** **

**U.S. SECURITIES ANDEXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-Q**

 

**ý****        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**
| ** **                                | ** ** | ** ** |
|-------------------------------------------|------------|------------|
| **For the Quarter ended March 31,  2006** |
|                                      |       |       |
| **OR**                                    |

 

**o****        TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**
|                                                                                                                                                          |   |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| **For the transition period  from          to          ** |

 

**Commissionfile number 1-11568**

 

**DYNTEK, INC.**

(Exact Name of Registrant asSpecified in its Charter)

 

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

 

**19700Fairchild Road, Suite 230**

**Irvine, CA92612**

(Address of principal executiveoffices) (Zip code)

 

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

 

Indicate by check whether the Registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12months, (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filings requirements forthe past 90 days.  Yes ý  Noo

 

Indicate by check mark whether the registrantis a large accelerated filter, an accelerated filer, or a non-acceleratedfiler.  See definition of “accelerated filer”in Rule 12b-2 of the Exchange Act.  Large Acclerated Filer o  AcceleratedFiler o  Non-Accelerated Filer ý

 

Indicate by check mark whether the Registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes o  No ý

 

As of May 16, 2006, the number of sharesoutstanding of the registrant’s Common Stock, $.0001 par value, was 214,245,977.

 

 

----

 

**DYNTEK,INC. AND SUBSIDIARIES**

** **

**INDEX**

 
| **PART I – FINANCIAL INFORMATION**                                                        |                                                                                                                                                                    |       |
|-----------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                                                                                |                                                                                                                                                                    |       |
| Item 1. Condensed Consolidated Financial Statements                                                 |                                                                                                                                                                    |       |
|                                                                                                |                                                                                                                                                                    |       |
|                                                                                                | Condensed Consolidated Balance Sheets – as of March 31, 2006  (unaudited) and June 30, 2005                                                                   | ** ** |   |
|                                                                                                |                                                                                                                                                                    |       |   |
|                                                                                                | Condensed  Consolidated Statements of Operations and Comprehensive Loss (unaudited) -  For the Three and Nine  Months Ended March 31, 2006 and March 31, 2005 | ** ** |   |
|                                                                                                |                                                                                                                                                                    |       |   |
|                                                                                                | Condensed  Consolidated Statements of Cash Flows (unaudited) - For the Nine Months Ended  March 31, 2006 and March 31, 2005                                   |       |   |
|                                                                                                |                                                                                                                                                                    |       |   |
|                                                                                                | 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                                                                                    |                                                                                                                                                                    |       |
|                                                                                                |                                                                                                                                                                    |       |
| **SIGNATURE**                                                                                       |                                                                                                                                                                    |       |
|                                                                                                     |                                                                                                                                                                         |            |  |  |

 

2

----

 

**1.             PART 1– FINANCIAL INFORMATION**

 

**ITEM 1.CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**DYNTEK, INC. AND SUBSIDIARIES**

# **CONDENSEDCONSOLIDATED BALANCE SHEETS**

# (inthousands, except share data)

 
| ** **                                                                                                                                                                          | ** ** | **March 31,  2006** | ** ** | **June 30, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                          | ** ** | **(unaudited)**          | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                                                                                              | ** ** | ** **               | ** ** | ** **                  | ** ** |
| CURRENT ASSETS:                                                                                                                                                                     | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Cash                                                                                                                                                                                |       | $                        | 638        |                        | $          | 963 |   |
| Cash – Restricted                                                                                                                                                              |       | 1,320                    |       | 334                         |       |
| Accounts receivable, net of allowance for  doubtful accounts of $581 and $618                                                                                                       |       | 11,067                   |       | 17,894                      |       |
| Inventory                                                                                                                                                                           |       | 1,158                    |       | 1,666                       |       |
| Prepaid expenses and other current assets                                                                                                                                           |       | 69                       |       | 75                          |       |
| Other receivables                                                                                                                                                                   |       | 438                      |       | 125                         |       |
| TOTAL CURRENT ASSETS                                                                                                                                                                |       | 14,690                   |       | 21,057                      |       |
|                                                                                                                                                                                |       |                     |       |                        |       |
| RESTRICTED CASH – over one year                                                                                                                                                |       | 711                      |       | 231                         |       |
|                                                                                                                                                                                |       |                     |       |                        |       |
| PROPERTY AND EQUIPMENT, net of accumulated  depreciation of $3,553 and $3,233                                                                                                       |       | 818                      |       | 959                         |       |
|                                                                                                                                                                                |       |                     |       |                        |       |
| GOODWILL                                                                                                                                                                            |       | 18,767                   |       | 18,579                      |       |
|                                                                                                                                                                                |       |                     |       |                        |       |
| ACQUIRED CUSTOMER LISTS, net of accumulated  amortization of $11,301 and $9,609                                                                                                     |       | 2,945                    |       | 4,637                       |       |
|                                                                                                                                                                                |       |                     |       |                        |       |
| DEFERRED FINANCING COSTS, net of  accumulated amortization of $104 and $476                                                                                                         |       | 348                      |       | 1,002                       |       |
|                                                                                                                                                                                |       |                     |       |                        |       |
| DEPOSITS AND OTHER ASSETS                                                                                                                                                           |       | 292                      |       | 871                         |       |
|                                                                                                                                                                                |       | $                        | 38,571     |                        | $          | 47,336 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                           |       |                     |       |                        |       |
|                                                                                                                                                                                |       |                     |       |                        |       |
| CURRENT LIABILITIES:                                                                                                                                                                |       |                     |       |                        |       |
| Cash overdraft                                                                                                                                                                      |       | $                        | 532        |                        | $          | 1,274 |   |
| Accounts payable                                                                                                                                                                    |       | 4,612                    |       | 8,937                       |       |
| Line of credit                                                                                                                                                                      |       | 6,524                    |       | 4,697                       |       |
| Acquisition indebtedness                                                                                                                                                            |       | —                   |       | 3,676                       |       |
| Accrued expenses                                                                                                                                                                    |       | 3,201                    |       | 2,564                       |       |
| Deferred revenue                                                                                                                                                                    |       | 1,064                    |       | 996                         |       |
| Notes payable-accrued interest                                                                                                                                                      |       | 451                      |       | 184                         |       |
| Notes payable-current portion                                                                                                                                                       |       | 2,350                    |       | 3,621                       |       |
| Current liabilities of discontinued  operations                                                                                                                                     |       | 258                      |       | 329                         |       |
| TOTAL CURRENT LIABILITIES                                                                                                                                                           |       | 18,992                   |       | 26,278                      |       |
|                                                                                                                                                                                |       |                     |       |                        |       |
| DEFERRED REVENUE                                                                                                                                                                    |       | 681                      |       | 588                         |       |
| ACQUISITION INDEBTEDNESS                                                                                                                                                            |       | —                   |       | 644                         |       |
| LONG TERM NOTES PAYABLE                                                                                                                                                             |       | 3,836                    |       | 6,371                       |       |
| TOTAL LIABILITIES                                                                                                                                                                   |       | 23,510                   |       | 33,881                      |       |
|                                                                                                                                                                                |       |                     |       |                        |       |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                       |       |                     |       |                        |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                          |       |                     |       |                        |       |
| Preferred stock, $.0001 par value,  10,000,000 shares authorized; 0 and 583,124 shares issued and outstanding as  of March 31, 2006 and June 30, 2005, respectively       |       | —                   |       | 1                           |       |
| Common stock, $.0001 par value, 450,000,000  shares authorized; 156,950,777 and 75,426,764 shares issued and outstanding  as of March 31, 2006 and June 30, 2005, respectively |       | 5                        |       | 5                           |       |
| Additional paid-in capital                                                                                                                                                          |       | 121,995                  |       | 109,551                     |       |
| Common shares to be issued for Notes  conversion in 2006 (205,706,440 shares) and acquisition in 2005 (4,280,000  shares)                                                           |       | 12,342                   |       | 1,544                       |       |
| Accumulated deficit                                                                                                                                                                 |       | (119,280                 | )          | (97,646                     | )          |
| TOTAL STOCKHOLDERS’ EQUITY                                                                                                                                                     |       | 15,062                   |       | 13,455                      |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                     |       | $                        | 38,571     |                        | $          | 47,336 |   |

 

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

 

3

----

 

**DYNTEK, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)****(Unaudited)(in thousands, except per share data)**

 
| ** **                                                                 | ** ** | **Three Months Ended  March 31,** | ** ** | **Nine Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                         | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| REVENUES:                                                                  | ** ** | ** **                                       | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product Revenues                                                           |       | $                                                | 9,370      |                                            | $          | 11,936 |   | $ | 37,953 |   | $ | 31,081 |   |
| Service Revenues                                                           |       | 4,926                                            |       | 7,113                                           |       | 18,622 |   | 22,753 |   |
| Total revenues                                                             |       | 14,296                                           |       | 19,049                                          |       | 56,575 |   | 53,834 |   |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| COST OF REVENUES:                                                          |       |                                             |       |                                            |       |   |   |   |   |
| Cost of products                                                           |       | 8,648                                            |       | 10,383                                          |       | 33,839 |   | 25,984 |   |
| Cost of services                                                           |       | 4,540                                            |       | 5,450                                           |       | 14,325 |   | 17,801 |   |
| Total cost of revenues                                                     |       | 13,188                                           |       | 15,833                                          |       | 48,164 |   | 43,785 |   |
| GROSS PROFIT                                                               |       | 1,108                                            |       | 3,216                                           |       | 8,411 |   | 10,049 |   |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| OPERATING EXPENSES:                                                        |       |                                             |       |                                            |       |   |   |   |   |
| Selling                                                                    |       | 3,491                                            |       | 3,096                                           |       | 9,667 |   | 7,469 |   |
| General and administrative                                                 |       | 1,816                                            |       | 1,490                                           |       | 4,301 |   | 4,256 |   |
| Non cash expense for warrants                                              |       |                                             |       | 51                                              |       |   |   | 94 |   |
| Depreciation and amortization                                              |       | 632                                              |       | 732                                             |       | 2,012 |   | 2,273 |   |
| Goodwill Impairment                                                        |       | —                                           |       | —                                          |       | — |   | 6,026 |   |
| Total operating expenses                                                   |       | 5,939                                            |       | 5,369                                           |       | 15,980 |   | 20,118 |   |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| LOSS FROM OPERATIONS                                                       |       | (4,831                                           | )          | (2,153                                          | )          | (7,569 | ) | (10,069 | ) |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| OTHER INCOME (EXPENSE):                                                    |       |                                             |       |                                            |       |   |   |   |   |
| Gain (Loss) on extinguishment of debt                                      |       | (8,521                                           | )          | (336                                            | )          | (8,521 | ) | (336 | ) |
| Loss on investment                                                         |       | —                                           |       | (604                                            | )          |   |   | (604 | ) |
| Gain on marketable securities                                              |       | —                                           |       | —                                          |       | 54 |   | — |   |
| Interest expense                                                           |       | (2,070                                           | )          | (529                                            | )          | (5,563 | ) | (1,205 | ) |
| Other income (expense)                                                     |       | (590                                             | )          | —                                          |       | (590 | ) | (50 | ) |
| Interest income                                                            |       | 18                                               |       | 8                                               |       | 42 |   | 20 |   |
| Total other income (expense)                                               |       | (11,163                                          | )          | (1,461                                          | )          | (14,578 | ) | (2,175 | ) |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| LOSS FROM CONTINUING OPERATIONS                                            |       | $                                                | (15,994    | )                                               | $          | (3,614 | ) | $ | (22,147 | ) | $ | (12,244 | ) |
| DISCONTINUED OPERATIONS                                                    |       |                                             |       |                                            |       |   |   |   |   |
| Gain on disposal of discontinued operations                                |       | 297                                              |       | (83                                             | )          | 513 |   | 1,593 |   |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| NET LOSS                                                                   |       | $                                                | (15,647    | )                                               | $          | (3,697 | ) | $ | (21,634 | ) | $ | (10,651 | ) |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| NET LOSS PER SHARE: Basic and Diluted                                      |       |                                             |       |                                            |       |   |   |   |   |
| Continuing Operations                                                      |       | (.10                                             | )          | (.05                                            | )          | (.21 | ) | (.20 | ) |
| Discontinued Operations                                                    |       | —                                           |       | —                                          |       | — |   | .03 |   |
|                                                                       |       | $                                                | (.10       | )                                               | $          | (.05 | ) | $ | (.21 | ) | $ | (.17 | ) |
| WEIGHTED AVERAGE NUMBER OF SHARES USED IN  COMPUTATION - Basic and Diluted |       | 152,462,740                                      |       | 66,811,175                                      |       | 103,683,206 |   | 62,760,620 |   |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| NET LOSS                                                                   |       | $                                                | (15,697    | )                                               | $          | (3,697 | ) | $ | (21,634 | ) | $ | (10,651 | ) |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| COMPREHENSIVE LOSS, NET OF TAX                                             |       |                                             |       |                                            |       |   |   |   |   |
| Change in unrealized gain (loss) on  available-for-sale-securities         |       | —                                           |       | (8                                              | )          | — |   | (29 | ) |
|                                                                       |       |                                             |       |                                            |       |   |   |   |   |
| COMPREHENSIVE LOSS                                                         |       | $                                                | (15,697    | )                                               | $          | (3,689 | ) | $ | (21,634 | ) | $ | (10,680 | ) |

 

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

 

4

----

 

