage of the
developed technologys life cycle. This analysis resulted in a valuation for developed technology that had reached technological feasibility and therefore was capitalized. The developed technology and other intangible assets were amortized on a
straight-line basis over 4 to 6 years.



In May 2003, the Company sold the
software acquired from PlanetCAD and discontinued the acquired PlanetCAD operations. Accordingly, pro forma operating data of PlanetCAD is not relevant to an understanding of the potential future effects of these operations on consolidated results
of operations, and therefore is not presented. See Note 4 for additional information.



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##### Table of Contents

4. Discontinued Operations of PlanetCAD and Certain Operating Segments



In June 2003, due to poor operating results, the Company closed three offices in New York,
Michigan and Ohio. These locations were authorized software dealers subject to the Companys channel partner agreement with its principal supplier. By virtue of these closings, the Company is no longer authorized to market or distribute
software products subject to the channel partner agreements in those states. In connection with the closure of these locations, the Company recognized a loss on disposal of approximately $179,000 in June 2003.



The Company closed another office located in California in August 2003, which was also an
authorized software dealer for which the Company is no longer authorized to market or distribute software products subject to the channel partner agreement with its principal supplier. In connection with the closing of the California office, the
Company did not incur a gain or loss.



In addition, the Company in May 2003
decided to discontinue the PlanetCAD business it acquired in November 2002. These operations were conducted from the Companys Boulder, Colorado office, which was closed in June 2003. The software product technology developed by PlanetCAD was
sold in May 2003 to an unrelated third party in the United Kingdom for $1,200,000. The purchase price is payable in cash by the purchaser as follows (i) $40,000 at closing, (ii) $200,000 in five monthly installments of $40,000 from July 2003 through
November 2003, (iii) 50% of monthly revenues generated by the purchaser from the acquired assets from December 2003 through May 2005, not to exceed $960,000, and (iv) any unpaid balance in June 2005. As of June 30, 2003 and 2004, the Company had
received minimal cash from the sale of the PlanetCAD software products, and significant uncertainties exist surrounding the ability of the purchaser to ultimately make the required payments. Accordingly, the consideration from the sale of the
PlanetCAD assets is being recorded as it is received. The Company recorded a loss on disposal of approximately $175,000 in June 2003. During 2004, the Company received approximately $13,000 from the buyer and believes that collection of any
significant remaining amounts is remote.



These discontinued operations
were components of the Company as their operations and cash flows were clearly distinguished, operationally and for financial reporting purposes, from the rest of the Company. The operations and cash flows of the components have been eliminated from
the ongoing operations of the Company, and the Company will not have any significant continuing involvement in the operations of the components. Accordingly, the historical results of operations of these components are presented in the accompanying
consolidated statements of operations as a separate component of operations classified as discontinued operations.



Summarized operating results of the discontinued operations are as follows:



|                            |  |                    |           |      |   |            |      |  |   |          |  
|--------------------------- |  | ------------------ | --------- | ---- | - | ---------- | ---- |  | - | -------- | -
|                            |  | Year ended June 30 |          
|                            |  | 2002               |           | 2003 |   |            | 2004 | 
|Revenue:                    |  |                    |           |      |   |            |      |  |   |          |  
|Reseller locations          |  | $                  | 3,172,111 |      | $ | 1,585,320  |      |  | $ | 42,532   |  
|PlanetCAD operations        |  |                    |          |      |   | 659,153    |      |  |   | 30,474   |  
|                            |  |                    |           |      |   |            |      |  |   |          |  
|Total revenue               |  | $                  | 3,172,111 |      | $ | 2,244,473  |      |  | $ | 73,006   |  
|                            |  |                    |           |      |   |            |      |  |   |          |  
|Pre-tax income (loss):      |  |                    |           |      |   |            |      |  |   |          |  
|Reseller locations          |  | $                  | 198,087   |      | $ | 61,770     |      |  | $ | (89,666  | )
|PlanetCAD locations         |  |                    |          |      |   | (1,564,308 | )    |  |   | (154,015 | )
|                            |  |                    |           |      |   |            |      |  |   |          |  
|Total pre-tax income (loss) |  | $                  | 198,087   |      | $ | (1,502,538 | )    |  | $ | (243,681 | )
|                            |  |                    |           |      |   |            |      |  |   |          |  



