** **

**U.S. SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 
| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                              | ** ** | ** ** |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|       |       |                                                                                                                                                                                                                                                                                |       |       |
| ** ** | ** ** | **For the Quarter ended September 30, 2005**                                                                                                                                                                                                                                   | ** ** | ** ** |
|       |       |                                                                                                                                                                                                                                                                                |       |       |
| ** ** | ** ** | **OR**                                                                                                                                                                                                                                                                              | ** ** | ** ** |
|       |       |                                                                                                                                                                                                                                                                                |       |       |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                             | ** ** | ** ** |
|       |       |                                                                                                                                                                                                                                                                                |       |       |
| ** ** | ** ** | **For the  transition period from                        to                   ** | ** ** | ** ** |
|       |       |                                                                                                                                                                                                                                                                                |       |       |
|       |       | **Commission file number 1-11568**                                                                                                                                                                                                                                                  |       |       |

 

**DYNTEK, INC.**

(Exact Name of Registrant as Specified in its Charter)

 
| **Delaware**                    | ** ** | **95-4228470**      |
|---------------------------------|------------|---------------------|
| (State or other jurisdiction of |       | (I.R.S Employer     |
| incorporation or organization)  |       | Identification No.) |

 

**19700 Fairchild Road, Suite 230**

**Irvine, CA 92612**

(Address of principal executive offices) (Zip code)

 

Registrant’s telephone number, including area code **(949) 271-6700**

 

Indicateby check whether the Registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months, (or for such shorter period that the Registrantwas required to file such reports), and (2) has been subject to suchfilings requirements for the past 90 days. Yes ý  No o

 

Indicateby check whether the Registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes o No ý

 

Indicateby check mark whether the Registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes oNo ý

 

As of November 10,2005, the number of shares outstanding of the registrant’s Common Stock, $.0001par value, was 81,164,636.

 

 

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**DYNTEK, INC. AND SUBSIDIARIESINDEX**

 
| **PART I  – FINANCIAL INFORMATION**                                                                                                                                   |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| ** **                                                                                                                                                                      |   |
| Item  1. Condensed Consolidated Financial Statements                                                                                                                            |   |
|                                                                                                                                                                            |   |
| Condensed  Consolidated Balance Sheets – as of September 30, 2005 (unaudited) and June 30,  2005                                                                 |   |
|                                                                                                                                                                            |   |
| Condensed  Consolidated Statements of Operations and Comprehensive Income (Loss)  (unaudited) - For the Three Months Ended September 30, 2005 and September 30,  2004 |   |
|                                                                                                                                                                            |   |
| Condensed  Consolidated Statements of Cash Flows (unaudited) - For the Three Months  Ended September 30, 2005 and September 30, 2004                                  |   |
|                                                                                                                                                                            |   |
| Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                                                               |   |
|                                                                                                                                                                            |   |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations                                                                            |   |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risk                                                                                                             |   |
| Item 4. Controls  and Procedures                                                                                                                                                |   |
|                                                                                                                                                                            |   |
| **PART II - OTHER  INFORMATION**                                                                                                                                           |   |
| ** **                                                                                                                                                                      |   |
| Item 6. Exhibits                                                                                                                                                                |   |
|                                                                                                                                                                            |   |
| **SIGNATURE**                                                                                                                                                                   |   |

 

2

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**1.****                                      PART 1– FINANCIAL INFORMATION**

 

**ITEM 1. CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**DYNTEK, INC. AND SUBSIDIARIES**

# **CONDENSED CONSOLIDATED BALANCESHEETS**

#  (in thousands, except share data)

 
| ** **                                                                                                                                                                                                | ** ** | **September  30, 2005** | ** ** | **June 30, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ASSETS                                                                                                                                                                                                    |       |                    |       |                   |       |
|                                                                                                                                                                                                      |       |                    |       |                   |       |
| CURRENT ASSETS:                                                                                                                                                                                           |       |                    |       |                   |       |
| Cash                                                                                                                                                                                                      |       | $                       | 1,180      |                   | $          | 963 |   |
| Cash - Restricted                                                                                                                                                                                         |       | 541                     |       | 334                    |       |
| Accounts receivable, net of allowance for doubtful  accounts of $467 and $618                                                                                                                             |       | 17,797                  |       | 17,894                 |       |
| Inventory                                                                                                                                                                                                 |       | 2,810                   |       | 1,666                  |       |
| Prepaid expenses and other current assets                                                                                                                                                                 |       | 177                     |       | 75                     |       |
| Other receivables                                                                                                                                                                                         |       | 191                     |       | 125                    |       |
| TOTAL CURRENT ASSETS                                                                                                                                                                                      |       | 22,696                  |       | 21,057                 |       |
|                                                                                                                                                                                                      |       |                    |       |                   |       |
| RESTRICTED CASH – over one year                                                                                                                                                                      |       | 722                     |       | 231                    |       |
|                                                                                                                                                                                                      |       |                    |       |                   |       |
| PROPERTY AND EQUIPMENT, net of accumulated  depreciation of $3,370 and $3,233                                                                                                                             |       | 897                     |       | 959                    |       |
|                                                                                                                                                                                                      |       |                    |       |                   |       |
| GOODWILL                                                                                                                                                                                                  |       | 18,579                  |       | 18,579                 |       |
|                                                                                                                                                                                                      |       |                    |       |                   |       |
| ACQUIRED CUSTOMER LISTS, net of accumulated  amortization of $10,202 and $9,609                                                                                                                           |       | 4,044                   |       | 4,637                  |       |
|                                                                                                                                                                                                      |       |                    |       |                   |       |
| DEFERRED FINANCING COSTS, net of accumulated  amortization of $606 and $476                                                                                                                               |       | 901                     |       | 1,002                  |       |
|                                                                                                                                                                                                      |       |                    |       |                   |       |
| DEPOSITS AND OTHER ASSETS                                                                                                                                                                                 |       | 856                     |       | 871                    |       |
|                                                                                                                                                                                                      |       | $                       | 48,695     |                   | $          | 47,336 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                 |       |                    |       |                   |       |
|                                                                                                                                                                                                      |       |                    |       |                   |       |
| CURRENT LIABILITIES:                                                                                                                                                                                      |       |                    |       |                   |       |
| Cash overdraft                                                                                                                                                                                            |       | $                       | 692        |                   | $          | 1,274 |   |
| Accounts payable                                                                                                                                                                                          |       | 11,297                  |       | 8,937                  |       |
| Line of credit                                                                                                                                                                                            |       | 8,249                   |       | 4,697                  |       |
| Acquisition indebtedness                                                                                                                                                                                  |       | 2,555                   |       | 3,676                  |       |
| Accrued expenses                                                                                                                                                                                          |       | 2,085                   |       | 2,564                  |       |
| Deferred revenue                                                                                                                                                                                          |       | 1,017                   |       | 996                    |       |
| Notes payable-accrued interest                                                                                                                                                                            |       | 315                     |       | 184                    |       |
| Notes payable-current portion                                                                                                                                                                             |       | 1,810                   |       | 3,621                  |       |
| Current liabilities of discontinued operations                                                                                                                                                            |       | 258                     |       | 329                    |       |
| TOTAL CURRENT LIABILITIES                                                                                                                                                                                 |       | 28,278                  |       | 26,278                 |       |
|                                                                                                                                                                                                      |       |                    |       |                   |       |
| DEFERRED REVENUE                                                                                                                                                                                          |       | 642                     |       | 588                    |       |
| ACQUISITION INDEBTEDNESS                                                                                                                                                                                  |       | —                  |       | 644                    |       |
| LONG TERM NOTES PAYABLE                                                                                                                                                                                   |       | 7,806                   |       | 6,371                  |       |
| TOTAL LIABILITIES                                                                                                                                                                                         |       | 36,726                  |       | 33,881                 |       |
|                                                                                                                                                                                                      |       |                    |       |                   |       |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                                             |       |                    |       |                   |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                                |       |                    |       |                   |       |
| Preferred stock, $.0001 par value, 10,000,000 shares  authorized; 0 and 583,124 shares issued and outstanding as of September 30,  2005 and June 30, 2005, respectively                         |       | —                  |       | 1                      |       |
| Class A Common stock, $.0001 par value,  150,000,000 shares authorized; 81,164,636 and 75,426,764 shares issued and  outstanding as of September 30, 2005 and June 30, 2005,  respectively |       | 5                       |       | 5                      |       |
| Additional paid-in capital                                                                                                                                                                                |       | 111,292                 |       | 109,551                |       |
| Common stock to be issued in connection with  acquisition (4,280,000 shares)                                                                                                                              |       | —                  |       | 1,544                  |       |
| Accumulated deficit                                                                                                                                                                                       |       | (99,328                 | )          | (97,646                | )          |
| TOTAL STOCKHOLDERS’ EQUITY                                                                                                                                                                           |       | 11,969                  |       | 13,455                 |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                           |       | $                       | 48,695     |                   | $          | 47,336 |   |

 

The accompanying notes are an integral part ofthese condensed consolidated financial statements.

 

3

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**DYNTEK, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)**

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

 
| ** **                                                               | ** ** | **Three months ended  September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                               | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| REVENUES                                                                 |       |                                       |       |   |   |
| Product  Revenues                                                        |       | $                                          | 16,155     |   | $ | 8,413 |   |
| Service  Revenues                                                        |       | 7,280                                      |       | 6,370 |   |
| TOTAL  REVENUES                                                          |       | 23,435                                     |       | 14,783 |   |
|                                                                     |       |                                       |       |   |   |
| COST OF REVENUES                                                         |       |                                       |       |   |   |
| Cost  of Products                                                        |       | 14,152                                     |       | 6,961 |   |
| Cost  of Services                                                        |       | 5,169                                      |       | 5,141 |   |
| TOTAL  COST OF REVENUES                                                  |       | 19,321                                     |       | 12,102 |   |
|                                                                     |       |                                       |       |   |   |
| GROSS PROFIT                                                             |       | 4,114                                      |       | 2,681 |   |
|                                                                     |       |                                       |       |   |   |
| OPERATING  EXPENSES:                                                     |       |                                       |       |   |   |
| Selling                                                                  |       | 3,176                                      |       | 1,825 |   |
| General  and administrative                                              |       | 1,434                                      |       | 1,370 |   |
| Depreciation  and amortization                                           |       | 730                                        |       | 760 |   |
| TOTAL  OPERATING EXPENSES                                                |       | 5,340                                      |       | 3,955 |   |
|                                                                     |       |                                       |       |   |   |
| LOSS FROM  OPERATIONS                                                    |       | (1,226                                     | )          | (1,274 | ) |
|                                                                     |       |                                       |       |   |   |
| OTHER INCOME  (EXPENSE)                                                  |       |                                       |       |   |   |
| Interest expense                                                         |       | (734                                       | )          | (273 | ) |
| Interest income                                                          |       | 9                                          |       | 9 |   |
| Gain on  marketable securities                                           |       | 54                                         |       | — |   |
| Other expense                                                            |       | (1                                         | )          | (50 | ) |
| TOTAL  OTHER EXPENSE                                                     |       | (672                                       | )          | (314 | ) |
| LOSS FROM  CONTINUING OPERATIONS BEFORE INCOME TAXES                     |       | (1,898                                     | )          | (1,588 | ) |
| INCOME TAX                                                               |       | —                                     |       | — |   |
| LOSS FROM  CONTINUING OPERATIONS                                         |       | (1,898                                     | )          | (1,588 | ) |
|                                                                     |       |                                       |       |   |   |
| DISCONTINUED  OPERATIONS                                                 |       |                                       |       |   |   |
| Gain  on disposal of discontinued operations                             |       | 216                                        |       | — |   |
| Gain  on discontinued operations                                         |       | —                                     |       | 1,635 |   |
| TOTAL GAIN FROM  DISCONTINUED OPERATIONS                                 |       | 216                                        |       | 1,635 |   |
|                                                                     |       |                                       |       |   |   |
| NET INCOME  (LOSS)                                                       |       | $                                          | (1,682     | ) | $ | 47 |   |
|                                                                     |       |                                       |       |   |   |
| NET INCOME  (LOSS) PER SHARE:                                            |       |                                       |       |   |   |
| Continuing  operations                                                   |       | $                                          | (0.02      | ) | $ | (0.03 | ) |
| Discontinued  operations                                                 |       | —                                     |       | .03 |   |
| NET LOSS PER  SHARE – basic and diluted                             |       | $                                          | (0.02      | ) | $ | — |   |
|                                                                     |       |                                       |       |   |   |
| WEIGHTED AVERAGE  NUMBER OF SHARES USED IN COMPUTATION-BASIC AND DILUTED |       | 78,482,667                                 |       | 58,430,597 |   |
|                                                                     |       |                                       |       |   |   |
| NET INCOME  (LOSS)                                                       |       | $                                          | (1,682     | ) | $ | 47 |   |
|                                                                     |       |                                       |       |   |   |
| OTHER  COMPREHENSIVE LOSS, NET OF TAX                                    |       |                                       |       |   |   |
| Unrealized  loss on available-for-sale securities                        |       | —                                     |       | (14 | ) |
|                                                                     |       |                                       |       |   |   |
| COMPREHENSIVE  INCOME (LOSS)                                             |       | $                                          | (1,682     | ) | $ | 33 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