**DYNTEK,INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(in thousands)**

 
| ** **                                                                   | ** ** | **Nine Months Ended   March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                              | ** ** | **2005** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                        |       |                                                  |       |   |   |
| Net  loss-Continuing operations                                              |       | $                                                     | (22,147    | ) | $ | (12,244 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                                                  |       |   |   |
| Depreciation  and amortization                                               |       | 2,012                                                 |       | 2,187 |   |
| Non-cash  interest                                                           |       | 3,970                                                 |       | 381 |   |
| Employee  option expense                                                     |       | 205                                                   |       | — |   |
| Write-down  of capitalized software costs                                    |       | —                                                |       | 82 |   |
| Options and  shares issued for services                                      |       |                                                  |       | 87 |   |
| Gain in  marketable securities                                               |       | (54                                                   | )          | —   |   |
| Impairment  of goodwill                                                      |       | —                                                |       | 6,026 |   |
| Loss (gain) on extinguishment of debt                                        |       | 8,521                                                 |       | 336 |   |
| Loss on preferred investment                                                 |       | 505                                                   |       | 604 |   |
| Note receivable                                                              |       |                                                  |       | 378 |   |
| Changes in  operating assets and liabilities:                                |       |                                                  |       |   |   |
| Accounts  receivable                                                         |       | 6,779                                                 |       | (698 | ) |
| Inventory                                                                    |       | 508                                                   |       | 405 |   |
| Accrued  interest                                                            |       | 165                                                   |       | — |   |
| Prepaid  expenses and other current assets                                   |       | 6                                                     |       | 48 |   |
| Other  receivables                                                           |       | (313                                                  | )          | — |   |
| Deposits and  other assets                                                   |       |  74                                              |       | (305 | ) |
| Accounts  payable                                                            |       | (3,103                                                | )          | (1,459 | ) |
| Deferred  revenue                                                            |       | 161                                                   |       | (26 | ) |
| Accrued  expenses                                                            |       | 811                                                   |       | (958 | ) |
| Restricted  cash                                                             |       |  (1,466                                          | )          | 62 |   |
| Total  adjustments                                                           |       | 18,780                                                |       | 7,150 |   |
| NET CASH USED IN OPERATING ACTIVITIES                                        |       | (3,367                                                | )          | (5,094 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                        |       |                                                  |       |   |   |
| Cash from  disposition of marketable securities                              |       | 54                                                    |       | — |   |
| Cash paid  for acquisitions                                                  |       | (2,530                                                | )          | (6,486 | ) |
| Cash  received from Redrock acquisition                                      |       | —                                                |       | 405 |   |
| Cash  received from ITI acquisition                                          |       | —                                                |       | 106 |   |
| Capital  expenditures                                                        |       | (179                                                  | )          | (622 | ) |
| NET CASH  USED IN INVESTING ACTIVITIES                                       |       | (2,655                                                | )          | (6,597 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                        |       |                                                  |       |   |   |
| Cash  overdraft                                                              |       | (742                                                  | )          | — |   |
| Proceeds  from debt financing                                                |       | 12,200                                                |       | 4,775 |   |
| Deferred  financing costs                                                    |       | (451                                                  | )          | — |   |
| Net proceeds  under line of credit                                           |       | 1,827                                                 |       | (78 | ) |
| Principal  payments                                                          |       | (7,971                                                | )          | — |   |
| Issuance of  Common Stock, net of expenses                                   |       | 392                                                   |       | 6,884 |   |
| NET CASH  PROVIDED BY FINANCING ACTIVITIES                                   |       | 5,255                                                 |       | 11,581 |   |
| CASH FLOWS OF DISCONTINUED OPERATIONS                                        |       |                                                  |       |   |   |
| Operating  cash flows                                                        |       | 442                                                   |       | (1,871 | ) |
| NET CASH PRODIVED BY (USED IN) DISCONTINUED  OPERATIONS                      |       | 442                                                   |       | (1,871 | ) |
| NET INCREASE (DECREASE) IN CASH                                              |       | (325                                                  | )          | (1,982 | ) |
| CASH AT BEGINNING OF PERIOD                                                  |       | 963                                                   |       | 2,810 |   |
| CASH AT END OF PERIOD                                                        |       | $                                                     | 638        |   | $ | 828 |   |

 

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

 

5

----

 

**DYNTEK, INC. AND SUBSIDIARIES**

# **CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 

(UNAUDITED)

(in thousands, except share data)

 
| ** **                                                              | ** ** | **Nine Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                              | ** ** | **2006**                                        | ** ** | **2005** | ** ** |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION:                      | ** ** | ** **                                      | ** ** | ** ** | ** ** |
|                                                                    |       |                                            |       |   |   |
| Cash paid for interest                                                  |       | $                                               | 2,017      |   | $ | 616 |   |
|                                                                    |       |                                            |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON-CASH  FINANCING AND INVESTING ACTIVITIES |       |                                            |       |   |   |
| Debt discount issued in connection with  convertible debt               |       | $                                               | —     |   | $ | 60 |   |
| Issuance of stock in connection with  convertible debt                  |       | —                                          |       | 40 |   |
| Conversion of senior subordinated debt  converted                       |       |                                            |       | 509 |   |
|                                                                    |       |                                            |       |   |   |
| Acquisition of Redrock Communications  Solutions, Inc. in 2004:    |       |                                            |       |   |   |
| Cash paid to shareholders                                               |       | 763                                             |       | 2,750 |   |
| Gross cash acquired                                                     |       | —                                          |       | 405 |   |
| Contingent consideration                                                |       | —                                          |       | 2,000 |   |
|                                                                    |       |                                            |       |   |   |
| Acquisition of Integration  Technologies, Inc. in 2004:            |       |                                            |       |   |   |
| Cash paid to shareholders                                               |       | —                                          |       | 2,500 |   |
| Gross cash acquired                                                     |       | —                                          |       | 105 |   |
| Contingent consideration                                                |       |                                            |       | 2,250 |   |
|                                                                    |       |                                            |       |   |   |
| Acquisition of AMR in 2004:                                             |       |                                            |       |   |   |
| Cash paid to shareholders                                               |       | —                                          |       | 786 |   |
|                                                                    |       |                                            |       |   |   |
| Entellus earn out paid                                                  |       |                                            |       | 200 |   |

 

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

 

6

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**DYNTEK, INC. &SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**March 31, 2006**

**(UNAUDITED)**

 

**1.****             ****BASIS OF PRESENTATION**

 

The accompanyingunaudited condensed consolidated financial statements of DynTek, Inc. andits subsidiaries (“DynTek”, “Company”, or “we”) have been prepared inaccordance with accounting principles generally accepted in the United Statesof America, for interim financial statements and pursuant to the instructionsto Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of theinformation and disclosures required for annual financial statements.  These condensed consolidated financialstatements should be read in conjunction with the consolidated financialstatements and related footnotes for the year ended June 30, 2005 includedin the Form 10-K for the year then ended.

 

The accompanyingcondensed consolidated financial statements reflect all adjustments, which, inthe opinion of management consist of normal recurring items that are necessaryfor a fair presentation in conformity with accounting principles generallyaccepted in the United States of America.  Preparing condensed consolidated financial statements requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenues and expenses. The results of operations for any interim period are not necessarilyindicative of the results attainable for a full fiscal year.

** **

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

 

The Company incurred a net loss of$21,634,000 for the nine months ended March 31, 2006, which includes$15,213,000 of non-cash charges resulting from $2,012,000 of depreciation andamortization; $205,000 in stock-based compensation; $3,970,000 in non-cashinterest charges; a $505,000 valuation adjustment on the investment inTekinsight; and a $9,401,000 loss on the extinguishment of debt obligationsunder the ITI Notes and the 9% Notes; offset by a gain on extinguishment oftrade payable debt of $880,000. At March 31, 2006, the Company had a workingcapital deficiency of approximately $4,302,000; which represents a $4,708,000increase in working capital at December 31, 2005 after giving effect to certaincapital transactions more fully described in Note 6.

 

Inthe first quarter of 2006, the Company instituted certain measures to reducethe amount of cash being used to support its operatingactivities. These measures include, among other things, streamlining operationsby reducing employee headcount, cutting overhead expenses and focusing revenuegenerating activities on products that are intended to generate higher profitmargins. The Company also effectuated certain conversions of debt toequity and raised additional capital during the quarter ended March 31, 2006 toalleviate its immediate cash flow needs.  Although the Companyhas taken certain measures to reduce costs and has effectuated certainchanges in its capital structure, such attempts to improve liquidity have not,to date, enabled the Company to support its operations without seekingadditional capital from outside sources.

 

TheCompany is continuing to pursue a variety of financial and operationalinitiatives intended to improve its liquidity; however, the Company muststill raise additional capital to sustain its operations. The Company cannotprovide any assurance that it will be successful in its efforts toimprove its financial condition. In addition, the Company has not securedany commitments for new financing at this time nor can it provide any assurancethat new capital will be available on acceptable terms, if atall.  These matters raise substantial doubt about the Company’sability to continue as a going concern. The financial statements do not includeany adjustments that may result from the outcome of this uncertainty.

 

The Company believes that the NETF APLAfacility has enabled it to more effectively manage its liquidity because thefacility is structured to provide the flexibility of matching the timing ofcash outflows for product purchases to cash amounts collected fromcustomers.  The financing fee under thefacility is calculated on a monthly basis depending on gross margin on suchproducts, and days sales outstanding. The Company may also use the APA facilityas a general financing arrangement for certain product and servicesreceivables.

 

In October 2005, the Company raised gross proceeds of $2,500,000,upon its issuance of notes to certain investors (the “Bridge Notes”).  The proceeds were used to pay acquisitiondebt and for working capital.  In Marchof 2006, the Company entered into an agreement with the holders of the BridgeNotes to convert subject to certain conditions the $2,609,315 in aggregateprincipal and accrued interest into shares of its common stock at a conversionprice of $0.02 per share. The conversion will be effective and the debtobligation cancelled upon the date immediately following the effective date ofthe Company’s contemplated 1 for 10 reverse stock split, which the Company isrequired to effectuate on or before June 30, 2006; otherwise the Bridge Noteswill continue to be outstanding obligations of the Company.

 

As described in Note 4, the Company paid$3,000,000 to the sellers of Redrock Communication Solutions

 

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(“Redrock”) as partial consideration for the acquisition of suchbusiness in October 2004, and paid $850,000 in contingent consideration inJuly 2005.  In October 2005,the Company paid an additional $650,000 in contingent consideration upon theresolution and settlement of a litigation matter brought against the formerRedrock shareholders/sellers by a former Redrock employee, as described in Note4, together with a settlement amount of $120,000 payable over 24 months, less$26,000 of fees and expenses incurred by the Company in connection with suchlitigation.

 

As described in Note 4, the Company paid$2,500,000 to the sellers of Integration Technologies, Inc. (“ITI”) aspartial consideration for the acquisition of ITI in October 2004. TheCompany accrued an additional $2,845,748 of contingent consideration, of which$270,993 was paid in August 2005. In September 2005, the Company entered into promissory notes (the “ITINotes”) with three former shareholders of ITI, including the Company’s currentchief executive officer, Casper Zublin, Jr., to defer an aggregate of$2,574,735 in payments due in connection with the acquisition of ITI.  Principal payments are due quarterly, withthe balance due July 31, 2006.  InSeptember 2005, the Company paid $643,684 in principal pursuant to the ITINotes.  As described in Notes 4 and 6, inMarch 2006, the Company entered into agreements with the holders of the ITINotes to convert $2,043,272 in the aggregate of principle and accrued interestunder the ITI Notes into shares of the Company’s common stock at a conversionprice of $0.02 per share.  The agreementseffected a complete settlement of the debt outstanding under the ITI Notes andprovide that the shares will be issued immediately following the effective dateof the Company’s contemplated 1 for 10 reverse stock split.

 

On October 26, 2005, the Company amendedits Restated Secured Convertible Term Note (the “Laurus Note”), to deferprincipal payments from December 2005 until March 2006. In exchange,the Company was required to decrease the exercise price of warrants issued inconnection with the Laurus Note from $.65 per share to $.25 per share.  Laurus entered into this transaction toassist the Company in alleviating its immediate liquidity constraints.  This transaction deferred approximately$831,249 in aggregate payments originally due through March 2006 (Note 6).In March 2006, the remaining principal balance of $6,649,999 along with accruedinterest of $102,198 was paid in full.

 

On October 26, 2005, the Company amendedthe 9% Subordinated Convertible Notes (the “9% Notes”) with a majority of theholders thereof, and deferred all payments of principal due under the 9% Notesuntil January 2007.  In exchange forthe deferral, the Company (i) reduced the conversion price under the 9%Notes from $.65 to $.22 per share, (ii) reduced the exercise price ofwarrants held by the holders of the 9% Notes from $.50 to $0.22 per share, and(iii) increased the number of shares exercisable under the 9% Notes by anaggregate of 491,400 shares. This transaction deferred approximately $1,893,629in aggregate principal payments otherwise due and payable throughJanuary 2007. In March 2006, the Company entered into agreements with theholders of the 9% Notes to convert $2,665,112 in aggregate principle andaccrued interest into shares of the Company’s common stock at a conversionprice of $0.02 per share.  Theseagreements effected a complete settlement of the debt outstanding under the 9%Notes and provide that the shares will be issued immediately following theeffective date of the Company’s contemplated 1 for 10 reverse stock split.

 

On March 8, 2006, the Company 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 SecuredNotes in the aggregate principal amount of $6.7 million with warrants forcommon stock (Note6). Proceeds from the sale of the Senior Notes were used topay indebtedness outstanding under the Laurus Notes.

 

Under the Note Purchase Agreement, the Company also issued a JuniorSecured Convertible Note to Trust A-4 - Lloyd I. Miller III (the “Junior Lender”and together with the Senior Lenders, the “Lenders”) in the aggregate principalamount of $3.0 million (the “Junior Note”) (Note6). Proceeds from the issuanceof the Junior Note were used to reduce additional indebtedness of the Companyand for general corporate purposes. The Junior Note issued to the Junior Lenderis convertible into 150,000,000 shares of Common Stock of the Company, assuminginterest thereunder is paid in cash.

 

OnMarch 8, 2006, the Company entered into a Securities Purchase Agreement withcertain accredited investors (the “Securities Purchase Agreement”), pursuant towhich the Company raised approximately $759,140 in gross proceeds through theinitial closing of a private placement of an aggregate of 37,957,000 shares ofcommon stock at a purchase price of $0.02 per share. The accredited investorsalso received warrants to purchase an aggregate of 7,591,400 shares of commonstock (Note 8). Proceeds from the private placement of equity were used, inconjunction with the proceeds from the issuance of the Junior Note, to reduceadditional indebtedness of the Company, and will also be used for generalcorporate purposes.

 

**3.****             ****SUMMARY OF 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

 

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and outlined in SAB 104 which provides forrevenue to be recognized when (i) persuasive evidence of an arrangementexists, (ii) delivery has occurred, (iii) the vendor’s fee is fixedor determinable, and (iv) collect ability is probable.

 

*Computer Hardware Product Revenues*

 

TheCompany requires its hardware product sales to be supported by a writtencontract or other evidence of a sale transaction that clearly indicates theselling price to the customer, shipping terms, payment terms (generally 30days) and refund policy, if any. Since the Company’s hardware sales aresupported by a contract or other document that clearly indicates the terms ofthe transaction, and the selling price is fixed at the time the sale isconsummated, the Company records revenue on these sales at the time in which itreceives a confirmation that the goods were tendered at their destination whenshipped “FOB destination,” or upon confirmation that shipment has occurred whenshipped “FOB shipping point.”