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##### Table of Contents

5. Borrowings Under Line-of-Credit



On September 11, 2003, the Company entered into a loan and security agreement with a bank, which replaced the revolving credit facility with
another lending institution. In conjunction with the loan and security agreement, the Company issued 45,000 warrants to purchase common shares at $0.01 per share. The new loan agreement provides for a $2.5 million revolving line of credit that is
payable within 60 days of demand by the lender. However, the loan balance is limited to $2.0 million because of covenant restrictions contained in a loan agreement with a software vendor (described in Note 6). The credit extended under this new
arrangement is limited to the lesser of $2.5 million or 75% of the Companys aggregate outstanding eligible accounts receivable and expires in September 2006. Borrowings under this line-of-credit bear interest at the greater of 7.5%, or the
prime rate plus 2.0% (7.5% at June 30, 2004) and are secured by the assets of the Company. In addition, the bank has the right to restrict any prepayment of other indebtedness by the Company.



In August 2004, the bank amended the loan and security agreement to limit the credit extended
to the lesser of $3.0 million or 85% of the Companys aggregate outstanding eligible accounts receivable. In addition, restrictions on the loan balance were temporarily amended by the aforementioned lender and software vendor to allow for a
$2.5 million outstanding balance. The restriction will revert back to the original $2.0 million limit in November 2004.



The balance outstanding under this line-of-credit was $1,640,180, at June 30, 2004. Because the interest rate adjusts with changes in the prime rate, the estimated fair
value of the borrowings under the line of credit is equal to the carrying amount.



6. Long-Term Debt and Gain on the Extinguishment of Debt



Loans From Software Vendor



On July 22, 2003, the Company
entered into a marketing and channel distribution agreement with a software vendor. Under this agreement, Avatech will provide marketing, distribution and related services for the vendors products. In connection with this agreement, the
software vendor has agreed to fund certain marketing costs incurred by the Company. Additionally, the arrangement provides for a loan by the software vendor to fund working capital needs related to the distribution of these products.



The terms of the loan agreement provide for a loan of $1,500,000 funded in two payments.
Initial funding of $1,000,000 occurred on July 25, 2003 and the remaining $500,000 was provided on February 5, 2004. The loan agreement provides for repayment of principal plus interest at 6% per annum in thirty-five equal quarterly installments
commencing in January 2005. The Company is required to meet certain financial and non-financial covenants in connection with this agreement.



Subordinated Notes Payable



At June 30, 2003, the Company had outstanding notes payable of $250,000 due on January 1, 2004 and subordinated to other borrowings. The notes accrued interest at rates
ranging from 10% to 12% per annum, payable quarterly. On January 1, 2004, the Company retired or refinanced the subordinated notes payable. The Company paid $51,000 in cash to retire certain notes and issued new subordinated notes totaling $199,000
bearing interest at rates ranging from 10% to 12% per annum. The new notes mature on July 1, 2005, except for payments totaling $26,000 due on July 1, 2004. In conjunction with this refinancing, the Company issued 45,000 warrants to purchase common
stock for $0.21 per share. These warrants expire on July 1, 2005 and were valued at $7,275 using the Black-Scholes option pricing model.



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##### Table of Contents

6. Long-Term Debt and Gain on the Extinguishment of Debt (continued)



Note Payable To Related Party



On May 28, 2003, the Company issued a $1.0 million senior subordinated note to a director
and shareholder. The note was issued in consideration for cash of $500,000 and satisfaction of a $500,000 note originally issued in August 2002. The note accrued interest at 12% per annum, with quarterly interest payments due commencing September 1,
2003, and matured on July 1, 2004. In connection with the issuance of the notes, the director and shareholder received warrants to purchase 97,200 shares of common stock for $0.27 per share that expire on June 1, 2008. These warrants were valued at
$36,288 using the Black-Scholes option pricing model, and resulted in debt discount of $36,288 being recorded and amortized over the term of the note as additional interest expense. At June 30, 2003 the balance outstanding under the note was
$966,503.



On April 1, 2004, the Company satisfied the note by issuing a new
note to the director and shareholder with a face value of $902,000 that matures on July 1, 2005. The new note bears interest at 12% per annum, with interest payments due each quarter commencing July 1, 2004. In connection with the issuance of the
new note, the director and shareholder was issued warrants to purchase 51,838 shares of common stock for $0.45 per share expiring on April 1, 2009. These warrants were valued at $24,000 using the Black-Scholes option pricing model, and resulted in
debt discount of $24,000 that is being amortized over the term of the note as additional interest expense. The balance of the note payable was $878,725 at June 30, 2004.



