**U.S. SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

 

| **x**                                                                                                                                         | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**  |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
|                                                                                                                                          |
| **For the Quarter ended September 30, 2007**                                                                                             |
|                                                                                                                                          |
| **OR**                                                                                                                                        |
|                                                                                                                                          |
| **o**                                                                                                                                         | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                          |
| **For the transition period  from                   to** |

 

**Commission file number 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 230Irvine, 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 x  No o

 

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

 
| Large accelerated filer o |   | Accelerated  filer o |   | Non-accelerated filer x |
|---------------------------|--------|----------------------|--------|-------------------------|

Indicateby check mark whether the Registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o  No x

 

As of November 14,2007, the number of shares outstanding of the registrant’s Common Stock,$0.0001 par value, was 58,234,989.

 

 

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**DYNTEK, INC. AND SUBSIDIARIES**

 

**INDEX**

 
| **PART I – FINANCIAL  INFORMATION**                                                                                                                                   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                                                                                                                                                            |       |   |
| Item 1. Condensed Consolidated  Financial Statements                                                                                                                            |       |   |
| ** **                                                                                                                                                                      | ** ** | ** ** |
| Condensed  Consolidated Balance Sheets – as of September 30, 2007 (unaudited) and  June 30, 2007                                                                 |       |   |
| ** **                                                                                                                                                                      | ** ** | ** ** |
| Condensed  Consolidated Statements of Operations and Comprehensive Income (Loss)  (unaudited) - For the Three Months Ended September 30, 2007 and  September 30, 2006 |       |   |
|                                                                                                                                                                            |       |   |
| Condensed  Consolidated Statements of Cash Flows (unaudited) - For the Three Months  Ended September 30, 2007 and September 30, 2006                                  |       |   |
|                                                                                                                                                                            |       |   |
| Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                                                               |       |   |
|                                                                                                                                                                            |       |   |
| Item 2.  Management’s Discussion and Analysis of Financial Conditions and Results of  Operations                                                                           |       |   |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risk                                                                                                             |       |   |
| Item 4. Controls and  Procedures                                                                                                                                                |       |   |
|                                                                                                                                                                            |       |   |
| **PART II - OTHER  INFORMATION**                                                                                                                                           | ** ** | ** ** |
|                                                                                                                                                                            |       |   |
| Item 1. Legal Proceedings                                                                                                                                                       |       |   |
| Item 6. Exhibits                                                                                                                                                                |       |   |
| ** **                                                                                                                                                                      | ** ** | ** ** |
| **SIGNATURE**                                                                                                                                                                   | ** ** | ** ** |

 

2

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**PART 1 – FINANCIAL INFORMATION**

 

**ITEM 1.CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**DYNTEK, INC. ANDSUBSIDIARIES**

# **CONDENSED CONSOLIDATED BALANCESHEETS**

# (in thousands, except per share data)

 
| ** **                                                                                                                                                                    | ** ** | **September 30,  2007** | ** ** | **June 30, 2007** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                    | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                                                                                        |       |                         |       |                        |       |
| CURRENT ASSETS:                                                                                                                                                               |       |                         |       |                        |       |
| Cash                                                                                                                                                                          |       | $                            | 838        |                        | $          | 1,922 |   |
| Cash –  Restricted                                                                                                                                                       |       | 431                          |       | 519                         |       |
| Accounts  receivable, net                                                                                                                                                     |       | 5,499                        |       | 3,554                       |       |
| Due from NETF                                                                                                                                                                 |       | 2,811                        |       | 4,034                       |       |
| Inventory                                                                                                                                                                     |       | 289                          |       | 289                         |       |
| Prepaid expenses  and other current assets                                                                                                                                    |       | 380                          |       | 197                         |       |
| Other  receivables                                                                                                                                                            |       | 83                           |       | 20                          |       |
| TOTAL CURRENT  ASSETS                                                                                                                                                         |       | 10,331                       |       | 10,535                      |       |
|                                                                                                                                                                          |       |                         |       |                        |       |
| RESTRICTED CASH –  non current portion                                                                                                                                   |       | 11                           |       | 72                          |       |
| PROPERTY AND  EQUIPMENT, net                                                                                                                                                  |       | 596                          |       | 662                         |       |
| GOODWILL                                                                                                                                                                      |       | 19,247                       |       | 19,201                      |       |
| ACQUIRED  CUSTOMER LISTS, net                                                                                                                                                 |       | 2,184                        |       | 2,487                       |       |
| DEFERRED  FINANCING COSTS, net                                                                                                                                                |       | 278                          |       | 307                         |       |
| DEPOSITS AND  OTHER ASSETS                                                                                                                                                    |       | 793                          |       | 704                         |       |
| TOTAL ASSETS                                                                                                                                                                  |       | $                            | 33,440     |                        | $          | 33,968 |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                    |       |                         |       |                        |       |
|                                                                                                                                                                          |       |                         |       |                        |       |
| CURRENT  LIABILITIES:                                                                                                                                                         |       |                         |       |                        |       |
| Cash overdraft                                                                                                                                                                |       | $                            | 426        |                        | $          | 433 |   |
| Accounts payable                                                                                                                                                              |       | 3,666                        |       | 2,038                       |       |
| Accrued expenses                                                                                                                                                              |       | 2,079                        |       | 2,383                       |       |
| Deferred revenue                                                                                                                                                              |       | 1,331                        |       | 1,289                       |       |
| Liabilities of  discontinued operations                                                                                                                                       |       | 258                          |       | 258                         |       |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                    |       | 7,760                        |       | 6,401                       |       |
|                                                                                                                                                                          |       |                         |       |                        |       |
| DEFERRED REVENUE  – non current portion                                                                                                                                  |       | 11                           |       | 46                          |       |
| DEFERRED INCOME  TAXES                                                                                                                                                        |       | 275                          |       | 275                         |       |
| NOTES PAYABLE –  (net of discounts of $6,690 and $7,315 as of September 30, 2007 and  June 30, 2007, respectively                                              |       | 14,919                       |       | 13,626                      |       |
| TOTAL  LIABILITIES                                                                                                                                                            |       | 22,965                       |       | 20,348                      |       |
|                                                                                                                                                                          |       |                         |       |                        |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                                |       |                         |       |                        |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                   |       |                         |       |                        |       |
| Preferred stock,  $.0001 par value, 10,000,000 shares authorized; 0 shares issued and  outstanding as of September 30, 2007 and June 30, 2007,  respectively        |       | —                       |       | —                      |       |
| Common stock,  $.0001 par value, 450,000,000 shares authorized; 58,234,989 shares issued and  outstanding as of September 30, 2007 and June 30, 2007,  respectively |       | 6                            |       | 6                           |       |
| Additional  paid-in capital                                                                                                                                                   |       | 150,693                      |       | 150,571                     |       |
| Accumulated  other comprehensive income (loss)                                                                                                                                |       | (3                           | )          | 67                          |       |
| Accumulated  deficit                                                                                                                                                          |       | (140,221                     | )          | (137,024                    | )          |
| TOTAL  STOCKHOLDERS’ EQUITY                                                                                                                                              |       | 10,475                       |       | 13,620                      |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                              |       | $                            | 33,440     |                        | $          | 33,968 |   |

 

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

 

3

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**DYNTEK, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONSAND COMPREHENSIVE INCOME (LOSS)**

(Unaudited)

(in thousands, except per share data)

 
| ** **                                                                                        | ** ** | **Three months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                        | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
| REVENUES                                                                                          |       |                                                 |       |   |   |
| Product Revenues                                                                                  |       | $                                                    | 22,040     |   | $ | 16,783 |   |
| Service Revenues                                                                                  |       | 8,042                                                |       | 4,994 |   |
| TOTAL REVENUES                                                                                    |       | 30,082                                               |       | 21,777 |   |
|                                                                                              |       |                                                 |       |   |   |
| COST OF REVENUES                                                                                  |       |                                                 |       |   |   |
| Cost of Products                                                                                  |       | 19,095                                               |       | 14,595 |   |
| Cost of Services                                                                                  |       | 6,059                                                |       | 3,566 |   |
| TOTAL COST OF  REVENUES                                                                           |       | 25,154                                               |       | 18,161 |   |
|                                                                                              |       |                                                 |       |   |   |
| GROSS PROFIT                                                                                      |       | 4,928                                                |       | 3,616 |   |
|                                                                                              |       |                                                 |       |   |   |
| OPERATING  EXPENSES:                                                                              |       |                                                 |       |   |   |
| Selling                                                                                           |       | 3,770                                                |       | 2,593 |   |
| General and  administrative                                                                       |       | 1,662                                                |       | 1,343 |   |
| Depreciation and  amortization                                                                    |       | 669                                                  |       | 693 |   |
| TOTAL OPERATING  EXPENSES                                                                         |       | 6,101                                                |       | 4,629 |   |
|                                                                                              |       |                                                 |       |   |   |
| LOSS FROM  OPERATIONS                                                                             |       | (1,173                                               | )          | (1,013 | ) |
|                                                                                              |       |                                                 |       |   |   |
| OTHER INCOME  (EXPENSE)                                                                           |       |                                                 |       |   |   |
| Interest expense                                                                                  |       | (2,014                                               | )          | (1,554 | ) |
| Interest income                                                                                   |       | 6                                                    |       | 19 |   |
| Other expense                                                                                     |       | 1                                                    |       | 2 |   |
| TOTAL OTHER  EXPENSE                                                                              |       | (2,007                                               | )          | (1,533 | ) |
|                                                                                              |       |                                                 |       |   |   |
| LOSS FROM  CONTINUING OPERATIONS BEFORE INCOME TAXES                                              |       | (3,180                                               | )          | (2,546 | ) |
| INCOME TAXES                                                                                      |       | 16                                                   |       | 38 |   |
|                                                                                              |       |                                                 |       |   |   |
| NET LOSS                                                                                          |       | $                                                    | (3,196     | ) | $ | (2,584 | ) |
|                                                                                              |       |                                                 |       |   |   |
| NET LOSS PER  SHARE – basic and diluted                                                      |       | $                                                    | (0.05      | ) | $ | (0.05 | ) |
|                                                                                              |       |                                                 |       |   |   |
| WEIGHTED AVERAGE  NUMBER OF SHARES OUTSTANDING, BASIC AND DILUTED                                 |       | 58,234,989                                           |       | 56,592,351 |   |
|                                                                                              |       |                                                 |       |   |   |
| NET LOSS                                                                                          |       | $                                                    | (3,196     | ) | $ | (2,584 | ) |
|                                                                                              |       |                                                 |       |   |   |
| OTHER  COMPREHENSIVE INCOME (LOSS), NET OF INCOME TAXES Foreign currency translation  gain (loss) |       | (64                                                  | )          | 12 |   |
|                                                                                              |       |                                                 |       |   |   |
| COMPREHENSIVE  LOSS                                                                               |       | $                                                    | (3,260     | ) | $ | (2,572 | ) |

