**U.S. SECURITIES AND EXCHANGE COMMISSION**Washington,D.C.  20549

**FORM 10-Q**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe Quarter ended March 31, 2007**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition periodfrom         to         **

**Commissionfile number 1-11568**

**DYNTEK,INC.**

(Exact Name of Registrantas Specified in its Charter)

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

 

| **19700 Fairchild Road, Suite 230**                                    |
|-----------------------------------------------------------------------------|
| **Irvine,  CA 92612**                                                       |
| (Address of  principal executive offices) (Zip code)                        |
|                                                                        |
| Registrant’s  telephone number, including area code **(949) 271-6700** |

 

Indicate by check whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months, (or for suchshorter period that the Registrant was required to file such reports), and(2) has been subject to such filings requirements for the past 90days.  Yes  x   No  o

Indicateby check mark whether the registrant is a large accelerated filter, anaccelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one): 
| Large accelerated filer  o | Accelerated filer  o | Non-accelerated filer  x |
|--------------------------------------|--------------------------------|------------------------------------|

 

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

As of May  21, 2007, the number of sharesoutstanding of the registrant’s Common Stock, $.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 March 31, 2007 (unaudited) and June 30, 2006                                                                  |   |
|                                                                                                 |                                                                                                                                                                   |   |
|                                                                                                 | Condensed Consolidated  Statements of Operations and Comprehensive Loss (unaudited) - For the Three  and Nine Months Ended March 31, 2007 and March 31, 2006 |   |
|                                                                                                 |                                                                                                                                                                   |   |
|                                                                                                 | Condensed Consolidated Statements  of Cash Flows (unaudited) - For the Nine Months Ended March 31, 2007 and  March 31, 2006                                  |   |
|                                                                                                 |                                                                                                                                                                   |   |
|                                                                                                 | Notes to Condensed  Consolidated Financial Statements (unaudited)                                                                                                      |   |
|                                                                                                 |                                                                                                                                                                   |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations |                                                                                                                                                                   |
| Item 3. Quantitative  and Qualitative Disclosures About Market Risk                                  |                                                                                                                                                                   |
| Item 4. Controls and  Procedures                                                                     |                                                                                                                                                                   |
|                                                                                                 |                                                                                                                                                                   |
| **PART II - OTHER  INFORMATION**                                                                |                                                                                                                                                                   |
| Item 1A. Risk Factors                                                                                |                                                                                                                                                                   |
| Item 6. Exhibits                                                                                     |                                                                                                                                                                   |
|                                                                                                 |                                                                                                                                                                   |
| **SIGNATURES**                                                                                       |                                                                                                                                                                   |
|                                                                                                      |                                                                                                                                                                        |        |  |

 

2

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**1. PART 1 — FINANCIALINFORMATION**

**ITEM1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**DYNTEK, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(in thousands,except share data)**
| ** **                                                                                                                                                                             | ** ** | ** March 31, 2007 ** | ** ** | **June 30, 2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                             | ** ** | **(Unaudited)**                          | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                                                                                                 |       |                                     |       |                        |       |
| CURRENT ASSETS:                                                                                                                                                                        |       |                                     |       |                        |       |
| Cash                                                                                                                                                                                   |       | $                                        | 361        |                        | $          | 546 |   |
| Cash —  Restricted                                                                                                                                                                |       | 618                                      |       | 644                         |       |
| Accounts  receivable, net                                                                                                                                                              |       | 1,952                                    |       | 1,881                       |       |
| Due from NETF                                                                                                                                                                          |       | 3,076                                    |       | 2,817                       |       |
| Inventory                                                                                                                                                                              |       | 64                                       |       | 193                         |       |
| Prepaid expenses  and other current assets                                                                                                                                             |       | 422                                      |       | 101                         |       |
| Other  receivables                                                                                                                                                                     |       | 47                                       |       | 118                         |       |
| TOTAL CURRENT  ASSETS                                                                                                                                                                  |       | 6,540                                    |       | 6,300                       |       |
|                                                                                                                                                                                   |       |                                     |       |                        |       |
| RESTRICTED CASH — non  current portion                                                                                                                                            |       | 128                                      |       | 559                         |       |
|                                                                                                                                                                                   |       |                                     |       |                        |       |
| PROPERTY AND EQUIPMENT,  net                                                                                                                                                           |       | 694                                      |       | 763                         |       |
|                                                                                                                                                                                   |       |                                     |       |                        |       |
| GOODWILL                                                                                                                                                                               |       | 18,754                                   |       | 18,767                      |       |
|                                                                                                                                                                                   |       |                                     |       |                        |       |
| ACQUIRED CUSTOMER  LISTS, net                                                                                                                                                          |       | 3,989                                    |       | 2,722                       |       |
|                                                                                                                                                                                   |       |                                     |       |                        |       |
| DEFERRED FINANCING  COSTS, net                                                                                                                                                         |       | 260                                      |       | 304                         |       |
|                                                                                                                                                                                   |       |                                     |       |                        |       |
| DEPOSITS AND OTHER  ASSETS                                                                                                                                                             |       | 702                                      |       | 273                         |       |
|                                                                                                                                                                                   |       | $                                        | 31,067     |                        | $          | 29,688 |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                             |       |                                     |       |                        |       |
|                                                                                                                                                                                   |       |                                     |       |                        |       |
| CURRENT LIABILITIES:                                                                                                                                                                   |       |                                     |       |                        |       |
| Cash overdraft                                                                                                                                                                         |       | $                                        | 310        |                        | $          | 168 |   |
| Accounts payable                                                                                                                                                                       |       | 3,267                                    |       | 2,090                       |       |
| Accrued expenses                                                                                                                                                                       |       | 2,130                                    |       | 2,705                       |       |
| Acquisition indebtedness                                                                                                                                                               |       | 633                                      |       | —                      |       |
| Deferred revenue                                                                                                                                                                       |       | 1,125                                    |       | 1,036                       |       |
| Current  liabilities of discontinued operations                                                                                                                                        |       | 258                                      |       | 258                         |       |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                             |       | 7,723                                    |       | 6,257                       |       |
|                                                                                                                                                                                   |       |                                     |       |                        |       |
| DEFERRED REVENUE — non  current portion                                                                                                                                           |       | 178                                      |       | 529                         |       |
| NOTES PAYABLE, net of  discounts amounting to $7,719                                                                                                                                   |       | 7,604                                    |       | 2,021                       |       |
| TOTAL  LIABILITIES                                                                                                                                                                     |       | 15,505                                   |       | 8,807                       |       |
|                                                                                                                                                                                   |       |                                     |       |                        |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                                         |       |                                     |       |                        |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                             |       |                                     |       |                        |       |
| Preferred stock,  $.0001 par value, 10,000,000 shares authorized; 0 and 0 shares issued and  outstanding as of March 31, 2007 and June 30, 2006, respectively                          |       | —                                   |       | —                      |       |
| Class A Common  stock, $.0001 par value, 450,000,000 shares authorized; 58,234,989 and  55,180,586 shares issued and outstanding as of March 31, 2007 and June 30,  2006, respectively |       | 6                                        |       | 6                           |       |
| Additional  paid-in capital                                                                                                                                                            |       | 149,024                                  |       | 146,783                     |       |
| Accumulated  other comprehensive loss — foreign currency translation                                                                                                              |       | (127                                     | )          | —                      |       |
| Accumulated  deficit                                                                                                                                                                   |       | (133,341                                 | )          | (125,908                    | )          |
| TOTAL  STOCKHOLDERS’ EQUITY                                                                                                                                                       |       | 15,562                                   |       | 20,881                      |       |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                       |       | $                                        | 31,067     |                        | $          | 29,688 |   |

 

The accompanying notes are anintegral part of these condensed consolidated financial statements.

3

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**DYNTEK, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS AND COMPREHENSIVE LOSS**

**(Unaudited)(in thousands, except per share data)**
| ** **                                                                 | ** ** | **Three Months Ended  March 31,** | ** ** | **Nine Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2007**                                         | ** ** | **2006**                                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| REVENUES:                                                                  |       |                                             |       |                                            |       |   |   |   |   |
| Product Revenues                                                           |       | $                                                | 14,581     |                                            | $          | 9,370 |   | $ | 43,717 |   | $ | 37,953 |   |
| Service Revenues                                                           |       | 5,906                                            |       | 4,926                                           |       | 17,070 |   | 18,622 |   |
| Total revenues                                                             |       | 20,487                                           |       | 14,296                                          |       | 60,787 |   | 56,575 |   |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| COST OF REVENUES:                                                          |       |                                             |       |                                            |       |   |   |   |   |
| Cost of products                                                           |       | 12,261                                           |       | 8,648                                           |       | 37,293 |   | 33,839 |   |
| Cost of services                                                           |       | 4,195                                            |       | 4,540                                           |       | 12,124 |   | 14,325 |   |
| Total cost of  revenues                                                    |       | 16,456                                           |       | 13,188                                          |       | 49,417 |   | 48,164 |   |
| GROSS PROFIT                                                               |       | 4,031                                            |       | 1,108                                           |       | 11,370 |   | 8,411 |   |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| OPERATING EXPENSES:                                                        |       |                                             |       |                                            |       |   |   |   |   |
| Selling                                                                    |       | 3,083                                            |       | 3,491                                           |       | 8,316 |   | 9,667 |   |
| General and  administrative                                                |       | 928                                              |       | 1,816                                           |       | 3,304 |   | 4,301 |   |
| Depreciation and  amortization                                             |       | 805                                              |       | 632                                             |       | 2,177 |   | 2,012 |   |
| Total operating  expenses                                                  |       | 4,816                                            |       | 5,939                                           |       | 13,797 |   | 15,980 |   |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| LOSS FROM OPERATIONS                                                       |       | (785                                             | )          | (4,831                                          | )          | (2,427 | ) | (7,569 | ) |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| OTHER INCOME (EXPENSE):                                                    |       |                                             |       |                                            |       |   |   |   |   |
| Gain (Loss) on  extinguishment of debt                                     |       | —                                           |       | (8,521                                          | )          | — |   | (8,521 | ) |
| Gain on  marketable securities                                             |       | —                                           |       | —                                          |       | — |   | 54 |   |
| Interest expense                                                           |       | (1,473                                           | )          | (2,070                                          | )          | (4,963 | ) | (5,563 | ) |
| Other expense                                                              |       | (38                                              | )          | (590                                            | )          | (50 | ) | (590 | ) |
| Interest income                                                            |       | 24                                               |       | 18                                              |       | 59 |   | 42 |   |
| Total other  income (expense)                                              |       | (1,487                                           | )          | (11,163                                         | )          | (4,954 | ) | (14,578 | ) |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| LOSS FROM CONTINUING  OPERATIONS BEFORE INCOME TAXES                       |       | $                                                | (2,272     | )                                               | (15,994    | ) | (7,381 | ) | (22,147 | ) |
| INCOME TAXES                                                               |       | 14                                               |       | —                                          |       | 52 |   | — |   |
| LOSS FROM CONTINUING  OPERATIONS                                           |       | $                                                | (2,286     | )                                               | $          | (15,994 | ) | $ | (7,433 | ) | $ | (22,147 | ) |
| DISCONTINUED OPERATIONS                                                    |       |                                             |       |                                            |       |   |   |   |   |
| Gain on disposal  of discontinued operations                               |       | —                                           |       | 297                                             |       | — |   | 513 |   |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| NET LOSS                                                                   |       | $                                                | (2,286     | )                                               | $          | (15,697 | ) | $ | (7,433 | ) | $ | (21,634 | ) |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| NET LOSS PER SHARE:  Basic and Diluted                                     |       |                                             |       |                                            |       |   |   |   |   |
| Continuing  Operations                                                     |       | (.04                                             | )          | (1.03                                           | )          | (.13 | ) | (2.09 | ) |
| Discontinued  Operations                                                   |       | —                                           |       | —                                          |       | — |   | — |   |
|                                                                       |       | $                                                | (.04       | )                                               | $          | (1.03 | ) | $ | (.13 | ) | $ | (2.09 | ) |
| WEIGHTED AVERAGE NUMBER  OF SHARES USED IN COMPUTATION - Basic and Diluted |       | 58,210,262                                       |       | 15,246,274                                      |       | 57,500,550 |   | 10,368,321 |   |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| NET LOSS                                                                   |       | $                                                | (2,286     | )                                               | $          | (15,697 | ) | $ | (7,433 | ) | $ | (21,634 | ) |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| COMPREHENSIVE LOSS, NET  OF TAX                                            |       |                                             |       |                                            |       |   |   |   |   |
| Foreign currency  translation adjustment                                   |       | (167                                             | )          | —                                          |       | (127 | ) | — |   |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| COMPREHENSIVE LOSS                                                         |       | $                                                | (2,453     | )                                               | $          | (15,697 | ) | $ | (7,560 | ) | $ | (21,634 | ) |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

4

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**DYNTEK, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(inthousands)**
| ** **                                                                       | ** ** | **Nine Months Ended   March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2007**                                              | ** ** | **2006** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                           |       |                                                  |       |   |   |
| Net  loss-Continuing operations                                                  |       | $                                                     | (7,433     | ) | $ | (22,147 | ) |
| Adjustments to  reconcile net loss to net cash provided by operating activities: |       |                                                  |       |   |   |
| Depreciation and  amortization                                                   |       | 2,177                                                 |       | 2,012 |   |
| Non-cash  interest                                                               |       | 3,835                                                 |       | 3,970 |   |
| Stock based  compensation                                                        |       | 767                                                   |       | 205 |   |
| Gain in  marketable securities                                                   |       | —                                                |       | (54 | ) |
| Loss on  extinguishment of debt                                                  |       | —                                                |       | 8,521 |   |
| Loss on  preferred investments                                                   |       | —                                                |       | 505 |   |
| Changes in  operating assets and liabilities:                                    |       |                                                  |       |   |   |
| Accounts  receivable                                                             |       | (50                                                   | )          | 16,831 |   |
| Due from NETF                                                                    |       | (259                                                  | )          | (1,870 | ) |
| Inventory                                                                        |       | 128                                                   |       | 1,170 |   |
| Prepaid expenses  and other current assets                                       |       | (321                                                  | )          | 6 |   |
| Other  receivables                                                               |       | 71                                                    |       | (313 | ) |
| Deposits and  other assets                                                       |       | (430                                                  | )          | 74 |   |
| Accounts payable                                                                 |       | 1,179                                                 |       | (5,081 | ) |
| Deferred revenue                                                                 |       | (803                                                  | )          | 161 |   |
| Accrued expenses                                                                 |       | (583                                                  | )          | 633 |   |
| Restricted cash                                                                  |       | 457                                                   |       | (1,466 | ) |
| Total  adjustments                                                               |       | 6,168                                                 |       | 25,304 |   |
| NET CASH  PROVIDED BY (USED IN) CONTINUING OPERATIONS                            |       | (1,265                                                | )          | 3,157 |   |
|                                                                             |       |                                                  |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                           |       |                                                  |       |   |   |
| Cash from  disposition of marketable securities                                  |       | —                                                |       | 54 |   |
| Cash paid for  acquisitions                                                      |       | (1,676                                                | )          | (2,530 | ) |
| Capital  expenditures                                                            |       | (190                                                  | )          | (179 | ) |
| NET CASH USED IN  INVESTING ACTIVITIES                                           |       | (1,866                                                | )          | (2,655 | ) |
|                                                                             |       |                                                  |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                           |       |                                                  |       |   |   |
| Cash overdraft                                                                   |       | 142                                                   |       | (742 | ) |
| Proceeds from  debt financing                                                    |       | 3,000                                                 |       | 12,200 |   |
| Deferred  financing costs                                                        |       | (26                                                   | )          | (451 | ) |
| Net proceeds  under line of credit                                               |       | —                                                |       | (4,697 | ) |
| Purchase of  Treasury stock                                                      |       | (108                                                  | )          | — |   |
| Issuance of  Common Stock, net of expenses                                       |       | —                                                |       | 392 |   |
| Principal  payments                                                              |       | —                                                |       | (7,971 | ) |
| NET CASH  PROVIDED BY FINANCING ACTIVITIES                                       |       | 3,008                                                 |       | (1,269 | ) |
| CASH FLOWS OF  DISCONTINUED OPERATIONS:                                          |       |                                                  |       |   |   |
| Operating cash  flows                                                            |       | —                                                |       | 442 |   |
| NET CASH PROVIDED  BY DISCONTINUED OPERATIONS                                    |       | —                                                |       | 442 |   |
| Effects of exchange  rate changes on cash and cash equivalents                   |       | (62                                                   | )          | — |   |
| NET DECREASE IN CASH                                                             |       | (185                                                  | )          | (325 | ) |
| CASH AT BEGINNING OF  PERIOD                                                     |       | 546                                                   |       | 963 |   |
| CASH AT END OF PERIOD                                                            |       | $                                                     | 361        |   | $ | 638 |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

5

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**DYNTEK, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS****(Unaudited)(in thousands, except share data)**
| ** **                                                              | ** ** | **Nine Months Ended   March 31,** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                              | ** ** | **2007**                                              | ** ** | **2006** | ** ** |
| SUPPLEMENTAL DISCLOSURE  OF CASH FLOW INFORMATION:                      |       |                                                  |       |   |   |
|                                                                    |       |                                                  |       |   |   |
| Cash paid for  interest                                                 |       | $                                                     | 839        |   | $ | 2,017 |   |
|                                                                    |       |                                                  |       |   |   |
| SUPPLEMENTAL DISCLOSURE  OF NON-CASH FINANCING AND INVESTING ACTIVITIES |       |                                                  |       |   |   |
| Acquisition of  Redrock Communications Solutions, Inc.in 2004:          |       |                                                  |       |   |   |
| Cash paid to  shareholders                                              |       | —                                                |       | 763 |   |
|                                                                    |       |                                                  |       |   |   |
| Acquisition of  Sensible Security Solutions, Inc. in October 2006:      |       |                                                  |       |   |   |
| Fixed assets                                                            |       | 70                                                    |       | — |   |
| Accounts  receivable                                                    |       | 32                                                    |       | — |   |
| Intangible  assets customer list                                        |       | 1,534                                                 |       | — |   |
| Non cash  consideration                                                 |       | (300                                                  | )          | — |   |
| Contingent  consideration                                               |       | (633                                                  | )          | — |   |
| Cash paid to  acquire businesses                                        |       | 1,113                                                 |       | — |   |
|                                                                    |       |                                                  |       |   |   |
| Acquisition of  TekConnect Inc. in October 2006:                        |       |                                                  |       |   |   |
| Intangible  assets customer list                                        |       | 1,003                                                 |       | — |   |
| Deferred Revenue  (contract obligations)                                |       | (540                                                  | )          | — |   |
| Cash paid to acquire  businesses                                        |       | 563                                                   |       | — |   |
|                                                                         |            |                                                       |            |  |  |  |  |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

6

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**DYNTEK, INC. &SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSMarch 31, 2006(UNAUDITED)**

**1.****              BASISOF PRESENTATION**

The accompanying unaudited condensed consolidatedfinancial statements of DynTek, Inc. and its subsidiaries (“DynTek”, “Company”,or “we”) have been prepared in accordance with accounting principles generallyaccepted in the United States of America, for interim financial statements andpursuant to the instructions to Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, they do notinclude all of the information and disclosures required for annual financialstatements.  These condensed consolidatedfinancial statements should be read in conjunction with the consolidatedfinancial statements and related footnotes for the year ended June 30,2006 included in the Form 10-K for the year then ended.