4

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**DYNTEK, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

(Unaudited)(in thousands)

 
| ** **                                                                   | ** ** | **Three Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                       | ** ** | ** **                                 | ** ** | ** ** | ** ** |
| Net loss-Continuing operations                                               |       | $                                          | (1,898     | ) | $ | (1,588 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                                       |       |   |   |
| Depreciation and amortization                                                |       | 730                                        |       | 720 |   |
| Non-cash interest                                                            |       | 185                                        |       | 117 |   |
| Write-down of capitalized software costs                                     |       | —                                     |       | 41 |   |
| Stock-based compensation - employees                                         |       | 205                                        |       | — |   |
| Gain in marketable securities                                                |       | (54                                        | )          | — |   |
|                                                                         |       |                                       |       |   |   |
| Changes in operating assets and liabilities:                                 |       |                                       |       |   |   |
| Accounts receivable                                                          |       | 97                                         |       | 714 |   |
| Inventory                                                                    |       | (1,144                                     | )          | (223 | ) |
| Accrued interest on notes payable                                            |       | 138                                        |       | 27 |   |
| Prepaid expenses and other current assets                                    |       | (102                                       | )          | (70 | ) |
| Other receivables                                                            |       | (66                                        | )          | — |   |
| Deposits and other assets                                                    |       | 15                                         |       | 35 |   |
| Accounts payable                                                             |       | 2,360                                      |       | (1,044 | ) |
| Deferred revenue                                                             |       | 75                                         |       | (103 | ) |
| Accrued expenses                                                             |       | (479                                       | )          | (221 | ) |
| Restricted cash                                                              |       | (698                                       | )          | 112 |   |
| Total adjustments                                                            |       | 1,262                                      |       | 105 |   |
| NET CASH USED IN CONTINUING OPERATIONS                                       |       | (636                                       | )          | (1,483 | ) |
| NET CASH PROVIDED BY (USED IN) DISCONTINUED  OPERATIONS                      |       | 145                                        |       | (510 | ) |
| NET CASH USED IN  OPERATING ACTIVITIES                                       |       | (491                                       | )          | (1,993 | ) |
|                                                                         |       |                                       |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                       |       |                                       |       |   |   |
| Cash from disposition of marketable securities                               |       | 54                                         |       |   |   |
| Cash received from Redrock acquisition                                       |       | —                                     |       | 405 |   |
| Cash paid for acquisition earn-out                                           |       | (1,765                                     | )          | — |   |
| Capital expenditures                                                         |       | (75                                        | )          | (36 | ) |
| NET CASH PROVIDED BY INVESTING ACTIVITIES                                    |       | (1786                                      | )          | 369 |   |
|                                                                         |       |                                       |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                       |       |                                       |       |   |   |
| Cash overdraft                                                               |       | (582                                       | )          | — |   |
| Proceeds from debt financing, net of expenses                                |       | —                                     |       | (116 | ) |
| Deferred financing costs                                                     |       | (29                                        | )          | — |   |
| Net proceeds under line of credit                                            |       | 3,552                                      |       | 3 |   |
| Issuance of common stock, net of expenses                                    |       | (9                                         | )          | 3 |   |
| Principal payments                                                           |       | (438                                       | )          | — |   |
| NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES                          |       | 2,494                                      |       | (113 | ) |
| NET INCREASE  (DECREASE) IN CASH                                             |       | 217                                        |       | (1,737 | ) |
| CASH AT  BEGINNING OF PERIOD                                                 |       | 963                                        |       | 2,810 |   |
| CASH AT END OF  PERIOD                                                       |       | $                                          | 1,180      |   | $ | 1,073 |   |
|                                                                         |       |                                       |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                           |       |                                       |       |   |   |
|                                                                         |       |                                       |       |   |   |
| Cash paid for  interest                                                      |       | $                                          | 431        |   | $ | 208 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

5

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**DYNTEK, INC. & SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**September 30, 2005(UNAUDITED)**

 

**1.****              BASIS OFPRESENTATION**

 

The accompanying unaudited condensed consolidatedfinancial statements of DynTek, Inc. and its subsidiaries (“DynTek”, “Company”,or “we”) have been prepared in accordance with accounting principles generallyaccepted in the United States of America, for interim financial statements andpursuant to the instructions to Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, they do notinclude all of the information and disclosures required for annual financialstatements.  These condensed consolidatedfinancial statements should be read in conjunction with the consolidatedfinancial statements and related footnotes for the year ended June 30, 2005included in the Form 10-K for the year then ended.

 

The accompanying condensed consolidated financialstatements reflect all adjustments, which, in the opinion of management consistof normal recurring items that are necessary for a fair presentation inconformity with accounting principles generally accepted in the United Statesof America. Preparing condensed consolidated financial statements requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenues and expenses. The results of operations for any interim period are not necessarilyindicative of the results attainable for a full fiscal year.

 

**2.****              LIQUIDITY ANDFINANCIAL CONDITION**

 

The Companyincurred a net loss of $1,682,000 for the three months ended September 30,2005, which includes $1,120,000 of non-cash charges resulting from $730,000 ofdepreciation and amortization; $205,000 in non-cash option expense; and $185,000in non-cash interest charges.  At September 30,2005, the Company had a working capital deficiency of approximately $5,582,000.  

 

In August 2005,the Company terminated its credit facility agreement with an agency of TextronFinancial Corporation (“Textron”).  TheTextron facility provided a full notification factoring facility for up to$7,000,000 of working capital.  Eligibleaccounts receivable expected to be collected within 90 days were purchased withrecourse, with a holdback amount of 15%. Interest was charged on the outstanding balance at the prime rate plus2.0% (8.25% at June 30, 2005). Additionally, a 0.15% discount fee was charged at the time ofpurchase.  In August 2005, theCompany terminated this agreement, and paid the entire balance then outstandingof approximately $4,800,000.

 

On August 8,2005, the Company entered into a series of related agreements with New EnglandTechnology Finance, LLC (“NETF”), an affiliate of Global Technology Finance,which is a provider of structured financing solutions to technology companiesthat operates in partnership with Credit Suisse First Boston, CIT Group, Inc.and others, that together provided a new working capital credit facility.  

 

Thenew credit facility is comprised of two primary components:  (1) an Asset Purchase and LiabilityAssumption Agreement (the “APLA”), under which NETF agreed to finance certainof qualified product purchases under an arrangement that provides for us toassign accounts receivable (resulting from the sale of such products tocustomers) and for NETF to assume the liability for payment to product vendors;and  (2) an Asset Purchase Agreement(the “APA”), under which NETF purchased $7,500,000 of qualified accountsreceivables (services and products).  Theproceeds received under the APA were used to repay in full the $4,800,000balance on our credit line with Textron, for acquisition debt, and generalcorporate purposes.  In addition to theaccounts receivable purchased on August 8, 2005, NETF may purchase up to80% of additional qualified accounts receivable in the future on the sameterms. 

 

The Companybelieves that the NETF APLA facility will enable it to more effectively manageliquidity. The facility is structured to provide the flexibility of matchingthe timing of cash outflows for product purchases to cash amounts collectedfrom customers.  The financing fee underthe facility is calculated on a monthly basis depending on gross margin on suchproducts, and days sales outstanding, which fee the Company anticipates will beless than prior fees charged under its prior financing

 

6

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arrangement with Textron.The Company may also use the APA facility as a general financing arrangementfor certain product and services receivables. 

 

In October 2005,the Company raised gross proceeds of $2,500,000, upon its issuance of notes to certainInvestors (the “Bridge Notes”).  Theproceeds were used to pay acquisition debt and for working capitalpurposes.  The Bridge Notes currentlybear interest at 12%, and mature on December 31, 2006.  The Bridge Notes include a provision formandatory redemption upon the closing of the Company’s announced rights offeringfor $15,000,000.

 

Asdescribed in Note 4, the Company paid $3,000,000 to the sellers of Redrock CommunicationSolutions (“Redrock”) as partial consideration for the acquisition of suchbusiness in October 2004, and paid $850,000 in contingent consideration inJuly 2005.  In October 2005,the Company paid an additional $650,000 in contingent consideration upon theresolution and settlement of a litigation matter brought against the formerRedrock shareholders/sellers by a former Redrock employee, as described in Note4, less fees and expenses of $26,000 incurred by the Company in connection withsuch litigation.

 

Asdescribed in Note 4, the Company paid $2,500,000 to the sellers of IntegrationTechnologies, Inc. (“ITI”) as partial consideration for the acquisition ofITI in October 2004. The Company accrued an additional $2,845,748 ofcontingent consideration, of which $270,993 was paid in August 2005.  In September 2005, the Company enteredinto promissory notes (the “ITI Notes”) with three former shareholders of ITI,including the Company’s current chief executive officer, Casper Zublin, Jr.,to defer an aggregate of $2,575,755 in payments due in connection with theacquisition of ITI.  Principal paymentsare due quarterly, with the balance due July 31, 2006.  In September 2005, the Company paid $643,683in principal pursuant to the ITI Notes. 

 

In October 2005,the Company amended its Restated Secured Convertible Term Note (the “LaurusNote”), and deferred principal payments under the Laurus Note from December 2005until March 2006 in return for a decrease in the exercise price of  warrants issued in connection with issuance ofthe Laurus Note from $.65 per share to $.25 per share.  This transaction deferred approximately$831,249 in aggregate payments otherwise due and payable through March 2006(Note 6).

 

In October 2005,the Company amended its 9% Subordinated Convertible Notes (the “9% Notes”) witha majority of the holders thereof, and deferred all payments of principal due underthe 9% Notes until January 2007.  Inexchange for deferral of principal payments under the 9% Notes, DynTek (i) reducedthe conversion price under the 9% Notes to $.22 per share, (ii) amendedwarrants to reduce the exercise price to $0.22 per share (the “Amended Warrants”)and (iii) increased the number of shares exercisable under the 9% Notes byan aggregate of 5,251,101 shares. This transaction deferred approximately $1,893,629in aggregate principal payments otherwise due and payable through January 2007(Note 6).

 

In November 2005,the Company announced its intention to offer up to $15,000,000 of shares of theCompany’s common stock in connection with a rights offering (the “RightsOffering”) pursuant to which each stockholder of the Company will receive theright to purchase two (2) shares of the Company’s common stock at a priceof $.10 per share for each share of common stock owned by such stockholder onthe record date for the Rights Offering. The Company expects that a limited number of stockholders of the Companywill purchase all of the shares of common stock not purchased in the RightsOffering by other stockholders pursuant to a stand-by purchase agreement.  The purchase of shares by such stand-bypurchasers together with the shares purchased by other stockholders in theRights Offering would result in $15,000,000 of gross proceeds to theCompany.  The definitive agreements withrespect to the stand-by purchase agreement will not be entered into until theshares to be issued in the Rights Offering have been registered with theSecurities and Exchange Commission.

 

TheCompany’s new management team instituted certain measures during the quarterended September 30, 2005 to reduce the amount of cash that the Company hasbeen using in its operating activities. More specifically, the Company hasannounced a reduction in its overhead expenses by approximately $1,600,000 annuallyand has concentrated its revenue generating activities on providing high-end ITservices, which has traditionally been the core competency of the business. TheCompany believes that these measures, when taken together with the (a) $15,000,000of additional equity capital expected to be raised as part of the RightsOffering,  (b) $2,500,000 ofproceeds received upon the issuance of the Bridge Notes, (c) restructuring of payments due under the Laurus Note and 9% Notes and (d) deferralof payments due to the sellers of ITI, have substantially improved its liquidityand that these measures will likely enable management to sustain the business atleast through December 2007.

 

7

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The receiptof proceeds under the Rights Offering is subject to the Company’s filing of a registrationstatement for the sale of such securities and a declaration of effectiveness ofsuch registration statement by the Securities and Exchange Commission.  While the Company intends to file aregistration statement in the near future, there can be no assurance that suchstatement, if filed, will be declared effective or that the Company will beable to consummate the Rights Offering on the proposed terms, or at all.  Failure to complete the Rights Offering on theterms contemplated could have a material adverse effect on the Company’sfinancial condition and operations.  As aresult, there is substantial doubt about the Company’s ability to continue as agoing concern.  The financial statementsof the Company do not include any adjustments that might result from theoutcome of this uncertainty.

 

**3.  SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES****    **

 

A.           Principles ofConsolidation - The consolidated financial statements include the accounts ofthe Company and its wholly-owned subsidiaries. All significant inter-companytransactions have been eliminated.