 

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

 

4

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**DYNTEK, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited)

(in thousands)

 
| ** **                                                         | ** ** | **Three Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                         | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                             |       |                                                 |       |   |   |
| Net loss                                                           |       | $                                                    | (3,196     | ) | $ | (2,584 | ) |
| Adjustments to  reconcile net loss to net cash used in operations: |       |                                                 |       |   |   |
| Depreciation and  amortization                                     |       | 669                                                  |       | 693 |   |
| Non-cash  interest                                                 |       | 1,377                                                |       | 1,150 |   |
| Stock-based  compensation                                          |       | 66                                                   |       | 528 |   |
| Changes in  operating assets and liabilities:                      |       |                                                 |       |   |   |
| Accounts  receivable                                               |       | (1,945                                               | )          | (645 | ) |
| Due from NETF                                                      |       | 1,223                                                |       | 280 |   |
| Inventory                                                          |       | —                                               |       | 150 |   |
| Prepaid expenses  and other current assets                         |       | (183                                                 | )          | (101 | ) |
| Other receivables                                                  |       | (63                                                  | )          | 7 |   |
| Deposits and  other assets                                         |       | (89                                                  | )          | 31 |   |
| Accounts payable                                                   |       | 1,628                                                |       | 742 |   |
| Deferred revenue                                                   |       | 7                                                    |       | (208 | ) |
| Accrued expenses                                                   |       | (303                                                 | )          | (351 | ) |
| Restricted cash                                                    |       | 149                                                  |       | 125 |   |
| Total  adjustments                                                 |       | 2,536                                                |       | 2,413 |   |
| NET CASH USED IN  OPERATING ACTIVITIES                             |       | (660                                                 | )          | (171 | ) |
|                                                               |       |                                                 |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                             |       |                                                 |       |   |   |
| Cash paid for  acquisition                                         |       | (212                                                 | )          | (100 | ) |
| Capital  expenditures                                              |       | (33                                                  | )          | (80 | ) |
| NET CASH USED IN  INVESTING ACTIVITIES                             |       | (245                                                 | )          | (180 | ) |
|                                                               |       |                                                 |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                             |       |                                                 |       |   |   |
| Cash overdraft                                                     |       | (7                                                   | )          | 53 |   |
| Proceeds from  debt financing                                      |       | —                                               |       | 3,000 |   |
| Deferred  financing costs                                          |       | (29                                                  | )          | (26 | ) |
| Exercise of  options and warrants                                  |       | —                                               |       | 1 |   |
| Shares  repurchased and held in Treasury                           |       | —                                               |       | (108 | ) |
| NET CASH  PROVIDED BY FINANCING ACTIVITIES                         |       | (36                                                  | )          | 2,920 |   |
|                                                               |       |                                                 |       |   |   |
| Effect of  Exchange Rate on Cash and Cash Equivalents              |       | (143                                                 | )          | 12 |   |
|                                                               |       |                                                 |       |   |   |
| NET INCREASE  (DECREASE) IN CASH                                   |       | (1,084                                               | )          | 2,569 |   |
|                                                               |       |                                                 |       |   |   |
| CASH AT  BEGINNING OF PERIOD                                       |       | 1,922                                                |       | 546 |   |
|                                                               |       |                                                 |       |   |   |
| CASH AT END OF  PERIOD                                             |       | $                                                    | 838        |   | $ | 3,115 |   |

 

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

 

5

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**DYNTEK, INC. ANDSUBSIDIARIES**

# **CONSOLIDATED STATEMENTS OF CASH FLOWS**

 

# (Unaudited)

# (in thousands)

 
| ** **                                                   | ** ** | **Three Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                   | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
|                                                         |       |                                                 |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:           |       |                                                 |       |   |   |
|                                                         |       |                                                 |       |   |   |
| Cash paid for  interest                                      |       | $                                                    | 637        |   | $ | 140 |   |
| Cash paid for  taxes                                         |       | $                                                    | 99         |   | $ | — |   |
|                                                         |       |                                                 |       |   |   |
| Acquisition of  Coast Business Group, LLC in July 2007: |       |                                                 |       |   |   |
| Intangible  assets – customer list                      |       | $                                                    | 227        |   | $ | — |   |
| Accrued expenses  (contract obligation)                      |       | (15                                                  | )          |   |   |
| Cash paid to  acquire business                               |       | $                                                    | 212        |   | $ | — |   |

 

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

 

6

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**DYNTEK, INC. & SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**SEPTEMBER 30, 2007**

 

**(UNAUDITED)**

 

**1.*BASIS OFPRESENTATION***

 

The accompanying unaudited interim condensedconsolidated financial statements of DynTek, Inc. and its subsidiaries (“DynTek”,“Company”, or “we”) have been prepared in accordance with accounting principlesgenerally accepted in the United States of America, for interim financialstatements and pursuant to the instructions to Form 10-Q and Article 10of Regulation S-X. Accordingly, they do not include all of the information anddisclosures required for annual financial statements. These unaudited interimcondensed consolidated financial statements should be read in conjunction withthe audited consolidated financial statements and notes included in the AnnualReport on Form 10-K, as amended, for the year ended June 30, 2007.

 

The accompanying unaudited interim condensedconsolidated financial statements reflect all adjustments, which, in theopinion of management, consist of normal recurring items that are necessary fora fair presentation in conformity with accounting principles generally acceptedin the United States of America. Preparing unaudited interim condensedconsolidated financial statements requires management to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenuesand expenses. The results of operations for any interim period are notnecessarily indicative of the results attainable for a full fiscal year.

 

**2.*LIQUIDITY AND FINANCIAL CONDITION***

 

The Company incurred a net loss of $3,196,000 for thethree months ended September 30, 2007, which includes $2,112,000 ofnon-cash charges resulting from $669,000 of depreciation and amortization; $66,000in non-cash stock based compensation expense; and $1,377,000 in non-cashinterest charges. At September 30, 2007, the Company had working capitalof approximately $2,571,000.

 

The Company believes that its strategy of streamliningthe business around its core competency of providing IT solutions is enablingit to operate under a more efficient cost structure than it had in the past.The Company is also not required to make principal payments under any of itsnote obligations until June 2009 and its accounts receivable and productfinancing arrangement with New England Technology Finance, LLC (“NETF”) isproviding it with timely working capital resources.

 

The Company is continuingits financial and operational restructuring initiatives and will continue toimplement its strategic business plan, which could include further cost cuttinginitiatives and possible divestitures of assets, if considered necessary.Although the Company believes that it has sufficient liquidity to sustain thebusiness through October 1, 2008, there is no assurance that unforeseencircumstances will not have a material affect on the business that couldrequire it to raise additional capital or take other measures to sustainoperations in the event outside sources of capital are not available. TheCompany has not secured any commitments for new financing at this time nor canit provide any assurance that new capital (if needed) will be available toit on acceptable terms, if at all.

 

**3.*SIGNIFICANT ACCOUNTING POLICIES***

 

A. Principles ofConsolidation - The unaudited interim condensed consolidated financialstatements include the accounts of the Company and its wholly-ownedsubsidiaries. All significant inter-company transactions have been eliminatedin consolidation.

 

B.   Foreign CurrencyTranslation—The unaudited interim condensed consolidated financial statementsare presented in United States Dollars in accordance with Statement ofFinancial Accounting Standard(“SFAS”) No. 52, “Foreign CurrencyTranslation” (“SFAS 52”). The functional currency of DynTek Canada, Inc.,the Company’s Canadian Subsidiary is the Canadian dollar. Assets andliabilities are translated at exchange rates in effect at the balance sheetdate and revenue and expense accounts are translated at average exchange ratesduring the period. Resulting translation adjustments are recorded directly toaccumulated other comprehensive income.

 

7

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C. Revenue Recognition—The Company applies the revenuerecognition principles set forth under AICPA Statement of Position 97-2 (“SOP97-2”) and Securities and Exchange Commission’s Staff Accounting Bulletin104  (“SAB 104”) with respect to all ofits revenue. Accordingly, the Company recognizes revenue when (i) persuasiveevidence of an arrangement exists, (ii) delivery has occurred, (iii) thevendor’s fee is fixed or determinable, and (iv) collectability isprobable.

 

*Computer Hardware Product Revenues*

 

The Company requires its hardware product sales to besupported by a written contract or other evidence of a sale transaction thatclearly indicates the selling price to the customer, shipping terms, paymentterms (generally 30 days) and refund policy, if any. Since the Company’shardware sales are supported by a contract or other document that clearlyindicates the terms of the transaction, and the selling price is fixed at thetime the sale is consummated, the Company records revenue on these sales at thetime at which it receives a confirmation that the goods were tendered at theirdestination when shipped “FOB destination,” or upon confirmation that shipmenthas occurred when shipped “FOB shipping point.”