 

*SoftwareProduct Revenues*

 

TheCompany makes substantially all of its software product sales as a reseller oflicenses, which may include a post contract customer support arrangement andaccess to product and upgrades, and enhancements that are provided exclusivelyby the manufacturer following delivery and the customer’s acceptance of thesoftware product. The Company does not presently sell any software that itdevelops internally.  Any responsibilityfor technical support and access to upgrades and enhancements to these softwareproducts are solely the responsibility of the software manufacturer, whicharrangement is known to the customer at the time the sale is consummated.  With respect to delivery, the Companyrequires that the customer has received transfer of the software or, at aminimum, an authorization code (“key”) to permit access to the product.  If a software license is delivered to thecustomer, but the license term has not begun, the Company does not record therevenue prior to inception of the license term.

 

TheCompany requires its software product sales to be supported by a writtencontract or other evidence of a sale transaction, which generally consists of acustomer 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.

 

Forproduct sales, the Company applies the factors discussed in Emerging IssuesTask Force Issue “EITF” 99-19 in determining whether to recognize productrevenues on a gross or net basis.  In asubstantial majority of transactions, the Company (i) acts as principal;(ii) takes title to the products; and (iii) has the risks and rewardsof ownership, including the risk of loss for collection, delivery orreturns.  For these transactions, theCompany 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, 2006,  no revenues wererecognized on a net basis.

 

*ITServices Revenue*

 

TheCompany generally bills its customers for professional IT services based onhours of time spent on any given assignment at its hourly billing rates. As itrelates to delivery of these services, the Company recognizes revenue underthese arrangements as the work is completed and the customer has indicatedacceptance of services by approving a work order milestone or completionorder.   For certain engagements, theCompany enters fixed bid contracts, and recognizes revenue as phases of theproject 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.

 

*BPOServices Revenue*

 

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

 

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

 

D.            Allowance for Doubtful Accounts - The Companyhas a policy of reserving for uncollectible accounts based on its best estimateof the amount of probable credit losses in its existing accounts receivable.The Company periodically

 

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reviews its accounts receivable to determine whether an allowance isnecessary based on an analysis of past due accounts and other factors that mayindicate that the realization of an account may be in doubt. Account balancesdeemed to be uncollectible are charged to the allowance after all means ofcollection have been exhausted and the potential for recovery is consideredremote.

 

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

 

F.    Income(loss) 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 of potential common stock equivalentsoutstanding as of March 31, 2006 and 2005 is as follows:

 

| ** **           | ** ** | **As of March 31,** | ** ** |
|----------------------|------------|------------------------------------|------------|
| ** **           | ** ** | **2006**                           | ** ** | **2005** | ** ** |
| Common stock         |       | 156,950,777                        |       | 74,633,144 |   |
| Options and warrants |       | 130,632,559                        |       | 30,061,274 |   |
| Convertible debt     |       | 150,000,000                        |       | 16,734,172 |   |
| Preferred Stock      |       | —                             |       | 1,457,810 |   |
|                 |       | 437,583,336                        |       | 104,629,833 |   |

 

Thedetermination of loss per share includes an aggregate of 205,706,440 sharesissuable to the former holders of the ITI Notes (see Note 4), 9% Notes (seeNote 6), and certain trade debt settled for shares (see Note 6). The weightedaverage calculation effect for the three months ending March 31, 2006 was52,569,424 shares and the effect for the nine months ending March 31, 2006 was17,267,329 shares. These shares have been included in the determination of lossper share in accordance with the provision of SFAS 128 “Earning Per Share.”Under SFAS 128, shares issuable for little or no cash consideration upon thesatisfaction of certain conditions are deemed to be outstanding for purposes ofcomputing basic EPS as of the date that all necessary conditions have beensatisfied (in essence, when issuance of the shares is no longer contingent).

 

G.   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.

 

H.            Stock BasedCompensation – Prior to July 1, 2005, the Company accounted for employeestock transactions in accordance with Accounting Principle Board, APB OpinionNo. 25, “Accounting for Stock Issued to Employees.” The Company hasadopted the pro forma disclosure requirements of Statement of FinancialAccounting Standards No. 123, “Accounting For Stock-Based Compensation.”

 

Effective July 1, 2005, the Companyadopted FASB Statement of Financial Accounting Standard (“SFAS”) No. 123R “ShareBased Payment”.  This statement is arevision of SFAS Statement No. 123, andsupersedes APB Opinion No. 25, and its related implementationguidance. SFAS 123R addresses all forms of share based payment (“SBP”) awardsincluding shares issued under employee stock purchase plans, stock options,restricted stock and stock appreciation rights. Under SFAS 123R, SBP awardsresult in a cost that will be measured at fair value on the awards’ grant date,based on the estimated number of awards that are expected to vest that willresult in a charge to operations. Consequently, during the nine months ended March 31, 2005, theCompany recognized $205,000 in expenses, which represents the fair value ofstock option awards that the Company elected to accelerate vesting during thatperiod.

 

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For the nine months ended March 31,2005, the Company had applied APB Opinion No. 25, “Accounting for StockIssued to Employees.”  As required underSFAS No. 148, “Accounting for Stock-based Compensation – Transition andDisclosure,” the following table presents pro- forma net income and basic anddiluted earnings per share as if the fair value-based method had been appliedto all awards during that period.

 
| **(in thousands except per share data)**                                  | ** ** | **Three Months  Ended  March 31,  2005** | ** ** | **Nine Months  Ended  March 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| Net Loss                                                                                           |       | $                                                  | (3,697     | )                                                 | $          | (10,651 | ) |
| Stock-based employee compensation cost, net  of tax effect, under fair value accounting            |       | 35                                                 |       | (140                                              | )          |
| Pro-forma net loss under Fair Value Method                                                         |       | $                                                  | (3,732     | )                                                 | $          | (10,791 | ) |
| Loss per share                                                                                     |       |                                               |       |                                              |       |
| Basic                                                                                              |       | $                                                  | (0.05      | )                                                 | $          | (0.17 | ) |
| Diluted                                                                                            |       | (0.05                                              | )          | $                                                 | (0.17      | ) |
| Per share stock-based employee compensation  cost, net of tax effect, under fair value accounting: |       |                                               |       |                                              |       |
| Pro-forma loss share basic                                                                         |       | (0.05                                              | )          | (0.17                                             | )          |
| Pro-forma loss share diluted                                                                       |       | $                                                  | (0.05      | )                                                 | $          | (0.17 | ) |

 

The fair value of all options granted wasestimated at the date of grant using the Black-Scholes option valuationmodel.  The Black-Scholes optionvaluation model was developed for use in estimating the fair value of tradedoptions that have no vesting restrictions and are fully transferable.  Because the Company’s stock options havecharacteristics significantly different from those of traded options, andbecause changes in the subjective input assumptions can materially affect thefair value estimate, in management’s opinion, the existing models do notnecessarily provide a reliable single measure of the fair value estimate of itsstock options. In calculating the fair values of the stock options, thefollowing assumptions were used:

 

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

 

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

 

M.         Goodwill -Goodwill represents the excess of the purchase price over the fair value of netassets 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 30thfor the Company) and between annual tests when circumstances indicate that therecoverability of the carrying amount of goodwill may be in doubt. Applicationof the goodwill impairment test requires judgment, including the identificationof reporting units, assigning assets and liabilities to reporting units,assigning goodwill to reporting units, and determining the fair value.Significant judgments required to estimate the fair value of reporting unitsinclude estimating future cash flows, determining appropriate discount ratesand other assumptions. Changes in these estimates and assumptions couldmaterially affect the determination of fair value and/or goodwill impairmentfor each reporting unit.

 

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

 

O.            Inventory -Inventory consist primarily of finished goods, which are recorded at the lowerof cost or market.

 

P.    Convertible Notes

 

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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” (“SFAS 133”)and EITF 00-19 “Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock” (“EITF 00-19”).  SFAS 133 generally requires Companies tobifurcate conversion options embedded in convertible notes from their hostinstruments and to account for them as free standing derivative financialinstruments in accordance with EITF 00-19. SFAS 133 provides for an exception to this rule when convertible notes,as host 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” inIssue No. 00-19.

 

The Company accounts for convertible notes (deemed conventional) inaccordance 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 98-5 to CertainConvertible Instruments,” Accordingly, the Company records, as a discount toconvertible notes, the intrinsic value of such conversion options based uponthe differences between the fair value of the underlying common stock at thecommitment date of the note transaction and the effective conversion priceembedded in the note. Debt discounts under these arrangements are amortizedover the term of the related debt to their earliest date of redemption.

 

The Company’s convertible notes do not host embedded conversion optionsthat are deemed to be free standing derivatives financial instruments orbeneficial conversion features the commitment date fair value of the underlyingcommon stock.

 

Q.            New AccountingStandards

 

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

 

EITFIssue 04-8, “The Effect of Contingently Convertible Instruments on DilutedEarnings per Share.”  The EITF reached aconsensus that contingently convertible instruments, such as contingentlyconvertible debt, contingently convertible preferred stock, and other suchsecurities should be included in diluted earnings per share (if dilutive)regardless of whether the market price trigger has been met.  The consensus became effective for reportingperiods ending after December 15, 2004. The adoption of this pronouncement does not currently have an effect onthe Company’s financial statements because the inclusion of common stockequivalents in earnings per share is anti-dilutive.

 

InSeptember 2005, the FASB ratified the Emerging Issues Task Force’s (“EITF”)Issue No. 05-7, “Accounting for Modifications to Conversion OptionsEmbedded in Debt Instruments and Related Issues,” which addresses whether amodification to a conversion option that changes its fair value affects therecognition of interest expense for the associated debt instrument after themodification and whether a borrower should recognize a beneficial conversionfeature, not a debt extinguishment if a debt modification increases theintrinsic value of the debt (for example, the modification reduces theconversion price of the debt).  InSeptember 2005, the FASB also ratified the EITF’s Issue No. 05-8, “IncomeTax Consequences of Issuing Convertible Debt with a Beneficial ConversionFeature,” which discusses whether the issuance of convertible debt with abeneficial conversion feature results in a basis difference arising from theintrinsic value of the beneficial conversion feature on the commitment date(which is treated recorded in the shareholder’s equity for book purposes, butas a liability for income tax purposes), and, if so, whether that basisdifference is a temporary difference under FASB Statement No. 109, “Accountingfor Income Taxes.”  The Company iscurrently in the process of evaluating the effect that the adoption of thispronouncement may have on its financial statements.

 

In September 2005, theFASB also ratified the EITF’s Issue No. 05-8, “Income Tax Consequences ofIssuing Convertible Debt with a Beneficial Conversion Feature,” which discusseswhether the issuance of convertible debt with a beneficial conversion featureresults in a basis difference arising from the intrinsic value of thebeneficial conversion feature on the commitment date (which is treated recordedin the shareholder’s equity for book purposes, but as a liability for incometax purposes), and, if so, whether that basis difference is a temporarydifference under FASB Statement No. 109, “Accounting for Income Taxes.” The Company is currently in the process of evaluating the effect that theadoption of this pronouncement may have on its financial statements.

 

Other  accounting standards  that have been  issued or proposed by the FASB or other standards-setting  bodies that do not require adoption until afuture date are not  expected  to have a  material  impact on the  consolidated  financial statements upon adoption.

 

**4.****             ****BUSINESS ACQUISITIONS**

 

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

 

OnSeptember 29, 2004, the Company entered into a Stock Purchase Agreement(the “Redrock Agreement”) by and among the Company and the two holders ofrecord (the “Sellers”) of the outstanding shares of Redrock, to acquire all ofthe

 

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outstanding Common Stock ofRedrock for purchase consideration consisting of $4,500,000 in cash, includingan earn-out cash payment of $1,500,000 due July 31, 2005 (the “Earn-OutPayment”), and $500,000 of the Company’s common stock at a price of $.63 pershare.

 

After the transaction closed, a formeremployee of Redrock claimed that he was owed up to one-third (1/3) of theoutstanding shares of Redrock at the time of the Company’s acquisition ofRedrock (the “Redrock Dispute”).  TheRedrock Agreement provides an indemnification for the benefit of the Company bythe Sellers with respect to Redrock’s capital structure, its securitiesthen-outstanding, and the Sellers’ ownership of Redrock shares.

 

In August 2005, the Company paid$850,000 of the Earn-Out Payment, withholding the remaining portion pendingresolution of the Redrock Dispute.  InOctober 2005, the Sellers and the former employee of Redrock entered intoa settlement agreement, and the Company paid the remaining $650,000 of theEarn-Out Payment to the Sellers, plus $120,000 in a settlement amount to theformer employee of Redrock payable over 24 months, less $26,000 in fees andexpenses incurred by the Company in connection with such litigation, terminatedthe former employee of Redrock, and obtained a release in connection with theRedrock Dispute.

 

**Integration Technologies Inc.**

 

On October 14, 2004, the Company enteredinto an Agreement and Plan of Merger (the “Merger Agreement”), by and among theCompany, ITI Acquisition Corp., a California corporation and wholly ownedSubsidiary of the Company (“Merger Sub”), Integration Technologies, Inc.,a California corporation (“ITI”), the shareholders of ITI (the “ITIShareholders”) and Casper Zublin, Jr., in his capacity as the shareholderrepresentative (the “Representative”).

 

On October 18, 2004, the Merger Sub wasmerged into ITI with ITI becoming a wholly-owned subsidiary of the Company (the“Merger”).  The consideration paid or payable to the ITI Shareholders inconnection with the Merger was comprised of: (i) an initial cash paymentof $2,500,000; (ii) an earn-out cash payment up to a maximum amount of$1,500,000, based upon ITI’s EBITDA for the period between July 1, 2004through June 30, 2005; (iii) a earn-out cash payment up to a maximumamount of $1,500,000, based upon ITI’s revenue for the period betweenJuly 1, 2004 through June 30, 2005; and (iv) an aggregate numberof whole shares of Company common stock based on the average closing sale priceper share (the “Share Price”) of such common stock for the 30 trading daysprior to June 28, 2005 (the “Share Consideration”).  The Share Price was $.36 and the value of4,280,000 shares, the maximum number of shares to be issued under the MergerAgreement, was $1,544,252.  In the eventthe number of shares issuable as Stock Consideration was so limited, theCompany agreed to pay the difference between the share value and $2,140,000 tothe Shareholders in cash.  The resultingcash adjustment was $595,748 (the “Cash Adjustment”).

 

In February 2005, the Company and theITI Shareholders entered into a Satisfaction and Release Agreement based onperformance of the ITI business through January 31, 2005, the performanceof certain former ITI employees who had undertaken additional responsibilitiesat the Company, and the opportunity for the Company to consolidate the ITIoperations with Redrock and other operations of the Company.  Based on these considerations and therevenues and EBITDA from the ITI business through such date, the Company agreedto pay the amount of $2,250,000 to the Shareholders in satisfaction of theearn-out cash payments (the “ITI Earn-Out Payment”).  The ITI Earn-Out Payment and Cash Adjustmentequaled an aggregate of $2,845,748.  InAugust 2005, the Company paid $270,993 of this amount to two ITIShareholders who are currently employees of the Company.