 

B.             RevenueRecognition.  The Company applies therevenue recognition principles set forth under SOP 97-2 and SAB 104 withrespect to all revenue.  The Companyadheres strictly to the criteria set forth in paragraph .08 of SOP 97-2 andoutlined in SAB 104 which provides for revenue to be recognized when (i) persuasiveevidence of an arrangement exists, (ii) delivery has occurred, (iii) thevendor’s fee is fixed or determinable, and (iv) collectability is probable.

 

*ComputerHardware Product Revenues*

 

The Companyrequires its hardware product sales to be supported by a written contract orother evidence of a sale transaction that clearly indicates the selling priceto the customer, shipping terms, payment terms (generally 30 days) and refundpolicy, if any. Since the Company’s hardware sales are supported by a contractor other document that clearly indicates the terms of the transaction, and theselling price is fixed at the time the sale is consummated, the Company recordsrevenue on these sales at the time in which it receives a confirmation that thegoods were tendered at their destination when shipped “FOB destination,” orupon confirmation that shipment has occurred when shipped “FOB shipping point.”  

 

*Software Product Revenues*

 

The Company makessubstantially all of its software product sales as a reseller of licenses,which may include a post contract customer support arrangement and access toproduct and upgrades, and enhancements that are provided exclusively by themanufacturer following delivery and the customer’s acceptance of the softwareproduct. The Company does not presently sell any software that it developsinternally.  Any responsibility fortechnical support and access to upgrades and enhancements to these softwareproducts are solely the responsibility of the software manufacturer, whicharrangement is known to the customer at the time the sale is consummated.  With respect to delivery, the Company requiresthat the customer has received transfer of the software or, at a minimum, anauthorization code (“key”) to permit access to the product.  If a software license is delivered to thecustomer, but the license term has not begun, the Company does not record therevenue prior to inception of the license term. 

 

The Companyrequires its software product sales to be supported by a written contract orother evidence of a sale transaction, which generally consists of a customerpurchase order or on-line authorization. These forms of evidence clearly indicate the selling price to thecustomer, shipping terms, payment terms (generally 30 days) and refund policy,if any. The selling prices of these products are fixed at the time the sale isconsummated. 

 

For product sales,the Company applies the factors discussed in Emerging Issues Task Force Issue “EITF”99-19 in determining whether to recognize product revenues on a gross or netbasis.  In a substantial majority oftransactions, the Company (i) acts as principal; (ii) takes title tothe products; and (iii) has the risks and rewards of ownership, includingthe risk of loss for collection, delivery or returns.  For these transactions, the Companyrecognizes revenues based on the gross amounts billed to customers.  In certain circumstances, based on an analysisof the factors set forth in EITF 99-19, the Company has determined that it wasacting as an agent, and

 

8

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thereforerecognizes revenues on a net basis.  Forthe three months ended September 30, 2005, and the three months ended September 30,2004, no revenues were recognized on a net basis.

 

*IT Services Revenue*

 

The Companygenerally bills its customers for professional IT services based on hours oftime spent on any given assignment at its hourly billing rates. As it relatesto delivery of these services, the Company recognizes revenue under thesearrangements as the work is completed and the customer has indicated acceptanceof services by approving a work order milestone or completion order.   For certain engagements, the Company entersfixed bid contracts, and recognizes revenue as phases of the project arecompleted and accepted by the client. For its seat management services, the Company enters unit-price contracts(e.g., price per user for seat management), and recognizes revenue based onnumber of units multiplied by the agreed-upon contract unit price per month.

 

*BPO Services Revenue*

 

For businessprocess outsourcing (“BPO”) services, which primarily includes the Company’schild support service contracts in the states of Kansas and Nebraska, theCompany provides services under a fixed price (flat monthly fee) contract, andrecognizes revenue as the services are provided and billed.  In the state of North Carolina, the Companyhas one contract subject to revenue-sharing related to child supportservices.  Under that contract a fee fromamounts collected is shared by the Company with the county on a percentagebasis, and revenue is recognized monthly in arrears as a percentage of thetotal amount of collections received.

 

C.             Cashand Cash Equivalents – The Company considers all highly liquid temporary cashinvestments with an original maturity of three months or less when purchased,to be cash equivalents.

 

D.            Allowance forDoubtful Accounts - The Company has a policy of reserving for uncollectibleaccounts based on its best estimate of the amount of probable credit losses inits existing accounts receivable. The Company periodically reviews its accountsreceivable to determine whether an allowance is necessary based on an analysisof past due accounts and other factors that may indicate that the realizationof an account may be in doubt. Account balances deemed to be uncollectible arecharged to the allowance after all means of collection have been exhausted andthe potential for recovery is considered remote.

 

E.              Property andEquipment - Property and equipment is stated at cost and is depreciated on astraight-line basis over the estimated useful lives of the assets. Leaseholdimprovements are amortized over the term of their respective leases or servicelives of the improvements, whichever is shorter.

 

F.              Income (loss) perCommon Share – Basic earnings per share has been calculated based upon theweighted average number of common shares outstanding. Convertible preferredstock, convertible debt, options and warrants have been excluded as commonstock equivalents in the diluted earnings per share because they areanti-dilutive.  The aggregate number of potentialcommon stock equivalents outstanding as of September 30, 2005 was 124,716,922.  

 

Totaloutstanding stock, options, convertible preferred stock, convertible debt andwarrants are as follows:

 

 

| ** **            | ** ** | **As of September 30,** | ** ** |
|-----------------------|------------|------------------------------|------------|
| ** **            | ** ** | **2005**                     | ** ** | **2004** | ** ** |
| Common stock          |       | 81,164,590                   |       | 58,430,897 |   |
| Options and  warrants |       | 27,623,523                   |       | 19,030,626 |   |
| Convertible debt      |       | 15,928,809                   |       | 5,812,802 |   |
| Preferred Stock       |       | —                       |       | 1,708,293 |   |
|                  |       | 124,716,922                  |       | 84,892,618 |   |

 

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G.             Estimates - TheCompany’s financial statements and accompanying notes are prepared inaccordance with accounting principles generally accepted in the United States.Preparing financial statements requires management to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenue,and expenses. These estimates and assumptions are affected by management’sapplication of accounting policies. Critical accounting policies includerevenue recognition, impairment of goodwill, and accounting for discontinuedoperations.

 

H.            Stock BasedCompensation – Prior to July 1, 2005, the Company accounted for employeestock transactions in accordance with Accounting Principle Board, APB Opinion No. 25,“Accounting for Stock Issued to Employees.” The Company has adopted theproforma disclosure requirements of Statement of Financial Accounting StandardsNo. 123, “Accounting For Stock-Based Compensation.”

 

EffectiveJuly 1, 2005, the Company adopted FASB Statement of Financial AccountingStandard (“SFAS”) No. 123R “Share Based Payment”.  This statement is a revision of SFASStatement No. 123, and supersedesAPB Opinion No. 25, and its related implementation guidance. SFAS 123Raddresses all forms of share based payment (“SBP”) awards including sharesissued under employee stock purchase plans, stock options, restricted stock andstock appreciation rights. Under SFAS 123R, SBP awards result in a cost thatwill be measured at fair value on the awards’ grant date, based on theestimated number of awards that are expected to vest that will result in acharge to operations.  Consequently,during the three months ended September 30, 2005, the Company recognized $205,000in expenses, which represents the fair value of stock option awards that theCompany elected to accelerate vesting during that period.

 

Forthe three months ended September 30, 2004, the Company applied APB OpinionNo. 25, “Accounting for Stock Issued to Employees,”  As required under SFAS No. 148, “Accountingfor Stock-based Compensation – Transition and Disclosure,” the following tablepresents pro- forma net income and basic and diluted earnings per share as ifthe fair value-based method had been applied to all awards during that period. 

 

| ** **                                                                                         | ** ** | **Three Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| **(in thousands except per share data)**                                                           | ** ** | **2004**                                   | ** ** |
| Net Income (Loss)                                                                                  |       | $                                          | 47         |   |
| Stock-based employee compensation cost, net of tax  effect, under fair value accounting            |       | (22                                        | )          |
| Pro-forma net income (loss) under Fair Value Method                                                |       | $                                          | 25         |   |
| Income (Loss) per share                                                                            |       |                                       |       |
| Basic                                                                                              |       | $                                          | 0.0        |   |
| Diluted                                                                                            |       | $                                          | 0.0        |   |
| Per share stock-based employee compensation cost,  net of tax effect, under fair value accounting: |       |                                       |       |
| Pro-forma loss share basic                                                                         |       | 0.0                                        |       |
| Pro-forma loss share diluted                                                                       |       | $                                          | 0.0        |   |

 

Thefair value of all options granted was estimated at the date of grant using theBlack-Scholes option valuation model.  TheBlack-Scholes option valuation model was developed for use in estimating thefair value of traded options which have no vesting restrictions and are fullytransferable.  Because the Company’sstock options have characteristics significantly different from those of tradedoptions, and because changes in the subjective input assumptions can materiallyaffect the fair value estimate, in management’s opinion, the existing models donot necessarily provide a reliable single measure of the fair value estimate ofits stock options. In calculating the fair values of the stock options, thefollowing assumptions were used:                              

 

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| ** **                               | ** ** | **Fiscal 2005** | ** ** | **Fiscal 2004** | ** ** |
|------------------------------------------|------------|-----------------|------------|-----------------|------------|
| Dividend yield                           |       | —          |       | —          |       |
| Weighted average  expected life          |       | 8.8 years       |       | 4.7 years       |       |
| Weighted average risk-free interest rate |       | 1.35            | %          | 1.27            | %          |
| Expected  volatility                     |       | 35              | %          | 136             | %          |

 

L.              Fair Value ofFinancial Instruments - The carrying amounts reported in the balance sheet forcash, trade receivables, accounts payable and accrued expenses approximate fairvalue based on the short-term maturity of these instruments.  The carrying amounts of notes receivableapproximate fair value as such instruments feature contractual interest ratesthat are consistent with current market rates of interest. The carrying amountsof notes payable approximate fair value because the effective yields of suchinstruments, which includes the effect of contractual interest rates takentogether with discounts resulting from the concurrent issuances of common stockpurchase warrants, are consistent with current market rates of interest.

 

M.         Goodwill - Goodwillrepresents the excess of the purchase price over the fair value of net assetsacquired in business combinations (Note 4). SFAS 142, Goodwill and OtherIntangible Assets, requires that goodwill be tested for impairment atthe reporting unit level (operating segment or one level below an operatingsegment) on an annual basis (June 30th for the Company) andbetween annual tests when circumstances indicate that the recoverability of thecarrying amount of goodwill may be in doubt. Application of the goodwillimpairment test requires judgment, including the identification of reportingunits, assigning assets and liabilities to reporting units, assigning goodwillto reporting units, and determining the fair value. Significant judgmentsrequired to estimate the fair value of reporting units include estimatingfuture cash flows, determining appropriate discount rates and otherassumptions. Changes in these estimates and assumptions could materially affectthe determination of fair value and/or goodwill impairment for each reportingunit.   

 

N.            ComprehensiveIncome (Loss) – Comprehensive income (loss) is comprised of net income (loss)and all changes to the statements of stockholders’ equity, except for changesthat relate to investments made by stockholders, changes in paid-in capital anddistributions.  

 

O.            Inventory- Inventory consist primarily of finished goods in transit, which are recordedat the lower of cost or market. 

 

P.              New AccountingStandards

 

In December 2004,the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 153“Exchanges of Nonmonetary Assets”.  This Statement amends Opinion 29 toeliminate the exception for nonmonetary exchanges of similar productive assetsand replaces it with a general exception for exchanges of nonmonetary assetsthat do not have commercial substance. A nonmonetary exchange has commercialsubstance if the future cash flows of the entity are expected to changesignificantly as a result of the exchange. The provisions of this Statement,which is to be applied prospectively, are effective for nonmonetary assetexchanges occurring in fiscal periods beginning after June 15, 2005. Theadoption of this pronouncement did not have a material effect on the Company’sfinancial statements. 

 

EITF Issue 04-8, “TheEffect of Contingently Convertible Instruments on Diluted Earnings per Share.”  The EITF reached a consensus thatcontingently convertible instruments, such as contingently convertible debt,contingently convertible preferred stock, and other such securities should beincluded in diluted earnings per share (if dilutive) regardless of whether themarket price trigger has been met.  Theconsensus became effective for reporting periods ending after December 15,2004.  The adoption of this pronouncementdoes not currently have an effect on the Company’s financial statements becausethe inclusion of common stock equivalents in earnings per share isanti-dilutive.