The accompanying condensed consolidated financialstatements reflect all adjustments, which, in the opinion of management consistof normal recurring items that are necessary for a fair presentation inconformity with accounting principles generally accepted in the United Statesof America.   Preparing condensedconsolidated financial statements requires management to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenuesand expenses.  The results of operationsfor any interim period are not necessarily indicative of the results attainablefor a full fiscal year.

**2.****              LIQUIDITYAND FINANCIAL CONDITION**

The Company providesprofessional information technology (“IT”) solutions and sales of relatedproducts and services to mid-market commercial businesses, state and localgovernment agencies, and educational institutions.  During the nine months ended March 31, 2007,the Company incurred a net loss of $7,433,000, which includes $6,779,000 ofnon-cash charges resulting from $2,177,000 of depreciation and amortization;$767,000 in stock based compensation; and $3,835,000 in non-cash interestcharges.  At March 31, 2007, theCompany had a working capital deficiency of approximately $1,183,000.

As described in Note 6,the Company entered into a Second Amendment to Note Purchase Agreement (the “SecondAmendment”) on September 26, 2006 pursuant to which the Company issued to TrustA-4 — Lloyd I. Miller a Junior Secured Convertible Note in the aggregateprincipal amount of $3,000,000 (the “Third Junior Note”) on substantially thesame terms set forth in the Junior Note and the Additional Junior Note (both ofwhich are defined herein) with the additional collateralization of 66% of theCompany’s assets and stock of its wholly-owned Canadian subsidiary.  The proceeds of the Third Junior Note wereused to finance acquisitions and for general corporate purposes.

On October 6, 2006, theCompany utilized a portion of the proceeds from the Third Junior Note to enterinto an Asset Purchase Agreement for substantially all of the assets ofTekConnect, Inc.  In consideration forthe purchased assets, the Company paid to the sellers $400,000 at closing,incurred $63,000 of direct acquisition costs and assumed $540,000 pre-existingcontract obligations. The Company also made a final $100,000 earn-out paymentin September 2006 related to the initial June 2006 purchase of TekConnect’scustomer list.

The Company also utilizeda portion of the Third Junior Note on October 27, 2006, when the Company,DynTek Canada, an Ontario corporation and wholly-owned subsidiary of theCompany (“DynTek Canada”), Sensible Security Solutions, Inc., an Ontariocorporation (“SSS”), and Paul Saucier, an individual and 100% owner of SSS,entered into an Asset Purchase Agreement for substantially all of the assets ofSSS.  In consideration for the purchasedassets, the Company agreed to pay SSS at closing a cash payment of $1,063,000and 1,485,148 shares of the Company’s common stock-based upon the per sharefair value in accordance with EITF 99-12. Additional fees in connectionwith the acquisition of approximately $50,000 were also paid. In addition, theCompany agreed to make additional payments over a three-year period based uponthe achievement of certain EBITDA performance targets.  Such payments willbe paid using a combination of cash and the Company’s common stock, at theCompany’s election, provided that at least half of the payments will be in cash(see Note 4). The earn-out provisions are based upon achieved EBITDAperformance targets and are estimated to be approximately $223,000 for theperiod ended December 31, 2006 and $410,000 for the period ended March 31,2007; both  are classified as a currentliability in the accompanying balance sheet. The Company intends to distributepayment, half to be paid in cash and half to be issuable in shares of theCompany’s common stock at a price of $0.20 per share. On April 17, 2007, theCompany made an initial cash earn-out payment to the Seller of approximately$134,000.  

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On April 13, 2007, the Companyentered into a Junior Secured Convertible Note Purchase Agreement in which theCompany issued to Trust A-4 — Lloyd I. Miller a Junior Secured Convertible Notein the aggregate principal amount of $5,000,000 (the “Note”).  The interest rate for the Note is 9% perannum if paid in cash, or 13% per annum if paid in kind, which is at theCompany’s election for the first three years. Principal will be payable on thematurity date of April 13, 2012, and interest will be payable quarterlyin arrears beginning June 30, 2007, unless the Company chooses itspayment in kind option, in which case interest will be added to the principalamount of the Note during the period that the Company continues such election.The Note may be converted into common stock of the Company at any time at theelection of the holder at an initial conversion price of $0.175 per share ofcommon stock, subject to certain adjustments set forth therein. Proceeds fromthe issuance of the Note will be used to finance current operations, fundpotential acquisitions and for general corporate purposes.

The Companyexperiences timing differences in its operating cash flows resulting fromthe fact that much of its revenues are earned near the end of eachquarter and its operating expenses are incurred evenlythroughout the period. The Company also experiences slow collectioncycles with respect to customers that are educational and governmentinstitutions, which has been a growth area of the business.  Although theCompany has experienced a low incidence of uncollectible accounts, many ofits customers have historically failed to make timely payments.

Slow collections have causedthe Company to incur higher fees under its accounts receivable and productfinancing arrangements with New England Technology Finance, LLC (“NETF”)(see Note 7).   Although the Company uses its facility with NETFto better manage the timing differences in its operating cash flows, servicesrelated accounts receivable due from customers under its newly acquiredCanadian business are currently ineligible for transfer to NETF.These circumstances have caused the Company to experience additionalconstraints on its liquidity, which are likely to continue until suchtime that the acquired business is fully integrated.

Although the Company has madesubstantial efforts to accelerate collections under its Company wideoperations, slow collection cycles, ongoing timingdifferences, and efforts to integrate acquired businesses could causethe Company to seek additional outside financing.

The Company believes that itsstrategy of streamlining the business around its core competency of providingIT solutions is enabling it to operate under a more efficient cost structurethan it had in the past. The Company is also not required to make principalpayments under any of its note obligations until June 2009 and itsaccounts receivable and product financing arrangement with NETF is providing itwith timely working capital resources.

The Company may continue to expandthe scope of its products and services offerings by pursuing acquisitioncandidates with complementary technologies, services or products. The Companywould finance such acquisitions (if made) by using its own working capitaland/or issuing additional debt and equity securities. There can be noassurance, however, that the Company will identify appropriate acquisitioncandidates or that, if appropriate candidates are identified, that it will besuccessful in obtaining the financing needed to complete the acquisitions.

In the event of any additionalfinancing, any equity financing would likely result in dilution to our existingstockholders and any debt financing may include restrictive covenants.

In January 2007, the Company receiveda comment letter on a Registration Statement on Form S-1 indicating that theCompany may have violated Section 5 of the Securities Act in connection withits issuance of the Third Junior Note to the Junior Lender (Note 6).  Aninvestor’s remedy for violations of Section 5 of the Securities Act couldinclude making a demand for a rescission of the investment.  While theCompany believes that its issuance of these securities was in compliance withSection 5 and any other applicable regulations, it nonetheless requested andreceived from the Lenders, waivers and releases of any rescission rights inconnection with any such potential Section 5 violation. The Company obtainedsuch waivers on February 2, 2007. Accordingly, the Company hascontinued to classify the obligations under the notes as non-currentliabilities in the accompanying balance sheet as of March 31, 2007.

The Company believes that it hassufficient liquidity to sustain the business through March 31, 2008, however,there can be no assurance that unforeseen circumstances will not have amaterial affect on the business that could require it to raise additionalcapital or take other measures to sustain operations in the event outsidesources of capital are not available. The Company has not secured anycommitments for new financing at this time nor can it provide any assurancethat new capital will be available to it on acceptable terms, if at all.

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

A.           Principlesof Consolidation - The consolidated financial statements include the accountsof the Company and its wholly-owned subsidiaries. All significant inter-companytransactions have been eliminated.

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

*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 in 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.  Any responsibility for technical support andaccess to upgrades and enhancements to these software products are solely theresponsibility of the software manufacturer, which arrangement is known to thecustomer at the time the sale is consummated. With respect to delivery, the Company requires that the customer hasreceived transfer of the software or, at a minimum, an authorization code (“key”)to permit access to the product.  If asoftware license is delivered to the customer, but the license term has notbegun, the Company does not record the revenue prior to inception of thelicense term. The Company requires its software product sales to be supportedby a written contract or other evidence of a sale transaction, which generallyconsists of a customer purchase order or on-line authorization.  These forms of evidence clearly indicate theselling price to the customer, shipping terms, payment terms (generally 30days) and refund policy, if any. The selling prices of these products are fixedat the time the sale is consummated. For product sales, the Company applies thefactors discussed in Emerging Issues Task Force Issue “EITF” 99-19 indetermining whether to recognize product revenues on a gross or net basis.

In a substantial majority of transactions, the Company(i) acts as principal; (ii) takes title to the products; and (iii) has therisks and rewards of ownership, including the risk of loss for collection,delivery or returns.  For these transactions,the Company recognizes revenues based on the gross amounts billed tocustomers.  In certain circumstances,based on an analysis of the factors set forth in EITF 99-19, the Company hasdetermined that it was acting as an agent, and therefore recognizes revenues ona net basis.  For the nine months endedMarch 31, 2007 and 2006 respectively, no revenues were recognized on a netbasis.

*IT Services Revenue*

The Company generally bills its customers forprofessional IT services based on hours of time spent on any given assignmentat its hourly billing rates. As it relates to delivery of these services, theCompany recognizes revenue under these arrangements as the work is completedand the customer has indicated acceptance of services by approving a work ordermilestone or completion order.   Forcertain engagements, the Company enters fixed bid contracts, and recognizesrevenue as phases of the project are completed and accepted by the client.  For its seat management services, the Companyenters unit-price contracts (e.g., price per user for seat management), andrecognizes revenue based on number of units multiplied by the agreed-uponcontract unit price per month.

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

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The Company sells its eligible accounts receivablewith limited recourse to NETF under each of an Asset Purchase and LiabilityAssumption Agreement and an Asset Purchase Agreement that it entered into withNETF during the year ended June 30, 2006. The Company retains certainservicing rights under a related Master Servicing Agreement that provides forthe Company to manage collections and other ongoing interactions with customersfor certain contractual fees.

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 Financial Assets andExtinguishment 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 .

D.            Income(loss) per Common Share - Basic earnings per share has been calculated basedupon the weighted average number of common shares outstanding. Convertiblepreferred stock, convertible debt, options and warrants have been excluded ascommon stock equivalents in the diluted earnings per share because they areanti-dilutive.  The aggregate number ofpotential common stock equivalents outstanding as of March 31, 2007 is asfollows:
|                  | ** ** | **As of March 31,** | ** ** |
|------------------|------------|------------------------------------|------------|
| ** **       | ** ** | **2007**                           | ** ** | **2006** | ** ** |
| Common stock     |       | 58,234,989                         |       | 15,695,078 |   |
| Warrants         |       | 34,787,403                         |       | 10,342,864 |   |
| Options          |       | 10,857,064                         |       | 2,720,392 |   |
| Convertible debt |       | 39,025,614                         |       | 15,000,000 |   |
|             |       | 142,905,070                        |       | 43,758,334 |   |

 

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

F.              StockBased Compensation — The Company applies FASB Statement of Financial AccountingStandard (“SFAS”) No. 123R “Share Based Payment”.  This statement is a revision of SFASStatement No. 123, and supersedesAPB Opinion No. 25, and its related implementation guidance. SFAS 123Raddresses all forms of share based payment (“SBP”) awards including sharesissued under employee stock purchase plans, stock options, restricted stock andstock appreciation rights. Under SFAS 123R, SBP awards result in a cost thatwill be measured at fair value on the awards’ grant date, based on theestimated number of awards that are expected to vest that will result in acharge to operations.  Consequently,during the nine months ended March 31, 2006, the Company recognized$205,000 in expenses, which represents the fair value of stock option awardsthat the Company elected to accelerate vesting during that period.  During the nine months ended March 31, 2007,the Company recognized $767,000 in expenses, which includes $40,000 for thefair value of stock option awarded to two non-employee board members and$200,000 for the fair value of a stock grant awarded to a key employee.

G.             FairValue of Financial Instruments — The carrying amounts reported in the balancesheet for cash, trade receivables, accounts payable and accrued expensesapproximate fair value based on the short-term maturity of theseinstruments.  The carrying amounts ofnotes receivable approximate fair value as such instruments feature contractualinterest rates that are consistent with current market rates of interest. Thecarrying amounts of notes payable approximate fair value because the effectiveyields of such instruments, which includes the effect of contractual interestrates taken together with discounts resulting from the concurrent issuances ofcommon stock purchase warrants, are consistent with current market rates ofinterest.

H.            Goodwill— Goodwill represents the excess of the purchase price over the fair value ofnet assets acquired in business combinations (Note 4).  SFAS 142, Goodwill and Other Intangible Assets, requires that goodwill betested for impairment at the reporting unit level (operating segment or onelevel below an operating segment) on an annual basis (June 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 test requiresjudgment, including the identification of reporting units, assigning assets andliabilities to reporting units, assigning goodwill to reporting units, anddetermining the fair value. Significant judgments required to estimate the fairvalue of reporting units include estimating future cash flows, determiningappropriate discount rates and other assumptions. Changes in these estimatesand assumptions could materially affect the determination of fair value and/orgoodwill impairment for each reporting unit.

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

J.                AdvertisingCosts — Costs related to advertising and promotions of services are charged tosales operating expense as incurred. Advertising expense amounted toapproximately $86,200 and $133,800 for the nine months ended March 31, 2007 and2006 respectively. These expenses are included in selling expenses in theaccompanying statements of operations.

K.            Shippingand Handling Costs — The Company accounts for shipping and handling costs as acomponent of “Cost of Product Revenues.” These costs are primarily the directfreight costs related to the “drop shipment” of products to the Company’scustomers. Shipping and handling costs amounted to approximately $94,300 and$188,800 for the nine months ended March 31, 2007 and 2006, respectively.

L.              ConvertibleNotes — The Company accounts for conversion options embedded in convertiblenotes in accordance with Statement of Financial Accounting Standard (“SFAS)No. 133 “Accounting for Derivative Instruments and Hedging Activities” (“SFAS133”) and EITF 00-19 “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock” (“EITF 00-19”).SFAS 133 generally requires companies to bifurcate conversion options embeddedin convertible notes from their host instruments and to account for them asfree standing derivative financial instruments in accordance with EITF 00-19.SFAS 133 provides for an exception to this rule when convertible notes, ashost instruments, are deemed to be conventional as that term is described inthe implementation guidance under Appendix A to SFAS 133 and further clarifiedin EITF 05-2 “The Meaning of “Conventional Convertible Debt Instrument”in Issue No. 00-19.

The Company accounts for convertible notes (deemed conventional)in accordance with the provisions of Emerging Issues Task Force Issue (“EITF”)98-5 “Accounting for Convertible Securities with Beneficial ConversionFeatures,” (“EITF 98-5”), EITF 00-27 “Application of EITF 98-5to Certain Convertible Instruments,” Accordingly, the Company records, as adiscount 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 ofredemption.

M.         Foreign Currency — Theconsolidated financial statements are presented in United States dollars inaccordance with SFAS No. 52, “Foreign Currency Translation”. The functionalcurrency of DynTek Canada, Inc., the Company’s Canadian Subsidiary is theCanadian dollar.  Foreign denominatedmonetary assets are translated to United States dollars using foreign exchangerates in effect at the balance sheet date. Revenues and expenses are translatedat the average rate of exchange during the period. Gain or losses arising onforeign currency transactions are included in the determination of operatingresults. The effect of foreign currency transaction adjustments was a loss ofapproximately $127,000 for the nine months ended March 31, 2007.

N.            New AccountingStandards

InSeptember 2006, the FASB issued Statement of Financial Accountings StandardsNo. 157, Fair Value Measurements (“SFAS 157”). This Standard defines fairvalue, establishes a framework for measuring fair value in generally acceptedaccounting principles and expands disclosures about fair value measurements.SFAS 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007 and interim periods within thosefiscal years. The adoption of SFAS 157 is not expected to have a materialimpact on the Company’s financial position, results of operations or cashflows.

InJuly 2006, the FASB issued FASB Interpretation No. 48, Accounting forUncertainty in Income Taxes. This Interpretation prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.This Interpretation also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure, andtransition. The Interpretation is effective for fiscal years beginning afterDecember 15, 2006. We have not yet completed our analysis of theimpact this Interpretation will have on our financial condition, results ofoperations, cash flows or disclosures.

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InSeptember 2006, the Securities and Exchange Commission (“SEC”) issued StaffAccounting Bulletin 108, Considering the Effects on Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements, (“SAB 108”).SAB 108 requires registrants to quantify errors using both the income statementmethod (i.e. iron curtain method) and the rollover method and requiresadjustments if either method indicates a material error.  If a correction in the current year relatingto prior year errors is material to the current year, then the prior yearfinancial information needs to be corrected. A correction to the prior yearresults that are not material to those years, would not require a restatementprocess where prior financials would be amended.  SAB 108 is effective for fiscal years endingafter November 15, 2006. The Company does not anticipate that SAB 108 will havea material effect on its financial position, results of operations or cashflows.

InJune 2006, the EITF reached a consensus on Issue No. 06-3 (“EITF 06-3”), “DisclosureRequirements for Taxes Assessed by a Governmental Authority onRevenue-Producing Transactions.”  The consensus allows companies to choosebetween two acceptable alternatives based on their accounting policies fortransactions in which the company collects taxes on behalf of a governmentalauthority, such as sales taxes.  Under the gross method, taxes collectedare accounted for as a component of sales revenue with an offsettingexpense.  Conversely, the net method allows a reduction to sales revenue. If such taxes are reported gross and are significant, companies should disclosethe amount of those taxes.  The guidance should be applied to financialreports through retrospective application for all periods presented, if amountsare significant, for interim and annual reporting beginning after December 15, 2006. The Company adopted the provisions of this EITF and accounts for the collectionof sales taxes using the net method. The implementation of EITF 06-3 did nothave a material effect on the Company’s consolidated financial statements.

In November 2006, the EITF reached a final consensus in EITF Issue 06-6“Debtor’s Accounting for a Modification (or Exchange) of Convertible DebtInstruments” (“EITF 06-6”).  EITF 06-6 addresses the modification of aconvertible debt instrument that changes the fair value of an embeddedconversion option and the subsequent recognition of interest expense for theassociated debt instrument when the modification does not result in a debtextinguishment pursuant to EITF 96-19, “Debtor’s Accounting for a Modificationor Exchange of Debt Instruments.”  The consensus should be applied tomodifications or exchanges of debt instruments occurring in interim or annualperiods beginning after November 29, 2006.  The Company does notexpect the adoption of EITF 06-6 to have a material impact on its consolidatedfinancial position, results of operations or cash flows.

In November 2006, the FASB ratified EITF Issue No. 06-7, “Issuer’sAccounting for a Previously Bifurcated Conversion Option in a Convertible DebtInstrument When the Conversion Option No Longer Meets the Bifurcation Criteriain FASB Statement No. 133, Accounting for Derivative Instruments and HedgingActivities” (“EITF 06-7”). At the time of issuance, an embedded conversion optionin a convertible debt instrument may be required to be bifurcated from the debtinstrument and accounted for separately by the issuer as a derivative under FAS133, based on the application of EITF 00-19. Subsequent to the issuance of theconvertible debt, facts may change and cause the embedded conversion option tono longer meet the conditions for separate accounting as a derivativeinstrument, such as when the bifurcated instrument meets the conditions ofIssue 00-19 to be classified in stockholders’ equity. Under EITF 06-7, when anembedded conversion option previously accounted for as a derivative under FAS133 no longer meets the bifurcation criteria under that standard, an issuershall disclose a description of the principal changes causing the embeddedconversion option to no longer require bifurcation under FAS 133 and the amountof the liability for the conversion option reclassified to stockholders’equity. EITF 06-7 should be applied to all previously bifurcated conversionoptions in convertible debt instruments that no longer meet the bifurcationcriteria in FAS 133 in interim or annual periods beginning afterDecember 15, 2006, regardless of whether the debt instrument wasentered into prior or subsequent to the effective date of EITF 06-7. Earlierapplication of EITF 06-7 is permitted in periods for which financial statementshave not yet been issued. The Company is currently evaluating the impact ofthis guidance on its consolidated financial position, results of operations orcash flows.