 

In September 2005, the Company entered into promissory notes withthe three remaining ITI Shareholders (the “ITI Notes”), including the Company’scurrent chief executive officer, Casper Zublin, Jr., to pay an aggregateof $2,574,735.  Principal payments weredue quarterly beginning in September 2005, with the balance due onJuly 31, 2006.  The ITI Notes boreinterest at a rate of 8.9%.  The intereston Mr. Zublin’s note was payable in shares of the Company’s CommonStock.  The Company paid $643,684 inprincipal due under the ITI Notes in September 2005, with a remainingaggregate principal balance of $1,931,051.

 

On March 8, 2006, the Company entered intoConversion and Settlement Agreements with the holders of ITI Notes providingfor the surrender of the notes to the Company for their immediate andirrevocable cancellation in exchange for such number of shares of common stockderived by dividing the aggregate principal and interest of $2,665,112 by aconversion price of $.02 per share.  Asdescribed in Note 6, the Company accounted for the extinguishment of these andother notes that were also settled on March 8, 2006 as a troubled debtrestructuring in accordance with SFAS 15.

 

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

 

Restricted cash includes cash received in theamount of $1,379,000 in connection with maintenance agreements that arerestricted and will become available to the Company as revenue is earned andrecognized under the terms of the

 

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respective agreements, which are three years for which approximately$711,000 is classified as a non-current asset. Restricted cash also includes cash deposits from a subsequent closing ofa private placement in the amount of $652,000 made by prospective purchasers ofshares of the Company’s common stock and warrants to purchase common stockunder the terms of a securities purchase agreement. The cash deposits inconnection with the private placement became available to the Company upon theclosing of the private placement on May 15, 2006.

 

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

 

**9% Subordinated Convertible Note**

 

OnOctober 15, 2004, the Company entered into a 9% Senior SubordinatedConvertible Note Purchase Agreement with certain investors in which it issuedan aggregate of $4,438,775 in principal amount of the Company’s SeniorSubordinated Convertible Notes (the “9% Notes”), bearing interest at 9% perannum with a maturity of three years.  Interest payments were duequarterly on the first day of each calendar quarter.  Principal payments were due in monthlyinstallments of $145,844 beginning July 1, 2005 with any remainingprincipal due on October 15, 2007. The 9% Notes were convertible into shares of the Company’s common stockat a conversion price of $.65 per share, subject to certain adjustments.  At December 31, 2005, the net carryingvalue of these notes amounted to $2,993,637 including unamortized discounts ofapproximately $339,595.

 

Amortization of the debt discount inconnection with issuance of the 9% Notes amounted to $434,365 inclusive of a$308,005 adjustment upon conversion of the debt during the nine months endedMarch 31, 2006 and is included as a component of interest expense in theaccompanying condensed consolidated statement of operations.  Contractual interest expense on the 9% Notesfor the nine months ended March 31, 2006 amounted to $238,895 and is alsoincluded as a component of interest expense in the accompanying condensedconsolidated statement of operations.

 

On October 26, 2005, the Company amendedthe 9% Notes with a majority of the holders thereof, and deferred all paymentsof principal due under the 9% Notes until January 2007.  In exchange for the deferral, the Company(i) reduced the conversion price under the 9% Notes from $.65 to $.22 pershare, (ii) reduced the exercise price of warrants held by the holders ofthe 9% Notes from $.50 to $0.22 per share, and (iii) increased the numberof shares exercisable under the 9% Notes by an aggregate of 491,400 shares.This transaction deferred approximately $1,893,629 in aggregate principalpayments otherwise due and payable through January 2007.

 

The Company accounted for the modification ofthe 9% Notes in accordance with SFAS 15 “Accounting by Debtors and Creditorsfor Troubled Debt Restructuring” (“SFAS 15”). Accordingly, the Company recorded a non-cash interest charge of$1,742,853, which represented the incremental number of shares issuable uponconversion of the 9% Notes by having reduced the conversion price from $.65 to$.22, multiplied by $.20, the closing price of the Company’s common stock onOctober 26, 2005.  The Company alsorecorded a non-cash interest charge in the amount of $168,768, which representsthe increase in the fair value of the common stock purchase warrants held bythe holders of the 9% Notes that resulted from reducing their exercise pricefrom $.50 to $.22 as of the date of the modification.

 

On March 8, 2006, the Company entered intoConversion and Settlement Agreements with the holders of the 9% Notes providingfor the surrender of the notes to the Company for their immediate and irrevocablecancellation in exchange for such number of shares of common stock derived bydividing the aggregate principal and interest of $2,665,112 by a conversionprice of $.02 per share.  As describedbelow (Debt Extinguishment Accounting), the Company accounted for theextinguishment of these and certain other notes also settled on March 31, 2005as a troubled debt restructuring in accordance with SFAS 15.

 

**Laurus Funds Note**

 

On November 15, 2004, the Companyentered into an Amended and Restated Secured Convertible Term Note with LaurusMaster Fund, LTD (the “Laurus Note”). The Laurus Note was convertible into the Company’s common stock at theoption of Laurus Funds at a conversion price of $0.65 per share.  TheLaurus Note is subordinated to the Company’s working capital credit facility;however, substantially all other assets of the Company have been pledged assecurity for this obligation.

 

The Laurus Note provides for interest payableat the greater of the prime rate plus 1% per annum or 4% per annum.  Principalpayments were due in twenty-four monthly installments of $277,083 beginningDecember 1, 2005. Any pre-payments of principal that the Company chose tomake under the Laurus Note prior to its maturity was subject to a 2% prepaymentpremium.

 

In connection with this transaction, theCompany also issued to Laurus Funds a five-year amended and restated warrant topurchase 1,046,150 shares of the Company’s common stock, exercisable at $0.65per share (the “Laurus

 

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Warrant”)

 

In accordance with APB 14, the Companyallocated $6,551,000 of the proceeds to the Laurus Notes and $98,982 of theproceeds to the Laurus Warrant (including the effect of note amendments).  Accretion of the aforementioned discount (includingthe effect of note amendments) amounted to $163,733 inclusive of an $118,565adjustment upon cancellation of the debt for the nine months endedMarch 31, 2006, and is included as a component of interest expense in theaccompanying statement of operations. Contractual interest expense on theLaurus Notes amounted to $402,557 for the nine months ended March 31, 2006and is also included as a component of interest expense in the accompanyingstatement of operations

 

On October 26, 2005, the Company amendedthe Laurus Note, and deferred principal payments from December 2005 untilMarch 2006 in return for a decrease in the exercise price of warrantsissued in connection with issuance of the Laurus Note from $.65 per share to$.25 per share.  Laurus entered thistransaction to assist the Company in alleviating its immediate liquidityconstraints.  This transaction deferredapproximately $831,249 in aggregate payments otherwise due and payable throughMarch 2006.

 

The Company accounted for the modification ofthe Laurus Note in accordance with SFAS 15 “Accounting by Debtors and Creditorsfor Troubled Debt Restructurings” (“SFAS 15”). Accordingly, there was no change in the carrying value of the LaurusNote since the amendment affected only the timing of the payments and not theaggregate amount of the liability.  TheCompany also recorded a non-cash interest charge in the amount of $49,851,which represented the increase in the fair value of the common stock purchasewarrants held by Laurus that resulted from reducing their exercise price from$.65 to $.25 as of the date of the modification.

 

In March 2006, proceeds from the Senior Notes(see Note 2 and below) were used to satisfy the principal balance of $6,649,999on the Laurus Note debt obligation and related interest fees of $102,198; aprepayment premium was waived upon payment in full.

 

**Bridge Notes**

 

On October 26, 2005, the Company enteredinto a Note Purchase Agreement, whereby it obtained an aggregate loan of$2,500,000 from two shareholders of the Company pursuant to two SecuredPromissory Notes (the “Bridge Notes”), each in the original principal amount of$1,250,000.  The Bridge Notes bearinterest at 12% per annum until March 1, 2006, with the interest rateincreasing 2% each month until June 1, 2006, and then remaining constantat 20% until maturity, December 31, 2006. The Company is required to redeem the Bridge Notes on the earlier of(i) the closing of a rights offering to record holders of the Company’scommon stock in an aggregate amount of $15,000,000 or more; (ii) thestated maturity date, December 31, 2006; or (iii) an event ofdefault. Payment of principal and interest under the Bridge Notes is secured bya lien on substantially all the assets of the Company, which lien is subordinatedto the perfected security interests held by existing secured lenders.  The carrying value of the Bridge Notes isapproximately equal to its fair value due to its short maturity and the factthat the contractual interest rate is approximately equal to the effective rateof interest that would prevail for instruments with similar credit risk.

 

In connection with the issuance of the BridgeNotes, the Company issued warrants to purchase shares of its common stock (the “Warrants”).  The Warrants are exercisable for an aggregate1,000,000 shares of its common stock at an exercise price equal to $0.10 pershare of the price per.  The Warrantsexpire on October 26, 2015.  Inaccordance with APB14, the company recorded a $150,000 discount on the BridgeNotes based on the relative fair values of the Bridge Notes and the Warrants.

 

Contractual interest expense on the BridgeNotes for the nine months ended March 31, 2006 amounted to $109,315 and isalso included as a component of interest expense in the accompanying condensedconsolidated statement of operations

 

In connection with the new debt financing and private placement ofequity described within the new Senior and Junior Notes, on March 8, 2006, theCompany entered into binding agreements with Mr. Miller and SACC Partners toconvert, at a conversion rate of $0.02 per share, approximately $109,315 ofoutstanding interest and $2,500,000 in outstanding debt principal into anaggregate of 130,465,753 shares of the Company’s Common Stock. The conversionwill be effective and the debt obligation cancelled on the date immediatelyfollowing the effective date of the Company’s contemplated 1 for 10 reversestock split, which must occur on or before June 30, 2006; otherwise the BridgeNotes will continue to be outstanding obligations of the Company.

 

**Line of Credit**

 

In August 2005, the Company terminatedits credit facility agreement with an agency of Textron Financial Corporation (“Textron”).  The Textron facility provided a fullnotification factoring facility for up to $7,000,000 of working

 

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capital.  Eligible accountsreceivable expected to be collected within 90 days were purchased withrecourse, with a holdback amount of 15%. Interest was charged on the outstanding balance at the prime rate plus2.0% (8.25% at June 30, 2005). Additionally, a 0.15% discount fee was charged at the time ofpurchase.  In August 2005, theCompany terminated this agreement, and paid the entire balance then outstandingof approximately $4,800,000.

 

On August 8, 2005, the Company enteredinto a series of related agreements with New England Technology Finance, LLC (“NETF”),an affiliate of Global Technology Finance, which is a provider of structuredfinancing solutions to technology companies that operates in partnership withCredit Suisse First Boston, CIT Group, Inc. and others, that togetherprovided a new working capital credit facility.

 

The new credit facility is comprised of twoprimary components:  (1) an AssetPurchase and Liability Assumption Agreement (the “APLA”), under which NETFagreed to finance certain of the Company’s qualified product purchases under anarrangement that provides for the Company to assign accounts receivable(resulting from product sales to customers) and for NETF to assume theliability for payment to product vendors; and (2) an Asset PurchaseAgreement (the “APA”), under which NETF purchased $7,500,000 of qualifiedaccounts receivables (both services and products).  These agreements are secured by the Company’saccounts receivables that are transferred under the respective agreements.  The agreements also contain certainprovisions that allow NETF to return the liability to the Company if customershave not paid in 150 days. The proceeds received under the APA were used torepay in full the $4,800,000 balance on the credit line with Textron, foracquisition debt, and general corporate purposes.  In addition to the accounts receivablepurchased on August 8, 2005, NETF may purchase up to 80% of additionalqualified accounts receivable in the future on the same terms.  As of March 31, 2006, the balance on the NETFline of credit was $6,524,000; the APA account was approximately $1,478,000 andthe APLA account was approximately $5,046,000.

 

**Senior Notes**

** **

On March 8, 2006, the Company 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 SecuredNotes in the aggregate principal amount of $6.7 million with warrants forcommon stock (the “Senior Notes”). The interest rate for the Senior Notes is 8%per annum if paid in cash, or 11% per annum if paid in kind, which is at theCompany’s election for the first three years. Principal will be amortized overthree years and payable in monthly installments beginning March 31, 2009, withthe balance payable on the maturity date of March 1, 2010, and interest will bepayable quarterly in arrears beginning June 30, 2006, unless the Companychooses its payment in kind option, in which case interest will be added to theprincipal amount of the Senior Notes during the period that the Companycontinues such election. As a condition to the purchase of Senior Notes, theCompany issued warrants pro rata, according to each Senior Lender’s proportionof the aggregate principal amount of the Senior Notes, to purchase 19.9% of itsoutstanding Common Stock at the time of exercise, exercisable at $0.001 pershare of Common Stock, until December 31, 2016.

 

In accordance with APB 14, theCompany allocated $3,780,774 of the proceeds to the Senior Notes and $2,919,226of the proceeds to the warrants.  Thedifference between the carrying amount of the Senior Notes and theircontractual redemption amount is being accreted as interest expense to February2010, their earliest date of redemption. Accretion of the aforementioneddiscount amounted to $42,429 for the nine months ended March 31, 2006 and isincluded as a component of interest expense in the accompanying statement ofoperations.

 

The Company evaluated the warrants issued to the holders of these notesto determine whether, as free standing derivatives,  their classification as equity instruments asof March 31, 2006 would be required under EITF 00-19. The Company determined thatsince (as of March 31, 2006) it had sufficient, authorized but unissued sharesto net share settle these and all of its other derivative and convertibleinstruments, that the net share settlement was within its control. Accordingly,the Company classified these warrants as equity instruments in accordance withEITF 0019.  The fair value of thewarrants was calculated using the black-scholes option pricing model.

 

**Junior Notes**

** **

Under the Note Purchase Agreement, the Company also issued a JuniorSecured Convertible Note to Trust A-4 - Lloyd I. Miller (the “Junior Lender”and together with the Senior Lenders, the “Lenders”) in the aggregate principalamount of $3.0 million (the “Junior Note”). The interest rate for the JuniorNote is 10% per annum if paid in cash, or 14% per annum if paid in kind, whichis at the Company’s election for the first three years. Principal will bepayable at the maturity date of March 1, 2011 and interest will be payablequarterly in arrears beginning June 30, 2006, unless the Company chooses itspayment in kind option, in which case interest will be added to the principalamount of the Junior Note during the period that the Company continues suchelection. The Junior Note may be converted into common stock of the Company atany time at

 

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the election of the holder at a conversion price of $0.02 per share ofcommon stock. Proceeds from the issuance of the Junior Note were used to reduceadditional indebtedness of the Company and for general corporate purposes. TheJunior Note issued to the Junior Lender is convertible into 150,000,000 sharesof Common Stock of the Company, assuming the interest thereunder is paid incash.