 

In September 2005,the FASB ratified the Emerging Issues Task Force’s (“EITF”) Issue No. 05-7,“Accounting for Modifications to Conversion Options Embedded in DebtInstruments and Related Issues,” which addresses whether a modification to aconversion option that changes its fair value

 

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affects therecognition of interest expense for the associated debt instrument after themodification and whether a borrower should recognize a beneficial conversionfeature, not a debt extinguishment if a debt modification increases theintrinsic value of the debt (for example, the modification reduces theconversion price of the debt).  In September 2005,the FASB also ratified the EITF’s Issue No. 05-8, “Income Tax Consequencesof Issuing Convertible Debt with a Beneficial Conversion Feature,” whichdiscusses whether the issuance of convertible debt with a beneficial conversionfeature results in a basis difference arising from the intrinsic value of thebeneficial conversion feature on the commitment date (which is treated recordedin the shareholder’s equity for book purposes, but as a liability for incometax purposes), and, if so, whether that basis difference is a temporarydifference under FASB Statement No. 109, “Accounting for Income Taxes.”  The Company is currently in the process ofevaluating the effect that the adoption of this pronouncement may have on itsfinancial statements. 

 

**4.****              BUSINESSACQUISITIONS**

 

**Redrock Communications Solutions, Inc.(“Redrock”)**

 

On September 29, 2004, theCompany entered into a Stock Purchase Agreement (the “Redrock Agreement”) byand among the Company and the two holders of record (the “Sellers”) of theoutstanding shares of Redrock, to acquire all of the outstanding Common Stockof Redrock for purchase consideration consisting of $4,500,000 in cash,including an earn-out cash payment of $1,500,000 due July 31, 2005 (the “Earn-OutPayment”), and $500,000 of the Company’s common stock at a price of $.63 pershare.

 

Afterthe transaction closed, a former employee of Redrock claimed that he was owedup to one-third (1/3) of the outstanding shares of Redrock at the time of theCompany’s acquisition of Redrock (the “Redrock Dispute”).  The Redrock Agreement provides anindemnification for the benefit of the Company by the Sellers with respect toRedrock’s capital structure, its securities then-outstanding, and the Sellers’ownership of Redrock shares. 

 

In August 2005,the Company paid $850,000 of the Earn-Out Payment, withholding the remainingportion pending resolution of the Redrock Dispute.  In October 2005, the Sellers and theformer employee of Redrock entered into a settlement agreement, and the Companypaid the remaining $650,000 of the Earn-Out Payment, less $26,000 in fees andexpenses incurred by the Company in connection with such litigation, to theSellers for distribution in accordance with the terms of the settlement, andobtained a release in connection with the Redrock Dispute.  

 

**IntegrationTechnologies Inc.**

 

On October 14,2004, the Company entered into an Agreement and Plan of Merger (the “MergerAgreement”), by and among the Company, ITI Acquisition Corp., a Californiacorporation and wholly owned Subsidiary of the Company (“Merger Sub”),Integration Technologies, Inc., a California corporation (“ITI”), theshareholders of ITI (the “ITI Shareholders”) and Casper Zublin, Jr., inhis capacity as the shareholder representative (the “Representative”).                                                

 

On October 18,2004, the Merger Sub was merged into ITI with ITI becoming a wholly-ownedsubsidiary of the Company (the “Merger”).  The consideration paid orpayable to the ITI Shareholders in connection with the Merger is comprised of: (i) aninitial cash payment of $2,500,000; (ii) an earn-out cash payment up to amaximum amount of $1,500,000, based upon ITI’s EBITDA for the period between July 1,2004 through June 30, 2005; (iii) a earn-out cash payment up to amaximum amount of $1,500,000, based upon ITI’s revenue for the period between July 1,2004 through June 30, 2005; and (iv) an aggregate number of wholeshares of Company common stock  based onthe average closing sale price per share (the “Share Price”) of such commonstock for the 30 trading days prior to June 28, 2005 (the “ShareConsideration”).  The Share Price was $.36and the value of 4,280,000 shares, the maximum number of shares to be issuedunder the Merger Agreement, was $1,544,252. In the event the number of shares issuable as Stock Consideration was solimited, the Company agreed to pay the difference between the share value and$2,140,000 to the Shareholders in cash. The resulting cash adjustment was $595,748 (the “Cash Adjustment”).

 

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In February 2005,the Company and the ITI Shareholders entered into a Satisfaction and ReleaseAgreement based on performance of the ITI business through January 31,2005, the performance of certain former ITI employees who had undertakenadditional responsibilities at the Company, and the opportunity for the Companyto consolidate the ITI operations with Redrock and other operations of theCompany.  Based on these considerationsand the revenues and EBITDA from the ITI business through such date, theCompany agreed to pay the amount of $2,250,000 to the Shareholders in satisfactionof the earn-out cash payments (the “ITI Earn-Out Payment”).  The ITI Earn-Out Payment and Cash Adjustmentequaled an aggregate of $2,845,748.  In August 2005,the Company paid $270,993 of this amount to two ITI Shareholders who arecurrently employees of the Company.  

 

In September 2005,the Company entered into promissory notes with the three remaining ITI Shareholders(the “ITI Notes”), including the Company’s current chief executive officer,Casper Zublin, Jr., to pay an aggregate of $2,574,755.  Principal payments are due quarterlybeginning in September 2005, with the balance due on July 31,2006.  The ITI Notes bear interest at arate of 8.9%, which is payable in shares of the Company’s Common Stock.

 

**5.****              RESTRICTED CASH**

 

Restrictedcash includes cash received in connection with maintenance agreements that are restrictedand will become available to the Company as revenue is earned and recognizedunder the terms of the respective agreements, which are three years.  Approximately $722,000 is classified as anon-current asset.  

 

**6.****              NOTES PAYABLE**

 

**9% Subordinated Convertible Note**

 

On October 15,2004, the Company entered into a 9% Senior Subordinated Convertible NotePurchase Agreement with certain investors in which it issued an aggregate of$4,438,775 in principal amount of the Company’s Senior Subordinated ConvertibleNotes (the “9% Notes”), bearing 9% interest at per annum with a maturity ofthree years.  Interest payments are due quarterly on the first day of eachcalendar quarter.  Principal payments aredue in monthly installments of $145,844 beginning July 1, 2005 with anyremaining principal due on October 15, 2007.  The 9% Notes were convertible into shares ofthe Company’s common stock at a conversion price of $.65 per share, subject tocertain adjustments.  At September 30,2005, the net carrying value of these notes amounts to $3,113,264 includingunamortized discounts of approximately $386,980. 

 

Amortizationof the debt discount in connection with issuance of the 9% Notes amounted to $47,385during the three months ended September 30, 2005 and is included as acomponent of interest expense in the accompanying condensed consolidatedstatement of operations.  Contractualinterest expense on the 9% Notes for the three months ended September 30,2005 amounted to $89,584 and is also included as a component of interestexpense in the accompanying condensed consolidated statement of operations. 

 

In October 2005,the Company and the holders of the 9% Notes agreed to amend the terms as morefully described in Note 12.

 

**LaurusFunds Note**

 

On November 15,2004, the Company entered into an Amended and Restated Secured Convertible TermNote with Laurus Master Fund, LTD (the “Laurus Note”).  The Laurus Note is convertible into theCompany’s common stock at the option of Laurus Funds at a conversion price of$0.65 per share.  The Laurus Note is subordinated to the Company’s workingcapital credit facility; however, substantially all other assets of the Companyhave been pledged as security for this obligation.  At September 30, 2005, the remainingprincipal on the Laurus Note amounted to $6,649,999.

 

TheLaurus Note provides for interest payable at the greater of the prime rate plus1% per annum or 4% per annum.  Principal payments are due in twenty-fourmonthly installments of $277,083 beginning December 1, 2005. Any pre-paymentsof principal that the Company may choose to make under the Laurus Note prior toits maturity are subject to a 2% prepayment premium.  

 

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Inconnection with this transaction, the Company also issued to Laurus Funds afive-year amended and restated warrant to purchase 1,046,150 shares of theCompany’s common stock, exercisable at $0.65 per share (the “Laurus Warrant”) 

 

Inaccordance with APB 14, the Company allocated $6,551,000 of the proceeds to theLaurus Notes and $98,982 of the proceeds to the Laurus Warrant (including theeffect of note amendments).  Accretion ofthe aforementioned discount (including the effect of note amendments) amountedto $16,938 for the three months ended September 30, 2005, and is includedas a component of interest expense in the accompanying statement of operations.Contractual interest expense on the Laurus Notes amounted to $122,887 for thethree months ended September 30, 2005 and is also included as a componentof interest expense in the accompanying statement of operations

 

In October 2005,the Company and the Laurus Funds agreed to amend the terms of the Laurus Noteand Laurus Warrant as more fully described in Note 12, and deferredapproximately $831,249 of principal due under this note.  The Company has retroactively reflected thedeferral of these payments in its September 30 balance sheet, and hasclassified this amount as long-term debt.

 

**Line of Credit**

 

In August 2005,the Company terminated its credit facility agreement with an agency of TextronFinancial Corporation (“Textron”).  TheTextron facility provided a full notification factoring facility for up to$7,000,000 of working capital.  Eligibleaccounts receivable expected to be collected within 90 days were purchased withrecourse, with a holdback amount of 15%. Interest was charged on the outstanding balance at the prime rate plus2.0% (8.25% at June 30, 2005). Additionally, a 0.15% discount fee was charged at the time ofpurchase.  In August 2005, theCompany terminated this agreement, and paid the entire balance then outstandingof approximately $4,800,000.

 

On August 8,2005, the Company entered into a series of related agreements with New EnglandTechnology Finance, LLC (“NETF”), an affiliate of Global Technology Finance,which is a provider of structured financing solutions to technology companiesthat operates in partnership with Credit Suisse First Boston, CIT Group, Inc.and others, that together provided a new working capital credit facility.  

 

Thenew credit facility is comprised of two primary components:  (1) an Asset Purchase and LiabilityAssumption Agreement (the “APLA”), under which NETF agreed to finance certainof qualified product purchases under an arrangement that provides for theCompany to assign accounts receivable (resulting from product sales tocustomers) and for NETF to assume the liability for payment to product vendors;and  (2) an Asset Purchase Agreement(the “APA”), under which NETF purchased $7,500,000 of qualified accountsreceivables (both services and products). These agreements are secured by the Company’s accounts receivables thatare transferred under the respective agreements.  The agreements also contain certainprovisions that allow NETF to return the liability to the Company if customershave not paid in 150 days. The proceeds received under the APA were used torepay in full the $4,800,000 balance on the credit line with Textron, foracquisition debt, and general corporate purposes.  In addition to the accounts receivablepurchased on August 8, 2005, NETF may purchase up to 80% of additionalqualified accounts receivable in the future on the same terms.  At September 30, 2005, a balance of approximately$8,249,000 was outstanding under the APA facility.

 

**7.****              ACQUISITIONINDEBTEDNESS**

 

Acquisition indebtedness includes $624,000 of accruedcontingent consideration payable to the sellers of Redrock, which was paid in October 2005,and $1,930,982 of accrued contingent consideration payable to three of the sellersof ITI (see Note 4).  

 

**8.****              STOCKHOLDERS’EQUITY**

 

On August 14, 2005, the Company’s then outstanding Series Apreferred stock automatically converted into shares of its Class A CommonStock, at a rate of 2.5 common shares for each preferred share, pursuant to theterms of the Series A preferred stock certificate of designations.  During the three months ended September 30,2005, all remaining shares of the Company’s Series A Preferred Stock were exchangedor automatically converted into 1,457,827 shares of the Company’s Common Stock,including common shares issued for fractional shares.

 

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**9.****              COMMITMENTS,CONTINGENCIES, AND OTHER AGREEMENTS**

 

Westcon Settlement

 

On April 7, 2003 Westcon, Inc. filed abreach of contract complaint in the Supreme Court of New York State, County ofWestchester. The complaint arose from the Company’s failure to make paymentswithin the terms of the reseller agreement. The Company does not dispute the amount due of $ 413,000 and hasnegotiated payment terms.  The remainingbalance due Westcon under this settlement, which is included in accountspayable, amounts to $87,000 at September 30, 2005 and is now due andpayable.

 

SeparationAgreement with Former Chief Executive Officer 

 

On May 26,2005, the Company and Steven J. Ross, its then Chairman and Chief ExecutiveOfficer entered into a Separation Agreement and General Release (“SeparationAgreement”).  The Separation Agreementprovides for the mutual termination of an Employment Agreement, dated July 1,2004, between the Company and Mr. Ross, pursuant to which Mr. Rosswas employed as President and Chief Executive Officer of the Company.  The Separation Agreement also provides forsalary continuation for Mr. Ross based on his then current annual salaryof $440,000 through May 31, 2006, a portion of his bonus under theEmployment Agreement not to exceed $110,000, and continuation of insurancebenefits through May 31, 2006.  TheSeparation Agreement contains a mutual release, as well as certainnon-solicitation and non-competition covenants by Mr. Ross in favor of theCompany.

 

ContractManagement Services Agreement 

 

As of March 1, 2004, the Company entered into aseries of agreements with Young Williams, P.C. Under the services agreement,Young Williams will manage certain contracts of the Company pursuant to whichit provides child support services.  TheCompany agreed to pay Young Williams a fee of 12% of revenues under the contracts,and the Company will remain responsible for the operating expenses related tothe contracts managed by Young Williams for the current term and option yearextensions of each contract.  Themanagement fee paid to Young Williams was $105, 922 for the three months ended September 30,2005. In the event of contract renewals past the current terms and optionyears, Young Williams will have the right to bid the contracts. If YoungWilliams is awarded a new contract, it will pay the Company 4% of revenues undereach such contract during the awarded term through February 2010.  