 

*Software Product Revenues*

 

The Company makes substantially all of its softwareproduct sales as a reseller of licenses, which may include a post contractcustomer support arrangement and access to product and upgrades, andenhancements that are provided exclusively by the manufacturer followingdelivery and the customer’s acceptance of the software product. The Companydoes not presently sell any software that it develops internally. Anyresponsibility for technical support and access to upgrades and enhancements tothese software products are solely the responsibility of the softwaremanufacturer, which arrangement is known to the customer at the time the saleis consummated. With respect to delivery, the Company requires that thecustomer has received transfer of the software or, at a minimum, anauthorization code (“key”) to permit access to the product. If a software licenseis delivered to the customer, but the license term has not begun, the Companydoes not record the revenue prior to inception of the license term.

 

The Company requires its software product sales to be supported by awritten contract or other evidence of a sale transaction, which generallyconsists of a customer purchase order or on-line authorization. These forms ofevidence clearly indicate the selling price to the customer, shipping terms,payment terms (generally 30 days) and refund policy, if any. The selling pricesof these products are fixed at the time the sale is consummated.

 

For product sales, the Company applies the factors discussed inEmerging Issues Task Force Issue 99-19 (“EITF 99-19”) in determining whether torecognize product revenues on a gross or net basis.

 

In a substantial majority of transactions, the Company (i) acts asprincipal; (ii) takes title to the products; and (iii) has the risksand rewards of ownership, including the risk of loss for collection, deliveryor returns. For these transactions, the Company recognizes revenues based onthe gross amounts billed to customers. In certain circumstances, based on ananalysis of the factors set forth in EITF 99-19, the Company has determinedthat it was acting as an agent, and therefore recognizes revenues on a netbasis. For the three months ended September 30, 2007 and 2006, revenuesrecognized on a net basis totaled approximately $365,000 and $215,000,respectively.

 

*IT Services Revenue*

 

The Company generally bills its customers for professional IT servicesbased on hours of time spent on any given assignment at its hourly billingrates. As it relates to delivery of these services, the Company recognizesrevenue under these arrangements as the work is completed and the customer has indicatedacceptance of services by approving a work order milestone or completion order.

 

For certain engagements, the Company enters into fixed bid contracts,and recognizes revenue as phases of the project are completed and accepted bythe client. For its seat management services, the Company enters into unit-pricecontracts (e.g., price per user for seat management), and recognizes revenuebased on number of units multiplied by the agreed-upon contract unit price permonth.

 

8

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D.Accounts Receivable—The Company generates accounts receivable from sales ofservices and products to its customers. The Company establishes reserves foruncollectible accounts based on its best estimate of the amount of probable creditlosses in its existing accounts receivable. The Company periodically reviewsits accounts receivable to determine whether an allowance is necessary based onan analysis of past due accounts and other factors that may indicate thatthe realization of an account may be in doubt. Account balances deemed tobe uncollectible are charged to the allowance after all means of collectionhave been exhausted and the potential for recovery is considered remote.

 

The Company sells its eligible accounts receivable toNETF under each of an Asset Purchase and Liability Assumption Agreement and anAsset Purchase Agreement that it entered into with NETF during August 2005.The Company retains certain servicing rights under a related Master ServicingAgreement that provides for the Company to manage collections and other ongoinginteractions with customers for certain contractual fees. These agreements aremore fully described in Note 7.

 

The Company accounts for its transfers of accountsreceivable to NETF under each of these agreements in accordance with theprovision of SFAS 140 “Accounting for Transfers and Servicing of FinancialAssets and Extinguishment of Liabilities” as sales of such accounts receivablebalances. The gain or loss on sales of receivables to NETF is determined at thedate of transfer based upon the amount at which they are transferred to NETFless any fees, discounts and other charges provided under the agreements.

 

E. Net Loss Per Share—The Company computes net lossper share in accordance with SFAS No. 128. “Earnings per Share.”Accordingly, the Company computed its net loss per share by dividing its netloss for each of the periods presented by the weighted average number of commonshares outstanding for the period. The computation of net loss per shareexcluded the effect of potentially dilutive securities that would be issuableupon the exercise of convertible debt, stock options and common stock purchasewarrants. As of September 30, 2007, the Company excluded 44,503,134 sharesissuable upon the exercise of outstanding warrants, 10,976,605 shares issuableupon the exercise of outstanding options and 78,113,616 shares issuable uponthe conversion of convertible debt from the computation of basic and dilutedloss per share since their effect would be antidilutive.

 

F. Estimates—The Company’s unaudited interim condensedconsolidated 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, including revenue recognition, impairmentof goodwill, and accounting for discontinued operations. Actual results withrespect to estimates could differ from the outcome of one or more confirmingevents in future periods. The difference between actual results and management’sestimates could be material.

 

G. Stock BasedCompensation – Effective July 1, 2005, the Company adopted FinancialAccounting Standards Board (“FASB”) SFAS No. 123R (“SFAS 123R”). Thisstatement is a revision of SFAS Statement No. 123, and supersedes APB Opinion No. 25, and its relatedimplementation guidance. SFAS 123R addresses all forms of share based payment (“SBP”)awards including shares issued under employee stock purchase plans, stockoptions, restricted stock and stock appreciation rights. Under SFAS 123R, SBPawards result in a cost that will be measured at fair value on the awards’grant date using the Black-Scholes option pricing model, based on the estimatednumber of awards that are expected to vest that will result in a charge tooperations.

 

H. Goodwill and Amortizable Intangible Assets—Goodwillrepresents the excess of the purchase price over the fair value of net assetsacquired in business combinations. SFAS 142, Goodwill and Other IntangibleAssets, requires that goodwill be tested for impairment at the reporting unitlevel (operating segment or one level below an operating segment) on an annualbasis (June 30th for the Company) and between annual tests whencircumstances indicate that the recoverability of the carrying amount ofgoodwill may be in doubt. Application of the goodwill impairment testrequires judgment, including the identification of reporting units, assigningassets and liabilities to reporting units, assigning goodwill to reportingunits, and determining the fair value. Significant judgments required toestimate the fair value of reporting units include estimating future cashflows, determining appropriate discount rates and other assumptions. Changes inthese estimates and assumptions could materially affect the determination of fairvalue and/or goodwill impairment for each reporting unit.

 

9

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**Sensible Security Solutions, Inc.**

October 27, 2006, the Company, DynTek Canada, SSS, andPaul Saucier entered into an Asset Purchase Agreement for the acquisition byDynTek Canada of substantially all of the assets of SSS. SSS provides majorCanadian organizations, both in the private and public sector, with the designand implementation of comprehensive, enterprise-level anti-virus solutions. TheCompany acquired SSS because it was aligned with the Company’s existing coresecurity practice, provides a greater density within its Canadian region, andprovides for a more comprehensive delivery of its service support acrossvarious geographical regions.

In consideration for the purchased assets, the Companypaid SSS at closing a cash payment of $1,063,000 and 1,485,148 shares of theCompany’s common stock with an aggregate fair value of $300,000 based upon theper share fair value measured in accordance with EITF 99-12. Additional fees inconnection with the acquisition of approximately $50,000 were also paid.

The Company is obligated to make additional paymentsof up to $4.7 million over a three-year period based upon the achievement ofcertain EBITDA performance targets. Such payments are payable quarterly for thefirst year of the earn-out period and annually for each of the next two yearsusing a combination of cash and the Company’s common stock, at the Company’selection, provided that at least half of the payments will be in cash. Earn-outawards are calculated, subject to adjustment, based upon the cumulative effectof achieved EBITDA performance targets during the applicable earn-outperiod.  Determination and notificationof the EBITDA earn-out shall be provided to SSS within 45 days after the end ofeach earn-out period.  For the periodended September 30, 2007, no earn-out provision was payable.

The Company’s amortizable intangible assets includecustomer relationships that are being amortized using the straight-line methodover estimated useful lives of three to seven years. In accordance with SFAS144 “Long-Lived Assets”, the Company reviews the carrying value of intangiblesand other long-lived assets for impairment at least annually or whenever eventsor changes in circumstances indicate that the carrying amount of an asset may notbe recoverable.

 

Recoverability of amortizable intangible assets underSFAS 144 is measured by comparing the carrying amount to the undiscounted cashflows that the asset or asset group is expected to generate. If such assets areconsidered to be impaired, the impairment charge to be recognized is measuredbased on the carrying amount of the property that exceeds its fair marketvalue.

 

Amortization expense for acquired customer lists foreach of the three month periods ended September 30, 2007 and 2006 amounted toapproximately $563,000 and $575,000, respectively. The Company evaluated theacquired customer lists for possible impairment, in accordance with SFAS 142. Basedon the results of the evaluation, the Company determined that impairmentcharges were not required for the three month periods ended September 30, 2007and 2006.

 

I.             CommonStock Purchase Warrants and other Derivative Financial Instruments—The Companyaccounts for the issuance of Common Stock purchase warrants and otherfreestanding derivative financial instruments in accordance with the provisionsof EITF 00-19. Based on the provisions of EITF 00-19, the Company classifies asequity any contracts that (i) require physical settlement or net-sharesettlement, or (ii) gives the Company a choice of net-cash settlement orsettlement in its own shares (physical settlement or net-share settlement). TheCompany classifies as assets or liabilities any contracts that (i) requirenet-cash settlement (including a requirement to net cash settle the contract ifan event occurs and if that event is outside the control of the Company), or (ii) givethe counterparty a choice of net-cash settlement or settlement in shares(physical settlement or net-share settlement).

 

J. Convertible Notes - The Company accounts forconversion options embedded in convertible notes in accordance with SFAS No. 133“Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) andEITF 00-19. SFAS 133 generally requires Companies to bifurcate conversionoptions embedded in convertible notes from their host instruments and toaccount for them as free standing derivative financial instruments inaccordance with EITF 00-19. SFAS 133 provides for an exception to this rule whenconvertible notes, as host instruments, are deemed to be conventional as thatterm is described in the implementation guidance under Appendix A to SFAS 133and further clarified in EITF 05-2 “The Meaning of “Conventional ConvertibleDebt Instrument” in EITF Issue No. 00-19.