 

The Company evaluated the conversion feature embedded in the JuniorNote to determine whether under SFAS 133, such conversion feature should bebifurcated from its host instrument and accounted for as a free standingderivative. In performing this analysis the Company determined that the JuniorNotes meet the definition of a conventional debt instrument; accordingly, thenotes and related conversion option were accounted for in accordance with theprovisions of EITF 98-5 and EITF 00-27. Under this method, the Company recorded a $3,000,000 discount againstthe entire principal amount of the note, based on the intrinsic value of theembedded conversion option of $0.04 per share multiplied by 150,000,000 sharesissuable upon conversion; however, such discount was limited to the carryingvalue of the note. The discount of $3,000,000 is being amortized over the fiveyear term of the note.  Amortization ofthe discount amounted to $12,943 for the nine months ended March 31, 2006 andis included as a component of interest expense in the accompanying statement oroperations.

 

**Debt Extinguishment Related Accounting**

 

As described above (9% SubordinatedConvertible Notes) and in Note 4, the Company entered into Conversion andSettlement Agreements with the 9% Note holders of these obligations, whichprovide for their immediate and irrevocable cancellation in exchange for suchnumber of shares of common stock derived by dividing the aggregate principaland interest on the notes by a conversion price of $.02 per share.  These agreements effectuated a completesettlement of these debts. The Company accounted for these extinguishments inaccordance with SFAS 15 due to the fact that the holders of the notes grantedthe Company a concession intended to alleviate its immediate liquidityconstraints.  The concession that thecreditors granted to the Company enabled it to (a) effectuate their settlementthrough an exchange of equity instead of a use of cash and (b) consummate aprivate placement of equity securities (Note 8) that resulted in an infusion ofcash that was needed to sustain operations.

 

In accordance with the provisions of SFAS 15,the Company recorded, with respect to the 9% Notes, a $5,314,705 loss on theextinguishment of the debt, based on the difference between the (a) fair valueof 132,830,281 shares of common stock issuable to such holders for thesettlement of the notes (of which 35,329,141 were delivered to certain noteholders as of March 2006) and (b) the carrying value of the notes on March 8,2006, the settlement date, which amounted to $2,655,112.

 

With respect to the ITI Notes, the Companyrecorded a $4,086,547 loss on the extinguishment of the debt, based on thedifference between the (a) fair value of 102,163,648 shares of common stockissuable to such holders for the settlement of the notes and (b) the carrying valueof the notes on the settlement date, which amounted to $2,043,272.

 

The Company also entered into Conversion andSettlement Agreements with certain trade payable creditors to convertoutstanding debt balances in the aggregate of $170,833 into 8,541,650 shares ofcommon stock at the conversion price of $0.02 per share. With respect to thesecertain trade payable debts; the Company recorded a $341,666 loss on theextinguishment of the debt, based on the difference between the (a) fair valueof 8,541,650 shares of common stock issuable to such holders for the settlementof the debt and (b) the aggregate debt of $170,833 at the conversion price of$0.02 per share. On March 31, 2006, in accordance with a separation agreementwith the Chief Financial Officer, Robert Webber, 2,500,000 of these shares wereissued in exchange amounts for due of $50,000.

 

In connection with thenew debt financing and private placement of equity described in the Liquidityand Capital Resources,, on March 8, 2006, we entered into binding agreementswith various unsecured creditors of the Company holding approximately$1,947,000 of indebtedness; settlement of these debts in one-time cash paymentsamounted to approximately $725,000 from funds received through the Junior Notedescribed in Note 2 and 6, effectuating a one-time gain of $1,222,000.

 

Under the terms of these agreements, the noteholders irrevocably surrendered their right to demand cash settlement of theseobligations in exchange for shares of the company’s common stock. These sharesthat will be issued at the effective time of a 1 for 10 reversestock-split.  On December 14, 2005, amajority of the Company’s stockholders voted in favor of authorizing the boardto effectuate the reverse stock split at a time of its discretion. Suchauthorization was made as part of the Company’s overall initiative to createsufficient authorized but unissued shares that are needed to effectuate plannedfinancing transactions.  Under the termsof the Conversion and Settlement Agreements of March 8, 2006, the Company iscontractually obligated to effectuate such split by no later than June 30, 2006at which time, the shares issuable under these agreements will be released tothe note holders (in quantities that give effect the split) based on thecarrying values of the respective notes.

 

The Company also evaluated the classificationof the shares issuable under this arrangement to determine their properclassification as March 31, 2006. The Company determined that since, as ofMarch 31, 2006, it (a) controls settlement of the notes in shares, (b)effectuated an irrevocable cancellation of the notes, and (c) receivedauthorization to effectuate a split at the discretion of the board of directorsthat, all events necessary to settle such debt in shares was complete.Accordingly, the Company classified the fair value of the stock under thisarrangement as stock to be issued in the accompanying statement of changes instockholders’ equity and balance sheet as of March 31, 2006.

 

**7.**              **ACQUISITION INDEBTEDNESS**

 

In March 2006,acquisition indebtedness from the three sellers of ITI in the amount of$1,931,051 and accrued interest of approximately $112,221 was converted toequity (see Note 4).

 

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

 

At June 30,2005 there were 75,426,765 shares of the Company’s common stock issued andoutstanding.

 

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A reconciliation of the Company’scommon shares issued and outstanding during the nine month period from June 30,2005 through March 31, 2006 is a s follows:

 

SummaryReconciliation of Shares Issued and Outstanding

asof March 31, 2006

 

| ** **                                                      | ** ** | **Common Stock** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------|------------|
| Balance – June 30, 2005                                    |       | 75,426,765            |       |
|                                                            |       |                  |       |
| Common stock issued on conversion of  preferred shares          |       | 1,457,871             |       |
| Common stock issued on ITI acquisition                          |       | 4,280,000             |       |
| Common stock issued in private placements                       |       | 37,957,000            |       |
| Common stock issued on conversion of 9%  Notes payable (Note 6) |       | 35,329,141            |       |
| Common stock issued on separation agreement                     |       | 2,500,000             |       |
|                                                            |       |                  |       |
| Balance – March 31, 2006                                   |       | 156,950,777           |       |

 

During the period ending September 30, 2005, the Companyissued 4,280,000 shares of common stock to the holders of the ITI Notespursuant to the October 2004 acquisition of ITI (see Note 4) and theCompany automatically converted then outstanding Series A Preferred Stockinto 1,457,871 shares of its common stock, at a rate of 2.5 shares for eachpreferred share, pursuant to the terms of the Series A Preferred StockCertificate of Designations.

 

During the period ending March 31, 2006, theCompany, on March 8, 2006, entered into a Securities Purchase Agreement withcertain accredited investors (the “Securities Purchase Agreement”), pursuant towhich the Company raised approximately $759,140 in gross proceeds through theinitial closing of a private placement of an aggregate of 37,957,000 shares ofcommon stock at a purchase price of $0.02 per share. The accredited investorsalso received warrants to purchase an aggregate of 7,591,400 shares of commonstock, which is equal to 20% of the shares of common stock purchased by suchinvestors, at an exercise price of $0.02 per share (each an “Investor Warrant”and collectively, the “Investor Warrants”). Network 1 Financial Securities,Inc. (“Network 1”) acted as the placement agent for such financing and was paida fee of $75,914 and issued a warrant to purchase 7,591,400 shares of commonstock at an exercise price of $.02 per share. In March 2006, the Companyalso issued 35,329,141 shares of common stock under the Conversion andSettlement Agreements with the holders of the 9% to holders as described inNote 6.  On March 31, 2006 the companyalso issued 2,500,000 shares of common stock as part of separation agreementwith the Company’s Chief Financial Officer, Robert Webber.

 

**CommonStock to be Issued**

 

Additional shares of the Company’s commonstock will be issued immediately following the effective date of the Company’scontemplated 1 for 10 reverse stock split in the aggregate of 256,812,035shares to the former holder of the ITI Notes (see Note 4), 9% Notes (see Note6), and certain trade debt settled for shares, (see Note 6).

 

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

 

WestconSettlement

 

On April 7, 2003Westcon, Inc. filed a breach of contract complaint in the Supreme Court ofNew York State, County of Westchester. The complaint arose from the Company’sfailure to make payments within the terms of the reseller agreement. Thisdispute was settled in March 2006 upon payment of $87,000 to Westcon.

 

Separation Agreement with Former ChiefExecutive Officer 

 

On May 26, 2005, the Company and StevenJ. Ross, its then Chairman and Chief Executive Officer entered into aSeparation Agreement and General Release (“Separation Agreement”).  The Separation Agreement provides for themutual termination of an Employment Agreement, dated July 1, 2004, betweenthe Company and Mr. Ross, pursuant to which Mr. Ross was employed asPresident and Chief Executive Officer of the Company.  The Separation Agreement also provides

 

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for salary continuation for Mr. Ross based on his then currentannual salary of $440,000 through May 31, 2006, a portion of his bonusunder the Employment Agreement not to exceed $110,000, and continuation ofinsurance benefits through May 31, 2006. The Separation Agreement contains a mutual release, as well as certainnon-solicitation and non-competition covenants by Mr. Ross in favor of theCompany. In March 2006, the balance due under the separation agreement wasrestructured to a one time cash settlement of $43,333 with a remaining $73,333being converted into shares of the Company’s common stock at a conversion priceof $0.02 per share.

 

Contract Management Services Agreement 

 

As of March 1,2004, the Company entered into a series of agreements with Young Williams, P.C.Under the services agreement, Young Williams will manage certain contracts ofthe Company pursuant to which it provides child support services.  The Company agreed to pay Young Williams afee of 12% of revenues under the contracts, and the Company will remainresponsible for the operating expenses related to the contracts managed byYoung Williams for the current term and option year extensions of eachcontract.  The management fee paid toYoung Williams was $309,000 for the nine months ended March 31, 2006. Inthe event of contract renewals past the current terms and option years, YoungWilliams will have the right to bid the contracts. If Young Williams is awardeda new contract, it will pay the Company 4% of revenues under each such contractduring the awarded term through February 2010.

 

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

 

During 2003, the Company disposed of itsnon-emergency transportation business. At March 31, 2006, the total remaining liabilities of discontinuedoperations was $258,000.

 

Effective March 1, 2003, the Companyentered into an Asset Purchase Agreement with First Transit, Inc. (the “FirstTransit Agreement”), pursuant to which the Company sold to FirstTransit, Inc. certain specific assets relating to its former non-emergencytransportation brokerage services previously business.  The assets sold consisted of the Company’sinterests in three contracts to provide non-emergency transportation relatedservices and related assets used in connection with performance of such contractsby the Company as well as the assumption of all vendor and servicessub-contract agreements relating to the contracts. The purchase price consistedof $6,450,000 cash payments and up to $1,750,000 to be paid in the event thatFirst Transit, Inc. is able to obtain an extension of the IllinoisDepartment of Public Aid contract for a period of up to three years beyondMay 31, 2004, under certain specified conditions.  As part of the First Transit Agreement, the Companyagreed not to compete with First Transit in the business that was sold.  The Company received payments of $529,000during the nine-month period ended March 31, 2006 from the extension ofthe Illinois Department of Public Aid contract and no further payments areexpected.

 

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

 

The Company’soperations include two segments – Information Technology (“IT”) Services andBusiness Process Outsourcing Services. The Information Technology Services segment provides a range ofspecialized IT infrastructure services, including, system architectural design,legacy systems integration, network engineering, applications infrastructure,network security solutions, remote access implementation, help desk support andoperational support, primarily to mid-market commercial companies and state andlocal government entities. In conjunction with these service offerings, it alsosells hardware and software to its customers. Operations are distributed primarily among five states: California(including the principal executive office), New York, Michigan, Florida, andNevada, with employees situated in locations that are convenient to clientsites.

 

The BusinessProcess Outsourcing segment contracts outsourced program operations for stategovernment agencies in several areas including the privatization of childsupport enforcement services. The Company’s business process outsourcingcustomers have included various governmental departments in the states of NorthCarolina, Kansas and Nebraska.  Typicallythese contracts are for multi-year periods of performance, with options torenew for additional periods. Such contracts are generally awarded throughcompetitive procurements. Payment is based on either fixed-price,fixed-unit-price based on contractual allocations, revenue sharing, or acombination of the above.

 

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The Company’s reportablesegments are business units that offer differentservices and contract types and are managed separately due to the expertise anddifferent managed key factors in each area. Since the Business ProcessOutsourcing business segment was acquired as a unit, management has retainedseparate reporting and review criteria for that unit. The following tableprovides actual selected financial data for our business segments (inthousands):

 

| ** **                             | ** ** | **Reportable Business Segments**    | ** ** |
|----------------------------------------|------------|-------------------------------------|------------|
| ** **                             | ** ** | **Business****Process Outsourcing** | ** ** | **Information Technology Services** | ** ** | **Total** | ** ** |
| Three months ended March 31, 2006 |       |                                |       |   |   |   |   |
| Sales                                  |       | $                                   | 814        |   | $ | 13,482 |   | $ | 14,296 |   |
| Depreciation and amortization  expense |       | —                              |       | 632 |   | 632 |   |
| Goodwill impairment                    |       | —                              |       | — |   | — |   |
| 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 |   |
|                                   |       |                                |       |   |   |   |   |
| Three months ended March 31, 2005 |       |                                |       |   |   |   |   |
| Sales                                  |       | $                                   | 2,456      |   | $ | 16,593 |   | $ | 19,049 |   |
| Depreciation and amortization  expense |       | 117                                 |       | 615 |   | 732 |   |
| Goodwill impairment                    |       | —                              |       | — |   | — |   |
| Income (loss) from operations          |       | 47                                  |       | (2,200 | ) | (2,153 | ) |
| Interest expense                       |       | —                              |       | 529 |   | 529 |   |
| Total assets                           |       | 8,336                               |       | 42,482 |   | 50,818 |   |
| Capital expenditures                   |       | —                              |       | 78 |   | 78 |   |
|                                   |       |                                |       |   |   |   |   |
| 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 |   |
| Goodwill impairment                    |       | —                              |       | — |   | — |   |
| 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 |   |
|                                   |       |                                |       |   |   |   |   |
| Nine months ended March 31, 2005  |       |                                |       |   |   |   |   |
| Sales to external customers            |       | $                                   | 5,333      |   | $ | 48,501 |   | $ | 53,834 |   |
| Depreciation and amortization expense  |       | 351                                 |       | 1,922 |   | 2,273 |   |
| Goodwill impairment                    |       | 5,741                               |       | 285 |   | 6,026 |   |
| Income (loss) from operations          |       | (5,637                              | )          | (4,054 | ) | (10,069 | ) |
| Interest expense                       |       | —                              |       | 1,205 |   | 1,205 |   |
| Total assets                           |       | 8,336                               |       | 42,482 |   | 50,818 |   |
| Capital expenditures                   |       | 27                                  |       | 595 |   | 622 |   |
|                                        |            |                                     |            |  |  |  |  |  |  |  |  |  |

 

**12.****  SUBSEQUENTEVENTS**

 

On May 15, 2006, the Company effecteda second and final closing of a private placement and raised $1,145,904 ingross proceeds from the sale of 57,295,200 shares of common stock at $0.02 pershare and issued warrants to purchase 11,459,040 shares of common stock at anexercise price of $0.02 per share. At the second closing Network 1 was paid afee of $114,590 and issued a warrant to purchase 11,459,040 shares of commonstock at an exercise price of $0.02 per share. As a result of the secondclosing, the $652,000 in restricted funds as of March 31, 2006 became availableto the Company.