 

**10.****       DISCONTINUED OPERATIONS**

 

During2003, the Company disposed of its non-emergency transportation business.  At September 30, 2005, the totalremaining liabilities of discontinued operations was $258,000.  

 

EffectiveMarch 1, 2003, the Company entered into an Asset Purchase Agreement withFirst Transit, Inc. (the “First Transit Agreement”), pursuant to which theCompany sold to First Transit, Inc. certain specific assets relating to itsformer non-emergency transportation brokerage services previously business.  The assets sold consisted of the Company’sinterests in three contracts to provide non-emergency transportation relatedservices and related assets used in connection with performance of suchcontracts by the Company as well as the assumption of all vendor and servicessub-contract agreements relating to the contracts. The purchase price consistedof $6,450,000 cash payments and up to $1,750,000 to be paid in the event thatFirst Transit, Inc. is able to obtain an extension of the IllinoisDepartment of Public Aid contract for a period of up to three years beyond May 31,2004, under certain specified conditions. As part of the First Transit Agreement, the Company agreed not tocompete with First Transit in the business that was sold.  The Company received payments of $243,000 duringthe three-month period ended September 30, 2005 from the extension of theIllinois Department of Public Aid contract. There can be no assurance that the Company will obtain any additionalpayments as a result of additional extensions, if any, in any future periods.

 

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**11.****       BUSINESS SEGMENTS**

 

The Company’s operations include two segments –Information Technology (“IT”) Services and Business Process OutsourcingServices.  The Information TechnologyServices segment provides a range of specialized IT infrastructure services,including, system architectural design, legacy systems integration, networkengineering, applications infrastructure, network security solutions, remoteaccess implementation, help desk support and operational support, primarily tomid-market commercial companies and state and local government entities. Inconjunction with these service offerings, it also sells hardware and softwareto its customers.  Operations aredistributed primarily among five states: California (including the principalexecutive office), New York, Michigan, Florida, and Nevada, with employeessituated in locations that are convenient to client sites. 

 

The Business Process Outsourcing segment contractsoutsourced program operations for state government agencies in several areasincluding the privatization of child support enforcement services. The Company’sbusiness process outsourcing customers have included various governmentaldepartments in the states of North Carolina, Kansas and Nebraska.  Typically these contracts are for multi-yearperiods of performance, with options to renew for additional periods. Suchcontracts are generally awarded through competitive procurements. Payment isbased on either fixed-price, fixed-unit- price based on contractualallocations, revenue sharing, or a combination of the above. 

 

The Company’s reportable segments are business unitsthat offer different services and contract types and are managed separately dueto the expertise and different managed key factors in each area. Since theBusiness Process Outsourcing business segment was acquired as a unit,management has retained separate reporting and review criteria for that unit.The following table provides actual selected financial data for our businesssegments (in thousands):

 
| ** **                                 | ** ** | **Reportable Business Segments**     | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|
| ** **                                 | ** ** | **Business****Process  Outsourcing** | ** ** | **Information  Technology  Services** | ** ** | **Total** | ** ** |
| Three months ended September 30, 2005 |       |                                 |       |   |   |   |   |
| Sales to external customers                |       | $                                    | 985        |   | $ | 22,450 |   | $ | 23,435 |   |
| Depreciation and amortization  expense     |       | 35                                   |       | 695 |   | 730 |   |
| Net loss from operations                   |       | (11                                  | )          | (1,215 | ) | (1,226 | ) |
| Interest expense                           |       | —                               |       | (734 | ) | (734 | ) |
| Total assets                               |       | 472                                  |       | 48,223 |   | 48,695 |   |
| Capital expenditures                       |       | —                               |       | 75 |   | 75 |   |
|                                       |       |                                 |       |   |   |   |   |
| Three months ended September 30, 2004 |       |                                 |       |   |   |   |   |
| Sales to external customers                |       | $                                    | 2,676      |   | $ | 12,107 |   | $ | 14,783 |   |
| Depreciation and amortization  expense     |       | 117                                  |       | 643 |   | 760 |   |
| Net income (loss) from  operations         |       | 80                                   |       | (1,354 | ) | (1,274 | ) |
| Interest expense                           |       | —                               |       | (274 | ) | (274 | ) |
| Total assets                               |       | 14,614                               |       | 33,812 |   | 48,426 |   |
| Capital expenditures                       |       | —                               |       | 36 |   | 36 |   |

 

16

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**12.****       SUBSEQUENT EVENTS**

 

Amendment of 9%Notes.

 

In October 2005,the Company amended and restated its 9% Subordinated Convertible Notes (the “9%Notes”) representing a majority of the outstanding principal (the “Amended 9%Notes) to defer all payments of principal January 2007, but withoutchanging the maturity date.  In exchangefor deferral of principal payments under the 9% Notes, the Company (i) reducedthe conversion price under the Amended 9% Notes to $.22 per share; (ii) amendedthe warrants issued in connection with such notes to reduce the exercise priceto $.22 per share; and (iii) increased the number of shares exercisableunder the Amended 9% Notes by up to an aggregate of 842,770 shares.  This transaction deferred aggregate paymentsof $1,893,630 in cash otherwise due and payable prior to January 2007, $1,623,111of which was retroactively re-classified from current debt to long-term debt inthe Company’s September 30, 2005 balance sheet.  See Note 6.

 

Amendment ofLaurus Note.

 

In October 2005,the Company amended its Amended and Restated Secured Convertible Term Note (the“Laurus Note”), and deferred principal payments under the Laurus Note from December 2005until March 2006.  In exchange forthe deferral under the Laurus Note, the Company amended warrants issued inconnection with issuance of the Laurus Note to reduce the exercise price from$.65 per share to $.25 per share.  Thistransaction deferred aggregate payments of $831,249 in cash otherwise due andpayable prior to March 2006.  Thisamount was retroactively re-classified from current to long-term debt in theCompany’s September 30, 2005 balance sheet. See Note 6.

 

Bridge Notes.

 

In October 2005,the Company entered into a Note Purchase Agreement (the “Purchase Agreement”),whereby it obtained an aggregate loan of $2,500,000 from two shareholders ofthe Cmpany, pursuant to two Secured Promissory Notes (the “Bridge Notes”) eachin the original principal amount of $1,250,000. Under the terms of the Purchase Agreement, the Company is required toredeem the Notes with principal and accrued interest upon the earlier of (i) theclosing of a rights offering to record holders of the Company’s common stock inan aggregate amount of $15,000,000 or more; (ii) December 31, 2006,the stated maturity date of the Notes; or (iii) an event of default.  The Bridge Notes bear interest at a rate of12% per annum until March 1, 2006, increasing 2% each month to 20% perannum from June 1, 2006 until they are due and payable on December 31,2006.  Payment of all principal andinterest under the Bridge Notes are secured by a lien to substantially allassets of DynTek, which lien is subordinated to the perfected securityinterests held by existing secured lenders. In connection with the issuance of the Bridge Notes, the Company issuedwarrants to purchase an aggregate 1,000,000 shares of its common stock at anexercise price equal to the greater of $0.10 per share or the price per shareat which common stock is sold in any rights offering to record holders of itscommon stock.  

 

Rights Offering.

 

In November 2005, the Company announced itsintention to offer up to $15,000,000 of shares of common stock in connectionwith a rights offering (the “Rights Offering”), pursuant to which it intends todistribute non-transferable subscription rights to purchase shares of commonstock upon the effectiveness of a registration statement to stockholders ofrecord as of the record date, which has not yet been determined.  Each subscription right will entitle eachstockholder to purchase two (2) shares of common stock for each share ofcommon stock owned as of the record date. The price for each share purchased in the rights offering will be $.10per share.  Only stockholders of recordon the rights offering record date will receive rights to purchase suchshares.  The Company expects that alimited number of stockholders of the Company will purchase all of the sharesof common stock not purchased in the Rights Offering by other stock holderspursuant to a stand-by purchase agreement. The purchase of shares by such stand-by purchasers together with theshares purchased by other stockholders in the Rights Offering would result in$15,000,000 of gross proceeds to the Company. 

 

17

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITIONS AND RESULTS OF OPERATIONS 

 

The following discussionand analysis of our results of operations and financial position should be readin conjunction with our audited consolidated financial statements and relatednotes included in our Annual Report on Form 10-K for the year ended June 30,2005 and the unaudited consolidated financial statements and related notesincluded in this Quarterly Report on Form 10-Q.  Depending upon the context, the terms DynTek, “we,”“our,” and “us,” refers to either DynTek alone, or DynTek and its subsidiaries.

 

**Forward-Looking Statements**

 

Thisreport contains “forward-looking statements” within the meaning of such term inSection 27A of the Securities Act of 1933, Section 21E of theSecurities Exchange Act of 1934, and the Private Securities Litigation ReformAct of 1995. We wish to caution readers not to place undue reliance on any suchforward-looking statements, each of which speaks only as of the date made.  Forward-looking statements involve known andunknown risks, uncertainties and other factors which could cause actualfinancial or operating results, performance or achievements expressed orimplied by such forward-looking statements not to occur or be realized. Suchstatements are subject to certain risks and uncertainties that could causeactual results to differ materially from historical results and those presentlyanticipated or projected.  See below, anda discussion of such risks and factors discussed in Item 1 (Business) of Part Iand Item 7 (Management’s Discussion and Analysis of Financial Condition andResults of Operations) of Part II of our Annual Report on Form 10-Kfor the fiscal year ended June 30, 2005 as filed with the Securities andExchange Commission.  Forward-lookingstatements made in this Form 10-Q generally are based on our bestestimates of future results, performances or achievements, predicated uponcurrent conditions and the most recent results of the companies involved andtheir respective industries. Forward-looking statements may be identified bythe use of forward-looking terminology such as “may,” “will,” “could,” “should,”“project,” “expect,” “believe,” “estimate,” “anticipate,” “intend,” “continue,”“potential,” “endeavor,”  “opportunity”or similar terms, variations of those terms or the negative of those terms orother variations of those terms or comparable words or expressions. Readersshould carefully review those risks, as well as additional risks described in thisreport and other documents we file from time to time with the Securities andExchange Commission.  Potential risks anduncertainties include, among other things, such factors as: 

 

•   Our ability to reach target marketsfor services and products and our ability to retain current and attract futurecustomers;

 

•   Our ability to attract and retainprofessional staff, successfully integrate acquired companies into ouroperations, and our ability to acquire additional companies, if any;

 

•   Market acceptance, revenues andprofitability of our current and future products and services;

 

•   Our ability to finance andsustain operations, including the ability to fund, maintain, replace and/orextend the 9% Notes and/or the Laurus Funds Note, when due, respectively, or toreplace such instruments with alternative financing;

 

•   Our ability to raise equitycapital or debt in the future, despite historical losses from operations;

 

•   General economic conditions inthe United States and elsewhere, as well as the economic conditions affectingthe industries in which we operate, our customers and suppliers;

 

•   The competitive environment inthe regions in which we compete, and the cost-effectiveness of our products andservices;

 

•   Political and regulatory mattersthat affect the industries in which we operate; 

 

•   Our continued ability to tradeon the NASD bulletin board; and

 

•   Other risks detailed in ourfilings with the Securities and Exchange Commission.

 

The Company has noobligation to publicly release the results of any revisions to anyforward-looking statements to reflect anticipated or unanticipated events orcircumstances occurring after the date of such statements.

 

18

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**Business Overview**

** **

DynTek, Inc. provides professional informationtechnology (“IT”) services and sales of related products to mid-marketcommercial businesses, state and local government agencies, and educationalinstitutions. We operate our business primarily through our subsidiary, DynTekServices, Inc.  

 

We provide a broad range of multi-disciplinary ITsolutions that address the critical business needs of our clients, including ITsecurity, converged networking (including voice-over-internet-protocol “VOIP”),application infrastructure, and access infrastructure.  Our primary operations are located in four ofthe top ten largest IT spending states: California, New York, Florida, andMichigan.  We deliver complexinfrastructure technology solutions through teams of professional consultantsin close geographic proximity to our clients. Members of our technical and consulting services team have advancedcertifications with leading vendor-manufacturers, including Microsoft, Cisco,McAfee and Citrix.   As a professionalservices firm and value-added reseller of hardware and software from leadingmanufacturers, we help organizations assess, design, build, implement, manageand support their technology infrastructure. 

 

Webelieve that our services-led approach, combined with expertise inmulti-disciplinary practice areas such as IT security, converged networking(VOIP), application infrastructure, and access infrastructure, will continue toprovide the platform we need to capture an increasing share of our targetmarkets.  Our strategy allows our clientsto rely on DynTek as their primary IT vendor. Additionally, we believe that our multi-disciplinary capabilities helpdifferentiate us from our competitors in the markets in which we compete.  