 

The Companyaccounts for convertible notes (deemed conventional) in accordance with theprovisions of EITF Issue 98-5 “Accounting for Convertible Securities withBeneficial Conversion Features,” (“EITF 98-5”), EITF 00-27 “Application of EITF98-5 to Certain Convertible Instruments,” Accordingly, the Company records, asa discount to convertible notes, the intrinsic value of such conversion optionsbased upon the differences between the fair value of the underlying commonstock at the commitment date of the note transaction and the effectiveconversion price embedded in the note. Debt discounts under these arrangementsare amortized over the term of the related debt to their earliest date of redemption.

 

K.            Income Taxes - TheCompany accounts for income taxes in accordance with Statement of FinancialAccounting Standards No. 109, “Accounting for Income Taxes” (“SFASNo. 109”). SFAS No. 109 requires the recognition of deferred taxassets and liabilities for both the expected impact of differences between thefinancial statements and tax basis of assets and liabilities and for theexpected future tax benefit to be derived from tax loss and tax credit carryforwards. SFAS No. 109 additionally requires the establishment of avaluation allowance to reflect the likelihood of realization of deferred taxassets. Deferred tax assets, which principally arise from net operating losses,are fully reserved due to management’s assessment that it is more likely thannot that the benefit of these assets will not be realized in future periods.

 

In July 2006,the FASB issued FASB Interpretation No. 48, *“Accounting for Uncertainty in Income Taxes - an interpretation of FASBStatement No. 109”* (“FIN 48”), which clarifies the accountingand disclosure for uncertainty in tax positions by prescribing a minimumprobability threshold a tax position must meet to be recognized in thefinancial statements. FIN 48 requires an entity to recognize all or a portionof the financial statement benefit of an uncertain income tax position only ifthe position, based solely on its technical merits and on all relevantinformation as of the reporting date, would have a greater than 50% probabilityof being sustained were the relevant taxing authority to audit the applicationtax returns. If a tax position meets the threshold, then the entity willevaluate the benefits it would recognize at increasing levels of cumulativeprobabilities, and will record the largest amount of benefit that would have agreater than 50% probability of being sustained on audit (including resolutionof any related appeals or litigation). An entity will not recognize any benefitof an uncertain income tax position that fails to meet the greater than 50%probability threshold.

 

The Company is subject to the provisions of FIN 48 as of July1, 2007. The Company completed its initial assessment upon its adoption of FIN48 and does not believe it has any material uncertain tax positions. 

 

10

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The Company files income tax returns in the United StatesFederal jurisdiction and in certain state jurisdictions as well as Canada. TheCompany monitors geographic locations in which it conducts business todetermine its appropriate filing requirements. With limited exceptions, theCompany is no longer subject to US Federal income tax examinations for fiscalyears before 2004 and is no longer subject to state and local income taxexaminations by tax authorities for fiscal years before 2003.Neither the Company nor itssubsidiaries is currently under examination by any taxing authorities.The Company does not anticipate thattotal unrecognized tax benefits will significantly change due to the settlementof audits and the expiration of statutes of limitation prior to June 30,2008.

 

**RecentlyIssued Accounting Pronouncements**

 

In September 2006,the FASB issued Statement of Financial Accountings Standards No. 157, FairValue Measurements (“SFAS 157”). This Standard defines fair value, establishesa framework for measuring fair value in generally accepted accountingprinciples and expands disclosures about fair value measurements. SFAS 157 iseffective for financial statements issued for fiscal years beginning after November 15,2007 and interim periods within those fiscal years. The adoption of SFAS 157 isnot expected to have a material impact on the Company’s consolidated financialposition, results of operations or cash flows.

 

In February 2007,the FASB issued SFAS 159, “The Fair Value Option for Financial Assets andFinancial Liabilities” (“SFAS 159”). SFAS 159 provides companies withan option to report selected financial assets and liabilities at fair value andestablishes presentation and disclosure requirements designed to facilitate comparisonsbetween companies that choose different measurement attributes for similartypes of assets and liabilities. SFAS 159 is effective for fiscal yearsbeginning after November 15, 2007. The Company is in the process ofevaluating the impact of the adoption of this statement on the Company’sconsolidated financial position, results of operations and cash flows.

 

In June 2007,the FASB ratified the consensus on EITF Issue No. 06-11, Accounting forIncome Tax Benefits of Dividends on Share-Based Payment Awards (“EITF 06-11”).EITF 06-11 requires companies to recognize the income tax benefit realized fromdividends or dividend equivalents that are charged to retained earnings andpaid to employees for non-vested equity-classified employee share-based paymentawards as an increase to additional paid-in capital. EITF 06-11 is effectivefor fiscal years beginning after September 15, 2007. The adoption is notexpected to have a material impact on the Company’s consolidated financialposition, results of operations and cash flows.

 

Other accountingstandards that have been issued or proposed by the FASB or otherstandards-setting bodies that do not require adoption until a future date arenot expected to have a material impact on the Company’s consolidated financialstatements upon adoption.

 

**4.*BUSINESS ACQUISITIONS***

 

**Coast BusinessGroup**

** **

On July 2, 2007, theCompany, Dyntek Services, Inc., entered into an Asset Purchase Agreementwith Coast Business Group, LLC (“Coast”) and Paul Freeman and Stuart Flamm,principal owners, for all of Coast’s right, title and interest in its assetsused in connection with the business. Coast is engaged in the business ofproviding information technology resources and professional services. Inconsideration for the purchased assets, the Company paid to Coast $200,000 atclosing, $15,000 upon the delivery of a consent to the assignment of a materialagreement and incurred approximately $12,000 of direct acquisition costs.

 

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Inaddition to the payment made at closing, Coast is entitled to receive anadditional payment (the “Incentive Payment”) contingent upon the achievement ofspecified operating targets during the full twelve calendar month periodbeginning on the first full calendar month following closing, as outlinedbelow:

 
| **Operating Income   Milestone** | ** ** | **Contingent  Consideration** | ** ** |
|--------------------------------------------|------------|-------------------------------|------------|
| $ 200,000 to $349,999                 |       | $                             | 200,000    |   |
| $ 350,000 to $499,999                 |       | $                             | 300,000    |   |
| $ 500,000 or more                     |       | $                             | 400,000    |   |

 

Thepayment of the Incentive Payment is to be made in cash or common stock of theCompany, at the Company’s election, provided that at least $133,333 of any suchIncentive Payment shall be paid in cash.

 

Asof July 2, 2007, Coast’s results of operations were consolidated with theCompany’s results of operations. The increase in the value of intangible assets(customer list) of approximately $227,000 is being amortized over a three yearperiod.

 

Asummary of the business assets acquired (in thousands) is as follows:

 
| *Consideration paid:*                                                         |   |   |   |
|-------------------------------------------------------------------------------|--------|--------|--------|
| Cash                                                                          |   | $      | 215    |   |
| Transaction expenses                                                          |   | 12     |   |
| Total consideration                                                           |   | $      | 227    |   |
| Allocation of Purchase Price:                                                 |   |   |   |
| Value of excess of purchase  price plus net liabilities assumed allocated to: |   |   |   |
| Customer list                                                                 |   | $      | 227    |   |
| Fair value of assets acquired                                                 |   | $      | 227    |   |

** **

**5.*RESTRICTEDCASH***

 

Restrictedcash includes cash received in connection with maintenance agreements that willbecome available to the Company as revenue is earned and recognized under theterms of the respective agreements, which are three years. The non-currentportion, which amounts to approximately $11,000, is classified as a non-currentasset.

 

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

 

**Senior Secured Notes**

** **

OnMarch 8, 2006, the Company entered into a Note Purchase Agreement (the “NotePurchase Agreement”) with SACC Partners, L.P. and Lloyd I. Miller, III(the “Senior Lenders”), pursuant to which the Company issued Senior SecuredNotes (the “Senior Notes”) in the aggregate principal amount of $6,700,000 withwarrants to purchase up to 19.9% of the Company’s outstanding common stock on afully diluted basis at the time of exercise. The warrants have an exerciseprice of $0.001 per share and expire on December 31, 2016. The SeniorNotes bear interest at the rate 8% per annum if paid in cash, or 11% per annumif paid in kind, which forms of payment can be made at the Company’sdiscretion. The principal amount of the Senior Notes will be amortized overthree years and is payable in equal monthly installments on the last day ofeach month beginning on March 31, 2009, with the balance to be paid infull on March 1, 2010. Interest is payable quarterly in arrears beginning June 30,2006, unless the Company chooses to make its payments in kind, in which casesuch interest is added to the principal amount of the Senior Notes.

 

TheCompany may prepay the Senior Notes at 105% of the aggregate unpaidprincipal and interest at any time prior to their maturity. The Senior Notesare also subject to mandatory prepayment at 105% of the aggregate unpaidprincipal and interest in the event of a change in control, as defined. TheCompany is also required to prepay the Senior Notes upon the occurrence of asubstantial asset sale in an amount equal to 50% of the gross proceeds receivedin such asset sale plus a penalty equal to 2% of the prepayment amount. Pursuantto the terms of the Note Purchase Agreement, substantial asset sales aredefined as any single asset sale resulting in gross proceeds of $100,000 or anyseries of assets sales occurring during a twelve month period resulting ingross cumulative proceeds of $100,000 or more. Change in control eventsdescribed in the Note Purchase Agreement requires approval by the Board ofDirectors prior to being submitted to a vote of the Company’s stockholders.Accordingly, the redemption provision is not within the control of the SeniorNote holders.

 

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On September 30, 2007, theCompany elected to pay contractual interest on the Senior Notes in kind andrecorded an aggregate interest charge of $214,000, which increased theprincipal amount of the Senior Notes to $7,939,000. Contractual interest paidin kind amounted to $192,147 for the three months ended September 30, 2006. Inaddition, the Senior Notes were fully discounted as of June 30, 2007 as aresult of having issued warrants to the investors of the Senior Notes. TheseSenior Warrants are more fully described below. Amortization of the Notediscount amounted to $431,986 and $421,349 for the three months ended September30, 2007 and 2006, respectively.