 

**ITEM2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OFOPERATIONS**

 

The following discussion andanalysis of our results of operations and financial position should be read inconjunction with our audited consolidated financial statements and relatednotes included in our Annual Report on Form 10-K for the year endedJune 30, 2005 and the unaudited consolidated financial statements andrelated notes included in this Quarterly Report on Form 10-Q. Dependingupon the context, the terms the “Company”, “we,” “our,” and “us,” refers toeither the Company alone, or the Company and its subsidiaries.

 

**Forward-LookingStatements**

 

This report contains “forward-lookingstatements” within the meaning of such term in Section 27A of theSecurities

 

20

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Act of 1933, Section 21E of theSecurities Exchange Act of 1934, and the Private Securities Litigation ReformAct of 1995. We wish to caution readers not to place undue reliance on any suchforward-looking statements, each of which speaks only as of the date made.Forward-looking statements involve known and unknown risks, uncertainties andother factors which could cause actual financial or operating results,performance or achievements expressed or implied by such forward-lookingstatements not to occur or be realized. Such statements are subject to certainrisks and uncertainties that could cause actual results to differ materiallyfrom historical results and those presently anticipated or projected. Seebelow, and a discussion of such risks and factors discussed in Item 1(Business) of Part I and Item 7 (Management’s Discussion and Analysis ofFinancial Condition and Results of Operations) of Part II of our AnnualReport on Form 10-K for the fiscal year ended June 30, 2005 as filedwith the Securities and Exchange Commission, and Part II, Item 1A of thisForm 10-Q. Forward-looking statements made in this Form 10-Qgenerally are based on our best estimates of future results, performances orachievements, predicated upon current conditions and the most recent results ofthe companies involved and their respective industries. Forward-lookingstatements may be identified by the use of forward-looking 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 thenegative of those terms or other variations of those terms or comparable wordsor expressions. Readers should carefully review those risks, as well asadditional risks described in this report and other documents we file from timeto time with the Securities and Exchange Commission. Potential risks anduncertainties 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, outstandingindebtedness, when due, or to replace such indebtedness with alternativefinancing;

 

•        Our abilityto raise equity capital or debt in the future, despite historical losses fromoperations and in the absence of such fund raising , our ability to continue asa going concern;

 

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

 

•        Political andregulatory matters that affect the industries in which we operate;

 

•        Our continuedability to trade on the NASD bulletin board; and

 

•        Other risksdetailed in our filings with the Securities and Exchange Commission.

 

The Company has no obligationto publicly release the results of any revisions to any forward-lookingstatements to reflect anticipated or unanticipated events or circumstancesoccurring after the date of such statements.

 

**BusinessOverview**

 

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

 

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

 

We believe that ourservices-led approach, combined with expertise in multi-disciplinary practiceareas such as IT security, converged networking (VOIP), applicationinfrastructure, and access infrastructure, will continue to provide the

 

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platform we need to capture an increasingshare of our target markets. Our strategy allows our clients to rely on us astheir primary IT vendor. Additionally, we believe that our multi-disciplinarycapabilities help differentiate us from our competitors in the markets in whichwe compete.

 

We recognize revenue from salesof products and services. Services are primarily provided to the client athourly rates that are established for each of our employees or third-partycontractors based upon their skill level, experience and the type of workperformed. We also provide project management and consulting work which arebilled either by an agreed upon fixed fee or hourly rates, or a combination ofboth. The majority of our services are provided under purchase orders withcommercial customers or bid contracts with government entities. (See “RevenueRecognition,” 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 ofproducts consist of our cost of products purchased and sold to our customers.Selling, general and administrative expenses consist primarily of salaries andbenefits of personnel responsible for administrative, finance, sales andmarketing activities and all other corporate overhead expenses. Corporateoverhead expenses include rent, telephone and internet charges, insurancepremiums, accounting and legal fees, and other general administrative expenses.Selling, general and administrative costs also include a calculation of thefair 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 periods indicated, the relative percentages that certain income andexpense items bear to net sales.

 
| ** **                                    | ** ** | **Nine Months Ended  March 31,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                        | ** ** | **2005** | ** ** |
| Product Revenue                               |       | 67                                              | %          | 58 | % |
| Service Revenue-Information Technology        |       | 28                                              | %          | 32 | % |
| Service Revenue-Business Process  Outsourcing |       | 5                                               | %          | 10 | % |
|                                          |       |                                            |       |   |   |
| Cost of Products                              |       | 89                                              | %          | 84 | % |
| Cost of Service-Information Technology        |       | 76                                              | %          | 77 | % |
| Cost of Service-Business Process  Outsourcing |       | 80                                              | %          | 84 | % |
|                                          |       |                                            |       |   |   |
| Gross profit                                  |       | 15                                              | %          | 19 | % |
|                                          |       |                                            |       |   |   |
| SG & A                               |       | 25                                              | %          | 22 | % |
| Interest expense                              |       | 10                                              | %          | 2 | % |
| Loss from continuing operations               |       | (39                                             | )%         | (23 | )% |
| Gain from discontinued operations             |       | 1                                               | %          | 3 | % |
| Net Income (loss)                             |       | (38                                             | )%         | (20 | )% |

 

***Nine months ended March 31,2006 and March  31, 2005***

*** ***

**Revenues.**Forthe nine months ended March 31, 2006, our revenues increased toapproximately $56,575,000 from approximately $53,834,000 for the nine monthsended March 31, 2005. This $2,741,000 increase, or 5%, is principallyattributable to an increase of $4,326,000 from new business in our Midwestregion, primarily composed of new accounts in both the education and commercialmarkets, and additional growth of $985,000 in our IT Services segment revenuesfrom our other regions; less a decrease of $2,570,000 in sales from our BPObusiness, which is being de-emphasized.

 

Our product sales increased from$31,081,000 during the nine months ended March 31, 2005 to $37,953,000 duringthe nine months ended March 31, 2006. The increase of $6,872,000, or 22%, resultedprimarily from an increase in our Midwest region by $4,128,000, primarily composedof new accounts in both the education and commercial markets. Our Southwestregion increased by $2,744,000 from sales of network communications equipmentand software, including voice-over-internet protocol (“VOIP”) products. Thebalance of the growth came from sales of other networking and computerequipment and software products in our other regions.

 

Our services revenues decreasedfrom $22,753,000 during the nine months ended March 31, 2005 to$18,622,000 during the same period in fiscal year 2006, a decrease of $4,131,000.This decrease resulted from a $2,570,000 decrease in service revenues from ourBusiness Process Outsourcing (“BPO”) segment, coupled by a $1,561,000 decreasein IT service revenues. Our BPO services revenues decreased from approximately$5,333,000 during the nine months ended March 31, 2005 to $2,763,000during the nine months ended March 31, 2006 as we are no longer pursuingopportunities in that segment

 

22

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due to its relatively lower margin rates.Service revenues from our Information Technology Services segment decreasedfrom $17,420,000 in the nine months ended March 31, 2005, to $15,869,000in the nine months ended March 31, 2006, or a decrease of 9%.  We believe that the decrease in service revenueswas largely reflective of the Company’s liquidity/funding concerns early in theMarch 2006 quarter and lower utilization of service personnel..

 

The following table sets forthfor the periods presented information derived from our consolidated statementsof operations (in thousands):

 

| **REVENUES**  | ** ** | **For the Nine Months ended March 31** | ** ** |
|---------------|------------|----------------------------------------------------------------------|------------|
| **2006**      | ** ** | **2005**                                                             | ** ** | **Percentage  change** | ** ** | **Amount** |
| ***Product*** |       | $                                                                    | 37,953     |   | 31,081 |   | 22 | % | 6,872 |   |
|          |       |                                                                 |       |   |   |   |   |   |   |
| ***Service*** |       | 18,622                                                               |       | 22,753 |   | (18 | )% | (4,131 | ) |
|          |       |                                                                 |       |   |   |   |   |   |   |
| ***Total***   |       | 56,575                                                               |       | 53,834 |   | 5 | % | 2,741 |   |
|               |            |                                                                      |            |  |  |  |  |  |  |  |

 

Ourcustomers are primarily state and local government entities and mid-sizedcorporations in diversified industries. For the nine months ended March 31,2006, 56% of our revenues were derived from commercial clients, compared to 35%from government agencies and 9% from educational institutions.

 

**Grossprofit.**Gross profit decreased from $10,049,000 in thenine months ended March 31, 2005 to $8,411,000 in the nine months ended March31, 2006, a decrease of 16%. Total gross margin for the nine months ended March31, 2006 was 15%, compared to 19% for the similar period in the prior fiscalyear. While our services margin increased from 22% to 23%, our product margindecreased from 16% to 11%. Services margin increased primarily due to anincrease in the overall level of utilization year to date with respect toconsultants throughout the company, a greater mix of higher-end services, and alower percentage of BPO services. The decrease in overall product gross marginis primarily the result of the competitive marketplace in commercial accountsas well as having consummated several large, lower-margin product sales undercontracts with certain state and local government clients, and fewer vendorrebates that were received during the nine months ended March 31, 2006.Although we have improved our service margins, and will seek opportunities tomake further improvements, our product margins in particular are subject tocompetitive pricing pressures and fluctuate from period to period depending onthe mix of products we provide. We believe that current product margins aremore reflective of the present marketplace and likely to continue at or near presentlevels into the foreseeable future.  Weintend to meet the challenges of aggressive price reductions and discountpricing by certain product suppliers by focusing our offerings aroundrelatively higher margin practice areas, including security solutions, VOIP,and access infrastructure. There can be no assurance, however, that we will beable to improve profit margins, especially for our sale of products, andcompete profitably in all areas, given the intense competition that exists inthe IT industry.

 

**Selling,general and administrative expenses.**General andadministrative expenses increased to approximately $4,301,000 for the ninemonths ended March 31, 2006, from approximately $4,256,000 for the ninemonths ended March 31, 2005. As a percent of revenues, general andadministrative expenses remained at 8% for both the nine months ending March2005 and March 2006.. The company incurred significant one-time restructuringand reorganization charges as part of the announced cost reductions during thefirst quarter of 2005 and the third quarter of 2006, coupled by increases in professionalservices expense to implement these improvements for the purpose of lowering ouroverall future cost structure.

 

Selling costs increased toapproximately $9,667,000 for the nine months ended March 31, 2006 from $7,469,000in the nine months ended March 31, 2005. As a percent of revenues, sellingexpenses increased from 14% to 17% in the nine months ended March 31, 2006 onlower than expected sales for the 2006 third quarter. Approximately $287,000 ofthe increase arose from one time restructuring and re-organization costs duringthe March 2006 quarter. The balance of the increase was primarily due to theaddition of sales and business development personnel from the integration ofthe Redrock and ITI businesses, a $205,000 expense for employee stock optionsvested by sales personnel during the period, and increased sales commissionsand other expenses commensurate with approximately $2,741,000 in higherrevenues during the 2006 period.

 

**Depreciationand amortization expense.**Depreciation andamortization expense decreased to approximately $2,012,000 for the nine-monthperiod ended March 31, 2006, from approximately $2,273,000 during the sameperiod in the prior year. The decrease is primarily due to lower amortizationof customer lists from acquisitions completed in late 2004.

 

**Interestexpense.**Interest expense for the nine months ended March 31,2006 increased to $5,563,000, as compared to $1,205,000 for the nine monthsended March 31, 2005. This increase is primarily due to $1,742,853 in non-cashinterest charges resulting from the reduction in the conversion price of our 9%Notes, $168,768 in non-cash interest charges resulting

 

23

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from the reduction in warrant exercise pricesunder warrants issued to holders of our 9% Notes and $49,851 in non-cashinterest charges resulting from the reduction in warrant exercise price of thewarrant issued to Laurus; year to date non-cash interest amortization on thedebt discounts of $161,734 on the Laurus Note, and $426,365 on the 9% Notes;and the retirement of the balances on deferred financing costs of $508,940 onthe 9% Notes and $526,421 on the Laurus Note. Additional deferred financing costs in the aggregate of approximately$124,000 on the Bridge Notes, the Senior Notes, and the Junior Note. Alsoincluded was $112,211 of non-cash interest converted to equity due on the ITINotes, $39,211 of non-cash interest converted to equity due on the 9% Notes,and $109,315, of non-cash interest converted to equity due on the Bridge Notes.The increase also includes contractual interest due on notes that we enteredinto in January and October 2004, the Bridge Notes entered into inNovember 2005, and an increase in the average borrowings under our creditfacility.

 

**Other Income (expense).**We recorded a net non-cashloss 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 between the fair valueof the equity instruments to be received under the Conversion and SettlementAgreements as of March 8, 2006 and the conversion price per share for the ITINotes (see Note 4), the 9% Notes (see Note 6) 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 must occur on or beforeJune 30, 2006.

 

We recorded a net gainof 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

 

The Company maintains aminority interest in Tekinsight, a full-service network infrastructure and webapplication services company.  Managementassessed the value for the investment in Tekinsight and took a one-time expenseof $505,043 in March 2006. The Company continues to maintain a minority interestin Tekinsight.