Otheraccounting standards 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 consolidated financial statementsupon adoption.

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**4.****              BUSINESSACQUISITIONS**

**Sensible Security Solutions, Inc**

On October 27, 2006, theCompany, DynTek Canada, an Ontario corporation and wholly owned subsidiary ofthe Company (“DynTek Canada”), Sensible Security Solutions, Inc., an Ontariocorporation (“SSS”), and Paul Saucier, an individual and 100% owner of SSS,entered into an Asset Purchase Agreement for the acquisition by DynTek Canadaof substantially all of the assets of SSS. SSS provides major Canadianorganizations, both in the private and public sector, with the design andimplementation of comprehensive, enterprise-level anti-virus solutions. TheCompany acquired SSS because it was aligned with the Company’s existing coresecurities practice, provides a greater density within its Canadian region, andprovides for a more comprehensive delivery of its service support coast tocoast.

 In consideration for the purchased assets, theCompany paid SSS at closing a cash payment of $1,063,000 and 1,485,148 sharesof the Company’s common stock based upon the per share fair value in accordancewith EITF 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 $4,700,000 over a three-year period basedupon the achievement of certain EBITDA performance targets. Such paymentswill be paid quarterly for the first year of the earn-out and annually for eachof the next two years using a combination of cash and the Company’s commonstock, at the Company’s election, provided that at least half of the paymentswill be in cash. Earn-out awards will be calculated, subject to adjustment,based upon the cumulative effect of achieved EBITDA performance targets duringthe 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. Progressive cashpayments and/or stock issuances are due within 15 days of the notification ofthe EBITDA Earn-out.  Earn-out sharesissued are to be held in escrow by the Company until the final annual EBITDAEarn-out provision is determined. SSS is obligated to repay over payments madeby the Company with respect to the cumulative effect of achieved annual EBITDAperformance; however, the repayment obligation may be satisfied in either cashor the return of earn-out shares at the sole discretion of SSS and in no eventshall the repayment obligation exceed the number of Earn-out shares issued bythe Company. In the event that Paul Saucier, the former owner of SSS, isterminated by the Company without cause, the Company will be required to pay toSSS pursuant to the earn-out an amount equal to $3.6 million, less theaggregate purchase price previously paid to SSS as of the date of termination.  In addition, if the total of the earn-outpayments would exceed $3.6 million, then the Company will be required tocontinue payments under the earn-out in accordance with the Asset PurchaseAgreement (see Note 10).

For the period endedMarch 31, 2007, the Earn-Out provision was estimated to be $633,366based upon achieved EBITDA performance targets. The Company intends to distribute payment, half to be paid in cash andhalf to be issuable in shares of the Company’s common stock at a price of $0.20per share.

A summary of the business assets acquired (in thousands) is as follows:
| Consideration paid:                                                           |   |   |   |
|-------------------------------------------------------------------------------|--------|--------|--------|
| Cash                                                                          |   | $      | 1,063  |   |
| Common stock                                                                  |   | 300    |   |
| Earn-Out Cash                                                                 |   | 633    |   |
| Transaction expenses                                                          |   | 50     |   |
| Total consideration                                                           |   | $      | 2,046  |   |
| Allocation of Purchase Price:                                                 |   |   |   |
| Fair value of  tangible assets:                                               |   |   |   |
| Accounts receivable                                                           |   | 32     |   |
| Property and equipment                                                        |   | 70     |   |
| Total tangible assets                                                         |   | 102    |   |
| Value of excess of purchase price plus net  liabilities assumed allocated to: |   |   |   |
| Customer list                                                                 |   | 1,944  |   |
| Fair value of  assets acquired                                                |   | $      | 2,046  |   |

 

The increase in the valueof intangible assets (customer list) of approximately $1,944,000 is being  amortized over a three year period. Thevaluation of the customer list is based upon the best available information tothe Company at this time. The Company plans to further analyze the valuation ofthe customer list associated with the SSS acquisition including seeking avaluation by an independent third party.

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As of October 27,2006, SSS results of operations are being consolidated with the Company’sresults of operations. The following unaudited pro-forma information reflectsthe results of continuing operations of the Company as though the acquisitionof SSS had been consummated as of the beginning of the period presented (inthousands):
| ** **         | ** ** | **For the Three  Months ended  March 31** | ** ** | **For the Nine  Months ended  March 31** | ** ** |
|--------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **         | ** ** | **2007**                                                      | ** ** | **2006**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenue            |       | $                                                             | 20,487     |                                                         | $          | 16,654 |   | $ | 61,800 |   | $ | 59,882 |   |
| Net Loss           |       | (2,286                                                        | )          | (15,076                                                      | )          | (7,494 | ) | (20,983 | ) |
| Net Loss per share |       | $                                                             | 0.04       |                                                         | $          | .99 |   | $ | 0.13 |   | $ | 2.02 |   |

 

**TekConnect**

On October 6, 2006, theCompany utilized a portion of the proceeds from the Third Junior Note to enterinto Asset Purchase Agreement for substantially all of the assets ofTekConnect, Inc., a privately-held educational technology integration andconsulting firm. In consideration for the purchased assets, the Company paid tosellers $400,000 at closing, incurred $63,000 of direct acquisition costs andassumed $540,000 pre-existing contract obligations.

A summary of the business assets acquired (inthousands) is as follows:
| Consideration paid:                                                           |   |   |   |
|-------------------------------------------------------------------------------|--------|--------|--------|
| Cash                                                                          |   | 500    |   |
| Transaction expenses                                                          |   | 63     |   |
| Total consideration                                                           |   | $      | 563    |   |
| Allocation of Purchase Price:                                                 |   |   |   |
| Fair value of  liabilities assumed:                                           |   |   |   |
| Liabilities  assumed                                                          |   |   |   |
| Deferred Revenue                                                              |   | 540    |   |
| Total liabilities assumed                                                     |   | 540    |   |
| Net liabilities assumed                                                       |   | (540   | )      |
| Value of excess of purchase price plus net  liabilities assumed allocated to: |   |   |   |
| Customer list                                                                 |   | 1,103  |   |
| Fair value of  assets acquired                                                |   | $      | 563    |   |

 

As of October 6, 2006,TekConnect’s results of operations are being consolidated with the Company’sresults of operations. The increase in the value of intangible assets (customerlist) of approximately $1,103,000 will be amortized over a three year period.

**5.**              **BALANCE SHEET ASSET ACCOUNTS**

**RestrictedCash**

Restrictedcash includes cash received in connection with maintenance agreements that isrestricted until the related revenue is earned and recognized under the termsof the respective agreements, which are three years.  The Company classified $618,000 as a currentasset and $128,000 as a non-current asset, which represents the amount of cashthat will become available to the Company under portions of the contracts thatexpire during and subsequent to the next twelve months, respectively.

**PrepaidExpenses and Other Assets**

Prepaidexpenses and other assets total $422,000 and consist of $94,000 of generalamortizable prepaid expenses and $338,000 of aggregate payments made to thirdparty contractors in connection with current service contracts in place withvarious customers for which we are not yet able to recognize as revenue.

**Depositsand Other Assets**

Depositsand other assets total $702,000, comprised of $321,000 for security depositsand a net carrying value of $381,000 in long-term receivables for which$348,000 is collectible in July 2008 and $33,000 is collectible in July 2009.

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

**Senior Notes**

On March 8, 2006, theCompany entered into a Note Purchase Agreement (the “Note Purchase Agreement”)with SACC Partners, L.P. and Lloyd I. Miller, III (the “Senior Lenders”),pursuant to which the Company issued Senior Secured Notes (the “Senior Notes”)in the aggregate principal amount of $6,700,000 with warrants (the “SeniorWarrants”) to purchase up to 19.9% of the Company’s outstanding common stock ona fully diluted basis at the time of exercise. The Senior Warrants have an exercise price of $0.001 per share andexpire on December 31, 2016.  TheSenior Notes bear interest at the rate of 8% per annum if paid in cash, or therate of 11% per annum if paid in kind anytime up through March 31, 2009, whichforms of payment can be made at the Company’s discretion.  Interest is payable quarterly in arrearsbeginning June 30, 2006, unless the Company chooses to make its paymentsin kind, in which case such interest is added to the principal amount of theSenior Notes.  The principal amount ofthe Senior Notes will be amortized over three years and is payable in equalmonthly installments on the last day of each month beginning on March 31, 2009,with the balance to be paid in full on March 1, 2010. 

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The Company may prepaythe Senior Notes at 105% of the aggregate unpaid principal and interest at anytime prior to their maturity. The Senior Notes are also subject to mandatoryprepayment at 105% of the aggregate unpaid principal and interest in the eventof a change in control. The Company is also required to prepay the Senior Notesupon the occurrence of a substantial asset sale in an amount equal to 50% ofthe gross proceeds received in such asset sale plus a penalty equal to 2% ofthe prepayment amount. Pursuant to the terms of the Note Purchase Agreement,substantial asset sales are defined as any single asset sale resulting in grossproceeds of $100,000 or any series of assets sales occurring during a twelvemonth period resulting in gross cumulative proceeds of $100,000 or more. Changein control events described in the Note Purchase Agreement require approval bythe Board of Directors prior to being submitted to a vote of the Company’sstockholders. Accordingly, the redemption provision is not within the controlof the Senior Note holders.

In accordance with APB 14, the Company allocated $2,982,071of the proceeds to the Senior Notes and $3,717,929 of the proceeds to theSenior Warrants (see Senior Warrants below).

On June 30, 2006, the Company elected to paycontractual interest on the Senior Notes in kind and recorded an aggregateinterest charge of $230,186 for the period ended June 30, 2006 whichincreased the principal amount of the notes to $6,930,186.

On September 30, 2006, the Company elected to paycontractual interest on the Senior Notes in kind and recorded an aggregateinterest charge of $192,147 for the period ended September 30, 2006 whichincreased the principal amount of the notes to $7,122,333.

On December 31, 2006, the Company elected to paycontractual interest on the Senior Notes in kind and recorded an aggregateinterest charge of $197,474 for the period ended December 31, 2006 whichincreased the principal amount of the notes to $7,319,807.

On March 31, 2007, the Company elected to pay contractualinterest on the Senior Notes in kind and recorded an aggregate interest chargeof $198,537 for the period ended March 31, 2007 which increased theprincipal amount of the notes to $7,518,344. The total contractual interestpaid in kind for the nine month period ended March 31, 2007 is $588,158 and isincluded as a component of interest expense.

**Senior Warrants**

On March 8, 2006, inconnection with entering into the Note Purchase Agreement with the SeniorLenders, the Company entered into warrants (the “Senior Warrants”) to purchaseup to 19.9% of the Company’s outstanding common stock on a fully diluted basisat the time of exercise.  The SeniorWarrants have an exercise price of $0.001 per share and expire onDecember 31, 2016.

In accordance with APB 14, the Company allocated $2,982,071of the proceeds to the Senior Notes and $3,717,929 of the proceeds to theSenior Warrants. The aggregate fair value of the Senior Warrants was calculatedusing the Black-Scholes option pricing model based on all outstanding shares ofthe Company’s common stock, outstanding options, Senior Warrants and issuableshares of stock under the conversion and debt settlement agreements ofMarch 2006 (excluding the Bridge Notes) totaling 13,859,028 SeniorWarrants issuable to the holders of the Senior Notes at the commitment date ofthis financing transaction. The difference between the carrying amount of theSenior Notes and their contractual redemption amount is being accreted asinterest expense to February 2010, their earliest date of redemption.

The number of shares issuable upon exercise of the warrantsis subject to increase each time the Company issues additional shares of commonstock or common stock equivalents. The incremental number of shares under anyincrease is equal to the amount needed to cause the Senior Warrants to beexercisable for 19.9% of all outstanding common stock on a fully diluted basis.

On May 5, 2006, theCompany completed a second closing of the March 8, 2006 private placementin which 5,729,520 shares of common stock and warrants to purchase an aggregateof 1,145,904 shares of common stock at an exercise price of $0.20 per sharewere issued. The Company also issued to the placement agent in thistransaction, warrants to purchase 1,145,904 shares of common stock ascompensation for services rendered. Accordingly, the number of shares issuableto the holders of the Senior Warrants upon their exercise was increased by1,992,814 shares to an aggregate of up to 15,851,842 shares. The fair value ofthe additional Senior Warrants, which amounted to $850,483, is being amortizedover the remaining term of the Senior Notes.

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On June 6, 2006 theCompany, immediately following the completion of its 1 for 10 reverse stocksplit, issued 13,046,574 shares to the Bridge Note holders. Accordingly, thenumber of shares issuable to the holders of the Senior Warrants upon theirexercise was increased by 3,241,284 shares to an aggregate of up to 19,093,126shares. The fair value of the additional Senior Warrants, which amounted to$1,286,480, is being amortized over the remaining term of the Senior Notes.

On June 15, 2006,the Company issued an additional Junior Secured Convertible Note to Trust A-4 —Lloyd I. Miller (“the Junior Lender”) in the aggregate principal amount of$1,000,000 (the “Additional Junior Note”) with substantially identical terms tothe Junior Note issued on March 8, 2006 (see discussion regarding “JuniorNotes” below).  The Additional JuniorNote is convertible into 5,000,000 shares of the Company’s common stock.Accordingly, the number of shares issuable to the holders of the SeniorWarrants upon their exercise was increased by 1,242,197 shares to an aggregateof up to 20,335,323 shares. The fair value of the additional Senior Warrants,which amounted to $344,990, is being amortized over the remaining term of theSenior Notes.

On June 30, 2006,the Company electedto pay interest on the Junior Notes in kind and recorded an aggregate interestcharge of $136,932 for the period ended June 30, 2006 which was added tothe principal amount of the Junior Notes, increasing the convertible shares ofthe notes by 684,658 shares at a conversion price of $0.20 per share.Accordingly, the number of shares issuable to the holders of the SeniorWarrants upon their exercise was increased by 170,096 shares to an aggregate ofup to 20,505,419 shares. The fair value of the additional Senior Warrants,which amounted to $28,587, is being amortized over the remaining term of theSenior Notes.

On July 1, 2006,each of the two non-employee directors of the Company received a stock grantfor 117,647 shares of our common stock, which is equal to $20,000 dividedby the closing price of our common stock as reported on the Over the CounterBulletin Board on June 30, 2006, which was equal to $0.17 per share. Alsoon July 1, 2006, Mr. Ron Ben-Yishay received a stock grant for1,176,471 shares of our common stock, which is equal to $200,000 divided by$0.17 per share.  On July 1, 2006the Company (under its 2005 Plan) granted to two non-employee directors,options to purchase an aggregate of 2,100,000 shares of its common stock at$0.17 per share that have a five year term. Accordingly, the number of sharesissuable to the holders of the Senior Warrants upon their exercise wasincreased by 872,461 shares to an aggregate of up to 21,377,880 shares. Thefair value of the additional Senior Warrants, which amounted to $155,283 and$6,383,751 in the cumulative, is being amortized over the remaining term of theSenior Notes.

On September 26, 2006,the Company issued another Junior Secured Convertible Note to the Junior Lenderin the aggregate principal amount of $3,000,000 (the “Third Junior Note”) withsubstantially identical terms to the Junior Note (as defined below) and theAdditional Junior Note.  The Third JuniorNote is convertible into 15,000,000 shares of the Company’s common stock.Accordingly, the net number of shares issuable to the holders of the SeniorWarrants upon their exercise was increased by 3,592,975 shares to an aggregateof up to 24,970,855 shares. The fair value of the additional Senior Warrantsamounted to $481,528; however the cumulative total of the debt discount per theissuable Senior Warrants connected with the Senior Notes is limited to thecarrying value of the notes, therefore $316,249, or a cumulative of $6,700,000is being amortized over the remaining term of the Senior Notes and $165,279 isa direct charge against non-cash interest expense.

On September 30, 2006,the Company electedto pay contractual interest on the Junior Notes in kind and recorded anaggregate interest charge of $150,585 for the period ended September 30,2006 which was added to the principal amount of the Junior Notes, increasingthe convertible shares of the notes by 752,927 shares at a conversion price of$0.20 per share. Accordingly, the number of shares issuable to theholders of the Senior Warrants upon their exercise was increased by 187,057shares to an aggregate of up to 25,157,912 shares. The fair value of theadditional Senior Warrants amounted to $26,923 and is being charged directly tointerest expense.

As of September 30, 2006, the fair value of the 19.9%Senior Warrants was approximately $6,892,000, however, such discount is limitedto the carrying value of the note. Therefore, only $6,700,000 was recorded as adiscount and approximately $192,000 was charged directly as a component ofinterest expense. Prospectively, any charges incurred due to events causing anincrease in the amount of warrants issuable to the Senior Note warrant holderswill be charged directly as a component of interest expense.

On October 27, 2006, theCompany entered into an Asset Purchase Agreement with SSS.  As part of the consideration, the Companyissued to SSS, and Paul Saucier, an individual, 1,485,148 shares of the Company’scommon stock, based upon a per share value of $0.202.  Accordingly, thenumber of shares issuable to the holders of the Senior Warrants upon theirexercise was increased by 368,969 shares to an aggregate of up to 25,526,881shares. The fair value of the additional Senior Warrants amounted to $88,373and is being charged directly to interest expense.

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On December 14, 2006, theCompany’s stockholders voted to approve the Company’s 2006 Nonqualified StockOption Plan which resulted in the grant of 7,805,000 stock options (Note 8).  Accordingly, the number ofshares issuable to the holders of the Senior Warrants upon their exercise was increasedby 1,932,088 shares to an aggregate of up to 27,458,969 shares. The fair valueof the additional Senior Warrants amounted to $298,490 and is being chargeddirectly to interest expense.

On December 19, 2006, the Company entered into asatisfaction and release agreement to terminate the earn-out paymentobligations under the Asset Purchase Agreement entered into between the Companyand AMR Networks, LLC in exchange for issuing shares of the Company’s commonstock having a value of $100,000.  Thecompany issued 677,966 shares of common stock of $0.147 based on the averagetrading price for the proceeding 15 day period The Company also retired 30,000shares that were originally issued and held in escrow pursuant to the earn-outprovision in the original agreement. Accordingly, the number of shares issuableto the holder of the Senior Warrants upon their exercise was increased by159,506 shares to an aggregate of up to 27,618,475 shares. The fair value ofthe additional Senior Warrants amounted to $22,254 and is being charged directlyto interest expense.

On December 31, 2006, theCompany electedto pay contractual interest on the Junior Notes in kind and recorded anaggregate interest charge of $257,160 for the period ended December 31, 2006which was added to the principal amount of the Junior Notes, increasing theconvertible shares of the notes by 1,285,798 shares at a conversion price of$0.20 per share. Accordingly, the number of shares issuable to theholders of the Senior Warrants upon their exercise was increased by 319,443 sharesto an aggregate of up to 27,937,919 shares. The fair value of the additionalSenior Warrants amounted to $47,763 and is being charged directly to interestexpense.