 

**Senior Warrants**

** **

OnMarch 8, 2006, in connection with entering into the Note PurchaseAgreement with the Senior Lenders, the Company also issued to the seniorlenders warrants (the “Senior Warrants”) to purchase up to 19.9% of the Company’soutstanding common stock on a fully diluted basis at the time of exercise. TheSenior Warrants have an exercise price of $0.001 per share and expire on December 31, 2016.

 

OnSeptember 30, 2007, the Company elected to pay contractual intereston the Junior Notes in kind and recorded an aggregate interest charge of$453,425 for the three months ended September 30, 2007 which was added tothe principal amount of the Junior Notes, increasing the convertible shares ofthe notes by 2,591,000 shares at a conversion price of $0.175 per share. Accordingly, the number of shares issuable tothe holders of the Senior Warrants upon their exercise was increased by 566,639shares, net of the effect of cancelled stock options, to an aggregate of38,173,841 shares. The fair value of the additional Senior Warrants amounted to$56,392 and is included as a component of interest expense in the accompanyingunaudited condensed consolidated statements of operations and comprehensiveloss for the three months ended September 30, 2007. Assumptions relatingto the estimated fair value of these warrants, which the Company is accountingfor using a Black Scholes calculation, are as follows: risk—free interest rateof 5.25%; expected dividend yield zero percent; expected option life of fiveyears; and current volatility of 170%.

 

Theamortization of the combined $6,700,000 debt discount in connection with theSenior Warrants has accreted to approximately $2,524,000 as of September 30,2007, for which approximately $432,000 is included as a component of interestexpense in the accompanying unaudited interim condensed consolidated statementsof operations and comprehensive loss.

 

**Junior Notes**

** **

Underthe Note Purchase Agreement, the Company also issued a Junior SecuredConvertible Note to Trust A-4—Lloyd I. Miller (the “Junior Lender” and togetherwith the Senior Lenders, the “Lenders”) in the aggregate principal amount of$3.0 million (the “Junior Note”). The interest rate for the Junior Note is 10%per annum if paid in cash, or 14% per annum if paid in kind, which forms ofpayment are at the Company’s election for the first three years. Principal willbe payable at the maturity date of March 1, 2011 and interest is payablequarterly in arrears beginning June 30, 2006, unless the Company choosesto pay the interest in kind option, in which case the interest will be added tothe principal amount of the Junior Note during the period in which the Companymakes such election.

 

TheJunior Note is convertible into common stock of the Company at any time at theelection of the holder and was convertible at an adjusted conversion price of$0.175 per share of common stock. The adjusted conversion price is subject to furtheradjustment in the event of stock splits, stock dividends and similar types ofrecapitalization transactions and also in the event that the Companyeffectuates subsequent financing transactions at prices more favorable than theconversion price featured in these notes. The Company is restricted fromprepaying any or all of the Junior Notes prior to March 1, 2010 withoutthe consent of the holder of the Junior Notes, which consent is at the solediscretion of the note holder.

 

Thenotes and related conversion option were accounted for in accordance with theprovisions of EITF 98-5 and EITF 00-27. Under this method, the Company recordeda $3,000,000 discount against the entire principal amount of the note. Thediscount of $3,000,000 is being amortized over the five year term of the note.

 

OnJune 15, 2006, the Company entered into a First Amendment to Note PurchaseAgreement (the “First Amendment”) with the Lenders pursuant to which theCompany issued an additional Junior Secured Convertible Note to the JuniorLender in the aggregate principal amount of $1,000,000 (the “Second Junior Note”)on substantially similar terms set forth in the Junior Note. A portion of theproceeds from the issuance of the Second Junior Note were used to purchasecertain assets primarily consisting of a customer list from the Long IslandDivision of TekConnect Corporation, (“TekConnect”), and the remaining proceedswill be used for general corporate purposes. The Company determined that theSecond Junior Note is a convertible debt instrument and is therefore beingaccounted for in accordance with EITF 98-5 and EITF 00-27. Accordingly, theCompany originally recorded a $400,000 discount against the principal amount ofthe note. The discount of $400,000 was being amortized over the term of thenote.

 

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Asdescribed below, the Company issued an additional convertible note on April 13,2007 with a conversion price of $0.175 per share. Accordingly, the Companyrecorded an additional $200,000 of discounts with respect to the Second JuniorNote issued on June 15, 2006.

 

OnSeptember 26, 2006, the Company entered into a Second Amendment to NotePurchase Agreement (the “Second Amendment”) with the Lenders pursuant to whichthe Company issued an additional Junior Secured Convertible Note to the JuniorLender in the aggregate principal amount of $3,000,000 (the “Third Junior Note”)on substantially similar terms set forth in the Junior Note and the SecondJunior Note. A portion of the proceeds from the Third Junior Note were used topurchase substantially all of the assets of SSS, pursuant to an Asset PurchaseAgreement dated October 27.

 

OnApril 13, 2007, the Company entered into a Junior Secured Convertible NotePurchase Agreement (the “Junior Note Purchase Agreement”) with the JuniorLender pursuant to which the Company issued to the Lender a Junior SecuredConvertible Promissory Note (the “Fourth Junior Note”) in the aggregateprincipal amount of $5,000,000. The Fourth Junior Note bears interest at therate of 9% per annum if paid in cash, or 13% per annum if paid in kind, whichis at the Company’s election for the first three years. All other terms in thisnote are substantially identical to the terms set forth in the previouslyissued Junior Notes. Principal will be payable at the maturity date of April 13,2012, and interest will be payable quarterly in arrears beginning June 30,2007, unless the Company chooses its payment in kind option, in which caseinterest will be added to the principal amount of the Fourth Junior Note duringthe period that the Company continues such election. The Fourth Junior Note may beconverted into common stock of the Company at any time at the election of theholder at an initial conversion price of $0.175 per share of common stock,subject to certain adjustments.

 

Paymentof all principal and interest under each of the First, Second, Third and FourthJunior Note, as well as performance thereunder of the obligations of DynTekServices, Inc., our wholly-owned subsidiary, are secured by a perfectedsecurity interest under a security and pledge agreement which grants to theJunior Lender a lien to substantially all assets of the Company, which lien issubordinated to the perfected security interest held by certain other lendersas described therein.

 

On September 30, 2007, theCompany elected to pay contractual interest in kind on all the junior securedconvertible promissory notes, and recorded an aggregate interest charge ofapproximately $453,000 which isincluded as a component of interest expense in the accompanying condensedconsolidated statement of operations and comprehensive loss for the threemonths ended September 30, 2007.

 

The Company evaluated, at eachquarterly interest payment date in which it elected to pay the interest inkind, whether it was required to record additional debt discount inconnection with the noteholder’s option to convert such interest into commonstock. In accordance with EITF 00-27, the Company determined that themeasurement date for recording interest paid in kind is the interestpayment date since the option to pay the interest in kind isdiscretionary. Accordingly, the Company determined that it is notnecessary to record any discounts because the fair value of the commonstock at each interest payment date was less then the conversionprice embedded in this obligation.

 

The combined debt discount pursuantto the Junior Note and Second Junior Note of March 8, 2006 and June 15,2006, respectively, was $3,600,000. Amortizationof the discount has accreted to approximately $1,086,000 as of September 30,2007 for which approximately $193,000 and $171,000 are included as a componentof interest expense in the accompanying unaudited interim condensedconsolidated statements of operations and comprehensive loss, for the threemonths ended September 30, 2007 and 2006, respectively.

 

**7.*DUE FROM NETF***

 

OnAugust 8, 2005, the Company entered into a series of relatedthree-year agreements with NETF providing for NETF to purchase eligibleaccounts receivable balances and to finance “qualified purchases” (as defined).This facility is comprised of three components: (1) an Asset Purchase and Liability Assumption Agreement (the “APLA”),under which NETF finances certain of the Company’s qualified product purchasesin connection with consummating sales to customers , (2) an Asset PurchaseAgreement (the “APA”), and (3) a Master Servicing Agreement (“MSA”).

 

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Qualifiedproduct purchases under the APLA are repaid from collections of accountsreceivable balances that the Company generates from its sales of such productsto customers. NETF remits periodically to the Company an amount equal to themonthly gross profit margin on the product sales less the contractual fees.Under the APA, the Company transfers eligible accounts receivable to NETF inexchange for advances of up to 80% of their gross amount. NETF charges theCompany fees (the “Discount Factor”) in an amount equal to the LIBOR rate plus4% annum on advances made at the time of the transfer. The Company also retainsservicing rights under the MSA. Under the terms of the MSA, the Company managescollections and other ongoing interactions with its customers in exchange forfees amounting to approximately 20% of the gross invoice amount. NETF settlesfees payable to the Company under this arrangement net of the Discount Factor.

 

Thisfacility contains customary affirmative and negative covenants as well asspecific provisions related to the quality of the accounts receivables sold.The Company has also indemnified NETF for the risk of loss under any transferredbalances except for loss incurred as a result of customer credit risk.

 

Duringthe three months ended September 30, 2007 and 2006, the Company soldapproximately $20,649,000 and $15,361,000, respectively, of its product revenueunder the terms of the APLA agreement and approximately $4,923,000 and$4,013,000, respectively, of its service revenue under the terms of the APAagreement. In addition, the Company incurred an aggregate fee of approximately$635,000 and $395,000, respectively, which is included as a component ofinterest expense in the accompanying unaudited interim condensed consolidatedstatements of operations and comprehensive loss for the three months ended September 30,2007 and 2006.

 

**8.*STOCKHOLDERS’ EQUITY***

 

*Senior Warrants*

As more fully described in Note 6, on March 8,2006, the Company issued warrants to the investors of the Senior Notes topurchase up to 19.9% of the Company’s fully diluted outstanding common stock atthe time of exercise, exercisable at $.001 per share of common stock throughDecember 31, 2016. As described in Note 6, the number of sharesissuable upon the exercise of these warrants increases based on all subsequentissuances of common stock or common stock equivalents.