Debt Maturities



The fair value of long-term debt at June 30, 2003 and 2004 approximates its carrying value based on assessment of market interest rates for similar instruments at those
dates. The following summarizes the maturities of long-term debt as of June 30, 2004:



|                     |  |   |          
|-------------------- |  | - | ---------
|Year ending June 30: |  |   |          
|2005                 |  | $ | 92,544   
|2006                 |  |   | 1,189,887
|2007                 |  |   | 147,169  
|2008                 |  |   | 156,200  
|2009                 |  |   | 165,266  
|2010 and thereafter  |  |   | 826,409  
|                     |  |   |          
|                     |  | $ | 2,577,475
|                     |  |   |          



Gain on Extinguishment of Debt



At June 30, 2002, the Company was obligated to one of its suppliers under
a note agreement in the amount of $2.96 million, bearing interest at 6.5% per annum. In August 2002, the Company entered into an agreement to extinguish the outstanding $2.96 million debt for a cash payment of $1.0 million and compliance with
certain non-financial covenants. The gain on the extinguishment of the debt of $1.96 million was recorded in August 2002.



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##### Table of Contents

7. Preferred Stock



At June 30, 2003, the Company had issued and outstanding 172,008 shares of Series C Convertible Preferred Stock (Series C). On December 31, 2003, the Series C
was converted into 484,487 shares of newly authorized Series D Convertible Preferred Stock (Series D).



The Company in 2004 issued 813,050 shares of Series D for cash proceeds totaling $330,000 and a reduction in notes payable to a related party of $98,000. In connection
with the issuance of Series D, 1,730,043 warrants were granted to preferred shareholders. The warrants entitle the holder to purchase common stock at an exercise price of $0.45 per share up to one year after the date of grant.



The Series D shares outstanding at June 30, 2004 totaled 1,297,537, and were issued with the
following terms:



Redemption Feature



The preferred stock is redeemable in the event that the Company is engaged in a business
combination that is approved by the Board of Directors and subsequently submitted and approved by a vote of the Companys shareholders. Any director who holds shares of Series D is not eligible to vote on the proposed business combination. The
redemption price is $0.60 per share plus an amount equal to all declared and unpaid dividends accrued on such shares since the original issue date.



Voting Rights



Each holder of the preferred stock shall vote together with all other classes and series of stock of the Company as a single class on all actions. Each share shall entitle the holder to one vote per share of common
stock into which the preferred stock is then convertible on each such action.



Dividend Rate



The holders of the Series D are entitled to
receive cumulative dividends at a rate of 10.0% per annum when and as declared by the Board of Directors. Dividends are paid quarterly to preferred shareholders.



Conversion Feature



The preferred stock is convertible at any time beginning 120 days after the original issuance date at the option of the holder and automatically converts into common
stock if the common stock trades for more than $2.25 per share for 60 consecutive trading days.



Each share of preferred stock is convertible into shares of common stock by multiplying the appropriate conversion rate in effect by the number of shares of preferred stock being converted. Currently, the conversion
rate is two shares of common stock for each share of Series D; however, this rate may be adjusted due to stock splits, dividends, and other events defined in the stock purchase agreement.



Liquidation Preference



In the event of a liquidation, dissolution or winding up of the Company, the holders of Series D are entitled to receive for each share, prior and in preference to any
distribution of any of the assets or surplus funds to the holders of common stock, an amount equal to $0.60 per share plus all accumulated but unpaid dividends. If upon the occurrence of such event, the assets and funds thus distributed among the
holders are insufficient to permit the payment of the preferential amount, then the entire assets and funds of the Company legally available for distribution shall be distributed ratably among the preferred stockholders.