 

The following table sets forthoperating expenses for the periods presented from information derived from ourconsolidated statements of operations (in thousands):

 

| ** **                                 | ** ** | **For the Nine Months ended  March 31,** | ** ** |
|--------------------------------------------|------------|-------------------------------------------------------------------|------------|
| **OPERATING  EXPENSES**                    | ** ** | **Dollars**                                                       | ** ** | **Percentage of  Revenues** | ** ** |
| **2006**                                   | ** ** | **2005**                                                          | ** ** | **2006** | ** ** | **2005** |
| ***Selling***                              |       | 9,667                                                             |       | 7,469 |   | 17 | % | 14 | % |
|                                       |       |                                                              |       |   |   |   |   |   |   |
| ***General & Administrative***    |       | 4,301                                                             |       | 4,350 |   | 8 | % | 8 | % |
|                                       |       |                                                              |       |   |   |   |   |   |   |
| ***Depreciation & Amortization*** |       | 2,012                                                             |       | 2,273 |   | 4 | % | 4 | % |
|                                       |       |                                                              |       |   |   |   |   |   |   |
| ***Goodwill Impairment***                  |       | —                                                            |       | 6,026 |   | — |   | 11 | % |
|                                       |       |                                                              |       |   |   |   |   |   |   |
| ***Total***                                |       | 15,980                                                            |       | 20,118 |   | 28 | % | 37 | % |

 

**Net loss.**Ournet loss for the nine months ended March 31, 2006 was $21,634,000 comparedto a net loss of $10,651,000 for the nine months ended March 31, 2005. The netloss during the nine months ended March 31, 2006 includes depreciation andamortization 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), avaluation adjustment on the investment in Tekinsight of $505,000, and a $9,401,000loss on the extinguishment of debt obligations under the ITI Notes and the 9%Notes;  offset by a gain onextinguishment of trade payable debt of $880,000. The net loss in the 2005period included a gain from discontinued operations of $1,593,000 and agoodwill impairment expense of $6,026,000.

 

***Discontinued Operations.***Incomefrom discontinued operations was $513,000 for the nine months ended March 31,2006 compared to income of $1,593,000 for the nine months ended March 31,2005. The 2005 period included a one-time gain from the resolution of certainliabilities associated with a discontinued transportation services business inthe State of Virginia. The 2005 period includes a payment from First Transitrelating to a contract extension related to assets sold in connection with ourformer non-emergency transportation brokerage services in Illinois.

 

24

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**Results of Operations**

** **

The following table sets forth,for the periods indicated, the relative percentages that certain income andexpense items bear to net sales.

 
| ** **                                    | ** ** | **Three Months  Ended March 31,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Product Revenue                               |       | 66                                               | %          | 63 | % |
| Service Revenue-Information Technology        |       | 29                                               | %          | 28 | % |
| Service Revenue-Business Process  Outsourcing |       | 5                                                | %          | 9 | % |
|                                          |       |                                             |       |   |   |
| Cost of Products                              |       | 92                                               | %          | 87 | % |
| Cost of Service-Information Technology        |       | 94                                               | %          | 75 | % |
| Cost of Service-Business Process  Outsourcing |       | 84                                               | %          | 81 | % |
|                                          |       |                                             |       |   |   |
| Gross profit                                  |       | 8                                                | %          | 17 | % |
|                                          |       |                                             |       |   |   |
| SG & A                               |       | 37                                               | %          | 24 | % |
| Interest expense                              |       | 14                                               | %          | 3 | % |
| Loss from continuing operations               |       | (112                                             | )%         | (19 | )% |
| Gain (loss) from discontinued operations      |       | 2                                                | %          | — |   |
| Net income (loss)                             |       | (110                                             | )%         | (19 | )% |

*** ***

***Three months ended March 31,2006 and March 31, 2005***

*** ***

**Revenues.**Forthe three months ended March 31, 2006, our revenues decreased toapproximately $14,296,000 from approximately $19,049,000 for the three monthsended March 31, 2005. This $4,753,000, or 25%, decrease is principallyattributable to a net decrease in product sales of $2,566,000 across allregions and a decrease of $545,000 in our IT Services segment revenues from ourall regions including the new businesses acquired as of August andOctober 2004, which now comprise our Southwest Region.  The BPO business, which is beingde-emphasized, decreased by $1,642,000 in sales for the three months ended March31, 2006. We believe the primarily cause for the decline in both product andservice revenue during the three months ended March 31, 2006 was largelyreflective of the Company’s liquidity/funding concerns and prolonged recapitalizationactivities during the period as well as lower utilization of service personnel.

 

Our product sales decreasedfrom $11,936,000 during the three months ended March 31, 2005 to $9,370,000during the three months ended March 31, 2006. The $2,566,000, or 21%, declineresulted primarily from the decrease in product sales of network communicationsequipment and software, including voice-over-internet protocol (“VOIP”)products, and the sales of other networking and computer equipment and softwareproducts in all of our business regions.

 

Our services revenues decreasedfrom $7,113,000 during the three months ended March 31, 2005 to $4,926,000during the same period in 2006. This decline of $2,187,000, or 31%, resultedprimarily from a drop of approximately $1,642,000 from our Business ProcessOutsourcing (“BPO”) segment which decreased from $2,456,000 during the threemonths ended March 31, 2005 to $814,000 during the same period in 2006, aswe de-emphasized that segment and did not pursue additional BPO servicesbusiness.  The IT services segmentrevenues also declined by approximately $545,000 in our combined operating regions.

 

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The following table sets forthfor the periods presented information derived from our consolidated statementsof operations (in thousands):

 

| **REVENUES**  | ** ** | **For the Three Months ended March 31** | ** ** |
|---------------|------------|-----------------------------------------------------------------------|------------|
| **2006**      | ** ** | **2005**                                                              | ** ** | **Percentage  change** | ** ** | **Amount** |
| ***Product*** |       | $                                                                     | 9,370      |   | 11,936 |   | (21 | )% | (2,566 | ) |
|          |       |                                                                  |       |   |   |   |   |   |   |
| ***Service*** |       | 4,926                                                                 |       | 7,113 |   | (31 | )% | (2,187 | ) |
|          |       |                                                                  |       |   |   |   |   |   |   |
| ***Total***   |       | 14,296                                                                |       | 19,049 |   | (25 | )% | (4,753 | ) |
|               |            |                                                                       |            |  |  |  |  |  |  |  |

 

Ourcustomers are primarily state and local government entities and mid-sizedcorporations in diversified industries. 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.

 

**Grossprofit.**Total gross profit decreased from $3,216,000in the quarter ended March 31, 2005 to $1,108,000 in the quarter ended March 31,2006, a decline of 66%, as result of a 25% decline in revenue. Total grossmargin as a percentage of sales decreased from 17% for the three months ended March31, 2005 to 8% for the three months ended March 31, 2006. Service margins droppedfrom 23% to 8%, largely reflective of the liquidity/funding concerns early inthe period and low utilization of service personnel. Our product margin fellfrom 13% to 8%. A one time inventory valuation loss of $223,000 was realized amountingto 2% of product sales. The overall product gross margin decline is primarilythe result of increased competitive pricing pressure and having consummatedseveral large, lower-margin product sales during the quarter, together withfewer vendor rebates that were received during the March quarter in 2006,compared to the March quarter in 2005. Our focus continues to be to improveour service margins, and we will seek opportunities to make further improvement.Our product margins in particular are subject to competitive pricing pressuresand fluctuate from quarter to quarter depending on the mix of products weprovide. We believe that current product margins are more reflective of thepresent marketplace and likely to continue at or near present levels into theforeseeable future.  We intend to meetthe challenges of aggressive price reductions and discount pricing by certainproduct suppliers by focusing our offerings around relatively higher marginpractice areas, including security solutions, VOIP, and access infrastructure.There can be no assurance, however, that we will be able to improve profitmargins, especially for our sale of products, and compete profitably in allareas, given the intense competition that exists in the IT industry.

 

**Selling,general and administrative expenses.**General andadministrative expenses increased by 15%, to approximately $1,816,000 for thethree months ended March 31, 2006, from approximately $1,490,000 for thethree months ended March 31, 2005. As a percent of revenues, general andadministrative expenses increased from 8% to 13%. This increase is mainly theresult of one-time restructuring and reorganization costs of $450,000, anincrease in legal expenses of $100,000, and additional audit fees incurred of$137,000.

 

Selling expenses increased toapproximately $3,491,000 for the three months ended March 31, 2006 from $3,096,000in the three months ended March 31, 2005. The increase was primarily due to one-timerestructuring and re-organization costs of $306,000 and an increase in doubtfulaccounts provision of $100,000 during the 2006 period. As a percent ofrevenues, selling expenses increased from 16% to 24% due to a 25% decrease inrevenue.

 

**Depreciationand amortization expense.**Depreciation andamortization expense decreased to approximately $632,000 for the three-monthperiod ended March 31, 2006, from approximately $732,000 during the sameperiod in the prior year. The decrease is primarily due to lower amortizationof customer lists from acquisitions completed in late 2005.

 

**Interestexpense.**Interest expense for the three months ended March 31,2006 increased to $2,070,000, as compared to $529,000 for the three monthsended March 31, 2005. This increase is primarily due to  non-cash interest amortization on the debtdiscounts of $129,857 on the Laurus Note, and $339,595 on the 9% Notes; and theretirement of the balances on deferred financing costs of $371,719 on the 9%Notes, and $378,300 on the Laurus Note. Additional deferred financing costs inthe aggregate of approximately $119,000 on the Bridge Notes, the Senior Notes,and the Junior Note Also included was $112,211 of non-cash interest converted toequity due on the ITI Notes, $39,211 of non-cash interest converted to equitydue on the 9% Notes, and $109,315, of non-cash interest on the Bridge Notes.The increase also includes contractual interest due on notes that we enteredinto in January and October 2004, the Bridge Notes entered into inNovember 2005, and an increase in the average borrowings under our creditfacility.

 

**Other Income (expense). ).**We recorded a net non-cashloss 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 between the fair valueof the equity instruments to be received under the Conversion

 

26

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and Settlement Agreements as ofMarch 8, 2006 and the conversion price per share for the ITI Notes (see Note4), the 9% Notes (see Note 6) wherein the note holders irrevocably cancelledtheir notes for the contractual right to receive shares of our common stockupon the date immediately following the effective date of our contemplated 1for 10 reverse stock split, which must occur on or before June 30, 2006.

 

We recorded a net gainof 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

 

The Company maintains aminority interest in Tekinsight, a full-service network infrastructure and webapplication services company.  Managementassessed the value for the investment in Tekinsight and took a one-time expenseof $505,043 in March 2006. The Company continues to maintain a minorityinterest in Tekinsight.

 

The following table sets forthoperating expenses for the periods presented from information derived from ourconsolidated statements of operations (in thousands):

 

| ** **                                 | ** ** | **For the Three Months ended  March 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------|------------|
| **OPERATING  EXPENSES**                    | ** ** | **Dollars**                                                        | ** ** | **Percentage of  Revenues** | ** ** |
| ** **                                 | **2006**   | ** **                                                         | **2005**   | ** ** | **2006** | ** ** | **2005** | ** ** |
| ***Selling***                              |       | 3,491                                                              |       | 3,096 |   | 24 | % | 16 | % |
|                                       |       |                                                               |       |   |   |   |   |   |   |
| ***General & Administrative***    |       | 1,816                                                              |       | 1,541 |   | 13 | % | 8 | % |
|                                       |       |                                                               |       |   |   |   |   |   |   |
| ***Depreciation & Amortization*** |       | 632                                                                |       | 732 |   | 4 | % | 4 | % |
|                                       |       |                                                               |       |   |   |   |   |   |   |
| ***Total***                                |       | 5,939                                                              |       | 5,369 |   | 42 | % | 28 | % |

 

**Net loss.**Ournet loss for the three months ended March 31, 2006 was $15,697,000compared to a net loss of $3,697,000 for the three months ended March 31,2005. The loss during the three months ended March 31, 2006 includesinterest expense of $2,070,000 (including a non-cash portion of $1,599,000), depreciationand amortization expense of $632,000; and a $505,000 valuation adjustment onthe investment in Tekinsight, and a $9,401,000 loss on the extinguishment ofdebt obligations under the ITI Notes and the 9% Notes; offset by a gain onextinguishment of trade payable debt of $880,000.  The net loss in the 2005 period includedinterest expense of $529,000, and depreciation and amortization expense of $732,000.

 

**Liquidityand Capital Resources**

 

We measure our liquidity in anumber of ways, as summarized in the following table:

 
| ** **                                            | ** ** | **(Dollars in thousands)**    | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------|------------|
| **As of  March 31, 2006**              | ** ** | **As of  June 30, 2005** | ** ** |
|                                                  |       |                                    |       |   |   |
| Cash and  cash equivalents                            |       | $                                       | 1,958      |   | $ | 1,297 |   |
|                                                  |       |                                    |       |   |   |
| Working  capital                                      |       | $                                       | (4,302     | ) | $ | (5,221 | ) |
|                                                  |       |                                    |       |   |   |
| Current  ratio                                        |       | .77:1                                   |       | .80:1 |   |
|                                                  |       |                                    |       |   |   |
| Notes  payable (current portion and accrued interest) |       | $                                       | 451        |   | $ | 3,805 |   |
|                                                       |            |                                         |            |  |  |  |  |  |

 

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. Such investments are stated at cost, which approximates fairvalue, and are considered cash equivalents for purposes of reporting cashflows.

 

We incurred a net loss of $21,634,000for the nine months ended March 31, 2006, which includes $15,213,000 of

 

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non-cash and/or non-recurring chargesresulting from $3,970,000 in non-cash interest charges; $2,012,000 ofdepreciation and amortization; $205,000 in stock based compensation; and a$505,000 valuation adjustment on the investment in Tekinsight; and a $9,401,000loss on the 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. AtMarch 31, 2006, the Company had a working capital deficiency ofapproximately $4,302,000.

 

In October 2005, we raisedgross proceeds of $2,500,000, upon issuance of notes to certain investors (the “BridgeNotes”). The proceeds were used to pay acquisition debt and for workingcapital. Interest on unpaid principal under the Bridge Notes is 12% per annumthrough March 1, 2006, 14% from March 1, 2006 to April 1, 2006,16% from April 1, 2006 to May 1, 2006, 18% from May 1, 2006 toJune 1, 2006, and 20% from June 1, 2006 until the maturity date,December 31, 2006.  In March of2006, we entered into an agreement with the holders of the Bridge Notes toconvert the $2,609,315 in aggregate principal and accrued interest under theBridge Notes into shares of our common stock at a conversion price of $0.02 pershare. The conversion will be effective and the debt obligation cancelled uponthe date immediately following the effective date of our contemplated 1 for 10reverse stock split, which must occur on or before June 30, 2006; otherwise theBridge Notes will continue of be outstanding obligations of the Company.