 

We recognizerevenue from sales of products and services. Services are primarily provided tothe client at hourly rates that are established for each of our employees orthird-party contractors based upon their skill level, experience and the type ofwork performed. We also provide project management and consulting work whichare billed either by an agreed upon fixed fee or hourly rates, or a combinationof both. The majority of our services are provided under purchase orders withcommercial customers or bid contracts with government entities.  (See “Revenue Recognition,” below)

 

Costsof services consist primarily of salaries of services personnel and relatedexpenses incurred in providing such services, and the cost of outsourced servicelabor.  Costs of products consist of ourcost of products purchased and sold to our customers. Selling, general andadministrative expenses consist primarily of salaries and benefits of personnelresponsible for administrative, finance, sales and marketing activities and allother corporate overhead expenses. Corporate overhead expenses include rent,telephone and internet charges, insurance premiums, accounting and legal fees, andother general administrative expenses.   Selling, general and administrative costs alsoinclude a calculation of the fair value of employee stock options and othershare-based payment awards calculated pursuant to SFAS No. 123R.

 

19

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**Resultsof Operations**

** **

The following table sets forth, for the periodsindicated, the relative percentages that certain income and expense items bearto net sales.

 
| ** **                                   | ** ** | **Three Months  Ended Sept. 30,** | ** ** |
|----------------------------------------------|------------|-----------------------------------|------------|
| ** **                                   | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Product Revenue                              |       | 69                                | %          | 57 | % |
| Service Revenue-Information Technology       |       | 27                                | %          | 30 | % |
| Service Revenue-Business Process Outsourcing |       | 4                                 | %          | 13 | % |
|                                         |       |                              |       |   |   |
| Cost of Products                             |       | 88                                | %          | 83 | % |
| Cost of Service-Information Technology       |       | 71                                | %          | 80 | % |
| Cost of Service-Business Process Outsourcing |       | 92                                | %          | 85 | % |
|                                         |       |                              |       |   |   |
| Gross profit                                 |       | 18                                | %          | 18 | % |
|                                         |       |                              |       |   |   |
| SG & A                              |       | 20                                | %          | 23 | % |
|                                         |       |                              |       |   |   |
| Loss from continuing operations              |       | (8                                | )%         | (11 | )% |
| Gain (loss) from discontinued operations     |       | 1                                 | %          | 11 | % |
| Net income (loss)                            |       | (7                                | )%         | (0 | )% |

 

***Three months endedSeptember 30, 2005 and September 30, 2004***

*** ***

**Revenues. **For the three months ended September 30,2005, our revenues increased to approximately $23,435,000 from approximately$14,783,000 for the three months ended September 30, 2004.  This $8,652,000 increase, or 59%, isprincipally attributable to a full quarter’s contribution from new businesseswe acquired as of August and October 2004, which now comprise ourSouthwest Region, and a 49% increase in revenues from our Northeast Region, fromapproximately $7,292,000 to approximately $10,831,000.  

 

Our product sales increased from $8,413,000 during thethree months ended September 30, 2004 to $16,155,000 during the threemonths ended September 30, 2005. The increase resulted primarily from the increase in product sales ofnetwork communications equipment and software in the Southwest Region, includingvoice-over-internet protocol (“VOIP”) products, and the sales of othernetworking and computer equipment and software products in our otherregions.  

 

Our services revenues increased from $6,370,000 duringthe three months ended September 30, 2004 to $7,281,000 during the sameperiod in 2005.  This increase resultedprimarily from additional services in our Southwest Region, offset by adecrease of approximately $1,691,000 from discontinued business processoutsourcing services. Service revenues from our Information Technology Servicessegment increased from $3,694,000 in the three months ended September 30,2004, to $6,296,000 in the three months ended September 30, 2005, or anincrease of 70%.  Services revenues fromour Business Process Outsourcing (“BPO”) segment decreased from $2,676,000 to $985,000during the same period, as we de-emphasized that segment and did not pursueadditional BPO services business.  

 

The following table sets forth for the periodspresented information derived from our consolidated statements of operations(in thousands):

* *
| ** **                | ** **   | ** **    | ** ** | **For the Three Months ended September 30** | ** ** |
|---------------------------|--------------|---------------|------------|--------------------------------------------------|------------|
| **REVENUES**              | ** **   | ** **    | ** ** | **2005**                                         | ** ** | **2004** | ** ** | **Percentage  change** | ** ** | **Amount** | ** ** |
| ***DynTek, excluding***   | *** *** | ***Product*** |       | $                                                | 10,905     |   | 6,396 |   | 70 | % | 4,509 |   |
| *** ***              | *** *** | *** ***  |       |                                             |       |   |   |   |   |   |   |
| ***Redrock and ITI (1)*** | *** *** | ***Service*** |       | 5,184                                            |       | 5,587 |   | (7 | )% | (403 | ) |
| *** ***              | *** *** | *** ***  |       |                                             |       |   |   |   |   |   |   |
| *** ***              |         | ***Total***   |       | 16,089                                           |       | 11,983 |   | 34 | % | 4,106 |   |
|                      |         |          |       |                                             |       |   |   |   |   |   |   |
| ***Redrock and ITI (2)*** | *** *** | ***Product*** |       | 5,250                                            |       | 2,017 |   | 160 | % | 3,233 |   |
| *** ***              | *** *** | *** ***  |       |                                             |       |   |   |   |   |   |   |
| *** ***              |         | ***Service*** |       | 2,096                                            |       | 783 |   | 168 | % | 1,313 |   |
| *** ***              |         | *** ***  |       |                                             |       |   |   |   |   |   |   |
| *** ***              |         | ***Total***   |       | 7,346                                            |       | 2,800 |   | 162 | % | 4,546 |   |
| *** ***              |         | *** ***  |       |                                             |       |   |   |   |   |   |   |
| *** ***              |         | ***Totals***  |       | $                                                | 23,435     |   | $ | 14,783 |   | 59 | % | $ | 8,652 |   |
|                           |              |               |            |                                                  |            |  |  |  |  |  |  |  |  |  |

 

20

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----

(1)          Revenues from Redrockand ITI during are excluded for comparative purposes

(2)          Represents revenuesgenerated by Redrock following its acquisition on August 1, 2004 and ITIfollowing its acquisition on October 1, 2004.  Redrock and ITI operations were combined on February 11,2005.  Therefore, revenues are combined.

 

Our customers are primarily state and local governmententities and mid-sized corporations in diversified industries.  For the three months ended September 30,2005, 50% of our revenues were derived from commercial clients, compared to 38%from government agencies and 12% from educational institutions.  

 

**Gross profit. **Gross profit increased from$2,681,000 in the quarter ended September 30, 2004 to $4,114,000 in thequarter ended September 30, 2005, an increase of 53%.  Gross margin for both periods wasapproximately 18%.  While our servicesmargin increased significantly, from 19% to 29%, our product margin decreasedfrom 17% to 12%. Services margin increased primarily due to an increase in theoverall level of utilization with respect to consultants throughout the company,and a greater mix of higher-end services. The decrease in overall product gross margin is primarily the result ofhaving consummated several large, lower-margin product sales under contractswith certain state and local government clients and fewer vendor rebates thatwere received during the September quarter.  Although we have improved our servicemargins, and will seek opportunities to make further improvements, our productmargins in particular are subject to competitive pricing pressures andfluctuate from quarter to quarter depending on the mix of products we provide.  We intend to meet the challenges ofaggressive price reductions and discount pricing by certain product suppliersby focusing our offerings around relatively higher margin practice areas,including security solutions, VOIP, and access infrastructure.  There can be no assurance, however, that wewill be able to improve profit margins, especially for our sale of products,and compete profitably in all areas, given the intense competition that existsin the IT industry.

 

**Selling, general and administrativeexpenses.**  General andadministrative expenses increased to approximately $1,434,000 for the threemonths ended September 30, 2005, from approximately $1,370,000 for thethree months ended September 30, 2004. As a percent of revenues, general and administrative expenses decreasedfrom 9% to 6%.  Additionally, there was asignificant decrease in general and administrative expenses from the immediatelyprior quarter ended June 30, 2005. During the three months ended June 30, 2005, general and administrativeexpenses were approximately $2,693,000, including a charge for approximately$514,000 related to severance costs. From the June quarter to the September quarter, general andadministrative expenses decreased $1,259,000, or a 47% reduction. This significantdecrease quarter-to-quarter is primarily the result of reduced costs fromrestructuring and re-organization by new management.  

 

Selling costs increased to approximately $3,176,000for the three months ended September 30, 2005 from $1,825,000 in the threemonths ended September 30, 2004.  Theincrease was primarily due to the addition of sales and business developmentpersonnel from the integration of the Redrock and ITI businesses, and a$205,000 expense for employee stock options vested by sales personnel duringthe period.  

 

As a percentage of total revenues, the aggregateselling, general and administrative expenses were 19.7% during the three monthsended September 30, 2005, compared to 21.6% for the same period ended September 30,2004.

 

**Depreciation and amortizationexpense.**  Depreciationand amortization expense decreased to approximately $730,000 for the three-monthperiod ended September 30, 2005, from approximately $760,000 during thesame period in the prior year.  The decreaseis primarily due to amortization of acquired customer lists from acquisitionscompleted in late 2004.  

 

21

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**Interest expense.**  Interest expense for the three months ended September 30,2005 increased to $734,000, as compared to $273,000 for the three months ended September 30,2004.  The increase includes contractualinterest due on notes that we entered into in January and October 2004,an increase in the average borrowings under our credit facility, and theamortization of deferred financing fees. 

 

Thefollowing table sets forth operating expenses for the periods presented frominformation derived from our consolidated statements of operations (inthousands):

 
| ** **               | ** **   | ** **                                     | ** ** | **For the Three Months ended** | ** ** |
|--------------------------|--------------|------------------------------------------------|------------|--------------------------------|------------|
| ** **               | ** **   | ** **                                     | ** ** | **September 30,**         | ** ** |
| ** **               | ** **   | ** **                                     | ** ** | ** **                     | ** ** | **Percentage of** | ** ** |
| **OPERATING**            | ** **   | ** **                                     | ** ** | **Dollars**                    | ** ** | **Revenues** | ** ** |
| **EXPENSES**             | ** **   | ** **                                     | ** ** | **2005**                       | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ***DynTek, excluding***  | *** *** | ***Selling(1)***                               |       | 1,885                          |       | 1,568 |   | 8 | % | 11 | % |
| *** ***             | *** *** | *** ***                                   |       |                           |       |   |   |   |   |   |   |
| ***Redrock and ITI(1)*** | *** *** | ***General &  Administrative(1)***    |       | 1,402                          |       | 1,307 |   | 6 | % | 10 | % |
| *** ***             | *** *** | *** ***                                   |       |                           |       |   |   |   |   |   |   |
| *** ***             |         | ***Depreciation &  Amortization(1)*** |       | 660                            |       | 693 |   | 3 | % | 5 | % |
| *** ***             |         | *** ***                                   |       |                           |       |   |   |   |   |   |   |
| *** ***             |         | ***Total***                                    |       | 3,947                          |       | 3,568 |   | 17 | % | 24 | % |
| *** ***             |         | *** ***                                   |       |                           |       |   |   |   |   |   |   |
| ***Redrock and ITI(2)*** | *** *** | ***Selling(2)***                               |       | 1,291                          |       | 257 |   | 6 | % | 2 | % |
| *** ***             | *** *** | *** ***                                   |       |                           |       |   |   |   |   |   |   |
| *** ***             |         | ***General &  Administrative(2)***    |       | 32                             |       | 63 |   | — |   | — |   |
| *** ***             |         | *** ***                                   |       |                           |       |   |   |   |   |   |   |
| *** ***             |         | ***Depreciation &  Amortization(2)*** |       | 70                             |       | 67 |   | — |   | — |   |
| *** ***             |         | *** ***                                   |       |                           |       |   |   |   |   |   |   |
| *** ***             |         | ***Total***                                    |       | 1,393                          |       | 387 |   | 6 | % | 3 | % |
| *** ***             |         | *** ***                                   |       |                           |       |   |   |   |   |   |   |
| *** ***             |         | ***Totals***                                   |       | 5,340                          |       | 3,955 |   | 23 | % | 27 | % |

 

----

(1)          Expenses from Redrockand ITI are excluded for comparative purposes

(2)          Represents expensesgenerated by Redrock following its acquisition on August 1, 2004 and ITIfollowing its acquisition on October 1, 2004.  Redrock and ITI operations were combined on February 11,2005.  Therefore, Selling, General andAdministrative expenses for the entities are combined.

 

**Net loss.**  Our net loss for the three months ended September 30,2005 was $1,682,000 compared to net income of $47,000 for the three monthsended September 30, 2004.  The netincome in the 2004 period included a gain from discontinued operations of $1,636,000.  Loss from operations during the three monthsended September 30, 2005 includes depreciation and amortization expense of$730,000, non-cash option expense of $205,000, and interest expense of $734,000(including a non-cash portion of $185,000).   