On January 12, 2007, theCompany’s Board granted to certain new employees options to purchase anadditional 1,160,000 stock options under the 2006 Plan at an exercise price of$0.14 per share. Accordingly, the number of shares issuable to the holder ofthe Senior Warrants upon its exercise will increase by approximately 278,252shares net of canceled options. Accordingly, the number of shares issuable tothe holders of the Senior Warrants upon their exercise was increased by 288,190shares to an aggregate of up to 28,226,109 shares. The fair value of theadditional Senior Warrants amounted to $40,126 and is being charged directly tointerest expense.

On March 31, 2007, theCompany electedto pay contractual interest on the Junior Notes in kind and recorded anaggregate interest charge of $260,446 for the period ended March 31, 2007which was added to the principal amount of the Junior Notes, increasing theconvertible shares of the notes by 1,302,230 shares at a conversion price of$0.20 per share.. Accordingly, the number of shares issuable to theholders of the Senior Warrants upon their exercise was increased by 212,000shares net of warrant terminations and forfeited options for the period to anaggregate of up to 28,438,109 shares. The fair value of the additional SeniorWarrants amounted to $21,097 and is being charged directly to interest expense.

The amortization of thecombined $6,700,000 debt discount in connection with the Senior Note SeniorWarrants has accreted to approximately $1,660,000 as of March 31, 2007 forwhich approximately $1,285,000 is included as a component of interest expensein the accompanying statement of operations for the nine months endedMarch 31, 2007. The aggregate expense with respect to the incrementalnumber of shares issuable under the Senior Warrants that was not recorded asadditional note discount amounted to $709,396 during the nine months endedMarch 31, 2007.

**Junior Notes**

Under the Note PurchaseAgreement, the Company issued a Junior Secured Convertible Note to the JuniorLender (the Junior Lender and the Senior Lenders are referred to collectivelyas 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 paidin cash, or 14% per annum if paid in kind, which forms of payment are at theCompany’s election for the first three years. Interest is payable quarterly inarrears beginning June 30, 2006, unless the Company chooses to pay theinterest in kind option, in which case the interest will be added to the principalamount of the Junior Note during the period in which the Company makes suchelection. The aggregate principal will be payable at the maturity date ofMarch 1, 2011unless the Notes are converted into shares of the Company’scommon stock. The Junior Note is convertible into common stock of the Companyat any time at the election of the holder at a conversion price of $0.20 pershare of common stock. The Junior Note issued to the Junior Lender isconvertible into 15,000,000 shares of the Company’s common stock, assuming theinterest thereon is paid in cash. The Company is restricted from prepaying anyor all of the Junior Notes prior to March 1, 2010 without the consent of theholder of the Junior Notes, which consent is at the sole discretion of the noteholder.

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The Company evaluated theconversion feature embedded in the Junior Note to determine whether, under SFAS133, such conversion feature should be bifurcated from its host instrument andaccounted for as a free standing derivative. In performing this analysis theCompany determined that the Junior Notes meet the definition of a conventionaldebt instrument; accordingly, the notes and related conversion option wereaccounted for in accordance with the provisions of EITF 98-5 and EITF 00-27.Under this method, the Company recorded a $3,000,000 discount against theentire principal amount of the note, based on the intrinsic value of theembedded conversion option of $0.40 per share as of March 8, 2006multiplied by 15,000,000 shares issuable upon conversion; however, suchdiscount was limited to the carrying value of the note. The discount of$3,000,000 is being amortized over the five year term of the note.

On June 15, 2006,the Company entered into a First Amendment to Note Purchase Agreement (the “FirstAmendment”) with the Lenders pursuant to which the Company issued an additionalJunior Secured Convertible Note to the Junior Lender in the aggregate principalamount of $1,000,000 (the “Additional Junior Note”) on substantially similarterms set forth in the Junior Note. Thus, the interest rate for the AdditionalJunior Note is 10% per annum if paid in cash, or 14% per annum if paid in kind,which is at the Company’s election for the first three years. Principal will bepayable at the maturity date of March 1, 2011 and interest will bepayable quarterly in arrears beginning June 30, 2006, unless theCompany chooses its payment in kind option, in which case interest will beadded to the principal amount of the Additional Junior Note during the periodthat the Company continues such election. The Additional Junior Note may beconverted into common stock at any time at the election of the holder at aconversion price of $0.20 per share of common stock. A portion of the proceedsfrom the issuance of the Additional Junior Note were used to purchase certainassets primarily consisting of a customer list from the Long Island Division ofTekConnect Corporation, (“TekConnect”), and the remaining proceeds are beingused for general corporate purposes. The Junior Note issued to the JuniorLender is convertible into 5,000,000 shares of common stock of the Company,assuming the interest thereunder is paid in cash. The Company recorded a$400,000 discount against the principal amount of the note, based on theintrinsic value of the embedded conversion option of $0.08 per share as ofJune 15, 2006 multiplied by 5,000,000 shares issuable uponconversion. The discount of $400,000 is being amortized over the remaining termof the note.

On June 30, 2006, the Company elected to paycontractual interest on all the Junior Notes in kind and recorded an aggregateinterest charge of $136,932 for the period ended June 30, 2006 whichwas added to the respective principal amount of the notes. The interest addedto the principal amount is convertible at $0.20 per share into 684,658 sharesof the Company’s common stock.

On September 26,2006, the Company entered into a Second Amendment to Note Purchase Agreement(the “Second Amendment”) with the Lenders pursuant to which the Company issuedan additional Junior Secured Convertible Note to the Junior Lender in theaggregate principal amount of $3,000,000 (the “Third Junior Note”) onsubstantially similar terms set forth in the Junior Note and the AdditionalJunior Note. Thus, the interest rate for the Third Junior Note is 10% per annumif paid in cash, or 14% per annum if paid in kind, which is at the Company’selection for the first three years. Principal will be payable at the maturitydate of March 1, 2011 and interest will be payable quarterly in arrearsbeginning September 30, 2006, unless the Company chooses its paymentin kind option, in which case interest will be added to the principal amount ofthe Third Junior Note during the period that the Company continues suchelection. The Third Junior Note may be converted into common stock at any timeat the election of the holder at a conversion price of $0.20 per share ofcommon stock as set on the commitment date of the note transaction. Theconversion price was not beneficial because the fair value of the stock wasless than the conversion price. A portion of the proceeds from the Third JuniorNote were used to purchase substantially all of the assets of SSS, pursuant toan Asset Purchase Agreement dated October 27. The Third Junior Note issued to the Junior Lender is convertible into15,000,000 shares of common stock of the Company, assuming the interestthereunder is paid in cash.

On September 30, 2006, the Company elected to paycontractual interest on all the Junior Notes in kind and recorded an aggregateinterest charge of $150,585 for the period ended September 30, 2006 whichwas added to the respective principal amount of the notes. The interest addedto the principal amount is convertible at $0.20 per share into 752,927 sharesof the Company’s common stock.

On December 31, 2006, the Company elected to paycontractual interest on all the Junior Notes in kind and recorded an aggregateinterest charge of $257,160 for the period ended December 31, 2006 whichwas added to the respective principal amount of the notes. The interest addedto the principal amount is convertible at $0.20 per share into 1,285,798 sharesof the Company’s common stock.

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On March 31, 2007, the Company elected to pay contractualinterest on all the Junior Notes in kind and recorded an aggregate interestcharge of $260,446 for the period ended March 31, 2007 accreting theprincipal amount of the notes to $7,805,123. The total contractual interestpaid in kind for the nine month period ended March 31, 2007 is $668,211 and isincluded as a component of interest expense. The interest added to theprincipal amount is convertible at $0.20 per share into 1,302,230 shares of theCompany’s common stock. 

The Company evaluated, at each quarterly interest paymentdate in which it elected to pay the interest in kind, whether it wasrequired to record additional debt discount in connection with the noteholder'soption to convert such interest into common stock. In accordance with EITF00-27, the Company determined that the measurement datefor recording interest paid in kind is the interest paymentsince the option to pay the interest is kind is discretionary. Accordingly,the Company determined that its is not necessary to record anydiscounts because the fair value of the the common stock at eachinterest payment date was less then the conversion price embeddedin this obligation.

The combined debt discount pursuant to the Junior Notes ofMarch 8, 2006 and June 15, 2006 was $3,400,000. Amortization of thediscount has accreted to approximately $721,000 as of March 31, 2007 for whichapproximately $514,000 is included as a component of interest expense in theaccompanying statement of operations for the nine months ended March 31, 2007.

**Juniorand Senior Notes and Senior Warrants Registration Rights**

The Note PurchaseAgreement relating to the issuances of the Junior and Senior Notes provide thenote holders with demand registration rights that required the Company, within30 days of such demand, to file a registration statement covering the resale ofshares underlying the convertible notes and senior note warrant and to causesuch registration to be declared effective within 90 or 120 days (depending onthe circumstances) thereafter. Such registration rights provide for the Companyto pay a share based penalty in an amount equal to 2% of the shares registrableunder the agreement until such time that the Company becomes compliant or theregistrable shares may be sold without registration or restriction underRule 144. The fair value of the registration rights agreement isinsignificant to the Company’s financial statements. The amount of sharesissuable under this penalty provision is contractually limited to an amountthat may not exceed the authorized but unissued shares of the Company’s commonstock. 

The Company filed arequired registration statement that became effective February 14, 2007.  The Company plans to file anotherregistration statement to cover the resale of additional shares underlying theconvertible notes and senior note warrants that were not included in theFebruary 14, 2007 registration statement.

In addition to the above,the Company is not precluded from issuing unregistered shares to the holders ofthe convertible notes or Senior Warrants in the event the holder elects toexercise these instruments prior to the time in which registered shares becomeavailable. In addition, the warrants do not feature any cash settlement alternativesthat are within the control of the holder. Accordingly, the Warrants areclassified as equity instruments in accordance with the provisions of EITF00-19.

**7.****             DUE FROM NETF**

On August 8, 2005, the Company entered into aseries of related three-year agreements with New England Technology Finance,LLC (“NETF”), an affiliate of Global Technology Finance, which is a provider ofstructured financing solutions to technology companies that operates inpartnership with Credit Suisse First Boston, CIT Group, Inc. and others,that together provided a new working capital credit facility. These agreementsprovide for NETF to purchase, eligible accounts receivable balances and tofinance qualified product purchases (as defined). This facility is comprised ofthree components:  (1) an AssetPurchase and Liability Assumption Agreement (the “APLA”), under which NETFfinances certain of the Company’s qualified product purchases in connectionwith consummating sales to customers and (2) an Asset Purchase Agreement(the “APA”), and (3) a Master Servicing Agreement (“MSA”).

Qualified productpurchases financed by NETF under the APLA are repaid from collections ofaccounts receivable balances that the Company generates from its sales of suchproducts to customers. The Company transfers title to the invoices to NETF atthe time these sales are financed and delivery is made to the customer. TheCompany pays contractual financing and servicing fees to NETF for its financingof these purchases in an amount that is equal to a percentage of the grossprofit margin on such sales. The percentages fees vary based on the(a) amount of gross profit on such sales and (b) number of days inwhich the receivables from such sales remain uncollected.

NETF remits periodicallyto the Company an amount equal to the monthly gross profit margin on the salesless the contractual fees. The APLA also provides for the Company torepurchase, after 150 days, any amounts that remain unpaid by the customer forreasons other than the customer’s inability to pay as a result of its financialcondition or possible insolvency. NETF pre-approves all product purchases andthe credit worthiness of the Company’s customers under this arrangement as aprecondition to financing the sale.

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Under the APA, theCompany transfers eligible accounts receivable to NETF in exchange for advancesof up to 80% of their gross amount.  NETFcharges the Company fees (the “Discount Factor”) in an amount equal to theLIBOR rate plus 4% per annum on advances made at the time of the transfer. TheCompany also retains servicing rights under the MSA. Under the terms of theMSA, the Company manages collections and other ongoing interactions with itscustomers in exchange for fees amounting to approximately 20% of the grossinvoice amount. NETF settles fees payable to the Company under this arrangementnet of the Discount Factor.

The APA also provides forthe Company to repurchase, after 150 days, any amounts that remain unpaid bythe customer for reasons other than the customers’ inability to pay as a resultof its financial condition or possible insolvency; however such repurchases arelimited to 15% of all receivables transferred to NETF under this arrangement.In addition, NETF pre-approves the credit worthiness of the Company’s customersunder this arrangement as a precondition to purchasing any invoice.

This facility containscustomary affirmative and negative covenants as well as specific provisionsrelated to the quality of the accounts receivables sold. The Company has alsoindemnified NETF for the risk of loss under any transferred balances except forloss incurred as a result of customer credit risk.

Duringthe nine month period ended March 31, 2007, the Company sold approximately$41,914,000 of its product revenue under the terms of the APLA agreement andapproximately $13,652,000 of its service revenue under the terms of the APAagreement and incurred aggregate fees of approximately $1,086,000 which isincluded as a component of interest expense in the accompanying statement of operations.

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

AtJune 30, 2006 there were 55,180,586 shares of the Company’s common stock issuedand outstanding.

Areconciliation of the Company’s common shares issued and outstanding during thenine month period from June 30, 2006 through March 31, 2007 is as follows:

Summary Reconciliation of Shares Issued and Outstandingas of March 31, 2007
|                                                | ** ** | **Common Stock** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| Balance — June  30, 2006                  |       | 55,180,586            |       |
|                                           |       |                  |       |
| Common stock  issued to directors              |       | 235,294               |       |
| Common stock  issued to employees              |       | 1,176,471             |       |
| Common stock  issued to SSS                    |       | 1,485,148             |       |
| Common stock  issued on AMR earn-out, net      |       | 647,966               |       |
| Common stock  issued upon exercise of warrants |       | 47,349                |       |
| Retirement of  treasury stock                  |       | (537,825              | )          |
|                                           |       |                  |       |
| Balance — March 31,  2007                 |       | 58,234,989            |       |

 

On July 1, 2006, theCompany issued stock grants in the aggregate of 1,411,765 shares of commonstock.  Two non-employee directors of theCompany each received a stock grant for 117,647 shares of our commonstock, which is equal to $20,000 divided by the closing price of our commonstock as reported on the Over the Counter Bulletin Board on June 30, 2006,which was equal to $0.17 per share. Also on July 1, 2006, The Companygranted 1,176,471 shares of its common stock to a Regional Vice President, whichwas equal to $200,000 divided by $0.17 per share.

On August 14, 2006, theCompany repurchased 537,825 shares of stock held by an investor at a price of$0.20 per share.  These shares wereretired by the unanimous written consent of the Board of Directors on December29, 2006.

On October 27, 2006, theCompany entered into an Asset Purchase Agreement with Sensible SecuritySolutions Inc.  As part of theconsideration, the Company issued to SSS, and Paul Saucier, an individual and100% owner of SSS, 1,485,148 shares of the Company’s common stock based uponthe per share fair value in accordance with EITF 99-12 (see Note 4).

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In October 2006, theCompany entered into a satisfaction and release agreement to terminate theearn-out payment obligations owing under the Asset Purchase Agreement, whichwas previously entered into between the Company and AMR Networks, LLC (“AMR”).  In exchange for AMR’s agreement to enter intothe satisfaction and release agreement, the Company agreed to issue AMR a totalof $100,000 in common stock, based on the average trading price for the 15-dayperiod preceding the issuance on December 19, 2006, which equaled $0.1475.  Thus, on December 19, 2006, the Companyissued 677,966 shares of its common stock to AMR, and retired 30,000 sharesthat were originally issued and held in escrow pursuant to the earn-outprovision in the original agreement.

On February 16, 2007, aninvestor converted 50,751 warrants in a cashless exercise to 47,349 shares ofthe Company’s common stock.

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

**1997 Plan**

In November 1997 theCompany’s Board of Directors authorized the adoption of the 1997 Stock OptionPlan for non-employee Directors. The 1997 Plan provided for the grant of up to30,000 stock options at an exercise price of 100% of the fair value of theCompany’s common stock on the date of grant. During the nine months ended March31, 2007, all remaining options under this plan expired and no further grantswill be made.

**2000 Plan**

On August 14, 2000,the Company assumed the Data Systems Network Corp Stock Option Plan inconnection with a business combination. Options granted under this Plan wereeither ISO’s or NSO’s. No further options may be granted under the Data SystemsPlan. Options granted under this plan expire at various times until 2010.During the nine months ended March 31, 2007, 177 options expired and options topurchase 5,764 shares of the Company’s Series A Preferred stock at anaverage exercise price of $22.95 per share remain outstanding. Each share ofSeries A Preferred issuable upon the exercise of these options isconvertible into 2.5 shares of the Company’s common stock.

**2001 Plan**

In 2001, the Company’sBoard of Directors authorized the adoption of the 2001 Employee Stock OptionPlan. The 2001 plan, as amended, provides for the grant of up to an aggregate400,000 ISO to employees and NSO’s to officers, directors, key employees orother individuals at the discretion of the compensation committee of the Boardof Directors. During the nine months ended March 31, 2007, 27,925 options wereforfeited and options to purchase 86,300 shares of the Company’s common stockunder this plan at an average price of $6.34 per share remain outstanding.

**2005 Plan**

In May 2005, theCompany’s Board of Directors authorized the adoption of the 2005 Employee StockOption Plan. The 2005 plan, as amended, provides for the grant of up to anaggregate 3,000,000 ISO to employees and NSO’s to officers, directors, keyemployees or other individuals at the discretion of the compensation committeeof the Board of Directors. During the nine months ended March 31, 2007, 100,000options were cancelled by the Company’s Chief Executive Officer and options topurchase a remaining 2,110,000 shares of the Company’s common stock under thisplan at an average price of $0.18 per share remain outstanding.

**2006 Plan**

On June 15, 2006, theCompany’s Board of Directors approved the 2006 Nonqualified Stock Option Plan(the “2006 Plan”), which provides for the grant of nonqualified stock optionsto purchase up to an aggregate of 11,790,672 shares of our common stock tomembers of our Board, employees and consultants. Our Board of Directors, or acommittee of two or more members of our Board, administers the 2006 Plan. Theadministrator has full authority to establish rules and regulations for theproper administration of the 2006 Plan, to select the employees, consultantsand directors to whom awards are granted, and to set the date of grant, theexercise price and the other terms and conditions of the awards, consistentwith the terms of the 2006 Plan. The administrator may modify outstandingawards as provided in the 2006 Plan.

The terms of the awardsare subject to the provisions in an option agreement, consistent with the termsof the 2006 Plan. The exercise price of a stock option shall not be less thanthe fair market value of our common stock on the date of grant. No stock optionshall be exercisable later than ten (10) years after the date it is granted.

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The administrator mayamend the 2006 Plan at any time. No such amendment may be made by our Board ofDirectors without the consent of an option holder if such amendment wouldsubstantially affect or impair the rights of such option holder. In addition,the administrator may terminate the 2006 Plan at any time. However, in no eventmay an award be granted pursuant to the 2006 Plan on or after June 15, 2016.

On December 14, 2006, atour Annual Meeting of Stockholders, the Company’s stockholders voted to approvethe 2006 Plan and the exercise price was determined to be $0.155 per stockoption. 

On January 12, 2007, theCompany’s Board granted to certain new employees options to purchase anadditional 1,160,000 stock options under the 2006 Plan at an exercise price of$0.14 per stock option. 