*Pending ReverseStock Split*

On October 19, 2007, theCompany’s Board of Directors agreed to seek stockholder approval to amend theCompany’s Certificate of Incorporation in order to effect up to a 1—for—20reverse split of the Company’s issued and outstanding common stock.  The Board also agreed to seek stockholderapproval to amend the Company’s Certificate of Incorporation to decrease (i) thenumber of shares of our capital stock that we would have the authority to issuefrom 460,000,000 shares to as few as 23,000,000 shares, and (ii) the number ofshares of our common stock, $0.0001 par value per share, that we would haveauthority to issue from 450,000,000 shares to as few as 22,500,000 shares, and(iii) the number of shares of our preferred stock, $0.0001 par value per share,that we would have authority to issue from 10,000,000 shares to as few as 500,000shares, conditioned on the approval and implementation of the proposal notedpreviously to effect the reverse split of the issued and outstanding commonstock.

 

**9.*SHARE-BASEDPAYMENT ARRANGEMENTS***

 

Forthe three months ended September 30, 2007, the Company applied SFAS123(R). Under SFAS 123(R) share based payment awards result in a cost thatis measured at fair value on the awards’ grant date, based on the estimatednumber of awards that are expected to vest that is reported as a charge tooperations. Accordingly, the Company recognized approximately $66,000 and$288,000 of stock based compensation charges during the three months ended September30, 2007 and 2006 for the fair value of stock options vested and expected tovest.

 

Asummary of option activity for the three months ended September 30, 2007is as follows:

 
| **Options**                            | ** ** | **Shares** | ** ** | **Weighted-   Average  Exercise  Price** | ** ** | **Weighted-   Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic   Value** | ** ** |
|----------------------------------------|------------|------------|------------|-----------------------------------------------|------------|------------------------------------------------------------|------------|---------------------------------------|------------|
| Outstanding at June 30, 2007      |       | 11,286,811 |       | .21                                           |       | 4.12                                                       |       | —                                |       |
| Granted                                |       | —     |       | —                                        |       | —                                                     |       | —                                |       |
| Exercised                              |       | —     |       | —                                        |       | —                                                     |       | —                                |       |
| Forfeited or expired                   |       | (310,206   | )          | .23                                           |       | —                                                     |       | —                                |       |
| Outstanding at September 30, 2007 |       | 10,976,605 |       | .21                                           |       | 7.94                                                       |       | —                                |       |
| Exercisable at September 30, 2007 |       | 4,671,705  |       | .21                                           |       | 6.52                                                       |       | —                                |       |

 

Theweighted-average remaining contractual term of options outstanding gives effectto employee terminations which, under the provisions of the plans, reduces theremaining life of such options to a period of 90 days following the respectivedates of such terminations.

 

TheCompany did not modify any stock options granted to employees or non-employeesunder any of its share-based payment arrangements other than accelerating thevesting of options prior to July 1, 2005. In addition, the Company did notcapitalize the cost associated with stock based compensation awards nor haveoptionees exercised any options during the three months ended September 30,2007 and 2006, respectively.

 

AtSeptember 30, 2007, there was no intrinsic value with respect to optionsoutstanding and options exercisable based on the September 30, 2007closing price of the Company’s common stock ($0.10 per share).

 

Theweighted-average grant date fair value of options granted during the threemonths ended September 30, 2007 amounted to $0.112 per share. Theweighted-average remaining contractual term of options outstanding gives effectto employee terminations which, under the provisions of the plans reduces theremaining life of such options to a period of 90 days following the respectivedates of such terminations.

 

Unamortizedcompensation costs amount to approximately $354,000 as of September 30, 2007,which the Company expects to recognize over a weighted average period of 2.0years.

 

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**10. *INCOMETAXES***

 

**Sensible Security Solutions, Inc.**

October 27, 2006, theCompany, DynTek Canada, SSS, and Paul Saucier entered into an Asset PurchaseAgreement for the acquisition by DynTek Canada of substantially all of theassets of SSS. SSS provides major Canadian organizations, both in the privateand public sector, with the design and implementation of comprehensive,enterprise-level anti-virus solutions. The Company acquired SSS because it wasaligned with the Company’s existing core security practice, provides a greaterdensity within its Canadian region, and provides for a more comprehensivedelivery of its service support across various geographical regions.

In consideration for thepurchased assets, the Company paid SSS at closing a cash payment of $1,063,000and 1,485,148 shares of the Company’s common stock with an aggregate fair valueof $300,000 based upon the per share fair value measured in accordance withEITF 99-12. Additional fees in connection with the acquisition ofapproximately $50,000 were also paid.

The Company is obligatedto make additional payments of up to $4.7 million over a three-year periodbased upon the achievement of certain EBITDA performance targets. Suchpayments are payable quarterly for the first year of the earn-out period andannually for each of the next two years using a combination of cash and theCompany’s common stock, at the Company’s election, provided that at least halfof the payments will be in cash. Earn-out awards are calculated, subject toadjustment, based upon the cumulative effect of achieved EBITDA performancetargets during the applicable earn-out period. Determination and notification of the EBITDA earn-out shall be providedto SSS within 45 days after the end of each earn-out period.  For the period ended September 30, 2007, noearn-out provision was payable. 

The Company has approximately $21.5 million of net deferred tax assets,a substantial portion of which includes the tax effects of approximately $36million of net operating loss carry forwards that will expire at varioustimes through 2027.

 

Utilization of the NOL carryforwards may be subject to a substantialannual limitation due to ownership change limitations that have occurredpreviously or that could occur in the future as provided in Section 382 ofthe Internal Revenue Code of 1986, as well as similar state and foreignprovisions. These ownership changes may limit the amount of NOL that can beutilized annually to offset future taxable income. In general, an ownershipchange, as defined by Section 382, results from transactions increasingthe ownership of certain shareholders or public groups in the stock of acorporation by more than fifty percentage points over a three-year period.Since its formation, the Company has raised capital through the issuance ofcapital stock and various convertible instruments which, combined with thepurchasing shareholders’ subsequent disposition of those shares, may haveresulted in a change of control, as defined by Section 382, or couldresult in a change of control in the future upon subsequent disposition.

 

The Company has initiated a study to assess whether a change in controlor multiple changes of control have occurred since the Company’s formation. Ifthe Company has experienced a change of control at any time since itsformation, utilization of NOL carryforwards would be subject to an annuallimitation under Section 382. This annual limitation is determined byfirst multiplying the value of the Company’s stock at the time of the ownershipchange by the applicable long-term tax-exempt rate, and could then be subjectto additional adjustments, as required. Any limitation may result in expirationof a portion of the NOL carryforwards before utilization. Until the study is completedand any limitation known, no amounts are being presented as an uncertain taxposition.

 

Interest and penalties related to uncertain tax positions will bereflected in income tax expense. As of September 30, 2007, the Company hadnot recorded any tax penalties or interest in its condensed consolidatedfinancial statements.

 

**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONSAND RESULTS OF OPERATIONS**

 

*The following discussion and analysis of our results of operations andfinancial position should be read in conjunction with our audited consolidatedfinancial statements and notes included in our Annual Report on Form 10-K.as amended, for the year ended June 30, 2007 and the unaudited interimcondensed consolidated financial statements and notes included in thisQuarterly Report on Form 10-Q. Depending upon the context, the terms “DynTek”,“we,” “our,” and “us,” refers to either DynTek, Inc. alone, or DynTek, Inc.and its subsidiaries.*

 

**Forward-Looking Statements**

 

This report contains “forward-looking statements”within the meaning of such term in Section 27A of the Securities Act of1933, as amended, Section 21E of the Securities Exchange Act of 1934, andthe Private Securities Litigation Reform Act of 1995. We wish to cautionreaders not to place undue reliance on any such forward-looking statements,each of which speaks only as of the date made. Forward-looking statementsinvolve known and unknown risks, uncertainties and other factors which couldcause actual financial or operating results, performance or achievementsexpressed or implied by such forward-looking statements not to occur or berealized. Such statements are subject to certain risks and uncertainties thatcould cause actual results to differ materially from historical results andthose presently anticipated or projected. See below, and a discussion of suchrisks and factors discussed in Item 1 (Business) of Part I and Item 7(Management’s Discussion and Analysis of Financial Condition and Results ofOperations) of Part II of our Annual Report on Form 10-K, as amended,for the year ended June 30, 2007 as filed with the Securities and ExchangeCommission. Forward-looking statements made in this Form 10-Q generallyare based on our best estimates of future results, performances orachievements, predicated upon current conditions and the most recent results ofthe companies involved and their respective industries. Forward-lookingstatements may be identified by the use of forward-looking terminologysuch as “may,” “will,” “could,” “should,” “project,” “expect,” “believe,” “estimate,”“anticipate,” “intend,” “continue,” “potential,” “endeavor,”  “opportunity” or similar terms, variations ofthose terms or the negative of those terms or other variations of those termsor comparable words or expressions. Readers should carefully review thoserisks, as well as additional risks described in this report and other documentswe file from time to time with the Securities and Exchange Commission. Potentialrisks and uncertainties include, among other things, such factors as:

 

•Our ability to reach target markets for servicesand products and our ability to retain current and attract future customers;

 

•Our ability to attract and retain professionalstaff, successfully integrate acquired companies into our operations, and ourability to acquire additional companies, if any;

 

•Market acceptance, revenues and profitability ofour current and future products and services;

 

•Our ability to finance and sustain operations,including the ability to fund, maintain, replace and/or extend the Senior Notesand/or Junior Notes, when due, respectively, or to replace such instrumentswith alternative financing;

 

•Our ability to raise equity capital or debt inthe future, despite historical losses from operations;

 

•General economic conditions in the United Statesand elsewhere, as well as the economic conditions affecting the industries inwhich we operate, our customers and suppliers;

 

•The competitive environment in the regions inwhich we compete, and the cost-effectiveness of our products and services;

 

•Political and regulatory matters that affect theindustries in which we operate;

 

•Our continued ability to trade on the Over theCounter Bulletin Board; and

 

•Other risks detailed in our filings with theSecurities and Exchange Commission.