 

***DiscontinuedOperations. ***Income fromdiscontinued operations was $216,000 for the three months ended September 30,2005 compared to income of $1,635,000 for the three months ended September 30,2004.  The 2004 period included aone-time gain from the resolution of certain liabilities associated with adiscontinued transportation services business in the State of Virginia.

 

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**Liquidityand Capital Resources**

 

We measure our liquidityin a number of ways, as summarized in the following table: 

 
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **As of   Sept. 30, 2005** | ** ** | **As of  June 30, 2005** | ** ** |
|                            |       |                                 |       |   |   |
| Cash and cash equivalents       |       | $                                    | 1,721      |   | $ | 1,297 |   |
|                            |       |                                 |       |   |   |
| Working capital                 |       | $                                    | (5,582     | ) | $ | (5,221 | ) |
|                            |       |                                 |       |   |   |
| Current ratio                   |       | .80:1                                |       | .80:1 |   |
|                            |       |                                 |       |   |   |
| Notes payable (current portion) |       | $                                    | 1,810      |   | $ | 3,621 |   |

 

Cashand cash equivalents generally consist of cash and money market funds. Weconsider all highly liquid investments purchased with maturities of threemonths or less to be cash equivalents. Such investments are stated at cost,which approximates fair value, and are considered cash equivalents for purposesof reporting cash flows. 

 

Duringthe three months ended September 30, 2005, we used approximately $491,000of cash in our operating activities including $636,000 that we used incontinuing operations offset by $145,000 of cash realized from discontinuedoperations. 

 

Weincurred a net loss of $1,682,000 for the three months ended September 30,2005, which includes $1,120,000 of non-cash and/or non-recurring chargesresulting from $730,000 of depreciation and amortization; $205,000 in non-cashoption expense; and $185,000 in non-cash interest charges.  At September 30, 2005, the Company had aworking capital deficiency of approximately $5,582,000.  

 

In November 2005, we announced our intention tooffer up to $15,000,000 of shares of common stock in connection with a rightsoffering (the “Rights Offering”).   Weintend to distribute non-transferable subscription rights to purchase shares ofcommon stock upon the effectiveness of a registration statement to stockholdersof record as of the record date, which has not yet been determined.  Each subscription right will entitle eachstockholder to purchase two (2) shares of common stock for each share ofcommon stock owned as of the record date. The price for each share purchased in the rights offering will be $.10per share.  Only stockholders of recordon the rights offering record date will receive rights to purchase such shares.  

 

We expectthat a limited number of stockholders of the Company will purchase all of theshares of common stock not purchased by other stockholders in the RightsOffering, pursuant to a stand-by purchase agreement.  The definitive agreements with respect to thestand-by purchase agreement will not be entered into until the shares to beissued in the Rights Offering have been registered with the Securities andExchange Commission.  The purchase ofshares by such stand-by purchasers together with the shares purchased by otherstockholders in the Rights Offering would result in $15,000,000 of grossproceeds to the Company.  

 

In October 2005,we raised gross proceeds of $2,500,000, upon issuance of notes to certaininvestors (the “Bridge Notes”).  Theproceeds were used to pay acquisition debt and for working capitalpurposes.  The Bridge Notes currently bearinterest at 12%, and mature on December 31, 2006.  The Bridge Notes include a provision formandatory redemption upon the closing of the Rights Offering.

 

In July 2005,we began making principal payments of approximately $146,000 per month on our9% Subordinated Convertible Notes (the “9% Notes”) due to certaininvestors.  In October 2005, weamended a majority of 9% Notes to defer all payments of principal due undersuch 9% Notes until January 2007. In connection with such amendment, we reduced the conversion price ofsuch notes from

 

23

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$.65 to $.22, and issued the 9% Note holders warrants to purchaseshares of our common stock at $.22 per share.

 

In October 2005,we amended our Amended and Restated Secured Convertible Term Note (the “LaurusNote”), and deferred principal payments under the Laurus Note from December 2005until March 2006 in return for a reduction in the exercise price ofwarrants issued in connection with issuance of the Laurus Note from $.65 pershare to $.25 per share.  Thistransaction deferred aggregate payments of $831,249 in cash otherwise due andpayable prior to March 2006.  Weanticipate paying off the Laurus Note, and a 2% pre-payment charge, with theproceeds of the Rights Offering.

 

In August 2005,we terminated our credit facility agreement with an agency of Textron FinancialCorporation (“Textron”).  The Textronfacility provided a full notification factoring facility for up to $7,000,000of working capital.  Eligible accountsreceivable expected to be collected within 90 days were purchased withrecourse, with a holdback amount of 15%. Interest was charged on the outstanding balance at the prime rate plus2.0% (8.25% at June 30, 2005). Additionally, a 0.15% discount fee was charged at the time ofpurchase.  As of June 30, 2005,$4,697,000 was outstanding on this facility. In August 2005, we terminated this agreement, and paid the entirebalance then outstanding of approximately $4,800,000.

 

On August 8,2005, we entered into a series of related agreements with New EnglandTechnology Finance, LLC (“NETF”), an affiliate of Global Technology Finance,which is a provider of structured financing solutions to technology companiesthat operates in partnership with Credit Suisse First Boston, CIT Group, Inc.and others, that together provided a new working capital credit facility.  

 

Thenew credit facility is comprised of two primary components:  (1) an Asset Purchase and LiabilityAssumption Agreement (the “APLA”), under which NETF agreed to finance certainof our qualified product purchases under an arrangement that provides for us toassign accounts receivable (resulting from the sale of such products to ourcustomers) and for NETF to assume the liability for payment to product vendors;and  (2) an Asset Purchase Agreement(the “APA”), under which NETF purchased $7,500,000 of our qualified accountsreceivables (services and products).  Theproceeds we received under the APA were used to repay in full the $4,800,000balance on our credit line with Textron, for acquisition debt, and generalcorporate purposes.  In addition to theaccounts receivable purchased on August 8, 2005, NETF may purchase up to80% of our additional qualified accounts receivable in the future on the sameterms. 

 

Webelieve that the NETF APLA facility will enable us to more effectively manageour liquidity. The facility is structured to provide us with the flexibility ofmatching the timing of cash outflows for product purchases to cash amounts thatwe collect from our customers.  Thefinancing fee under the facility is calculated on a monthly basis depending onour gross margin on such products, and days sales outstanding, which fee weanticipate will be less than prior fees charged under our prior financingarrangement with Textron. We may also use the APA facility as a generalfinancing arrangement for certain product and services receivables.  

 

In June 2005, Casper Zublin, Jr. wasappointed as our Chief Executive Officer, and Robert Webber was appointed ourPresident, at which time we re-evaluated our business strategy with respect toour BPO segment and our available capital resources.  We have recently taken certain steps to conserveour capital resources, including a projected reduction of our general andadministrative expenses by approximately $1,600,000 from the year ended June 30,2005 to the year ended June 30, 2006.   

 

Webelieve that these cost reduction measures, when taken together with the (a) $15,000,000of additional equity capital expected to be raised as part of the RightsOffering, (b) $2,500,000 of proceeds received upon the issuance of theBridge Notes, (c) restructuring of payments due under the Laurus Note and 9%Notes, have substantially improved our liquidity and that these measures willenable management to sustain our business at least through December 2007.  

 

Thereceipt of proceeds under the Rights Offering is subject to the Company’sfiling of a registration statement for the sale of such securities and adeclaration of effectiveness of such registration statement by the Securitiesand Exchange Commission.  While theCompany intends to file a registration statement intends to file a registrationstatement in the near future, there can be no assurance that such statement, iffiled, will be declared effective or that the Company will be able toconsummate the Rights Offering on the proposed terms or at all. Failure tocomplete the Rights Offering on the terms contemplated could have a materialadverse effect on the Company’s financial condition and operations.  As a result, there is substantial doubt aboutthe Company’s ability to continue as a going concern.  The

 

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financial statements of the Company do not include any adjustments thatmight result from the outcome of this uncertainty.

 

In thefuture, we may expand the scope of our product and services offerings bypursuing acquisition candidates with complementary technologies, services orproducts.  Should we commence suchacquisitions, we believe that we would finance the transactions with acombination of our working capital and the issuance of additional securities.  We may attempt to secure additional funding,including equity or debt financing where appropriate, for acquisitions.  There can be no assurance, however, that wewill be successful in identifying appropriate acquisition candidates or that,if appropriate candidates are identified, that we will be successful inobtaining the necessary financing to complete the acquisitions. 

 

In theevent of any additional financing, any equity financing would likely result indilution to our existing stockholders and any debt financing may includerestrictive covenants.  Should we requireadditional working capital, we would consider divesting certain of ourcontracts or other assets that may not be critical to the business. 

 

**Contractual Obligations**

 
| ** **                   | ** ** | **Payments due by period** | ** ** |
|------------------------------|------------|----------------------------|------------|
| ** **                   | ** ** | **(in thousands)**         | ** ** |
| ** **                   | ** ** | **Total**                  | ** ** | **Less  than 1  year** | ** ** | **1-3 years** | ** ** | **3-5  years** | ** ** | **More  than 5  years** | ** ** |
| *Contractual Obligations*    | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Convertible Debt Obligations |       | 9,616                      |       | 1,810 |   | 7,806 |   | — |   | — |   |
| Acquisition Debt             |       | 2,555                      |       | 2,555 |   | — |   | — |   | — |   |
| Operating Lease Obligations  |       | 2,084                      |       | 677 |   | 1,030 |   | 374 |   | 3 |   |
| Total                        |       | $                          | 14,255     |   | $ | 5,042 |   | $ | 8,836 |   | $ | 374 |   | $ | 3 |   |
|                              |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**CriticalAccounting Policies and Estimates**

 

TheCompany’s financial statements and accompanying notes are prepared inaccordance with accounting principles generally accepted in the United States.Preparing financial statements requires management to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenue,and expenses. These estimates and assumptions are affected by management’sapplication of accounting policies. Critical accounting policies for us includerevenue recognition, impairment of goodwill, and accounting for discontinuedoperations.

 

**Revenue Recognition.**  We apply the revenue recognition principlesset forth under SOP 97-2 and SAB 104 with respect to all of our revenue.  We adhere strictly to the criteria set forthin paragraph .08 of SOP 97-2 and outlined in SAB 104 which provides for revenueto be recognized when (i) persuasive evidence of an arrangement exists, (ii) deliveryhas occurred, (iii) the vendor’s fee is fixed or determinable, and (iv) collectabilityis probable.  A summary of our revenuerecognition policies, as they relate to our specific revenue streams, is asfollows:

 

*Computer Hardware Product Revenues*

 

We require our hardwareproduct sales to be supported by a written contract or other evidence of a saletransaction that clearly indicates the selling price to the customer, shippingterms, payment terms (generally 30 days) and refund policy, if any. 

 

Since our hardware salesare supported by a contract or other document that clearly indicates the termsof the transaction, and our selling price is fixed at the time the sale isconsummated, we record revenue on these sales at the time in which we receive aconfirmation that the goods were tendered at their destination when shipped “FOBdestination,” or upon confirmation that shipment has occurred when shipped “FOBshipping point.”  

 

*SoftwareProduct Revenues*

 

We make substantially allof our software product sales as a reseller of licenses, which may include apost contract customer support arrangement and access to product and upgrades,and enhancements that are provided exclusively by the manufacturer followingdelivery and the customer’s acceptance of the software product. We do notpresently sell any software that we develop internally.  Any responsibility for technical support andaccess to upgrades and enhancements to these software products are solely theresponsibility of the software manufacturer, which arrangement is known to thecustomer at the time the sale is consummated. With respect to delivery, we require that the customer has receivedtransfer of the software or, at a minimum, an authorization code (“key”) to permitaccess to the product.  If a softwarelicense is delivered to the customer, but the license term has not begun, we donot record the revenue prior to inception of the license term.  

 

We require our softwareproduct sales to be supported by a written contract or other evidence of a saletransaction, which generally consists of a customer purchase order or on-lineauthorization.  These forms of evidenceclearly indicate the selling price to the customer, shipping terms, paymentterms (generally 30 days) and refund policy, if any. The selling prices ofthese products are fixed at the time the sale is consummated. 

 

For product sales, weapply the factors discussed in EITF 99-19 “Reporting Revenue Gross as aPrincipal versus Net as an Agent” in determining whether to recognize productrevenues on a gross or net basis.  In asubstantial majority of our transactions, we (i) act as principal; (ii) taketitle to the products; and (iii) have the risks and rewards of ownership,including the risk of loss for collection, delivery or returns.  For these transactions, we recognize revenuesbased on the gross amounts billed to our customers.  In certain circumstances, based on ananalysis of the factors set forth in EITF 99-19, we have determined that wewere acting as an agent, and therefore recognize revenues on a net basis.  For the year ended June 30, 2005,revenues recognized on a net basis totaled approximately $1,455,000, or 3% oftotal product revenues during the period.