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##### Table of Contents

8. Minority Interest



The Company has issued convertible preferred stock through one of its subsidiaries. The preferred stock accrues dividends at a rate of 10% per annum. Dividends may be
paid each quarter from available cash of the subsidiary. The dividends on the subsidiarys preferred stock are recorded as minority interest expense in the consolidated statements of operations. All accrued but unpaid dividends must be paid in
cash at or before a liquidation event as defined in the preferred stock agreement. Each share of preferred stock will automatically convert into 3.3 shares of common stock of the parent upon the earlier of (i) 24 months from the issuance of the
preferred stock (November 19, 2004) or (ii) immediately preceding a liquidation event. On all matters submitted to the stockholders of the Company, the holders of the shares of Preferred Stock vote together as a single class on a one share, one vote
basis. The preferred stock is presented as minority interest in the accompanying balance sheets at June 30, 2004 and 2003.



9. Loss Per Share



Basic loss per common share is computed as net loss available to common stockholders divided by the weighted-average number of common shares outstanding for the period. Diluted earnings per common share include the
potential dilution that would occur from common shares issuable upon the exercise of outstanding stock options and warrants and the conversion of preferred stocks. Basic and diluted loss per common share are equal for all years presented because the
assumed exercise of options and warrants and the conversion of preferred stocks is antidilutive. As of June 30, 2004, 8,289,209 shares of common stock were issuable upon the conversion or exercise of options, warrants and preferred stocks.



The following summarizes the computations of basic and diluted loss per common
share:



|                                                                              |  |                    |           |   |      |   |            |      |  |   |           |  
|----------------------------------------------------------------------------- |  | ------------------ | --------- | - | ---- | - | ---------- | ---- |  | - | --------- | -
|                                                                              |  | Year ended June 30 |          
|                                                                              |  | 2002               |           |   | 2003 |   |            | 2004 | 
|Numerator:                                                                    |  |                    |           |   |      |   |            |      |  |   |           |  
|Loss from continuing operations                                               |  | $                  | (445,582  | ) |      | $ | (1,471,768 | )    |  | $ | (683,084  | )
|Less: preferred stock dividends                                               |  |                    |          |   |      |   |           |      |  |   | (56,305   | )
|                                                                              |  |                    |           |   |      |   |            |      |  |   |           |  
|Loss from continuing operations available to common shareholders              |  |                    | (445,582  | ) |      |   | (1,471,768 | )    |  |   | (739,389  | )
|Income (loss) from discontinued operations, net of income taxes               |  |                    | 198,087   |   |      |   | (1,856,538 | )    |  |   | (243,681  | )
|Cumulative effect of change in accounting for goodwill                        |  |                    |          |   |      |   | (520,000   | )    |  |   |          |  
|                                                                              |  |                    |           |   |      |   |            |      |  |   |           |  
|Net loss available to common shareholders                                     |  | $                  | (247,495  | ) |      | $ | (3,848,306 | )    |  | $ | (983,070  | )
|                                                                              |  |                    |           |   |      |   |            |      |  |   |           |  
|Denominator:                                                                  |  |                    |           |   |      |   |            |      |  |   |           |  
|Weighted average shares outstanding                                           |  |                    | 6,674,979 |   |      |   | 8,028,030  |      |  |   | 9,341,785 |  
|                                                                              |  |                    |           |   |      |   |            |      |  |   |           |  
|Loss per common share:                                                        |  |                    |           |   |      |   |            |      |  |   |           |  
|Loss from continuing operations                                               |  | $                  | (0.07     | ) |      | $ | (0.18      | )    |  | $ | (0.08     | )
|Income (loss) from operations of discontinued operations, net of income taxes |  |                    | 0.03      |   |      |   | (0.24      | )    |  |   | (0.03     | )
|Cumulative effect of change in accounting principle                           |  |                    |          |   |      |   | (0.06      | )    |  |   |          |  
|                                                                              |  |                    |           |   |      |   |            |      |  |   |           |  
|Loss per common share, basic and diluted                                      |  | $                  | (0.04     | ) |      | $ | (0.48      | )    |  | $ | (0.11     | )
|                                                                              |  |                    |           |   |      |   |            |      |  |   |           |  



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##### Table of Contents

10. Stock Purchase Warrants



As of June 30, 2004, the Company has outstanding warrants to purchase common stock. A summary of these warrants is as follows:



|                 |  |                |       |                 |              
|---------------- |  | -------------- | ----- | --------------- | -------------
|Number of Shares |  | Exercise Price |       | Expiration Date
|45,000           |  | $              | 0.01  |                 | August 2013  
|45,000           |  | $              | 0.21  |                 | July 2005    
|97,200           |  | $              | 0.27  |                 | June 2008    
|1,007,823        |  | $              | 0.45  |                 | December 2004
|722,220          |  | $              | 0.45  |                 | November 2004
|51,838           |  | $              | 0.45  |                 | April 2009   
|180,000          |  | $              | 43.33 |                 | February 2005
|                 |  |                |       |                 |              
|2,149,081        |  |                |       |                 |              
|                 |  |                |       |                 |              