As of March 31, 2007,options to purchase an aggregate of up to 8,655,000 were issued and outstandingunder the 2006 plan as 310,000 granted options were cancelled due to employeeturnover prior to the completion of the initial vesting period. In accordancewith SFAS 123R, the Company recognized compensation costs on a prorated basisaccording to the service inception dates of the grants in the amount of$193,900 during the nine months ended March 31, 2007.

**Share BasedPayments**

On July 1, 2006 theCompany (under its 2005 Plan) granted to two non-employee directors options topurchase an aggregate of 2,100,000 shares of its common stock at $0.17 pershare, each with a five year term and an aggregate fair value of $288,000.Assumptions relating to the estimated fair value of these stock options, whichthe Company estimated using the Black Sholes option pricing model, are asfollows: risk—free interest rate of 5.26%; expected dividend yield zeropercent; expected option life of five years; and current volatility of109.24%.  As of March 31, 2007, there areoptions to purchase 2,110,000 shares of common stock at an average price of $0.18per share.

On December 14, 2006 theCompany received shareholder approval for its 2006 option plan and granted toemployees options to purchase an aggregate of 7,805,000 of its common stock at$0.155 per share each with  a five yearterm and a three-year vesting period from the service inception date.   The aggregate fair value of the stock optionsamounted to $858,550.  Assumptionsrelating to the estimated fair value of these stock options, which the Company estimatedusing the Black Sholes option pricing model are as follows: risk—freeinterest rate of 4.97%; expected dividend yield zero percent; expected optionlife of five years; and current volatility of 86.56%.  

On January 12, 2007, theCompany’s Board granted to certain new employees options to purchase anadditional 1,160,000 stock options under the 2006 Plan at an exercise price of$0.14 per share. As of March 31, 2007, 310,000 granted options were cancelleddue to employee turnover prior to the completion of the initial vesting period.Theaggregate fair value of the stock options amounted to $114,840. Assumptionsrelating to the estimated fair value of these stock options, which the Company estimatedusing the Black Sholes option pricing model are as follows: risk—freeinterest rate of 5.06%; expected dividend yield zero percent; expected optionlife of five years; and current volatility of 85.86%. 

As described above, thefair value of awards granted during the nine month period ended March 31, 2007was estimated at the dates of grant using the Black-Scholes option pricingmodel. For purposes of performing the calculation under the Black-Scholesmodel, the risk-free rate is based on the U.S. Treasury yield curve in effectat the time of grant. The Company has not paid dividends to date and does notexpect to pay dividends in the foreseeable future due to its substantialaccumulated deficit and initiatives to conserve capital resources. Accordingly,expected dividend yields are currently zero. Expected volatility is principallybased on the historical volatility of the Company’s stock.

The expensing of sharebased payments in future periods (expectations of vesting) is based upon allavailable data including historical cancellations and forfeitures of stockoptions and current employee turnover as it occurs. The Company expectsapproximately 70% of the employee stock options will vest. The Company willprospectively monitor employee terminations, exercises and other factors thatcould affect the development of its expectations of vesting of options infuture periods.

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A summary of option activity for the nine months endedMarch 31, 2007 is as follows:

| Options_                            | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual   Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-------------------------------------|------------|------------|------------|-----------------------------------------|------------|------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at  June 30, 2006  |       | 231,166    |       | 5.33                                    |       |                                                       |       |                            |       |
| Granted                             |       | 11,065,000 |       | 0.16                                    |       |                                                       |       |                            |       |
| Exercised                           |       | —     |       | —                                  |       |                                                       |       |                            |       |
| Forfeited or  expired               |       | (439,102   | )          | 1.31                                    |       |                                                       |       |                            |       |
| Outstanding at  March 31, 2007 |       | 10,857,064 |       | 0.22                                    |       | 8.41                                                       |       | —                          |       |
| Exercisable at  March 31, 2007 |       | 2,202,064  |       | 0.48                                    |       | 4.37                                                       |       | —                          |       |

 

The weighted-averagegrant date fair value of options granted during the nine moths endedMarch 31, 2007 amounted to $0.16 per share. The weighted average remainingcontractual term of options outstanding gives effect to employee terminationswhich, under the provisions of the plans reduces the remaining life of suchvested options to a period of 90 days following the respective dates of suchterminations.

The aggregate fair valueof grants under the 2006 Plan amounted to approximately $936,000. The companyrecognized stock based compensation cost on a prorated basis amounting toapproximately $527,000 for the nine months ended March 31, 2007. Unrecognized unamortizedcompensation cost amounted to approximately $700,000 and will be amortizedincrementally over a weighted average remaining vesting period of2.4 years. The total stock based compensation expense for the nine monthsended March 31, 2007 was $767,000; $445,000 is included as a component ofgeneral and administration expenses and $322,000 is included as a component ofselling expenses.

The Company did notmodify any stock options granted to employees or non employees under any of itsshare-based payments other than having accelerated the vesting of options grantedprior to July 1, 2005 effective July 1, 2005. In addition, theCompany did not capitalize the cost associated with stock based compensationawards nor have optionees exercised any options during the nine months endedMarch 31, 2007.

**10.****       COMMITMENTSAND CONTINGENCIES**

On or about October 30,2006, Pangaea Education Systems, LLC (“Pangaea”) filed a lawsuit against theCompany alleging unfair competition, reverse passing off, misappropriation oftrade secrets, copyright infringement and breach of contract arising out ofservices performed in 2003 (the “Action”). Pangaea’s complaint does not specifythe amount of damages sought, but Pangaea has demanded in excess of $2,500,000in preliminary communications with the Company’s counsel. The Company contendsthat this demand is without factual or legal basis, that the Action has nomerit and is aggressively defending the Action.  The Company filed amotion to dismiss in response to the complaint on November 28, 2006. A trial isscheduled for July 2008. The Company intends to continue discussing an informalresolution. While the Company believes it has a strong position, it is notpossible at this time to state the likelihood of an unfavorable outcome orestimate the range of possible loss based on the early stage of the dispute,the positions taken by Pangaea and the inherent uncertainties of litigation.

On October 27, 2006, theCompany’s Canadian wholly owned subsidiary entered into a three-year employmentAgreement with Paul Saucier, the individual owner of SSS.  The agreement stipulates a base salary of$180,000 USD eligibility for stock based compensation and customary benefits.Under the agreement, the Company is obligated to continue the earn-outprovision of the Asset Purchase Agreement regardless of the continuedemployment status of Mr. Saucier.  Theemployment agreement also stipulates a separate performance bonus programcontingent upon continued employment and severance compensation in the event oftermination without cause.

**11.****       CONCENTRATIONS**

At March 31, 2007, threevendors accounted for approximately 41% of the gross accounts payable balance.Two of these vendors provide outside consulting services for the Company. TheCompany views all of its strategic partners as vital to their operations forwhich the loss of either of these vendors could result in a temporarydisruption in service to various customers. The Company believes it has accessto alternative vendors and resources to replace either vendor in the event of adisruption. The third vendor is a one-time non APLA product order. 

**12.****       DISCONTINUED OPERATIONS**

During 2003, theCompany disposed of its non-emergency transportation business.  At March 31, 2007, the total remainingliabilities of discontinued operations was $258,000.

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**13.****       BUSINESS SEGMENTS**

The Company completed itstransition out of its former Business Process Outsourcing Services (“BPO”)Segment during the quarter ended June 30, 2006. Accordingly, the Company’ operated within a single segment, theInformation Technology (“IT”) Solutions Segment, during the nine months endedMarch 31, 2007.

The acquisition of SSShas provided the Company greater density in our core securities practice andincreased our overall presence in the Canadian market.  As of the March 31, 2007, our wholly ownedsubsidiary, DynTek Canada Inc. had total assets of approximately $2,630,000 andtotal revenue of approximately $5,103,000 and a net loss of approximately$82,000 for the nine month period ended March 31, 2007.

Segment informationrelating to the Company’s operations for the three and nine months ended March31, 2007 and 2006, respectively, is as follows:
|                                       | ** ** | **Reportable Business Segments** | ** ** | ** **                             | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|
| ** **                            | ** ** | **Business  Process  Outsourcing**         | ** ** | **Information  Technology  Solutions** | ** ** | **Total** | ** ** |
| Three months  ended March 31, 2007    |       |                                       |       |                                   |       |   |   |
| Sales to external customers           |       | $                                          | —     |                                   | $          | 20,487 |   | $ | 20,487 |   |
| Depreciation and amortization expense |       | —                                     |       | 805                                    |       | 805 |   |
| Net loss from operations              |       | —                                     |       | (784                                   | )          | (784 | ) |
| Interest expense                      |       | —                                     |       | 1,473                                  |       | 1,473 |   |
| Total assets                          |       | —                                     |       | 31,067                                 |       | 31,067 |   |
| Capital expenditures                  |       | —                                     |       | 26                                     |       | 26 |   |
|                                  |       |                                       |       |                                   |       |   |   |
| Three months  ended March 31, 2006    |       |                                       |       |                                   |       |   |   |
| Sales to external customers           |       | $                                          | 814        |                                   | $          | 13,482 |   | $ | 14,296 |   |
| Depreciation and amortization expense |       | —                                     |       | 632                                    |       | 632 |   |
| Net income (loss) from operations     |       | (16                                        | )          | (4,815                                 | )          | (4,831 | ) |
| Interest expense                      |       | —                                     |       | 2,070                                  |       | 2,070 |   |
| Total assets                          |       | 228                                        |       | 38,343                                 |       | 38,571 |   |
| Capital expenditures                  |       | —                                     |       | 6                                      |       | 6 |   |
|                                  |       |                                       |       |                                   |       |   |   |
| Nine months  ended March 31, 2007     |       |                                       |       |                                   |       |   |   |
| Sales to external customers           |       | $                                          | —     |                                   | $          | 60,787 |   | $ | 60,787 |   |
| Depreciation and amortization expense |       | —                                     |       | 2,177                                  |       | 2,177 |   |
| Net loss from operations              |       | —                                     |       | (2,426                                 | )          | (2,426 | ) |
| Interest expense                      |       | —                                     |       | 4,963                                  |       | 4,963 |   |
| Total assets                          |       | —                                     |       | 31,067                                 |       | 31,067 |   |
| Capital expenditures                  |       | —                                     |       | 190                                    |       | 190 |   |
|                                  |       |                                       |       |                                   |       |   |   |
| Nine months  ended March 31, 2006     |       |                                       |       |                                   |       |   |   |
| Sales to external customers           |       | $                                          | 2,763      |                                   | $          | 53,812 |   | $ | 56,575 |   |
| Depreciation and amortization expense |       | 35                                         |       | 1,977                                  |       | 2,012 |   |
| Net income (loss) from operations     |       | 64                                         |       | (7,633                                 | )          | (7,569 | ) |
| Interest expense                      |       | —                                     |       | 5,563                                  |       | 5,563 |   |
| Total assets                          |       | 228                                        |       | 38,343                                 |       | 38,571 |   |
| Capital  expenditures                 |       | —                                     |       | 179                                    |       | 179 |   |

 

**14.****       SUBSEQUENT EVENTS**

On April 13, 2007,the Company entered into a Junior Secured Convertible Note Purchase Agreement(the “Junior Note Purchase Agreement”) with the Junior Lender pursuant to whichthe Company issued to the Lender a Junior Secured Convertible Promissory Notein the aggregate principal amount of $5,000,000 (the “Note”) in reliance onSection 4(2) of the Securities Act of 1933, as amended (the “Securities Act”),and Rule 506 promulgated thereunder. Interest rate for the Note is 9% per annumif paid in cash, or 13% per annum if paid in kind, which is at the Company’selection for the first three years. Principal will be payable at the maturitydate of April 13, 2012, and interest will be payable quarterly in arrearsbeginning 

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June 30, 2007, unless theCompany chooses its payment in kind option, in which case interest will beadded to the principal amount of the Junior Note during the period that theCompany continues such election. The Junior Note may be converted into commonstock of the Company at any time at the election of the holder at an initialconversion price of $0.175 per share of common stock, subject to certainadjustments set forth therein.  Proceedsfrom the issuance of the Note will be used to finance current operations, fundpotential acquisitions and for general corporate purposes. 

At any time untilthe Junior Note has been repaid in full, the Company may, at its sole option,redeem a portion of the outstanding principal amount of the Junior Note, fromtime to time, or the entire outstanding principal amount of the Junior Note,plus any and all accrued but unpaid interest on such principal amount, throughthe date of repayment (such entire outstanding principal amount, plus all suchaccrued but unpaid interest, hereinafter referred to for purposes of thisJunior Note Purchase Agreement as the “Redemption Amount”) by paying to theholder of the Note: (i) 113% of the Redemption Amount if the date of repaymentoccurs any time prior to or on the first anniversary of the Closing Date; (ii)109.75% of the Redemption Amount if the date of repayment occurs any time afterthe first anniversary of the Closing Date but prior to or on the secondanniversary of the Closing Date; (iii) 106.50% of the Redemption Amount if thedate of repayment occurs any time after the second anniversary of the ClosingDate but prior to or on the third anniversary of the Closing Date; (iv) 103.25%of the Redemption Amount if the date of repayment occurs any time after thethird anniversary of the Closing Date but prior to or on the fourth anniversaryof the Closing Date; and (v)  100.00% of the Redemption Amount if the dateof repayment occurs any time after the fourth anniversary of the Closing Datebut prior to or on April 13, 2012. 

Neither the Junior Note nor theshares of common stock issuable upon conversion of the Junior Note have beenregistered under the Securities Act, and the foregoing may not be offered orsold in the United States absent registration or availability of an applicableexemption from registration. With respect to all or any part of the shares ofcommon stock issuable by the Company upon the conversion of the Junior Note(collectively, the “Registrable Securities”), the Company granted to the JuniorLender piggyback registration rights in the event that the Company decides toregister any of its securities for its own account or for the account ofothers, subject to certain exceptions as provided in Junior Note PurchaseAgreement.  Such piggyback registration rights expire on April 13, 2012. If, on or after April 13, 2008, the Registrable Securities have not beenregistered by the Company pursuant to a piggyback registration, then the JuniorLender shall have the right, subject to certain exceptions as provided in theJunior Note Purchase Agreement, to request that the Company effect aregistration covering the resale of any Registrable Securities that have notbeen previously registered pursuant to a piggyback registration. 

Payment of allprincipal and interest under the Junior Note, as well as performance thereunderof the obligations of the Company are secured by a perfected security interestunder a Security and Pledge Agreement entered into on April 13, 2007, by andamong the Company and the Junior Lender (the “Security Agreement”).  TheSecurity Agreement grants to the Junior Lender a lien to substantially allassets of the Company, which lien is subordinated to the perfected securityinterest held by certain other lenders as described therein. 

As a result of theissuance of the Junior Note, the conversion price of each of those certainJunior Secured Convertible Promissory Notes issued to the Junior Lender onMarch 8, June 15 and September 26, 2006, has been reduced from $0.20 to $0.175in accordance with the antidilution provisions contained therein and willeffectively increase the number of shares issuable to the holders of the SeniorWarrants upon their exercise by 5,575,088 shares.  In accordance with the decrease in theexercise price, the intrinsic value of the embedded conversion option relatedexclusively to the June 15, 2006 Junior Note, convertible into 5,000,000shares, increased from $0.08 per share to $0.105 per share, increasing therecordable discount from $400,000 to $600,000.  The additional $200,000 discount will beamortized over the remaining term of the note. The March 8, 2006 Junior Notehas previously been fully discounted and the September 26, 2006 Junior Note’sreduced conversion price was not beneficial because the fair value of the stockwas less than the reduced conversion price. 

**ITEM 2.**   MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS

The following discussion and analysis of our resultsof operations and financial position should be read in conjunction with ouraudited consolidated financial statements and related notes included in ourAnnual Report on Form 10-K for the year ended June 30, 2005 and theunaudited consolidated financial statements and related notes included in thisQuarterly Report on Form 10-Q. Depending upon the context, the termsDynTek, “we,” “our,” and “us,” refers to either DynTek alone, or DynTek and itssubsidiaries.

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**Forward-Looking Statements**

Thisreport contains “forward-looking statements” within the meaning of such term inSection 27A of the Securities Act of 1933, Section 21E of the SecuritiesExchange Act of 1934, and the Private Securities Litigation Reform Act of 1995.We wish to caution readers not to place undue reliance on any such forward-lookingstatements, each of which speaks only as of the date made.  Forward-looking statements involve known andunknown risks, uncertainties and other factors which could cause actualfinancial or operating results, performance or achievements expressed or impliedby such forward-looking statements not to occur or be realized. Such statementsare subject to certain risks and uncertainties that could cause actual resultsto differ materially from historical results and those presently anticipated orprojected.  See below and a discussion ofsuch risks 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 for the fiscal yearended June 30, 2006 as filed with the SEC. Forward-looking statements made in this Form 10-Q generally are based onour best estimates of future results, performances or achievements, predicatedupon current conditions and the most recent results of the companies involvedand their respective industries. Forward-looking statements may be identifiedby the use of forward-looking terminology such as “may,” “will,” “could,” “should,”“project,” “expect,” “believe,” “estimate,” “anticipate,” “intend,” “continue,”“potential,” “endeavor,”  “opportunity”or similar terms, variations of those terms or the negative of those terms orother variations of those terms or comparable words or expressions. Readersshould carefully review those risks, as well as additional risks described inthis report and other documents we file from time to time with the SEC.  Potential risks and uncertainties include,among other things, such factors as:

·                  Ourability to reach target markets for services and products and our ability toretain current and attract future customers;

·                  Ourability to attract and retain professional staff, successfully integrateacquired companies into our operations, and our ability to acquire additionalcompanies, if any;

·                  Marketacceptance, revenues and profitability of our current and future products andservices;

·                  Ourability to finance and sustain operations, including the ability to fund,maintain, replace and/or extend the Senior Notes and/or Junior Notes, when due,respectively, or to replace such instruments with alternative financing;

·                  Ourability to raise equity capital or debt in the future, despite historicallosses from operations;

·                  Generaleconomic conditions in the United States and elsewhere, as well as the economicconditions affecting the industries in which we operate, our customers andsuppliers;

·                  Thecompetitive environment in the regions in which we compete, and thecost-effectiveness of our products and services;

·                  Politicaland regulatory matters that affect the industries in which we operate;

·                  Ourcontinued ability to trade on the NASD bulletin board; and

·                  Otherrisks detailed in our filings with the SEC.

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

**Business Overview**

DynTek, Inc.provides professional information technology (“IT”) solutions and sales ofrelated products and services to mid-market commercial businesses, state andlocal government agencies, and educational institutions. We operate ourbusiness primarily through our subsidiary, DynTek Services, Inc. and ourCanadian subsidiary DynTek Canada, Inc.

We provide a broad rangeof multi-disciplinary IT solutions that address the critical business needs ofour clients, including IT security, converged networking (includingvoice-over-internet-protocol “VOIP”), application infrastructure, and accessinfrastructure.  Our primary USoperations are located in four of the top ten largest IT spending states:California, New York, Florida, and Michigan. We deliver complex infrastructure technology solutions through teams ofprofessional consultants in close geographic proximity to our clients.  Members of our technical and consultingservices team have advanced certifications with leading vendor-manufacturers,including Microsoft, Cisco, McAfee and Citrix.  As a professional services firm and value-added reseller of hardware andsoftware from 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 (including VOIP), application infrastructure, and accessinfrastructure, will continue to provide the platform we need to capture anincreasing share of our target markets. Our strategy allows our clients to rely on DynTek as their primary ITvendor.  Additionally, we believe thatour multi-disciplinary capabilities help differentiate us from our competitorsin the markets in which we compete.