 

*ITServices Revenue*

 

We generally bill ourcustomers for professional IT services based on hours of time that we spend onany given assignment at our hourly billing rates. As it relates to delivery ofthese services, we recognize

 

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revenue under thesearrangements as the work is completed and the customer has indicated theiracceptance of our services by approving a work order milestone or completionorder.   For certain engagements, weenter fixed bid contracts, and we recognize revenue as phases of the projectare completed and accepted by our client. For our seat management services, we enter unit-price contracts (e.g.,price per user for seat management), and we recognize revenue based on numberof units multiplied by the agreed-upon contract unit price per month.

 

*BPO  Services Revenue*

 

For our business processoutsourcing (“BPO”) services, which primarily include our child support servicecontracts in the states of Kansas and Nebraska, we provide services under afixed price (flat monthly fee) contract, and recognize revenue as the servicesare provided and billed.  In the state ofNorth Carolina, we have one contract subject to revenue-sharing related tochild support services.  Under thatcontract a fee from amounts collected is shared with the county on a percentagebasis, and revenue is recognized monthly in arrears as a percentage of thetotal amount of collections received.

 

**Collectibilityof Receivables**.  Aconsiderable amount of judgment is required to assess the ultimate realization ofreceivables, including assessing the probability of collection and the currentcredit worthiness of our clients. Probability of collection is based upon the assessment of the client’sfinancial condition through the review of its current financial statements orcredit reports.

 

**Goodwill**.  SFAS 142, Goodwill and Other Intangible Assets, requires that goodwill betested for impairment at the reporting unit level (operating segment or onelevel below an operating segment) on an annual basis (June 30thfor the Company) and between annual tests in certain circumstances. Applicationof the goodwill impairment test requires judgment, including the identificationof reporting units, assigning assets and liabilities to reporting units,assigning goodwill to reporting units, and determining the fair value.Significant judgments required to estimate the fair value of reporting unitsinclude estimating future cash flows, determining appropriate discount ratesand other assumptions. Changes in these estimates and assumptions couldmaterially affect the determination of fair value and/or goodwill impairmentfor each reporting unit.   We haverecorded goodwill in connection with the Company’s acquisitions, most recentlythe acquisitions of Redrock in September 2004 and ITI in October 2004,and recorded goodwill in the amount of $4,664,000 and $6,568,000,respectively.  In these instances,goodwill was determined by comparing the purchase price and related transactioncosts with the fair value of the net tangible assets and liabilitiesacquired.    

 

**RecentAccounting Standards**

** **

In December 2004,the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 123R“Share Based Payment”.  This statement isa revision of SFAS Statement No. 123, “Accounting for Stock-Based Compensation” and supersedes APBOpinion No. 25, Accounting forStock Issued to Employees, and its related implementation guidance. SFAS123R addresses all forms of share based payment (“SBP”) awards including sharesissued under employee stock purchase plans, stock options, restricted stock andstock appreciation rights. Under SFAS 123R, SBP awards result in a cost thatwill be measured at fair value on the awards’ grant date, based on theestimated number of awards that are expected to vest that will result in acharge to operations.  This statement is effective forpublic entities that do not file as small business issuers—as of the beginningof the first annual reporting period that begins after June 15, 2005.  The Company began implementing this policyfor the three-month period ended September 30, 2005.

 

In December 2004,the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 153“Exchanges of Nonmonetary Assets”.  This Statement amends Opinion No. 29to eliminate the exception for nonmonetary exchanges of similar productiveassets and replaces it with a general exception for exchanges of nonmonetaryassets that do not have commercial substance. A nonmonetary exchange hascommercial substance if the future cash flows of the entity are expected tochange significantly as a result of the exchange. The provisions of thisStatement, which is to be applied prospectively are effective for nonmonetary asset exchanges occurring in fiscalperiods beginning after June 15, 2005. Earlier application is permittedfor nonmonetary asset exchanges occurring in fiscal periods beginning after June 15,2004. The adoption of this pronouncement is not expected to have materialeffect on the Company’s financial statements. 

 

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EmergingIssues Task Force (“EITF”) Issue 04-8, “The Effect of Contingently ConvertibleInstruments on Diluted Earnings per Share.” The EITF reached a consensus that contingently convertible instruments,such as contingently convertible debt, contingently convertible preferredstock, and other such securities should be included in diluted earnings pershare (if dilutive) regardless of whether the market price trigger has beenmet.  The consensus is effective forreporting periods ending after December 15, 2004.  The adoption of this pronouncement is notexpected to have material effect on the Company’s financial statements.

 

**ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

** **

Marketrisk associated with adverse changes in financial and commodity market pricesand rates could impact our financial position, operating results or cash flows.We are exposed to market risk due to changes in interest rates such as theprime rate and LIBOR. This exposure is directly related to our normal operatingand funding activities. Historically, and as of September 30, 2005, wehave not used derivative instruments or engaged in hedging activities.

 

TheLaurus Funds convertible secured term note exposes the Company to similarrisks, and it requires interest to be paid at 1% over the prime rate.  The table below provides information on the LaurusFunds Note as of September 30, 2005.

 
| ** **        | ** ** | **Principal Balance** | ** ** | **Interest Rate** | ** ** |
|-------------------|------------|-----------------------|------------|-------------------|------------|
| Laurus Funds Note |       | $                     | 6,649,999  |              | 7.75       | % |
|                   |            |                       |            |                   |            |  |

 

We have operated primarily in the United States.  Accordingly, we have not had any significantexposure to foreign currency rate fluctuations.

 

**ITEM 4.  CONTROLS AND PROCEDURES**

** **

Anevaluation as of the end of the period covered by this quarterly report wasperformed under the supervision and with the participation of the Company’smanagement, including its Chief Executive Officer, President and ChiefFinancial Officer, regarding the effectiveness of the design and operation ofthe Company’s disclosure controls and procedures.  Based on that evaluation, the Company’s ChiefExecutive Officer and President and Chief Financial Officer, have concludedthat the Company’s disclosure controls and procedures are effective to ensurethat the information required to be disclosed in the Company filings or whichit submits under the Securities Exchange Act is recorded, processed, summarizedand reported within the time periods specified in the Securities and ExchangeCommission’s rules and forms.  Therehave been no changes in the Company’s internal controls over financialreporting that occurred during the three months ended September 30, 2005that have materially affected, or are reasonably likely to materially affect,the Company’s internal control over financial reporting.

 

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**PART II- OTHER INFORMATION**

** **

# **ITEM 6.****                                                     EXHIBITS**

# ** **

(a)          Exhibits.

 
| 10.1   |   | Asset Purchase and Liability Assumption Agreement,  dated as of August 8, 2005, by and among DynTek, Inc., DynTek  Services, Inc. and New England Technology Finance, LLC.                        |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                             |
| 10.2   |   | Asset Purchase Agreement, dated as of August 8,  2005, by and among DynTek, Inc., DynTek Services, Inc. and New  England Technology Finance, LLC.                                                 |
|   |   |                                                                                                                                                                                                             |
| 10.3   |   | Form of Note Purchase Agreement, dated as of  October 26, 2005, by and among DynTek, Inc. and the accredited  investors named therein.                                                            |
|   |   |                                                                                                                                                                                                             |
| 10.4   |   | Form of Secured Promissory Note, dated as of  October 26, 2005, issued by DynTek, Inc. in favor of certain  accredited investors.                                                                 |
|   |   |                                                                                                                                                                                                             |
| 10.5   |   | Form of Security and Pledge Agreement, dated as  of October 26, 2005, by and among DynTek, Inc., DynTek  Services, Inc. and the investors identified in the Note Purchase  Agreement.        |
|   |   |                                                                                                                                                                                                             |
| 10.6   |   | Form of Common Stock Purchase Warrant, dated  October 26, 2005, issued by DynTek, Inc. in favor of the investors  identified in the Note Purchase Agreement.                                      |
|   |   |                                                                                                                                                                                                             |
| 10.7   |   | Agreement to Amend the Amended and Restated Secured  Convertible Term Note and Common Stock Purchase Warrant, dated as of  October 26, 2005, by and between DynTek, Inc. and Laurus Master  Fund, Ltd. |
|   |   |                                                                                                                                                                                                             |
| 10.8   |   | Form of Amended and Restated 9% Senior  Subordinated Convertible Note, issued by DynTek, Inc. in favor of  certain accredited investors.                                                               |
|   |   |                                                                                                                                                                                                             |
| 10.9   |   | Form of Amended and Restated Warrant, dated as of  October 26, 2005, issued by DynTek, Inc. in favor of certain accredited  investors.                                                            |
|   |   |                                                                                                                                                                                                             |
| 10.10  |   | Form of Amendment No. 1 to Registration  Rights Agreement, dated as of October 26, 2005, by and among  DynTek, Inc. and the investors set forth therein.                                     |
|   |   |                                                                                                                                                                                                             |
| 31.1   |   | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(d) / 15d-14(a) of the Securities Exchange Act of  1934.                                                                         |
|   |   |                                                                                                                                                                                                             |
| 31.2   |   | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(d) / 15d-14(a) of the Securities Exchange Act of  1934.                                                                         |
|   |   |                                                                                                                                                                                                             |
| 32.1   |   | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(b) / 15d-14(b) of the Securities Exchange Act of  1934 and 18 U.S.C. Section 1350.                                         |
|   |   |                                                                                                                                                                                                             |
| 32.2   |   | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(b) / 15d-14(b) of the Securities Exchange Act of  1934 and 18 U.S.C. Section 1350.                                         |

 

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SIGNATURE

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|   | DYNTEK, INC.                  |
|--------|-------------------------------|
|   |                          |
|   |                          |
|   | By:                           | /s/ Robert I.  Webber |   |
|   |                          | Robert I. Webber |
|   |                          | President |
|   |                          |
|   | Date:  November 11, 2005 |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                  |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Asset Purchase  and Liability Assumption Agreement, dated as of August 8, 2005, by and  among DynTek, Inc., DynTek Services, Inc. and New England  Technology Finance, LLC.                       |
|                |       |                                                                                                                                                                                                             |
| 10.2                |       | Asset Purchase  Agreement, dated as of August 8, 2005, by and among DynTek, Inc.,  DynTek Services, Inc. and New England Technology Finance, LLC.                                                 |
|                |       |                                                                                                                                                                                                             |
| 10.3                |       | Form of  Note Purchase Agreement, dated as of October 26, 2005, by and among  DynTek, Inc. and the accredited investors named therein.                                                            |
|                |       |                                                                                                                                                                                                             |
| 10.4                |       | Form of  Secured Promissory Note, dated as of October 26, 2005, issued by  DynTek, Inc. in favor of certain accredited investors.                                                                 |
|                |       |                                                                                                                                                                                                             |
| 10.5                |       | Form of  Security and Pledge Agreement, dated as of October 26, 2005, by and  among DynTek, Inc., DynTek Services, Inc. and the investors  identified in the Note Purchase Agreement.        |
|                |       |                                                                                                                                                                                                             |
| 10.6                |       | Form of Common  Stock Purchase Warrant, dated October 26, 2005, issued by  DynTek, Inc. in favor of the investors identified in the Note Purchase  Agreement.                                     |
|                |       |                                                                                                                                                                                                             |
| 10.7                |       | Agreement to  Amend the Amended and Restated Secured Convertible Term Note and Common Stock  Purchase Warrant, dated as of October 26, 2005, by and between  DynTek, Inc. and Laurus Master Fund, Ltd. |
|                |       |                                                                                                                                                                                                             |
| 10.8                |       | Form of  Amended and Restated 9% Senior Subordinated Convertible Note, issued by  DynTek, Inc. in favor of certain accredited investors.                                                               |
|                |       |                                                                                                                                                                                                             |
| 10.9                |       | Form of  Amended and Restated Warrant, dated as of October 26, 2005, issued by  DynTek, Inc. in favor of certain accredited investors.                                                            |
|                |       |                                                                                                                                                                                                             |
| 10.10               |       | Form of  Amendment No. 1 to Registration Rights Agreement, dated as of  October 26, 2005, by and among DynTek, Inc. and the investors set  forth therein.                                    |
|                |       |                                                                                                                                                                                                             |
| 31.1                |       | Certification of  Chief Executive Officer Pursuant to Rule 13a-14(d) /  15d-14(a) of the Securities Exchange Act of 1934.                                                                         |
|                |       |                                                                                                                                                                                                             |
| 31.2                |       | Certification of  Chief Financial Officer Pursuant to Rule 13a-14(d) / 15d-14(a) of  the Securities Exchange Act of 1934.                                                                         |
|                |       |                                                                                                                                                                                                             |
| 32.1                |       | Certification of  Chief Executive Officer Pursuant to Rule 13a-14(b) /  15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C.  Section 1350.                                        |
|                |       |                                                                                                                                                                                                             |
| 32.2                |       | Certification of  Chief Financial Officer Pursuant to Rule 13a-14(b) /  15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C.  Section 1350.                                        |

 

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