11. Employee Stock Compensation
Plans



Employee Stock Option Plans



The Board of Directors may grant options under four stock option plans to purchase shares of
the Companys common stock at a price not less than the fair market value of the common stock at the grant date. The Avatech Solutions, Inc. 2000 Stock Option Plan and the Avatech Solutions, Inc. 2002 Stock Option Plan are the only plans with
significant stock option awards available for grant. All plans provide for the granting of either qualified or non-qualified stock options to purchase an aggregate of up to 4,955,000 shares of common stock to eligible employees, officers, and
directors of the Company.



A summary of stock option activity and related
information is included in the table below:



|                                                                   |  |                    |   |      |                              |           |         |          |   |                              |   |           |  |           |                              |  |   |          
|------------------------------------------------------------------ |  | ------------------ | - | ---- | ---------------------------- | --------- | ------- | -------- | - | ---------------------------- | - | --------- |  | --------- | ---------------------------- |  | - | ---------
|                                                                   |  | Year ended June 30
|                                                                   |  | 2002               |   | 2003 |                              | 2004     
|                                                                   |  | Options            |   |      | WeightedAverageExercisePrice |           | Options |          |   | WeightedAverageExercisePrice |   | Options   |  |           | WeightedAverageExercisePrice
|Outstanding at beginning of year                                   |  | 445,491            |   |      | $                            | 3.81      |         | 775,950  |   |                              | $ | 3.81      |  | 554,386   |                              |  | $ | 1.88     
|Granted                                                            |  | 472,092            |   |      |                              | 3.81      |         | 482,442  |   |                              |   | 2.78      |  | 1,230,866 |                              |  |   | 0.70     
|Exercised                                                          |  |                   |   |      |                              |          |         |         |   |                              |   |          |  |          |                              |  |   |         
|Forfeited                                                          |  | (141,633           | ) |      |                              | 3.81      |         | (224,431 | ) |                              |   | 6.40      |  | (255,359  | )                            |  |   | 3.41     
|Cancelled                                                          |  |                   |   |      |                              |          |         | (479,575 | ) |                              |   | 3.79      |  |          |                              |  |   |         
|                                                                   |  |                    |   |      |                              |           |         |          |   |                              |   |           |  |           |                              |  |   |          
|Outstanding at end of year                                         |  | 775,950            |   |      | $                            | 3.81      |         | 554,386  |   |                              | $ | 1.88      |  | 1,529,893 |                              |  | $ | 0.67     
|                                                                   |  |                    |   |      |                              |           |         |          |   |                              |   |           |  |           |                              |  |   |          
|Exercisable at end of year                                         |  | 422,283            |   |      | $                            | 3.81      |         | 281,713  |   |                              | $ | 3.28      |  | 535,041   |                              |  | $ | 1.05     
|                                                                   |  |                    |   |      |                              |           |         |          |   |                              |   |           |  |           |                              |  |   |          
|Weighted-average remaining contractual life of outstanding options |  |                    |   |      |                              | 8.7 Years |         |          |   |                              |   | 7.4 Years |  |           |                              |  |   | 8.7 Years
|                                                                   |  |                    |   |      |                              |           |         |          |   |                              |   |           |  |           |                              |  |   |          



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##### Table of Contents

11. Employee Stock Compensation Plans (continued)



Employee Stock Option Plans (continued)