 

Wehave no obligation 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.

 

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**Business Overview**

 

DynTek, Inc. providesprofessional information technology (“IT”) services and sales of relatedproducts to mid-market commercial businesses, state and local governmentagencies, and educational institutions. We operate our business primarilythrough our subsidiary, DynTek Services, Inc. and our Canadian subsidiaryDynTek Canada, Inc.

 

We provide a broad range ofmulti-disciplinary IT solutions that address the critical business needs of ourclients, including IT security, converged networking (includingvoice-over-internet-protocol, or “VOIP”), application infrastructure, andaccess infrastructure. Our primary operations are located in four of the topten largest IT spending states: California, New York, Florida, and Michigan. Wedeliver complex infrastructure technology solutions through teams ofprofessional consultants in close geographic proximity to our clients. Membersof our technical and consulting services team have advanced certifications withleading vendor-manufacturers, including Microsoft, Cisco, McAfee and Citrix. Asa professional services firm and value-added reseller of hardware and softwarefrom leading manufacturers, we help organizations assess, design, build,implement, manage and support their technology infrastructure.

 

We believe that our services-led approach, combinedwith expertise in multi-disciplinary practice areas such as IT security,converged networking, application infrastructure, and access infrastructure, willcontinue to provide the platform we need to capture an increasing share ofour target markets. Our strategy allows our clients to rely on DynTek as theirprimary IT vendor. Additionally, we believe that our multi-disciplinarycapabilities help differentiate us from our competitors in the markets in whichwe compete.

 

We recognize revenue from sales of products andservices. Services are primarily provided to the client at hourly rates thatare established for each of our employees or third-party contractors based upontheir skill level, experience and the type of work performed. We also provideproject management and consulting work which are billed either by an agreedupon fixed fee or hourly rates, or a combination of both. The majority of ourservices are provided under purchase orders with commercial customers or bidcontracts with government entities. (See “Revenue Recognition,” below.)

 

Costs of services consist primarily of salaries ofservices personnel and related expenses incurred in providing such services,and the cost of outsourced service labor. Costs of products consist of our costof 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,and other general administrative expenses. Selling, general and administrativecosts also include a calculation of the fair value of employee stock optionsand other share-based payment awards calculated pursuant to SFAS No. 123R.

 

**Results of Operations**

** **

The following table sets forththe relative percentages that certain income and expense items bear to netsales. 

 
| ** **                                          | ** ** | **Three Months Ended Sept. 30,** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                          | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
| Product Revenue                                     |       | 74                                                   | %          | 77 | % |
| Service Revenue                                     |       | 26                                                   | %          | 23 | % |
|                                                |       |                                                 |       |   |   |
| Cost of Products                                    |       | 63                                                   | %          | 67 | % |
| Cost of Service                                     |       | 20                                                   | %          | 16 | % |
|                                                |       |                                                 |       |   |   |
| Gross Profit                                        |       | 17                                                   | %          | 17 | % |
|                                                |       |                                                 |       |   |   |
| Selling, General & Administrative Expenses |       | 18                                                   | %          | 18 | % |
|                                                |       |                                                 |       |   |   |
| Loss from Continuing Operations                     |       | (11                                                  | )%         | (12 | )% |

*** ***

***17***

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*** ***

***Three months ended September 30, 2007 and September 30, 2006***

*** ***

**Revenues.**For the three months ended September 30,2007, our revenues increased to approximately $30,082,000 from approximately$21,777,000 for the three months ended September 30, 2006. This$8,305,000, or 38% increase, is principally attributable to an increase inrevenues following our acquisitions of TekConnect, Inc. in October 2006and Sensible Security Solutions in October 2006, educational sales in newmarkets of approximately $2,800,000 and increase in service projects in ourSouthwest region.

 

Our product sales increased to$22,040,000 during the three months ended September 30, 2007 from$16,783,000 during the three months ended September 30, 2006. This$5,257,000, or 31%, increase resulted primarily from the additional productsales generated by our acquisitions of TekConnect, Inc. and SensibleSecurity Solutions and increased educational sales in new geographic markets.

 

Our services revenues increasedto $8,042,000 during the three months ended September 30, 2007 from$4,994,000 during the three months ended September 30, 2006. This$3,048,000, or 61% increase, is primarily attributable to the additionalservices revenue generated by our recent acquisitions and an increase inprojects in our Southwest region.

 

Our customers are primarily stateand local government entities and mid-sized corporations in diversifiedindustries. For the three months ended September 30, 2007, 37% of ourrevenues were derived from commercial clients, compared to 34% from governmentagencies and 29% from educational institutions. For the three months ended September 30, 2006, 38% of our revenueswere derived from commercial clients, compared to 41% from government agenciesand 21% from educational institutions.

 

**Gross profit.**Grossprofit increased to $4,928,000 for the three months ended September 30,2007 from $3,616,000 for the three months ended September 30, 2006, anincrease of 36%. Our gross margins remained approximately the same, at 17%, forthe two comparative periods. We will continue to focus on improving our overalllevel of service utilization with respect to consultants throughout thecompany, and a greater mix of higher-end services. We continue to expectproduct margins to be subject to competitive pricing pressures and fluctuatefrom quarter to quarter depending on the mix of products we provide. We intendto meet the challenges of aggressive price reductions and discount pricing bycertain product suppliers by focusing our offerings around relatively highermargin practice areas, including security solutions, VOIP, and accessinfrastructure. There can be no assurance, however, that we will be able toimprove profit margins, especially for our sale of products, and competeprofitably in all areas, given the intense competition that exists in the ITindustry.

 

**Sellingexpenses.**Sellingexpenses increased to approximately $3,770,000 for the three months ended September 30,2007 from $2,593,000 in the three months ended September 30, 2006. The 45%increase in selling expenses is primarily the result of increased revenue fromorganic growth and acquisitions, expansion of offices into new geographicmarkets and growth in our sales team in our Southwest market.

 

As a percentage of totalrevenues, selling expenses were 13% during the three months ended September 30,2007, compared to 12% for the same three months ended September 30, 2006.

 

**Generaland administrative expenses.** General and administrative expenses increased to approximately $1,662,000for the three months ended September 30, 2007 from approximately$1,343,000 for the three months ended September 30, 2006. This increase ingeneral and administrative expenses is primarily the result of support costsrelated to acquisitions and revenue growth and costs related to a settlementagreement. As a percent of revenues, general and administrative expensesdeclined slightly between the two periods, from 6% to 5%.

 

**Depreciationand amortization expense.**Depreciationand amortization expense decreased to approximately $669,000 for the threemonths ended September 30, 2007 from approximately $693,000 during thesame three months ended September 30, 2006. The decrease is primarily dueto the certain customer lists of prior acquisitions having been fullyamortized.

 

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**Interestexpense.**Interestexpense for the three months ended September 30, 2007 increased to$2,014,000, as compared to $1,554,000 for the three months ended September 30,2006, primarily due to significantly higher non-cash interest of approximately$1,377,000 for the three months ended September 30, 2007 compared to only$1,150,000 for the three months ended September 30, 2006. For the threemonths ended September 30, 2007, the non-cash amortization on the debtdiscounts on the Senior Notes and Junior notes was approximately $432,000 and$193,000, respectively. Fees incurred on the NETF APA and APLA agreements wereapproximately $635,000. On September 30, 2007, the Company elected to payin kind the interest on the Senior Notes of approximately $214,000 and $453,000on the Junior Notes. Amortization of deferred financing fees amounted toapproximately $28,000. For the three months ended September 30, 2006, thenon-cash amortization on the debt discounts on the Senior Notes and Juniornotes was approximately $421,000 and $172,000, respectively. Fees incurred onthe NETF APA and APLA agreements were approximately $395,000. On September 30,2006, the Company elected to pay in kind the interest on the Senior Notes ofapproximately $193,000 and $150,000 on the Junior Notes. Amortization ofdeferred financing fees amounted to approximately $23,000.

 

**Net loss.**Our net loss for the three months ended September 30,2007 was $3,196,000 compared to a net loss of $2,584,000 for the three monthsended September 30, 2006. The increase in net loss is primarilyattributable to higher interest expense in the three months ended September 30,2007 as compared to the three months ended September 30, 2006. Loss fromcontinuing operations during the three months ended September 30, 2007includes depreciation and amortization expense of $669,000, non-cash stock basedcompensation expense of $66,000, and interest expense of $2,014,000 (includingnon-cash interest of $1,377,000). Loss from operations during the three monthsended September 30, 2006 includes depreciation and amortization expense of$693,000, non-cash stock based compensation expense of $528,000, and interestexpense of $1,554,000 (including a non-cash portion of $1,150,000).

 

**Liquidity and Capital Resources**

 

Wemeasure our liquidity in a number of ways, as summarized in the following table(in thousands):

 
| ** **                | ** ** | **As of   Sept. 30, 2007** | ** ** | **As of   June 30, 2007** | ** ** |
|---------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
|                      |       |                                           |       |                                          |       |
| Cash and cash equivalents |       | $                                              | 1,269      |                                          | $          | 2,441 |   |
|                      |       |                                           |       |                                          |       |
| Working capital           |       | $                                              | 2,571      |                                          | $          | 4,134 |   |
|                      |       |                                           |       |                                          |       |
| Current ratio             |       | 1.33:1                                         |       | 1.65:1                                        |       |

 

Cash and cash equivalents generally consist of cash andmoney market funds. We consider all highly liquid investments purchased withmaturities of three months or less to be cash equivalents. Such investments arestated at cost, which approximates fair value, and are considered cashequivalents for purposes of reporting cash flows.

 

During the three months ended September 30, 2007,we used approximately $1,084,000 of cash in our operating activities.