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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 agreed uponfixed 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 consistprimarily of salaries of services personnel and related expenses incurred inproviding such services, and the cost of outsourced service labor.  Costs of products consist of our cost ofproducts purchased and sold to our customers. Selling, general and administrativeexpenses consist primarily of salaries and benefits of personnel responsiblefor administrative, finance, sales and marketing activities and all othercorporate 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 administrative costs also include a calculation ofthe fair value of employee stock options and other share-based payment awardscalculated pursuant to SFAS No. 123R.

**Results of Operations**

The following table sets forth, for the periodsindicated, the relative percentages that certain income and expense items bearto net sales.
|                                               | ** ** | **Nine Months Ended  March 31,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                    | ** ** | **2007**                                        | ** ** | **2006** | ** ** |
| Product Revenue                               |       | 72                                              | %          | 67 | % |
| Service  Revenue-Information Technology       |       | 28                                              | %          | 28 | % |
| Service  Revenue-Business Process Outsourcing |       | —                                          | %          | 5 | % |
|                                          |       |                                            |       |   |   |
| Cost of Products                              |       | 85                                              | %          | 89 | % |
| Cost of  Service-Information Technology       |       | 71                                              | %          | 76 | % |
| Cost of  Service-Business Process Outsourcing |       | —                                          | %          | 80 | % |
|                                          |       |                                            |       |   |   |
| Gross profit                                  |       | 19                                              | %          | 15 | % |
|                                          |       |                                            |       |   |   |
| SG & A                               |       | 19                                              | %          | 25 | % |
| Interest expense                              |       | 8                                               | %          | 10 | % |
| Loss from  continuing operations              |       | (12                                             | )%         | (39 | )% |
| Gain from  discontinued operations            |       | —                                          | %          | 1 | % |
| Net Income (loss)                             |       | (12                                             | )%         | (38 | )% |

 

***Ninemonths ended March 31, 2007 and March 31, 2006***

**Revenues.**Forthe nine months ended March 31, 2007, our revenues increased toapproximately $60,787,000 from approximately $56,575,000 for the nine monthsended March 31, 2006. This $4,212,000, or 7%, increase is principallyattributable to an increase of $4,248,000 in our Canadian subsidiary followingthe October 2006 acquisition of SSS, an increase in new business of $1,098,000related to our TekConnect acquisition, and net growth of $1,629,000 in theother regions of our IT Solutions; offset by a decrease of $2,763,000 ofrevenues due to the elimination of the Business Process Outsourcing (“BPO”)business.

Our product sales increased from $37,953,000 duringthe nine months ended March 31, 2006 to $43,717,000 during the nine monthsended March 31, 2007. The increase of $5,764,000, or 15%, resulted fromapproximately $3,847,000 in new product sales within our securities practice inour Canadian operation following the SSS acquisition in October 2006, adecrease of $2,348,000 in our Southwest region due to a high concentration ofnon-repetitive commercial accounts, and an increase of $4,265,000 in thecombined IT Solutions sales from all other regions particularly in thegovernment related sector.

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Our services revenues decreased from $18,622,000during the nine months ended March 31, 2006 to $17,070,000 during the sameperiod in fiscal year 2007, a decrease of $1,552,000 or 8%. This decreaseresulted from the elimination of $2,763,000 from our BPO business segment from theprior year, offet by a net increase of $808,000 in IT service revenue from allother regions combined, as well as the delivery and recognition of $403,000 ofpre-existing service support obligations assumed in the TekConnect acquisition.

The following table sets forth for the periodspresented information derived from our consolidated statements of operations(in thousands):
|               | ** ** | **For the Nine Months ended March 31** | ** ** |
|---------------|------------|----------------------------------------------------------------------|------------|
| **REVENUES**  | ** ** | **2007**                                                             | ** ** | **2006** | ** ** | **Percentage   change** | ** ** | **Amount** | ** ** |
| ***Product*** |       | $                                                                    | 43,717     |   | 37,953 |   | 15 | % | 5,764 |   |
|          |       |                                                                 |       |   |   |   |   |   |   |
| ***Service*** |       | 17,070                                                               |       | 18,622 |   | (8 | )% | (1,552 | ) |
|          |       |                                                                 |       |   |   |   |   |   |   |
| ***Total***   |       | 60,787                                                               |       | 56,575 |   | 7 | % | 4,212 |   |
|               |            |                                                                      |            |  |  |  |  |  |  |  |

 

Our customers are primarilystate and local government entities, educational institutions, and mid-sizedcorporations in diversified industries. For the nine months ended March 31,2007, 42% of our revenues were derived from commercial clients, compared to 39%from government agencies and 19% from educational institutions. For the ninemonths ended March 31, 2006, 56% of our revenues were derived from commercialclients, compared to 35% from government agencies and 9% from educationalinstitutions.

**Gross profit.**Grossprofit increased from $8,411,000 in the nine months ended March 31, 2006to $11,370,000 in the nine months ended March 31, 2007, an increase of 35%.Total gross margin for the nine months ended March 31, 2007 was 19%, comparedto 15% for the similar period in the prior fiscal year. Our services marginincreased from 23% in 2006 to 29% in 2007 due to improved margins created throughincreased internal resource utilization, especially in our Southwest region.Our product margin increased from 11% to 15%. The increase in overall productgross margin is primarily the result of new, higher margin business within allof our operating regions. 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 believe that our product margins willcontinue to be subject to competitive pricing pressures and fluctuate fromquarter to quarter depending on the mix of products we provide.  We intend to meet the challenges ofaggressive price reductions and discount pricing by certain product suppliersby focusing our offerings around relatively higher margin practice areas,including security solutions, VOIP, and application delivery.  There can be no assurance, however, that wewill be able to improve profit margins, especially for our sale of products,and compete profitably in all areas, given the intense competition that existsin the IT industry.

**Selling,general and administrative expenses.**General andadministrative expenses decreased to approximately $3,304,000 for the ninemonths ended March 31, 2007, from approximately $4,301,000 for the ninemonths ended March 31, 2006. As a percent of revenues, general andadministrative expenses decreased 5% for the period ended March 31, 2007compared to 8% for the nine months ending March 31, 2006. During the periodended March 31, 2007, an aggregate $445,000 in non-cash stock basedcompensation expense was incurred which included (i) $40,000 in stock grants totwo non-employee board members, (ii) $288,000 in fully vested stock optiongrants, and (iii) $117,000 in employee stock options expense under the 2006Plan, calculated using a black scholes pricing model on the fair value of theoptions on the date granted. A similar charge was not incurred during the sameperiod in 2006. Accordingly the decrease in general and administrative expensesin 2007 compared to 2006, excluding the effects of stock based compensation,was approximately $1,442,000 as a result of restructuring and cost reductionprograms that we implemented in fiscal year 2005 and fiscal year 2006.

Selling costs decreased to approximately $8,316,000for the nine months ended March 31, 2007 from $9,667,000 in the ninemonths ended March 31, 2006. As a percent of revenues, selling expensesdeclined from 17% to 14% in the nine months ended March 31, 2007 compared tothe same period in 2006. During the nine month period ended March 31, 2007, a$200,000 of stock based compensation expense was incurred for a stock grantissued in July 2006 and $122,000 in employee stock options under the 2006 Plan.  During the nine month period ended March 31,2006, a $205,000 charge was incurred for the accelerated vesting of employeestock options issued primarily to sales personnel. Accordingly the decrease inselling costs in 2007 compared to 2006, excluding the effects of stock basedcompensation, was approximately $2,326,000 as a result of restructuring andcost reduction programs in two of our IT Solutions operating regions that weundertook beginning in fiscal year 2005; offset by increased selling costs of$858,000 pursuant to our two acquisitions during the quarter ended December 31,2006.

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**Depreciation and amortizationexpense.**Depreciation and amortization expense increased toapproximately $2,177,000 for the nine-month period ended March 31, 2007,from approximately $2,012,000 during the same period in the prior year. Theincrease is primarily due to an increase in the amortization of customer listsfrom the SSS and TekConnect acquisitions completed in fiscal year 2007.

**Interest expense.**Interestexpense for the nine months ended March 31, 2007 decreased to $4,963,000,as compared to $5,563,000 for the nine months ended March 31, 2006. Thedecrease is primarily due to significantly lower non-cash interest for the ninemonths ended March 31, 2007, particularly during the three months ended March31, 2007 compared to the three months ended March 31, 2006 when the companywent through its recapitalization which included the retirement of certain debtand related discounts and debt financing costs. During the period ended March31, 2007, total non-cash interest charges amounted to $3,385,000 which includesthe amortization on the debt discounts on the Senior Notes of approximately$1,285,000 as well as approximately $710,000 of non-cash interest related tothe fair value of the issuable Senior Note warrants in excess of the carryingvalue of the Senior Notes.  The non-cashinterest amortization on the debt discounts on the Junior Notes wasapproximately $514,000. During the nine months ended March 31, 2007, theCompany elected to pay in kind of approximately $588,000 of interest on theSenior Notes and approximately $668,000 on the Junior Notes. Amortization ofdeferred financing fees amounted to approximately $70,000. In addition to noncash interest expense, the Company incurred fees on the APA and APLA agreementswere approximately $1,086,000 and miscellaneous charges of $42,000. 

During the period ended March 31, 2006, we incurredapproximately 3,970,000 of total non-cash interest inclusive of $1,742,000 innon-cash interest charges resulting from the reduction in the conversion priceof our 9% Notes, $169,000 in non-cash interest charges resulting from thereduction in warrant exercise prices under warrants issued to holders of our 9%Notes and $50,000 in non-cash interest charges resulting from the reduction inwarrant exercise price of the warrant issued to Laurus; year to date non-cashinterest amortization on the debt discounts of $162,000 on the Laurus Note, and$427,000 on the 9% Notes; and the retirement of the balances on deferredfinancing costs of $509,000 on the 9% Notes and $527,000 on the LaurusNote.  Additional deferred financingcosts in the aggregate of approximately $124,000 on the Bridge Notes, theSenior Notes, and the Junior Note. Also included was $112,000 of non-cashinterest converted to equity due on the ITI Notes, $39,000 of non-cash interestconverted to equity due on the 9% Notes, and $109,000, of non-cash interestconverted to equity due on the Bridge Notes. In addition to non cash interestexpense, we incurred fees on the APA and APLA agreements and additionalcontractual interest on various Notes amounting to approximately $1,593,000.

**OtherIncome (expense).**During the nine months ended March 31,2007, other income was insignificant. However, during the nine months ended March 31, 2006, we recorded a netnon-cash loss on the extinguishment of debt obligations in the aggregate of$8,521,000. We recorded a loss of $9,401,000 based on the difference betweenthe fair value of the equity instruments issued under the Conversion andSettlement Agreements as of March 8, 2006 and the conversion price per sharefor the ITI Notes and the 9% Notes wherein the note holders irrevocablycancelled their notes for the contractual right to receive shares of our commonstock upon the date immediately following the effective date of ourcontemplated 1 for 10 reverse stock split which occurred on June 5, 2006.

During the nine months ended March 31, 2006, werecorded a net gain of approximately $880,000 in connection with settling tradedebts of approximately $1,947,000. Settlement of these debts in one time cashpayments amounted to approximately $725,000, effectuating a one-time gain of$1,222,000; offset by a $342,000 loss on the extinguishment of the debt as wealso entered into Conversion and Settlement Agreements with certain tradepayable creditors to convert outstanding debt balances in the aggregate ofapproximately $171,000 into 8,541,650 shares of common stock at a conversionprice of $0.02 per share based on the difference between the (a) fair value of8,541,650 shares of common stock issuable to such holders for the settlement ofthe debt and (b) the aggregate debt of $171,000 at the conversion price of$0.02 per share.

Also, during the nine months ended March 31, 2006, werecorded a one-time expense of $505,043 on an investment deemed to have no recoverablevalue.

The following table sets forth operating expenses forthe periods presented from information derived from our consolidated statementsof operations (in thousands):
|                                             | ** ** | **For the Nine Months ended  March 31,** | ** ** |
|---------------------------------------------|------------|-------------------------------------------------------------------|------------|
| **OPERATING **                         | ** ** | **Dollars**                                                       | ** ** | **Percentage of   Revenues** | ** ** |
| **EXPENSES**                                | ** ** | **2007**                                                          | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ***Selling***                               |       | 8,316                                                             |       | 9,667 |   | 14 | % | 17 | % |
|                                        |       |                                                              |       |   |   |   |   |   |   |
| ***General &  Administrative***    |       | 3,304                                                             |       | 4,301 |   | 5 | % | 8 | % |
|                                        |       |                                                              |       |   |   |   |   |   |   |
| ***Depreciation &  Amortization*** |       | 2,177                                                             |       | 2,012 |   | 4 | % | 4 | % |
|                                        |       |                                                              |       |   |   |   |   |   |   |
| ***Total***                                 |       | 13,797                                                            |       | 15,980 |   | 23 | % | 28 | % |

 

29

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**Net loss.**Ournet loss for the nine months ended March 31, 2007 was $7,433,000 comparedto a net loss of $21,634,000 for the nine months ended March 31, 2006. The netloss during the nine months ended March 31, 2007 includes depreciation andamortization expense of $2,177,000, non-cash option expense of $767,000,interest expense of $4,963,000 (including a non-cash portion of $3,835,000).

The net loss during the nine months endedMarch 31, 2006 includes depreciation and amortization expense of$2,012,000, non-cash option expense of $205,000, interest expense of $5,563,000(including a non-cash portion of $3,970,000), a valuation adjustment on theinvestment in Tekinsight of $505,000, and a $9,401,000 loss on theextinguishment of debt obligations under the ITI Notes and the 9% Notes; offsetby a gain on extinguishment of trade payable debt of $880,000. 

***DiscontinuedOperations.***Income from discontinued operations was$513,000 for the nine months ended March 31, 2006. The Company did not have anyincome from discontinued operations during the nine months ended March 31,2007.

 **Results of Operations**

The following table sets forth, for the periods indicated,the relative percentages that certain income and expense items bear to netsales.
|                                               | ** ** | **Three Months  Ended March 31,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                    | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Product Revenue                               |       | 71                                               | %          | 66 | % |
| Service  Revenue-Information Technology       |       | 29                                               | %          | 29 | % |
| Service Revenue-Business  Process Outsourcing |       | —                                           | %          | 5 | % |
|                                          |       |                                             |       |   |   |
| Cost of Products                              |       | 84                                               | %          | 92 | % |
| Cost of  Service-Information Technology       |       | 71                                               | %          | 94 | % |
| Cost of  Service-Business Process Outsourcing |       | —                                           | %          | 84 | % |
|                                          |       |                                             |       |   |   |
| Gross profit                                  |       | 20                                               | %          | 8 | % |
|                                          |       |                                             |       |   |   |
| SG & A                               |       | 15                                               | %          | 37 | % |
| Interest expense                              |       | 4                                                | %          | 14 | % |
| Loss from  continuing operations              |       | (4                                               | )%         | (112 | )% |
| Gain (loss) from  discontinued operations     |       | —                                           | %          | 2 | % |
| Net income (loss)                             |       | (11                                              | )%         | (110 | )% |

 

***Threemonths ended March 31, 2007 and March 31, 2006***

**Revenues.**Forthe three months ended March 31, 2007, our revenues increased toapproximately $20,487,000 from approximately $14,296,000 for the three monthsended March 31, 2006. This $6,191,000, or 43% increase is attributable toan increase of $7,005,000 in our IT solutions business. The IT solution’s increasewas comprised of an increase in our Canadian operations of $2,015,000 as aresult of the acquisition of SSS in October 2006, an increase in new businessof $645,000 related to our TekConnect acquisition, and a combined increase if$4,345,000 from all other regions, especially in the government sector; offsetby the reduction of revenues of $964,000 from the transition of our former BPObusiness.

 Our productsales increased from $9,370,000 during the three months ended March 31,2006 to $14,581,000 during the three months ended March 31, 2007. The$5,211,000, or 56%, increase resulted primarily from a $1,852,000 increase innew securities practice product revenue in our Canadian operations from the SSSacquisition in October 2006 and a combined increase if $3,359,000 from allother regions, especially in the government sector.

Our services revenues increased from $4,926,000 duringthe three months ended March 31, 2006 to $5,906,000 during the same periodin 2006. This increase of $980,000, or 20%, resulted from an increase in newbusiness of $505,000 related to our TekConnect acquisition, an increase of$1,289,000 in IT Solutions service revenue from all other regions combined;offset by a $814,000 decrease in service revenues related to the transitioned BPOsegment.

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The following table sets forth for the periodspresented information derived from our consolidated statements of operations(in thousands):
|               | ** ** | **For the Three Months ended March 31** | ** ** |
|---------------|------------|-----------------------------------------------------------------------|------------|
| **REVENUES**  | ** ** | **2007**                                                              | ** ** | **2006** | ** ** | **Percentage   change** | ** ** | **Amount** | ** ** |
| ***Product*** |       | $                                                                     | 14,581     |   | 9,370 |   | 56 | % | 5,211 |   |
|          |       |                                                                  |       |   |   |   |   |   |   |
| ***Service*** |       | 5,906                                                                 |       | 4,926 |   | 20 | % | 980 |   |
|          |       |                                                                  |       |   |   |   |   |   |   |
| ***Total***   |       | 20,487                                                                |       | 14,296 |   | 43 | % | 6,191 |   |
|               |            |                                                                       |            |  |  |  |  |  |  |  |

 

Our customers are primarilystate and local government entities and mid-sized corporations in diversifiedindustries. For the three months ended March 31, 2007, 43% of our revenueswere derived from commercial clients, compared to 45% from government agenciesand 12% from educational institutions. For the three months ended March 31,2006, 36% of our revenues were derived from commercial clients, compared to 30%from government agencies and 11% from educational institutions.

**Gross profit.**Totalgross profit increased from $1,108,000 in the quarter ended March 31, 2006to $4,031,000 in the quarter ended March 31, 2007, an increase of 264%, asresult of a 43% increase in total revenue. Total gross margin as a percentageof sales increased from 8% for the three months ended March 31, 2006 to 20% forthe three months ended March 31, 2007. Service margins climbed from 8% to 29%,primarily due a greater mix of higher-end services in our IT solutions segment,the elimination of lower margin BPO services, and continued improvement andconsiderably higher utilization of our internal consultants compared to thethree months ended March 2006.

Our overall product margin improved from 8% for thequarter ended March 2006 to 16% for the quarter ended March 2007. The increasein overall product gross margin is primarily due to a higher margin product mixin our product offerings in our Canadian acquisition, as well as in our corehistorical IT solutions offerings, and in our vendor partnership programscompared to the March quarter in 2006. Also, during the three months endedMarch 31, 2006, we incurred a one time inventory valuation loss of $223,000amounting to approximately 2% of product sales. Although we have improved ourservice margins, and will seek opportunities to make further improvements,product margins in particular are subject to competitive pricing pressures andfluctuate from quarter to quarter depending on the mix of products we provide.We intend to continually meet the challenges of aggressive price reductions anddiscount pricing by certain product suppliers by focusing our offerings onrelatively higher margin practice areas, including security solutions, VOIP,and application delivery. There can be no assurance that we will be able toimprove profit margins over an extended period, especially for our sale ofproducts, and compete profitably in all areas, given the intense competitionthat exists in the IT industry.