All options granted have an exercise price equal to the fair value of the Companys common stock on the date of grant. Exercise prices for options outstanding as of
June 30, 2004 ranged from $0.17 to $63.33 as follows:



|                         |  |                    |  |                                                       |       |                                                                |           |                    |         |                                                      |   |      
|------------------------ |  | ------------------ |  | ----------------------------------------------------- | ----- | -------------------------------------------------------------- | --------- | ------------------ | ------- | ---------------------------------------------------- | - | -----
|Range of Exercise Prices |  | OptionsOutstanding |  | Weighted AverageExercise Prices ofOptions Outstanding |       | Weighted AverageRemainingContractual Life ofOptionsOutstanding |           | OptionsExercisable |         | WeightedAverage ExercisePrices of OptionsExercisable
|$0.17 - 0.42             |  | 1,048,811          |  | $                                                     | 0.26  |                                                                | 8.4 years |                    | 412,637 |                                                      | $ | 0.26 
|0.75 -1.17               |  | 455,150            |  |                                                       | 0.84  |                                                                | 9.7 years |                    | 97,221  |                                                      |   | 0.87 
|3.81 -7.07               |  | 21,432             |  |                                                       | 3.93  |                                                                | 6.3 years |                    | 20,683  |                                                      |   | 3.92 
|63.33                    |  | 4,500              |  |                                                       | 63.33 |                                                                | 5.7 years |                    | 4,500   |                                                      |   | 63.33
|                         |  |                    |  |                                                       |       |                                                                |           |                    |         |                                                      |   |      
|                         |  | 1,529,893          |  |                                                       |       |                                                                |           |                    | 535,041 |                                                      |   |      
|                         |  |                    |  |                                                       |       |                                                                |           |                    |         |                                                      |   |      



Stock Option Cancellation Program



In April 2003, the Company offered its employees a voluntary option to
surrender and cancel certain outstanding stock option agreements. Under the terms of the arrangement, the employee, if still employed, received an equivalent number of stock options six months and a day after the specific cancellation periods. In
conjunction with this arrangement, the Company granted stock options for the purchase of 274,486 shares of common stock in November 2003, with exercise prices equal to the fair value of the Companys common stock that vest over various periods
of up to 24 months.



Employee Stock Purchase Plan



In June 1996, the Board of Directors adopted, and its stockholders
subsequently approved, the Employee Stock Purchase Plan (the Plan), under which 100,000 shares of common stock were initially reserved for issuance. As a result of amendments to the Plan in 1998, 1999, 2003 and 2004, there were 1,000,000
shares of common stock authorized for issuance, of which 734,068 are available for future issuance at June 30, 2004.



The Plan is administered by the Compensation Committee of the Board of Directors. Generally, each offering is of six months duration, but can extend as long as
twenty-seven months. Eligible employees may purchase up to 15% of their compensation in common stock at a price equal to 85% of the lower of the fair value of the common stock at the beginning or end of the offering period.



In fiscal year 2004, the Board of Directors authorized two six-month offerings to all
eligible employees, with the first offering concluding on June 30, 2004. The Board of Directors instituted a 10,000 share limit per employee for the first offering period. As of June 30, 2004, the balance withheld from employees pay totaled
$29,000. In July 2004, 147,729 shares of common stock were issued to employees under the Plan.



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##### Table of Contents

11. Employee Stock Compensation Plans (continued)



Restricted Stock Award Plan



In May 2003, the Companys Board of Directors approved the Avatech Solutions, Inc.
Restricted Stock Award Plan. Employees and consultants of the Company are eligible to receive stock awards under this plan if they are already shareholders or hold options to purchase shares of common stock. Additionally, officers or directors of
the Company are eligible to receive restricted stock awards regardless of any pre-existing ownership of common stock or stock options. Vesting for restricted stock awards granted under this plan may vary, but awards will generally vest based on
continued service of the recipient or achievement of specific performance goals. The Company has reserved 600,000 shares of common stock for issuance under the Restricted Stock Award Plan.



In July 2003, the Company awarded 570,000 shares of restricted stock to several of its
officers and one director. 270,000 shares vested immediately, and 300,000 shares vested over one or two years. The quoted market price of the common stock was $0.17 per share, resulting in compensation expense over the vesting period of
approximately $93,000. Through June 30, 2004, 90,000 unvested shares were forfeited by several officers when they voluntarily terminated employment with the Company.



In February and April 2004, the Company awarded 41,915 shares of restricted stock to certain directors as compensation for service on the
Companys Board of Directors. These shares were issued at quoted market prices on the date of grant (weighted-average fair value of $0.40 per share). The aggregate market value of these awards totaled $16,800.



In October 2003, the Company awarded 40,590 shares of unrestricted common stock to certain
directors as compensation for service on the Companys Board of Directors. These shares were issued at $0.29 per share, the quoted market price on the date of grant.