 

We incurred a net loss of $3,196,000 for the threemonths ended September 30, 2007, which includes $2,112,000 of non-cashcharges resulting from $669,000 of depreciation and amortization, $66,000 innon-cash stock compensation expense, and $1,377,000 in non-cash interest charges.

 

Slow collections have caused us to incur higher feesunder our accounts receivable and product financing arrangements with NETF. Asa result of our acquisition of TekConnect, we assumed approximately $540,000 ofpre-existing service obligations which have resulted in additional increasedcosts. Although we use our facility with NETF to better manage the timingdifferences in our operating cash flows, some accounts receivable due fromcustomers under our recently acquired Canadian business are ineligible fortransfer. These circumstances have caused us to experience additionalconstraints on liquidity, which are likely to continue until such time asTekConnect and Sensible Security Solutions are fully integrated.

 

Although we have made substantial efforts to acceleratecollections under our company-wide operations, slow collection cycles, ongoingtiming differences and efforts to integrate acquired businesses could cause usto seek additional outside financing. Although we believe that we havesufficient capital resources to sustain our business through September 30,2008, there can be no assurance that unforeseen circumstances will not have amaterial affect on our operations. These circumstances could require us to takea variety of measures to conserve and/or improve liquidity, includingcurtailing operations, cutting costs, and seeking additional outside financing.We have not secured any commitments for new financing at this time nor can weprovide assurance that any new financing will become available to us onacceptable terms, if at all.

 

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We believe that our strategy of streamlining thebusiness around our core competency of providing IT solutions is enabling us tooperate under a more efficient cost structure than we had in the past. We arealso not required to make principal payments under any of our note obligationsuntil June 2009 and our accounts receivable and product financingarrangement with NETF is providing us with timely working capital resources.

 

In the future, we may continue to expand the scopeof our product and services offerings by pursuing acquisition candidates withcomplementary technologies, services or products. Should we commence suchacquisitions, we believe that we would finance the transactions with acombination of our working capital, the issuance of additional equitysecurities, or the issuance of additional debt instruments. There can be noassurance, however, that we will be successful in identifying appropriateacquisition candidates or that, if appropriate candidates are identified, thatwe will be successful in obtaining the necessary financing to complete theacquisitions. In the event of any additional financing, any equity financingwould likely result in dilution to our existing stockholders and any debtfinancing may include restrictive covenants.

 

**ITEM 3. QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Marketrisk associated with adverse changes in financial and commodity market pricesand rates could impact our financial position, operating results or cash flows.This exposure is related to our normal operating and funding activities. We donot typically invest more than a nominal amount in securities that are subjectto interest rate risk, foreign currency exchange risk, commodity price risk orsimilar types of market risk. Accordingly, a hypothetical 100 basis pointadverse move in interest rates would not materially affect the fair marketvalue of our financial investments or our overall financial condition. As of September 30,2007, we have not used derivative instruments or engaged in hedging activitiesand are not subject to the types of market risks generally associated with suchinvestments.

 

InAugust 2005, we entered into a working capital credit facility with NETF.Pursuant to the credit facility, NETF finances certain qualified productpurchases by us and we assign our accounts receivable resulting from the saleof such products to our customers and NETF assumes liability for payment toproduct vendors. As consideration for the product financing, we pay NETF afinancing and servicing fee calculated on a monthly basis depending on severalfactors including our gross profit margin, the number of days sales areoutstanding and the LIBOR rate. In particular, the financing component of thefee is an amount equal to the then existing LIBOR rate plus 4% annum onadvances made at the time of the transfer. Other than the credit facility withNETF, we do not have any variable rate debt instruments outstanding and we arenot exposed to market risk due to changes in interest rates such as the primerate and LIBOR.

 

Historically,the vast majority of our operations were conducted solely in the United States.Accordingly, our financial position was not materially affected by foreignexchange rate transactions. Our acquisition of Sensible Security Solutions in October of2006 significantly increased our presence in the Canadian market and exposes usto greater risk from foreign currency rate fluctuations. However, we do notexpect that the exposure to foreign exchange transactions will have a materialimpact on our consolidated financial statements.

 

**ITEM 4. CONTROLSAND PROCEDURES**

 

Asof September 30, 2007, the Company carried out an evaluation, under thesupervision and with the participation of members of our management, includingthe Company’s Chief Executive Officer and the Company’s Chief FinancialOfficer, of the effectiveness and operation of the Company’s disclosurecontrols and procedures. Based upon that evaluation, the Company’s ChiefExecutive Officer and the Chief Financial Officer have concluded that theCompany’s disclosure controls and procedures were not effective as of September 30,2007, based on their evaluation of these controls and procedures required byparagraph (b) of Exchange Act Rules 13a-15 and 15d-15.

 

**DISCLOSURE CONTROLS AND INTERNAL CONTROLS**

** **

Disclosurecontrols are procedures that are designed with the objective of ensuring thatinformation required to be disclosed in our reports filed under the SecuritiesExchange Act of 1934, as amended, such as this Quarterly Report, is recorded,processed, summarized and reported within the time periods specified in the rules andforms of the Securities and Exchange Commission, or SEC. Disclosure controlsare also designed with the objective of ensuring that such information isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure. Internal controls are procedures which aredesigned with the objective of providing reasonable assurance that ourtransactions are properly authorized, recorded and reported and our assets aresafeguarded against unauthorized or improper use, and to permit the preparationof our financial statements in conformity with generally accepted accountingprinciples.

 

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Ourcompany is not an “accelerated filer” (as defined in the Securities Exchange Act)and is not required to deliver management’s report on control over ourfinancial reporting until our fiscal year ended June 30, 2008.Nevertheless, we identified certain matters that constitute material weakness(as defined under the Public Company Accounting Oversight Board AuditingStandard No. 5) in our internal controls over financial reporting.

 

Thematerial weaknesses that we have identified relate to the fact that that ouroverall financial reporting structure, internal accounting information systems,and current staffing levels are not sufficient to support the complexity of ourfinancial reporting requirements. We have experienced employee turnover in ouraccounting department including the position of Chief Financial Officer. As aresult, we have experienced difficulty with respect to our ability to record,process and summarize all of the information that we need to close our booksand records on a timely basis and deliver our reports to the SEC within thetime frames required under the SEC’s rules. We also need to increase the sizeof our staff and review assignments within our accounting department to ensurewe have adequate segregation of duties.

 

Wehave also identified a specific material weakness in our ability to ensure thatthe accounting for our equity-based transactions is accurate and complete.Historically, we have entered into various forms of complex equity transactionsinvolving the application of specialized accounting principles. The equitybased transactions that we consummated specifically relate to stock basedcompensation arrangements, issuances of complex instruments in financingtransactions, modifications to embedded and free standing derivatives andsettlements of debt for equity. We believe that equity transactions we completedin connection with our financial restructuring are unique and occurred as aresult of the fact that our liquidity was highly constrained. Although webelieve that these events are unique and that our equity based transactions inthe future are likely to be reduced, we are evaluating certain correctivemeasures to provide us with the structure we need at such times that we may engagein equity based transactions. These measures could include seeking theassistance of outside specialists with expertise in these areas.

 

Webelieve these material weaknesses have resulted from liquidity constraints thatcaused us to focus on using our resources to implement a financial andoperational restructuring plan. We have recently made substantial changes toour operating and capital structure and intend to take corrective measuresafter we finish evaluating our existing capabilities, the resources we have andresources we may need to make available to effectuate corrective measures.

 

Webelieve that any such risks that may have been created as a result ofthese material weaknesses are partially mitigated by the fact that we haveminimal assets that are subject to the risk of misappropriation. In addition,activities during our most recent reporting periods have been regularlyreviewed and approved by our Chief Executive and Chief Financial Officers.However, we acknowledge that additional control procedures are necessary toensure that our all of our transactions are properly recorded, our assets areappropriately safeguarded and that we can close and report our results withinthe time frames required by the SEC.

 

**PART II - OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

Fromtime to time the Company is involved in various legal proceedings and disputesthat arise in the normal course of business. These matters have includedintellectual property disputes, contract disputes, employment disputes andother matters.

 

Onor about July 19, 2006, Pangaea Education Systems, LLC (“Pangaea”) filed alawsuit against the Company alleging unfair competition, reverse passing off,misappropriation of trade secrets, copyright infringement and breach ofcontract arising out of services performed in 2003 (the “Action”). On September 11,2007 the Company entered into a settlement agreement with Pangaea and inexchange for a complete release from any further liability, the Company agreedto pay $47,500 to Pangaea.

 

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

 
|        | (a)    | Exhibits. |   |                                                                                                                                                                     |
|--------|--------|-----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |      |   |                                                                                                                                                                     |
|   |   | 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**

 

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

 

 
|        |   |   | DYNTEK, INC.             |
|--------|--------|--------|-------------------------------|
|   |   |   |                          |
|   |   |   |                          |
|   |   |   | By:                           | /s/  Casper W. Zublin, Jr. |   |
|   |   |   |                          |   | Casper  W. Zublin, Jr. |   |
|   |   |   |                          |   | Chief  Executive Officer |   |
|   |   |   |                          |   |   |   |
|   |   |   |                          |   |   |   |
|   |   |   | Date:  November 19, 2007 |
|   |   |   |                          |   |   |   |
|   |   |   |                          |   |   |   |
|   |   |   | By:                           | /s/  David W. Berry |   |
|   |   |   |                          |   | David  W. Berry |   |
|   |   |   |                          |   | Chief  Financial Officer |   |
|   |   |   |                          |   |   |   |
|   |   |   | Date:  November 19, 2007 |
|        |        |        |                               |  |  |  |  |  |

 

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**INDEX TOEXHIBITS**

 
| Exhibit Number | ** ** | **Description**                                                                                                                                                            |
|----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|           |       |                                                                                                                                                                       |
| 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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* Furnished herewith and not “filed” for purposes of Section 18of the Securities Exchange Act of 1934, as amended.

 

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