**Selling, general andadministrative expenses.**General and administrative expensesdeclined by 49%, to approximately $928,000 for the three months endedMarch 31, 2007, from approximately $1,816,000 for the three months endedMarch 31, 2006. As a percent of revenues, general and administrativeexpenses declined from 13 to 5%. This decrease is mainly the result of one-timecosts that occurred during the three month period ended March 31, 2006, such asrestructuring and reorganization costs of approximately $450,000, an increasein legal expenses of $100,000, and additional audit fees incurred of $137,000.During the three months ended March 2007, the Company incurred $23,000stock-based compensation expense. A similar charge was not incurred during thesame period in 2006.

Selling expenses decreased to approximately $3,083,000for the three months ended March 31, 2007 from $3,491,000 in the threemonths ended March 31, 2006.  The 12%decrease for the period ended March 31, 2007 is primarily due to the absence ofone-time restructuring and cost reduction programs that we implemented duringthe three months ended March 31, 2006. During the three month period endedMarch 31, 2007, approximately $67,000 in employee stock-based compensationexpense was incurred. During the three month period ended March 31, 2006, asimilar charge was not incurred.

**Depreciation and amortizationexpense.**Depreciation and amortization expense increased toapproximately $805,000 for the three-month period ended March 31, 2007,from approximately $632,000 during the same period in the prior year. Theincrease is primarily due to an increase in the amortization of customer listsfrom the SSS and TekConnect acquisitions completed in fiscal year 2007.

**Interest expense.**Interestexpense for the three months ended March 31, 2007 declined to $1,473,000,as compared to $2,070,000 for the three months ended March 31, 2006. Thisdecrease is primarily due to less non-cash interest incurred during the threemonths ended March 31, 2007. Non-cash interest for the period ended March 31,2007 was approximately $1,147,000. Non-cash interest charges include theamortization on the debt discounts on the Senior Notes which was approximately$433,000 with approximately $61,000 of non-cash interest related to the fairvalue of the issuable Senior Note 

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warrants in excess of thecarrying value of the Notes.  Thenon-cash interest amortization of the debt discounts on the Junior Notes wasapproximately $172,000. During the three months ended March 31, 2007, theCompany elected to pay in kind approximately $198,000 of interest on the SeniorNotes and approximately $260,000 on the Junior Notes. Amortization of deferredfinancing fees amounted to approximately $23,000. In addition to non cashinterest expense, we incurred fees on the APA and APLA agreements ofapproximately $321,000 and miscellaneous charges of $5,000.

During the three months ended March 2006,  non-cash interest includes amortization onthe debt discounts of $130,000 on the Laurus Note, and $340,000 on the 9%Notes; and the retirement of the balances on deferred financing costs of$372,000 on the 9% Notes, and $378,000 on the Laurus Note. Additional deferredfinancing costs in the aggregate of approximately $119,000 on the Bridge Notes,the Senior Notes, and the Junior Note Also included was $112,000 of non-cashinterest converted to equity due on the ITI Notes, $39,000 of non-cash interestconverted to equity due on the 9% Notes, and $109,000, of non-cash interest onthe Bridge Notes. In addition to non cash interest expense, we incurred fees onthe APA and APLA agreements and additional contractual interest on variousNotes amounting to approximately $471,000.

**Other Income (expense)**. Duringthe three months ended March 31, 2007, other income was insignificant.  However, during the three months ended March31, 2006, we recorded a net non-cash loss on the extinguishment of debtobligations in the aggregate of $8,521,000. We recorded a loss of $9,401,000based on the difference between the fair value of the equity instruments issuedunder the Conversion and Settlement Agreements as of March 8, 2006 and theconversion price per share for the ITI Notes and  the 9% Notes wherein the note holdersirrevocably cancelled their notes for the contractual right to receive sharesof our common stock upon the date immediately following the effective date ofour contemplated 1 for 10 reverse stock split which occurred on June 5, 2006.

During the three months ended March 31, 2006, we recordeda net gain of approximately $880,000 in connection with settling trade debts ofapproximately $1,947,000. Settlement of these debts in one time cash paymentsamounted to approximately $725,000, effectuating a one-time gain of $1,222,000;offset by a $342,000 loss on the extinguishment of the debt as we also enteredinto Conversion and Settlement Agreements with certain trade payable creditorsto convert outstanding debt balances in the aggregate of approximately $171,000into 8,541,650 shares of common stock at the conversion price of $0.02 pershare based on the difference between the (a) fair value of 8,541,650 shares ofcommon stock issuable to such holders for the settlement of the debt and (b)the aggregate debt of $171,000 at the conversion price of $0.02 per share.

Also, during the nine months ended March 31, 2006, werecorded a one-time expense of $505,043 on an investment deemed to have norecordable value.

The following table sets forth operating expenses forthe periods presented from information derived from our consolidated statementsof operations (in thousands):
|                                             | ** ** | **For the Three Months ended  March 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------------------------------|------------|
| **OPERATING **                         | ** ** | **Dollars**                                                        | ** ** | **Percentage   of Revenues** | ** ** |
| **EXPENSES**                                | ** ** | **2007**                                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ***Selling***                               |       | 3,083                                                              |       | 3,491 |   | 15 | % | 24 | % |
|                                        |       |                                                               |       |   |   |   |   |   |   |
| ***General &  Administrative***    |       | 928                                                                |       | 1,816 |   | 5 | % | 13 | % |
|                                        |       |                                                               |       |   |   |   |   |   |   |
| ***Depreciation &  Amortization*** |       | 805                                                                |       | 632 |   | 4 | % | 4 | % |
|                                        |       |                                                               |       |   |   |   |   |   |   |
| ***Total***                                 |       | 4,816                                                              |       | 5,939 |   | 24 | % | 42 | % |

 

**Net loss.**Ournet loss for the three months ended March 31, 2007 was $2,286,000 comparedto a net loss of $15,647,000 for the three months ended March 31, 2006.The loss during the three months ended March 31, 2007 includes interestexpense of $1,473,000 (including a non-cash portion of $1,147,000),depreciation and amortization expense of $805,000, and non-cash stock-basedcompensation expense of $91,000.

The loss during the three months ended March 31,2006 includes interest expense of $2,070,000 (including a non-cash portion of$1,599,000), depreciation and amortization expense of $632,000; and a $505,000valuation adjustment on the investment in Tekinsight, and a $9,401,000 loss onthe extinguishment of debt obligations under the ITI Notes and the 9% Notes;offset by a gain on extinguishment of trade payable debt of $880,000.  

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**Liquidity and Capital Resources**

We measure our liquidity in a number of ways, assummarized in the following table:
|                            | ** ** | **(Dollars in thousands)**    | ** ** |
|----------------------------|------------|-----------------------------------------|------------|
| ** **                 | ** ** | **As of  Mar. 31, 2007** | ** ** | **As of  June 30, 2006** | ** ** |
| Cash and cash  equivalents |       | $                                       | 979        |   | $ | 1,190 |   |
|                       |       |                                    |       |   |   |
| Working capital            |       | $                                       | (1,183     | ) | $ | 43 |   |
|                       |       |                                    |       |   |   |
| Current ratio              |       | 0.85:1                                  |       | 1.01:1 |   |

 

Cash and cash equivalentsgenerally consist of cash and money market funds. We consider all highly liquidinvestments purchased with maturities of three months or less to be cashequivalents.

During the nine monthsended March 31, 2007, we used approximately $1,265,000 of cash in our operatingactivities and had a working capital deficiency of approximately $1,183,000.

We incurred a net loss of$7,433,000 for the nine months ended March 31, 2007, which includes $6,779,000of non-cash charges resulting from $2,177,000 of depreciation and amortization,$767,000 in non-cash stock compensation expense, and $3,835,000 in non-cashinterest charges.

On September 26, 2006,the Company issued another Junior Secured Convertible Note to the Junior Lenderin the aggregate principal amount of $3,000,000.  Proceeds from the additional Junior Note wereused to fund two acquisitions and for general working capital.

On October 6, 2006, theCompany entered into an Asset Purchase Agreement with TekConnect, Inc pursuantto Section 363 of the United States Bankruptcy Code, for substantially allof its assets.  In consideration for thepurchased assets, the Company agreed to pay TekConnect at closing a cashpayment of $400,000. Additional fees in connection with the acquisition ofapproximately $63,000 were also paid.

On October 27, 2006, theCompany, through its wholly-owned subsidiary DynTek Canada, entered into anAsset Purchase Agreement with SSS and Paul Saucier whereby it agreed topurchase substantially all of the assets of SSS. In consideration for thepurchased assets, the Company agreed to pay SSS at closing a cash payment of$1,063,000 and 1,485,148 shares of the Company’s common stock, based upon a pershare value of $0.202. Additional fees in connection with the acquisition ofapproximately $50,000 were also paid. In addition, the Company has agreed tomake additional payments over a three-year period based upon the achievement ofcertain EBITDA performance targets.  Such payments will be paid using acombination of cash and the Company’ common stock, at the Company’s election,provided that at least half of the payments will be in cash. The earn-outprovisions are based upon the achievement of EBITDA targets and are estimatedto be approximately $223,000 for the period ended December 31, 2006 andapproximately $410,000 for the period ended March 31, 2007, both  are classified as a current liability inaccordance with SFAS No. 150. The Company intends to distribute payment, halfto be paid in cash and half to be issuable in shares of the Company’s commonstock at a price of $0.20 per share. On April 17, 2007, the Company made aninitial cash earn-out payment of approximately $134,000.  

On April 13, 2007, the Companyentered into a Junior Secured Convertible Note Purchase Agreement in which theCompany issued to the Junior Lender a Junior Secured Convertible Note in theaggregate principal amount of $5,000,000 (the “Note”).  The interest rate for the Note is 9% perannum if paid in cash, or 13% per annum if paid in kind, which is at theCompany’s election for the first three years. Principal will be payable at thematurity date of April 13, 2012, and interest will be payable quarterly inarrears beginning June 30, 2007, unless the Company chooses its payment in kindoption, in which case interest will be added to the principal amount of theJunior Note during the period that the Company continues such election. TheJunior Note may be converted into common stock of the Company at any time atthe election of the holder at an initial conversion price of $0.175 per shareof common stock, subject to certain adjustments set forth therein. Proceedsfrom the issuance of the Junior Note will be used to finance current operations,fund potential acquisitions and for general corporate purposes.

We experiencetiming differences in its operating cash flows resulting from the fact thatmuch of our revenues are earned near the end of each quarter and its operatingexpenses are incurred evenly throughout the period. The Company also experienceslow collection cycles since with respect to customers that are educational andgovernment institutions, which has been a growing area of our business.  Although the Company has experienced a lowincidence of uncollectible amounts, many of its customers have historicallyfailed to make timely payments.

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Slow collectionshave caused the Company to incur higher fees under its accounts receivable andproduct financing arrangements with NETF. The Company also recently used aportion of its cash resources to acquire TekConnect and SSS. The Company, inits acquisition of TekConnect, assumed approximately $540,000 of pre-existingservice obligations which have resulted in some increased costs. Although theCompany uses its facility with NETF to better manage the timing differences inits operating cash flows, services related accounts receivable due fromcustomers under its newly acquired Canadian business are ineligible fortransfer. These circumstances have caused the Company to experience additionalconstraints on its liquidity, which are likely to continue until such time thatthe acquired is fully integrated.

Although theCompany has made substantial efforts to accelerate collections under its Companywide operations, slow collection cycles, ongoing timing differences and effortsto integrate acquired businesses could cause the Company to seek additionaloutside financing. Although the Company believes that it has sufficient capitalresources to sustain the business through March 31, 2008, there can be noassurance that unforeseen circumstances will not have a material affect onoperations. These circumstances could require the Company to take a variety ofmeasures to conserve and/or improve liquidity including curtailing operations;cutting costs seek additional outside financing. The Company has not securedany commitments for new financing at this time nor can it provide assurancethat any new capital (if needed) will be available to it on acceptable terms,if at all.

The Companybelieves that its strategy of streamlining the business around its corecompetency of providing IT solutions is enabling it to operate under a moreefficient cost structure than it had in the past. The Company is also notrequired to make principal payments under any of its note obligations untilJune 2009 and its accounts receivable and product financing arrangement withNETF is providing it with timely working capital resources.

In the future, wemay continue to expand the scope of our product and services offerings bypursuing acquisition candidates with complementary technologies, services orproducts.  Should we commence suchacquisitions, we believe that we would finance the transactions with acombination of our working capital, 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 ofany additional financing, any equity financing would likely result in dilutionto our existing stockholders and any debt financing may include restrictivecovenants.

**ContractualObligations**
|                                   | ** ** | **Payments due by period  (in thousands)** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                        | ** ** | **Total**                                                      | ** ** | **Less  than 1  year** | ** ** | **1-3 years** | ** ** | **3-5  years** | ** ** | **More  than 5  years** | ** ** |
| *Contractual Obligations*         | * *   | * *                                                       | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Non-Convertible Debt  Obligations |       | 7,518                                                          |       | — |   | 7,518 |   |   |   | — |   |
| Convertible Debt  Obligations     |       | 12,805                                                         |       | — |   | — |   | 12,805 |   | — |   |
| Operating Lease  Obligations      |       | 2,201                                                          |       | 891 |   | 1,106 |   | 204 |   | — |   |
| Total                             |       | $                                                              | 22,524     |   | $ | 891 |   | $ | 8,624 |   | $ | 13,009 |   | $ | — |   |
|                                   |            |                                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Critical AccountingPolicies and Estimates**

Our financial statementsand accompanying notes are prepared in accordance with accounting principlesgenerally accepted in the United States. Preparing financial statementsrequires management to make estimates and assumptions that affect the reportedamounts of assets, liabilities, revenue, and expenses. These estimates andassumptions are affected by management’s application of accounting policies.Critical accounting policies for us include revenue recognition, impairment ofgoodwill, and accounting for discontinued operations.

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***Revenue******Recognition.*****  **We apply therevenue recognition principles set forth under SOP 97-2 and SAB 104 withrespect to all of our revenue. We adhere strictly to the criteria set forth inparagraph .08 of SOP 97-2 and outlined in SAB 104 which provides forrevenue to be recognized when (i) persuasive evidence of an arrangement exists,(ii) delivery has occurred, (iii) the vendor’s fee is fixed or determinable,and (iv) collectability is probable. A summary of our revenue recognitionpolicies, as they relate to our specific revenue streams, is as follows:

*Computer Hardware ProductRevenues*

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

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

*Software Product Revenues*

We make substantially allof our software product sales as a reseller of licenses, which may include apost contract customer support arrangement and access to product and upgrades,and enhancements that are provided exclusively by the manufacturer followingdelivery and the customer’s acceptance of the software product. We do notpresently sell any software that we develop internally. Any responsibility fortechnical support and access to upgrades and enhancements to these softwareproducts are solely the responsibility of the software manufacturer, whicharrangement is known to the customer at the time the sale is consummated. Withrespect to delivery, we require that the customer has received transfer of thesoftware or, at a minimum, an authorization code (“key”) to permit access tothe product. If a software license is delivered to the customer, but thelicense term has not begun, we do not record the revenue prior to inception ofthe license term.

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

*IT Services Revenue*

We generally bill ourcustomers for professional IT services based on hours of time that we spend onany given assignment at our hourly billing rates. As it relates to delivery ofthese services, we recognize revenue under these arrangements as the work iscompleted and the customer has indicated their acceptance of our services by approvinga work order milestone or completion order. For certain engagements, we enterfixed bid contracts, and we recognize revenue as phases of the project arecompleted and accepted by our client. For our seat management services, weenter unit-price contracts (e.g., price per user for seat management), and werecognize revenue based on number of units multiplied by the agreed-uponcontract unit price per month.

*BPO Services Revenue*

For our BPO services,which primarily included our child support service contracts in the states ofKansas and Nebraska, we provided services under a fixed price (flat monthlyfee) contract, and recognized revenue as the services are provided and billed.In the state of North Carolina, we had one contract subject to revenue-sharingrelated to child support services. Under that contract, a fee from amountscollected was shared with the county on a percentage basis, and revenue wasrecognized monthly in arrears as a percentage of the total amount ofcollections received.

***Collectability of Receivables.*****  **A considerableamount of judgment is required to assess the ultimate realization ofreceivables, including assessing the probability of collection and the currentcredit worthiness of our clients. Probability of collection is based upon theassessment of the client’s financial condition through the review of itscurrent financial statements or credit reports.

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***Goodwill.*****  **SFAS 142,Goodwill and Other Intangible Assets, requires that goodwill be tested forimpairment at the reporting unit level (operating segment or one level below anoperating segment) on an annual basis (June 30th for the company) and betweenannual tests in certain circumstances. Application of the goodwill impairmenttest requires 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 offair value and/or goodwill impairment for each reporting unit.

***Convertible Notes.*****  **The companyaccounts for conversion options embedded in convertible notes in accordancewith Statement of Financial Accounting Standard (“SFAS) No. 133 “Accounting forDerivative Instruments and Hedging Activities” (“SFAS 133”) and EITF 00-19“Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled in, a company’s Own Stock” (“EITF 00-19”). SFAS 133 generallyrequires companies to bifurcate conversion options embedded in convertiblenotes from their host instruments and to account for them as free standingderivative financial instruments in accordance with EITF 00-19. SFAS 133provides for an exception to this rule when convertible notes, as hostinstruments, are deemed to be conventional as that term is described in theimplementation guidance under Appendix A to SFAS 133 and further clarified inEITF 05-2 “The Meaning of “Conventional Convertible Debt Instrument” inIssue No. 00-19. The company accounts for convertible notes (deemedconventional) in accordance with the provisions of EITF 98-5.

“Accounting for ConvertibleSecurities with Beneficial Conversion Features,” (“EITF 98-5”), EITF 00-27“Application of EITF 98-5 to Certain Convertible Instruments.”Accordingly, the company records, as a discount to convertible notes, theintrinsic value of such conversion options based upon the differences betweenthe fair value of the underlying common stock at the commitment date of thenote transaction and the effective conversion price embedded in the note. Debtdiscounts under these arrangements are amortized over the term of the relateddebt to their earliest date of redemption.

**Recent Changes inAccounting Standards**

In September 2006, theFASB issued Statement of Financial Accountings Standards No. 157, Fair ValueMeasurements (“SFAS 157”). This Standard defines fair value, establishes aframework for measuring fair value in generally accepted accounting principlesand expands disclosures about fair value measurements. SFAS 157 is effectivefor 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 financial position,results of operations or cash flows.

In July 2006, theFinancial Accounting Standards Board issued FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes. This Interpretation prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. This Interpretation also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods,disclosure, and transition. The Interpretation is effective for fiscal yearsbeginning after December 15, 2006. We have not yet completed our analysis ofthe impact this Interpretation will have on our financial condition, results ofoperations, cash flows or disclosures.

In September 2006, theSEC issued Staff Accounting Bulletin 108, Considering the Effects on Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements, (“SAB 108”). SAB 108 requires registrants to quantify errors usingboth the income statement method (i.e. iron curtain method) and the rollovermethod and requires adjustments if either method indicates a materialerror.  If a correction in the currentyear relating to prior year errors is material to the current year, then theprior year financial information needs to be corrected. A correction to theprior year results that are not material to those years would not require arestatement process where prior financials would be amended.  SAB 108 is effective for fiscal years endingafter November 15, 2006. The Company does not anticipate that SAB 108 will havea material effect on its financial position, results of operations or cashflows.