12. Shares Reserved for Future Issuance



At June 30, 2004, the Company has reserved 12,526,470 shares of common stock for future issuance upon the exercise of any stock options granted under the Companys
stock option plans, exercise of outstanding stock purchase warrants, issuance of restricted stock awards, and the conversion of preferred stock.



13. Income Taxes



Income tax expense (benefit) includes current state income taxes of approximately $75,000, $35,000 and $30,000 for 2002, 2003, and 2004, respectively. In 2002 a federal deferred income tax benefit of approximately
$373,000 was recorded. This benefit resulted from a reduction in the valuation allowance for deferred tax assets due to expected taxable income resulting from a $1.96 million gain from the extinguishment of debt in the first quarter of 2003. In
2003, the Company incurred unexpected operating losses and increased the valuation allowance for the net deferred tax assets by $373,000 recorded in 2002.



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##### Table of Contents

13. Income Taxes (continued)



Significant components of the Companys deferred tax assets and liabilities are as follows:



|                                            |  |                    |            |   |      |   |            |  
|------------------------------------------- |  | ------------------ | ---------- | - | ---- | - | ---------- | -
|                                            |  | Year ended June 30 |           
|                                            |  | 2003               |            |   | 2004 |  
|Deferred tax assets:                        |  |                    |            |   |      |   |            |  
|Net operating loss carryforward             |  | $                  | 2,990,711  |   |      | $ | 3,178,143  |  
|Allowance for doubtful accounts             |  |                    | 25,184     |   |      |   | 40,000     |  
|Accrued vacation pay                        |  |                    | 3,738      |   |      |   |           |  
|Book over tax depreciation                  |  |                    | 52,758     |   |      |   | 54,856     |  
|                                            |  |                    |            |   |      |   |            |  
|Total deferred tax assets                   |  |                    | 3,072,391  |   |      |   | 3,272,999  |  
|                                            |  |                   
|Valuation allowance for deferred tax assets |  |                    | (3,072,391 | ) |      |   | (3,272,999 | )
|                                            |  |                    |            |   |      |   |            |  
|Net deferred tax assets                     |  | $                  |           |   |      | $ |           |  
|                                            |  |                    |            |   |      |   |            |  



The Company has recorded a valuation
allowance for its deferred tax assets due to the inability to conclude that it is more likely than not that these assets will be realized from future taxable income.



The Companys provision for income taxes resulted in effective tax rates attributable to loss from continuing operations before
cumulative effect of change in accounting principal that varied from the statutory federal income tax rate of 34%, as summarized in the table below.



|                                                                                |  |                    |          |   |      |   |          |      |  |   |          |  
|------------------------------------------------------------------------------- |  | ------------------ | -------- | - | ---- | - | -------- | ---- |  | - | -------- | -
|                                                                                |  | Year ended June 30 |         
|                                                                                |  | 2002               |          |   | 2003 |   |          | 2004 | 
|Expected federal income tax expense (benefit) from continuing operations at 34% |  | $                  | (252,699 | ) |      | $ | (361,657 | )    |  | $ | (222,083 | )
|Expenses not deductible for income tax purposes                                 |  |                    | 150,358  |   |      |   | 14,074   |      |  |   | 78,936   |  
|State income taxes, net of federal benefit                                      |  |                    | (24,601  | ) |      |   | 23,100   |      |  |   | (27,563  | )
|Change in valuation allowance for deferred tax assets                           |  |                    | (170,709 | ) |      |   | 732,555  |      |  |   | 200,608  |  
|                                                                                |  |                    |          |   |      |   |          |      |  |   |          |  
|Income tax expense (benefit)                                                    |  | $                  | (297,651 | ) |      | $ | 408,072  |      |  | $ | 29,898   |  
|                                                                                |  |                    |          |   |      |   |          |      |  |   |          |  



At June 30, 2004, the Company has net
operating loss carryforwards totaling approximately $8.4 million, which will begin to expire in 2012. Certain net operating loss carryforwards at June 30, 2004 are limited on their use under Internal Revenue Code Section 382.



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##### Table of Contents

14. Commitments and Contingencies



Operating Leases



The Company leases certain office space and equipment under noncancellable operating lease agreements that expire in various years through 2011, and generally do not
contain significant renewal options. The Company also leases one office location from an entity controlled by a stockholder under a noncancellable operating lease, which expires in December 2004. Future minimum payments under all noncancellable
operating leases with initial terms of one year or more consisted of the following at June 30, 2004:



|                             |  |               |        |       |   |           |  |   |          
|---------------------------- |  | ------------- | ------ | ----- | - | --------- |  | - | ---------
|                             |  | Related Party |        | Other |   | Total    
|Year ending June 30:         |  |               |        |       |   |           |  |   |          
|2005                         |  | $             | 47,490 |       | $ | 725,800   |  | $ | 773,290  
|2006                         |  |               |       |       |   | 732,155   |  |   | 732,155  
|2007                         |  |               |       |       |   | 682,306   |  |   | 682,306  
|2008                         |  |               |       |       |   | 567,726   |  |   | 567,726  
|2009                         |  |               |       |       |   | 380,023   |  |   | 380,023  
|2010 and thereafter          |  |               |       |       |   | 548,613   |  |   | 548,613  
|                             |  |               |        |       |   |           |  |   |          
|Total minimum lease payments |  | $             | 47,490 |       | $ | 3,636,623 |  | $ | 3,684,113
|                             |  |               |        |       |   |           |  |   |          



Rent expense consisted of the
following:



|             |  |                    |           |      |   |           |  |   |          
|------------ |  | ------------------ | --------- | ---- | - | --------- |  | - | ---------
|             |  | Year ended June 30
|             |  | 2002               |           | 2003 |   | 2004     
|Office space |  | $                  | 1,162,344 |      | $ | 1,085,858 |  | $ | 1,052,934
|Equipment    |  |                    | 40,361    |      |   | 14,695    |  |   | 37,269   
|             |  |                    |           |      |   |           |  |   |          
|             |  | $                  | 1,202,705 |      | $ | 1,100,553 |  | $ | 1,090,203
|             |  |                    |           |      |   |           |  |   |          



Rent expense for the years ended June
30, 2002, 2003 and 2004 included amounts paid to related parties of approximately $85,000, $90,000 and $87,000, respectively.



Agreements with Executives



The Company has entered into agreements certain executives and key management employees that provide for severance payments ranging from three to twelve months of salary
and immediate vesting of all stock options not previously vested upon termination of the employee or a change in control of the Company. At June 30, 2004, the total contingency payable in cash was approximately $796,000.



15. Employee Benefit and Incentive Compensation Plans



Effective January 1, 1998, the Company adopted the Avatech Solutions, Inc. 401(k) Retirement
Savings Plan and Trust (the Plan). The Plan is a defined contribution plan, which covers substantially all employees of the Company, or its wholly-owned subsidiaries, who have attained age 21 and have completed six months of service.
Participants may elect to contribute from 1% to 15% of eligible annual compensation to the Plan. Maximum salary deferrals are currently $10,000 per year. The Company will match 25% of the participant salary deferrals up to 6% of a participants
compensation for all participants employed on the last day of the Plan year. The Company may also make discretionary profit-sharing contributions to the Plan for all participants who are employed on the last day of the Plan year. The total amount
recorded by the Company as expense during the years ended June 30, 2002, 2003 and 2004 was approximately $62,000, $78,000 and $79,000, respectively.



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16. Significant Supplier



Approximately 92%, 88% and 94% of the Companys inventory purchases for the years ended June 30, 2002, 2003 and 2004, respectively, were from one vendor and
approximately 60% and 67% of accounts payable at June 30, 2003 and 2004, respectively, were due to this vendor. Approximately 90% of the Companys total product revenues are related to this suppliers products.



17. Liquidity and Capital Resources



The Company has incurred significant operating losses since its inception that have depleted
its capital resources. Operating results improved in 2004 as a result of increased revenues and reduced expenses. The Company expects operating results to improve further in 2005 as result of additional increases in revenue and further expense
reductions. For example, the Company anticipates increased revenues from its new product lifecycle management and facilities management product lines. Also, the Company in late 2004 revised its commission programs such that sales commissions as a
percentage of revenues are likely to decline, and hired additional professional staff to reduce third-party professional fees.



Based on an evaluation of likely cash to be generated from operations in the near term and available capital resources, management believes that it has sufficient sources
of working capital to fund its operations in the normal course of business through at least July 1, 2005.



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