In June 2006, the EITFreached a consensus on Issue No. 06-3 (“EITF 06-3”), “Disclosure Requirementsfor Taxes Assessed by a Governmental Authority on Revenue-ProducingTransactions.”  The consensus allows companies to choose between twoacceptable alternatives based on their accounting policies for transactions inwhich the company collects taxes on behalf of a governmental authority, such assales taxes.  Under the gross method, taxes collected are accounted for asa component of sales revenue with an offsetting expense.  Conversely, thenet method allows a reduction to sales revenue.  If such taxes arereported gross and are significant, companies should disclose the amount ofthose taxes.  The guidance should be applied to financial reports throughretrospective application for all periods presented, if amounts aresignificant, for interim and annual reporting beginning after December 15,2006.  The Company adopted the provisions of this EITF and accounts forthe collection of sales taxes using the net method. The implementation of EITF06-3 did not have a material effect on the Company’s consolidated financialstatements.

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In November 2006, the EITF reached a final consensusin EITF Issue 06-6 “Debtor’s Accounting for a Modification (or Exchange) ofConvertible Debt Instruments” (“EITF 06-6”).  EITF 06-6 addresses themodification of a convertible debt instrument that changes the fair value of anembedded conversion option and the subsequent recognition of interest expensefor the associated debt instrument when the modification does not result in adebt extinguishment pursuant to EITF 96-19, “Debtor’s Accounting for aModification or Exchange of Debt Instruments.”  The consensus should beapplied to modifications or exchanges of debt instruments occurring in interimor annual periods beginning after November 29, 2006.  The Company does notexpect the adoption of EITF 06-6 to have a material impact on its consolidatedfinancial position, results of operations or cash flows. 

In November 2006, the FASB ratified EITF Issue No.06-7, “Issuer’s Accounting for a Previously Bifurcated Conversion Option in aConvertible Debt Instrument When the Conversion Option No Longer Meets theBifurcation Criteria in FASB Statement No. 133, Accounting for DerivativeInstruments and Hedging Activities” (“EITF 06-7”). At the time of issuance, anembedded conversion option in a convertible debt instrument may be required tobe bifurcated from the debt instrument and accounted for separately by theissuer as a derivative under FAS 133, based on the application of EITF 00-19.Subsequent to the issuance of the convertible debt, facts may change and causethe embedded conversion option to no longer meet the conditions for separateaccounting as a derivative instrument, such as when the bifurcated instrumentmeets the conditions of Issue 00-19 to be classified in stockholders’ equity.Under EITF 06-7, when an embedded conversion option previously accounted for asa derivative under FAS 133 no longer meets the bifurcation criteria under thatstandard, an issuer shall disclose a description of the principal changescausing the embedded conversion option to no longer require bifurcation underFAS 133 and the amount of the liability for the conversion option reclassifiedto stockholders’ equity. EITF 06-7 should be applied to all previouslybifurcated conversion options in convertible debt instruments that no longermeet the bifurcation criteria in FAS 133 in interim or annual periods beginningafter December 15, 2006, regardless of whether the debt instrument was enteredinto prior or subsequent to the effective date of EITF 06-7. Earlierapplication of EITF 06-7 is permitted in periods for which financial statementshave not yet been issued. The Company is currently evaluating the impact ofthis guidance on its consolidated financial position, results of operations orcash flows.

Other accountingstandards that have been issued or proposed by the FASB or other standards-settingbodies that do not require adoption until a future date are not expected tohave a material impact on the consolidated financial statements upon adoption.

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

Market risk associatedwith adverse changes in financial and commodity market prices and rates couldimpact our financial position, operating results or cash flows. We do not haveany variable rate debt instruments and we are not exposed to market risk due tochanges in interest rates such as the prime rate and LIBOR.

Our acquisition ofSensible Security Solutions, Inc. in October of 2006 significantly increasesour presence in the Canadian market and creates greater exposure to foreigncurrency rate fluctuations.  We do notexpect this exposure to be significant.

**ITEM 4. CONTROLS AND PROCEDURES**

As of March 31,2007, the Company carried out an evaluation, under the supervision and with theparticipation of members of our management, including the Company’s ChiefExecutive Officer and the Company’s Chief Financial Officer, of theeffectiveness and operation of the Company’s disclosure controls andprocedures. Based upon that evaluation, the Company’s Chief Executive Officerand the Chief Financial Officer have concluded that the Company’s disclosurecontrols and procedures were not effective as of March 31, 2007, based ontheir evaluation of these controls and procedures required by paragraph(b) of Exchange Act Rules 13a-15 and 15d-15.

**DISCLOSURE CONTROLS ANDINTERNAL CONTROLS**

Disclosure controls areprocedures that are designed with the objective of ensuring that informationrequired to be disclosed in our reports filed under the Securities Exchange Actof 1934, as amended, such as this Report, is recorded, processed, summarizedand reported within the time periods specified in the SEC’s rules andforms. Disclosure controls are 

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alsodesigned with the objective of ensuring that such information is accumulatedand communicated to our management, including our Chief Executive Officer andChief Financial Officer, as appropriate, to allow timely decisions regardingrequired disclosure. Internal controls are procedures which are designed withthe objective of providing reasonable assurance that our transactions areproperly authorized, recorded and reported and our assets are safeguardedagainst unauthorized or improper use, to permit the preparation of ourfinancial statements in conformity with generally accepted accountingprinciples.

Our company is not an “acceleratedfiler” (as defined in the Securities Exchange Act) and is not required todeliver management’s report on control over our financial reporting until ourfiscal year ended June 30, 2008. Nevertheless, we identified certainmatters that constitute material weakness (as defined under the Public CompanyAccounting Oversight Board Auditing Standard No. 2) in our internalcontrols over financial reporting.

The material weaknessesthat we have identified relate to the fact that that our overall financialreporting structure, internal accounting information systems, and currentstaffing levels are not sufficient to support the complexity of our financialreporting requirements. We have experienced employee turnover in our accountingdepartment. As a result, we have experienced difficulty with respect to ourability to record, process and summarize all of the information that we need toclose our books and records on a timely basis and deliver our reports to theSEC within the time frames required under the Commission’s rules. We have recentlyincreased the size of our staff and have reviewed assignments within ouraccounting department to ensure we have adequate segregation of duties. 

We have also identified aspecific material weakness in our ability to ensure that the accounting for ourequity-based transactions is accurate and complete. Historically, we haveentered into various forms of complex equity transactions involving theapplication of specialized accounting principles. The equity based transactionsthat we consummated specifically relate to stock-based compensationarrangements, issuances of complex instruments in financing transactions,modifications to embedded and free standing derivatives and settlements of debtfor equity. We are evaluating certain corrective measures to provide us withthe structure we need at such times that we may engage in equity basedtransactions. These measures could include seeking the assistance of outsidespecialists with expertise in these areas.

We believe these materialweaknesses have resulted from liquidity constraints that caused us to focus onusing our resources to implement a financial and operational restructuringplan.

We believe that any risksthat may have been created as a result of these material weaknesses arepartially mitigated by the fact that we have minimal assets that are subject tothe risk of misappropriation. In addition, activities during our most recentreporting periods have been regularly reviewed and approved by our ChiefExecutive and Chief Financial Officers. However, we acknowledge that additionalcontrol procedures are necessary to ensure that all of our transactions areproperly recorded, our assets are appropriately safeguarded and that we canclose and report our results within the time frames required by the SEC.

As of May 21, 2007, weare presently engaged in a project to evaluate and recommend improvements inour internal systems and controls and we have added additional accountingstaff.  The Company has undertaken aprocess improvement project aimed at improving and streamlining its internalorder processing.  The initial phase wascompleted on March 2007.  The Company iscontinuing to evaluate specific improvements to be made to its internalaccounting system to reduce the time we have historically needed  to provide financial reports. We also havesought out additional assistance from outside specialists through localaccounting firns but have not employed any assistance as of yet.

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**PART II - OTHER INFORMATION**

**ITEM1.  LEGAL PROCEEDINGS**

From time to timewe are involved in various legal proceedings and disputes that arise in thenormal course of business. These matters have included intellectual propertydisputes, contract disputes, employment disputes and other matters. On or aboutOctober 30, 2006, Pangaea Education Systems, LLC (“Pangaea”) filed a lawsuitagainst 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”). Pangaea’scomplaint does not specify the amount of damages sought, but Pangaea haddemanded in excess of $2,500,000 in preliminary communications with the Company’scounsel. The Company contends that this demand is without factual or legalbasis, that the Action has no merit and is aggressively defending theAction.  Trial is scheduled for July 2008. The Company filed a motion todismiss in response to the complaint on November 28, 2006. The Company intendsto continue discussing an informal resolution. While the Company believes ithas a strong position, it is not possible at this time to state the likelihoodof an unfavorable outcome based on the early stage of the dispute, thepositions taken by Pangaea and the inherent uncertainties of litigation.

**ITEM 1A. RISK FACTORS**

Potential risks and uncertainties include, among otherthings, those 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 filed onOctober 13, 2006, Item 2 (Management’s Discussion and Analysis of FinancialCondition and Results of Operations) of Part I of this Quarterly Report onForm 10-Q, and as set forth below in this Item IA. Readers should carefullyreview those risks, as well as additional risks described in other documents wefile from time to time with the SEC. We undertake no obligation to publiclyrelease the results of any revisions to any forward-looking statements toreflect anticipated or unanticipated events or circumstances occurring afterthe date of such statements. The following risk factors include materialchanges to the risk factors previously disclosed in our Form 10-K filed onOctober 13, 2006, but are not a complete list of all of our risk factors.

***We may not be able to implement Section 404 of the Sarbanes-Oxley Acton a timely basis.***

The SEC, as directed by Section 404 of the Sarbanes-Oxley Act of 2002, adopted rules generally requiring each public company to include a report of management on the company’s internal controls over financial reporting in its annual report on Form 10-K that contains an assessment by management of the effectiveness of the company’s internal controls over financial reporting for fiscal years ending after July 15, 2007.  In addition,  the company’s independent registeredaccounting firm must attest to and report on management’s assessment of the effectiveness of the company’s internal controls over financial reporting.  This requirement will first apply to our annual report on Form 10-K for the fiscal year ending June 30, 2008. We have not yet developed a Section 404 implementation plan.  We have in the past discovered,  and may in the  future discover, areas of our internal controls that need  improvement.  How companies should be implementing these new requirements including internal control reforms to comply with Section  404’s requirements, and how independent  auditors will apply these requirements and test companies’ internal controls, is still reasonably uncertain.  We expect that we may need to hire and/or engage additional personnel and incur incremental costs in order to complete the work required by Section 404. We cannot guarantee that we will be able to complete a Section 404 plan on a timely basis.  Additionally, upon completion of a Section 404 plan,  we may not be able to conclude that our internal controls are effective, or in the event that we conclude that our internal controls are effective, our independent accountants may disagree with our assessment and may issue a report that is qualified.  Any failure to implement required new or improved controls, or difficulties encountered in their implementation, could negatively affect our operating results or cause us to fail to meet our reporting obligations.

***We will need additional capital in the future, or we will need to scaleback operations***.

We will need capital in the future,and if it is not available on terms acceptable to us, or at all, and we cannotgenerate enough cash through existing operations, we may have to scale backoperations and/or curtail expansion plans. During the fiscal year endedJune 30, 2006, we took steps to conserve our capital resources including areduction of our selling, general and administrative expenses by approximately$2,400,000 annually. We have also reduced the current portion of our debtburden by completing our recapitalization in March 2006, includingcanceling certain debt obligations through 

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equity conversion and debt settlement agreements.Additional financing transactions may be necessary if we are not able togenerate sufficient cash flow from operations through revenue growth andoverhead reduction to meet our requirements. As of the period ended March 31,2007, we had cash and cash equivalents of approximately $979,000 and had aworking capital deficiency of $1,183,000. On April 13, 2007 we entered into a Junior Secured Convertible NotePurchase Agreement in the amount of $5,000,000 to be used to finance currentoperations, fund potential acquisitions and for general corporate purposes..

We are continuingour financial and operational restructuring initiatives and will continue toimplement our strategic business plan. Although we believe that we havesufficient liquidity to sustain the business through March 31, 2008, there isno assurance that unforeseen circumstances will not have a material affect onthe business that could require us to raise additional capital or take othermeasures to sustain operations in the event outside sources of capital are notavailable. We have not secured any commitments for new financing at this timenor can we provide any assurance that new capital (if needed) will be availableto us on acceptable terms, if at all.

***We have a history of operating losses and may not be able to achievelong-term profitability.***

Since our inception in May 1989,we have incurred substantial operating losses. During the nine months endedMarch 31, 2007, we generated a net loss of $7,433,000. At March 31, 2007, wehad an accumulated deficit of $133,341,000. There can be no assurance that ourrevenues will exceed our operating expenses and cost of revenues in the future.

***The level of our indebtedness could adversely affect ourfinancial condition.***

We havesignificant debt service obligations. As of May 21, 2007, the aggregateprincipal amount owed under our debt instruments was $20.3 million.

The level of ourindebtedness could have important consequences. For example, it could:

·                  increase ourvulnerability to adverse economic and industry conditions;

·                  require us todedicate a substantial portion of our cash flow from operations to the paymentof our indebtedness, thereby reducing the availability of cash to fund workingcapital and capital expenditures and for other general corporate purposes;

·                  restrict us frommaking strategic acquisitions, acquiring new content or exploring otherbusiness opportunities;

·                  limit ourability to obtain financing for working capital, capital expenditures, generalcorporate purposes or acquisitions;

·                  place us at adisadvantage compared to our competitors that have less indebtedness; and

·                  limit ourflexibility in planning for, or reacting to, changes in our business andindustry.

***Dilution in ownership of our shares from the exercise or conversion ofoptions, warrants, and convertible securities.***

There are asignificant number of outstanding options, warrants, and convertible securitiesto acquire shares of our common stock and we may grant additional rights in thefuture. The holders of such options, warrants, and convertible securities canbe expected to exercise them at a time when our common stock is trading at aprice higher than the exercise price of these outstanding options, warrants,and convertible securities. If these options or warrants to purchase our commonstock are exercised, convertible debt is converted or other equity interestsare granted under our 2001, 2005 or 2006 stock option plans, or under otherplans or agreements adopted in the future, such equity interests will have adilutive effect on your ownership of common stock. The existence of suchoptions, warrants, and convertible securities may also adversely affect theterms on which we can obtain additional financing.

As of May 21,2007, we had 58,234,989 shares issued and outstanding. As of such date, we hadoutstanding options to purchase 10,857,064 shares of our common stock, warrantsto purchase approximately 43,250,745 shares of common stock, and $12,805,123 ofconvertible debt, convertible into 73,172,130 shares of common stock. Theprincipal amount of the convertible debt will continue to increase to theextent we elect not to pay interest as it accrues during the first three years,in which case the principal would increase to approximately $17,587,978, andthe number of shares issuable upon conversion 

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would be 100,502,734. Weintend to raise capital through offerings of our common stock, securitiesconvertible into our common stock, or rights to acquire such securities or ourcommon stock. Such other rights to acquire our common stock may be issued atexercise prices or conversion rates that are significantly lower than the priceat which you may have paid for our shares. In addition, the shares issuable uponexercise of certain of the warrants and upon conversion of convertible debt mayincrease subject to anti-dilutive rights, which we granted to certain warrantand debt holders.

***Lloyd I. Miller, III beneficially owns a majority ofour outstanding common stock, which may enable him to control many significantstockholder matters and corporate actions and may prevent a change in controlthat would otherwise be beneficial to other stockholders.***

Lloyd I. Millermay be deemed to beneficially own a total of 109,839,641 shares of our commonstock, or 68.3%, as of May 21, 2007, including shares issuable upon exercise ofwarrants held by Mr. Miller and his affiliates. The foregoing does nottake into account the exercise or conversion of other outstanding convertibleor exercisable securities of the Company, which would have the effect ofreducing the percentage beneficial ownership of Mr. Miller. Because of hishigh percentage of beneficial ownership, Mr. Miller may be able to controlmatters requiring the vote of stockholders, including the election of our boardof directors and certain other significant corporate actions. This controlcould delay, defer or prevent others from initiating a potential merger,takeover or other change in our control, even if these actions would benefitour other stockholders and us. This control could adversely affect the votingand other rights of our stockholders and could depress the market price of ourcommon stock.

***It is possible that we may have violated Section 5 of theSecurities Act.***

In March 2006, weentered into a Note Purchase Agreement (the “Note Purchase Agreement”) withSACC Partners, L.P. and Lloyd I. Miller, III (the “Senior Lenders”), pursuantto which we issued to the Senior Lenders certain Senior Secured Notes in the aggregateprincipal amount of $6.7 million (the “Senior Notes”).  Under the NotePurchase Agreement, we also issued a Junior Secured Convertible Note to TrustA-4 - Lloyd I. Miller (the “Junior Lender” and together with the SeniorLenders, the “Lenders”) in the aggregate principal amount of $3.0 million (the “FirstJunior Note”).  In June 2006, we issued an additional Junior SecuredConvertible Note to Trust A-4 - Lloyd I. Miller in the aggregate principalamount of $1.0 million (the “Second Junior Note”).  Pursuant to ourcontractual obligation to do so, we filed the registration statement of whichthis prospectus is a part in June 2006 to register for resale, among othershares, the shares of our common stock into which the First and Second JuniorNotes may be converted. In September 2006, while the registration statement wasstill pending and not yet declared effective, we issued an additional juniorsecured convertible note to the Junior Lender in the aggregate principal amountof $3,000,000 (the “Third Junior Note” and together with the First and SecondJunior Notes, the “Junior Notes”) on the same terms and conditions as were setforth in the First and Second Junior Notes. In April 2007, we entered into aJunior Secured Convertible Note Purchase Agreement (the “Note PurchaseAgreement”) with Trust A-4 - Lloyd I. Miller (the “Lender”), pursuant to whichwe issued to the Lender a Junior Secured Convertible Promissory Note in theaggregate principal amount of $5,000,000 (the “Note”). 

In a commentletter to the registration statement, the SEC notified us that by selling andissuing the Third Junior Note while the registration statement was stillpending, we may have violated Section 5 of the Securities Act.  If theLenders were to have brought an action to rescind the issuance of the Seniorand Junior Notes as a result of the Section 5 violation and prevailed, we wouldhave been required to repurchase the Senior Notes and Junior Notes at theiroriginal purchase price, plus statutory interest from the date of purchase. However, on February 2, 2007, we obtained waivers and releases from the Lendersof any rescission rights and, therefore, we will not record any contingentliability in connection therewith.  Although we are not aware of any otherpending claims or sanctions against us in connection with the possible Section5 violation, we still could be subject to enforcement actions by the SEC,resulting in injunctive relief or the imposition of fines.  We wouldvigorously contest any claim that the issuance of the Third Junior Note in themanner described above violated Section 5 of the Securities Act.

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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. |
|--------------------|--------|--------------|
|               |   |         |   |   |
|               |   |         |   |   |
| Date: May 21, 2007 |   | By:          |   | /s/ Casper Zublin, Jr. |
|               |   |         |   | Casper Zublin, Jr. |
|               |   |         |   | Chief Executive Officer |
|               |   |         |   | (principal executive officer) |
|               |   |         |   |   |
| Date: May 21, 2007 |   | By:          |   | /s/ Mark E. Ashdown |
|               |   |         |   | Mark E. Ashdown |
|               |   |         |   | Chief Financial Officer |
|               |   |         |   | (principal financial and accounting officer) |

 

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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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