 

In July 2005, we beganmaking principal payments of approximately $146,000 per month on our 9%Subordinated Convertible Notes (the “9% Notes”) due to certain investors. InOctober 2005, we amended a majority of 9% Notes to defer all payments ofprincipal due under such 9% Notes until January 2007. In connection withsuch amendment, we reduced the conversion price of such notes from $.65 to $.22,and issued the 9% Note holders warrants to purchase shares of our common stockat $.22 per share. In March 2006, we entered into agreements with the holdersof the 9% Notes to convert $2,665,112 in aggregate principle and accruedinterest into shares of our common stock at a conversion price of $0.02 pershare.  These agreements effected acomplete settlement of the debt outstanding under the 9% Notes and provide thatthe shares will be issued immediately following the effective date of ourcontemplated 1 for 10 reverse stock split.

 

In October 2005, weamended our Amended and Restated Secured Convertible Term Note (the “LaurusNote”), and deferred principal payments under the Laurus Note fromDecember 2005 until March 2006 in return for a reduction in theexercise price of warrants issued in connection with issuance of the LaurusNote from $.65 per share to $.25 per share. This transaction deferred aggregatepayments of $831,249 in cash otherwise due and payable prior toMarch 2006. We incurred a non-cash interest expense of $49,851 inconnection with the reduction in the exercise price of the warrants. In March2006, the remaining principal balance of $6,649,999 along with accrued interestof $102,198 was paid in full and the Laurus Note was cancelled.

 

In August 2005, weterminated our credit facility agreement with an agency of Textron FinancialCorporation (“Textron”). The Textron facility provided a full notificationfactoring facility for up to $7,000,000 of working capital. Eligible accountsreceivable expected to be collected within 90 days were purchased withrecourse, with a holdback amount of 15%. Interest was charged on theoutstanding balance at the prime rate plus 2.0% (8.25% at June 30, 2005).Additionally, a 0.15% discount fee was charged at the time of purchase. InAugust 2005, we terminated this agreement, and paid the entire balancethen outstanding of approximately $4,800,000.

 

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

 

The new credit facility iscomprised of two primary components: (1) an Asset Purchase and Liability Assumption Agreement (the “APLA”),under which NETF agreed to finance certain of our qualified product purchasesunder an arrangement that provides for us to assign accounts receivable(resulting from the sale of such products to our customers) and for NETF toassume the liability for payment to product vendors; and  (2) an Asset Purchase Agreement (the “APA”),under which NETF purchased $7,500,000 of our qualified accounts receivables(services and products). The proceeds we received under the APA were used torepay in full the $4,800,000 balance on our credit line with Textron, foracquisition debt, and general corporate purposes. In addition to the accountsreceivable purchased on August 8, 2005, NETF may purchase up to 80% of ouradditional qualified accounts receivable in the future on the same terms.

 

We believe that the NETF APLAfacility will enable us to more effectively manage our liquidity. The facilityis structured to provide us with the flexibility of matching the timing of cashoutflows for product purchases to cash amounts that we collect from ourcustomers. The financing fee under the facility is calculated on a monthly basisdepending on our gross margin on such products, and days sales outstanding,which fee we anticipate will be less than prior fees charged under our priorfinancing arrangement with Textron. We may also use the APA facility as ageneral financing arrangement for certain product and services receivables.

 

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During fiscal year 2006, wehave taken certain steps to conserve our capital resources, including ade-emphasis on the BPO segment and a projected reduction of our general andadministrative expenses by approximately $1,600,000 from the year endedJune 30, 2005 to the year ended June 30, 2006. Total G&A expensesfor the year ended June 30, 2005 were approximately $7,045,000 for the twelve-monthperiod. For the first nine months of the twelve-month period endingJune 30, 2006, G&A expenses were $4,301,000 inclusive of all one timerestructuring and re-organization costs , or $5,735,000 on an annualized basis.Thus, we believe that we will likely meet our projected G&A reductiontarget.  In March 2006, the companyannounced another $800,000 in projected annual savings from cost reductionsmeasures in selling and general and administrative expenses.  We expect the effects of these additionalreductions to begin during the fourth quarter ending June 30, 2006.

 

On March 8, 2006, we enteredinto a Note Purchase Agreement (the “Note Purchase Agreement”) with SACCPartners, L.P. and Lloyd I. Miller, III (the “Senior Lenders”), pursuant towhich we issued Senior Secured Notes in the aggregate principal amount of $6.7million (the “Senior Notes”). The interest rate for the Senior Notes is 8% perannum if paid in cash, or 11% per annum if paid in kind, which is at ourelection for the first three years. Principal will be amortized over threeyears and payable in monthly installments beginning March 31, 2009, with thebalance payable on the maturity date of March 1, 2010, and interest will bepayable quarterly in arrears beginning June 30, 2006, unless we choose paymentin kind option, in which case interest will be added to the principal amount ofthe Senior Notes during the period that we continue such election. As acondition to the purchase of Senior Notes, we issued warrants pro rata,according to each Senior Lender’s proportion of the aggregate principal amountof the Senior Notes, to purchase 19.9% of its outstanding common stock at thetime of exercise, exercisable at $0.001 per share of common stock, untilDecember 31, 2016.  Proceeds from thesale of the Senior Notes were used to pay indebtedness outstanding under theLaurus Notes.

 

Under the Note PurchaseAgreement, we also issued a Junior Secured Convertible Note to Trust A-4 -Lloyd I. Miller (the “Junior Lender” and together with the Senior Lenders, the “Lenders”)in the aggregate principal amount of $3.0 million (the “Junior Note”). Theinterest rate for the Junior Note is 10% per annum if paid in cash, or 14% perannum if paid in kind, which is at the Applicant’s election for the first threeyears. Principal will be payable at the maturity date of March 1, 2011 andinterest will be payable quarterly in arrears beginning June 30, 2006, unless wechooses payment in kind option, in which case interest will be added to theprincipal amount of the Junior Note during the period that we continue suchelection. The Junior Note may be converted into shares of our common stock atany time at the election of the holder at a conversion price of $0.02 per shareof common stock. Proceeds from the issuance of the Junior Note were used toreduce additional indebtedness of the Company and for general corporatepurposes. The Junior Note issued to the Junior Lender is convertible into150,000,000 shares of our common stock., assuming interest thereunder is paidin cash

 

On March 8, 2006, we enteredinto a Securities Purchase Agreement with certain accredited investors (the “SecuritiesPurchase Agreement”), pursuant to which we raised approximately $683,226 in netproceeds through the initial closing of a private placement of an aggregate of37,957,000 shares of common stock at a purchase price of $0.02 per share andwarrants to purchase 7,591,400 shares of common stock. On May 15, 2006, weeffected a second and final closing of this private placement and raised $1,145,904in gross proceeds from the sale of 57,295,200 shares of common stock at $0.02per share and issued warrants to purchase 11,459,040 shares of common stock atan exercise price of $0.02 per share. At the second closing Network 1 was paida fee of $114,590 and issued a warrant to purchase 11,459,040 shares of commonstock at an exercise price of $0.02 per share.

 

Despite these cost reductionmeasures and the recapitalization of the Company, continuing operating lossesseverely impacted our ability to sustain and grow our business and may continueto do so in the future. These losses and our limited cash resources raisesubstantial doubt about our ability to continue as a going concern without theinfusion of additional capital and/or significant improvement in sales and operations.We believe that cash and cash equivalents when taken together with cash from projectedoperations based on expected revenue and expense forecasts should providesufficient capital to fund our operations through the end of December 2006.

 

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Contractual Obligations

 
| ** **                       | ** ** | **Payments due by period  (in thousands)** | ** ** |
|----------------------------------|------------|----------------------------------------------------------------|------------|
| **Total**                        | ** ** | **Less  than 1  year**                                         | ** ** | **1-3 years** | ** ** | **3-5  years** | ** ** | **More  than 5  years** |
| *Contractual Obligations*        | ** ** | ** **                                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Non-Convertible Debt Obligations |       | 6,700                                                          |       | — |   | — |   | 6,700 |   |   |   |
| Convertible Debt Obligations     |       | 5,500                                                          |       | 2,500 |   | — |   | 3,000 |   | — |   |
| Acquisition Debt                 |       | —                                                         |       | — |   | — |   | — |   | — |   |
| Operating Lease Obligations      |       | 2,010                                                          |       | 697 |   | 1,073 |   | 220 |   | 20 |   |
| Total                            |       | $                                                              | 14,210     |   | $ | 3,197 |   | $ | 1,073 |   | $ | 9,920 |   | $ | 20 |   |
|                                  |            |                                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Critical Accounting Policies and Estimates**

 

The Company’s financialstatements and accompanying notes are prepared in accordance with accountingprinciples generally accepted in the United States. Preparing financialstatements requires management to make estimates and assumptions that affectthe reported amounts of assets, liabilities, revenue, and expenses. Theseestimates and assumptions are affected by management’s application ofaccounting policies. Critical accounting policies for us include revenuerecognition, impairment of goodwill, and accounting for discontinuedoperations.

 

**RevenueRecognition.** We apply the revenue recognitionprinciples set forth under SOP 97-2 and SAB 104 with respect to all of ourrevenue. We adhere strictly to the criteria set forth in paragraph .08 of SOP97-2 and outlined 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 isprobable. A summary of our revenue recognition policies, as they relate to ourspecific revenue streams, is as follows:

 

*ComputerHardware Product Revenues*

 

Werequire our hardware product sales to be supported by a written contract orother evidence of a sale transaction that clearly indicates the selling priceto the customer, shipping terms, payment terms (generally 30 days) and refundpolicy, if any.

 

Sinceour hardware sales are supported by a contract or other document that clearlyindicates the terms of the transaction, and our selling price is fixed at thetime the sale is consummated, we record revenue on these sales at the time inwhich we receive 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*

 

Wemake substantially all of our software product sales as a reseller of licenses,which may include a post contract customer support arrangement and access toproduct and upgrades, and enhancements that are provided exclusively by themanufacturer following delivery and the customer’s acceptance of the softwareproduct. We do not presently sell any software that we develop internally. Anyresponsibility for technical support and access to upgrades and enhancements tothese software products are solely the responsibility of the softwaremanufacturer, which arrangement is known to the customer at the time the saleis consummated. With respect to delivery, we require that the customer hasreceived transfer of the software or, at a minimum, an authorization code (“key”)to permit access to the product. If a software license is delivered to thecustomer, but the license term has not begun, we do not record the revenueprior to inception of the license term.

 

Werequire our software product sales to be supported by a written contract orother evidence of a sale transaction, which generally consists of a customerpurchase order or on-line authorization. These forms of evidence clearlyindicate the selling price to the customer, shipping terms, payment terms(generally 30 days) and refund policy, if any. The selling prices of theseproducts are fixed at the time the sale is consummated.

 

Forproduct sales, we apply the factors discussed in EITF 99-19 “Reporting RevenueGross as a Principal versus Net as an Agent” in determining whether torecognize product revenues on a gross or net basis. In a substantial majorityof our transactions, we (i) act as principal; (ii) take title to theproducts; and (iii) have the risks and rewards of ownership, including therisk of loss for collection, delivery or returns. For these transactions, werecognize revenues based on the gross amounts billed to our customers. Incertain circumstances, based on an analysis of the factors set forth in EITF99-19, we have determined that we were acting as an agent, and thereforerecognize revenues on a net basis. During the nine months ended

 

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December 31,2005, no revenues were recognized on a net basis.

 

*IT Services Revenue*

 

Wegenerally bill our customers for professional IT services based on hours oftime that we spend on any given assignment at our hourly billing rates. As itrelates to delivery of these services, we recognize revenue under thesearrangements as the work is completed and the customer has indicated their acceptanceof our services by approving a work order milestone or completion order. Forcertain engagements, we enter fixed bid contracts, and we recognize revenue asphases of the project are completed and accepted by our client. For our seatmanagement services, we enter unit-price contracts (e.g., price per user forseat management), and we recognize revenue based on number of units multipliedby the agreed-upon contract unit price per month.

 

*BPO Services Revenue*

 

Forour business process outsourcing (“BPO”) services, which primarily include ourchild support service contracts in the states of Kansas and Nebraska, we provideservices under a fixed price (flat monthly fee) contract, and recognize revenueas the services are provided and billed. In the state of North Carolina, wehave one contract subject to revenue-sharing related to child support services.Under that contract a fee from amounts collected is shared with the county on apercentage basis, and revenue is recognized monthly in arrears as a percentageof the total amount of collections received.

 

**Collectibilityof Receivables.** A considerable amount of judgmentis required to assess the ultimate realization of receivables, includingassessing the probability of collection and the current credit worthiness ofour clients. Probability of collection is based upon the assessment of theclient’s financial condition through the review of its current financialstatements or credit reports.

 

**Goodwill**.SFAS 142, Goodwill and OtherIntangible Assets, requires that goodwill be tested for impairment atthe reporting unit level (operating segment or one level below an operating 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,assigning assets and liabilities to reporting units, assigning goodwill toreporting units, and determining the fair value. Significant judgments requiredto estimate 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. We have recordedgoodwill in connection with the Company’s acquisitions, most recently theacquisitions of Redrock in September 2004 and ITI in October 2004,and recorded goodwill in the amount of $4,664,000 and $6,568,000, respectively.In these instances, goodwill was determined by comparing the purchase price andrelated transaction costs with the fair value of the net tangible assets andliabilities acquired.

 

**Convertible Notes.** The Company accounts for conversion options embedded in convertible notes in accordance with Statement of Financial Accounting Standard (“SFAS) No. 133 “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) and EITF 00-19 “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a  Company’s Own Stock” (“EITF 00-19”). SFAS 133 generally requires companies to bifurcate conversion options embedded in convertible notes from their host instruments and to account for them as free standing derivative financial instruments in accordance with EITF 00-19. SFAS 133 provides for an exception to this rule when convertible notes, as host instruments, are deemed to be conventional as that term is described in the implementation guidance under Appendix A to SFAS 133 and further clarified in 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 EITF 98-5 “Accounting for Convertible Securities 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, the intrinsic value of such conversion options based upon the differences between the fair value of the underlying common stock at the commitment date of the note transaction and the effective conversion price embedded in the note. Debt discounts under these arrangements are amortized over the term of the related debt to their earliest date of redemption.

 

**Recent Accounting Standards**

 

In December 2004, the FASBissued Statement of Financial Accounting Standard (“SFAS”) No. 123R “ShareBased Payment”. This statement is a revision of SFAS Statement No. 123, “Accounting for Stock-Based Compensation” andsupersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its relatedimplementation guidance. SFAS 123R addresses all forms of share based payment (“SBP”)awards including shares issued under employee stock purchase plans, stockoptions, restricted stock and stock appreciation rights. Under SFAS 123R, SBPawards result in a cost that will be measured at fair value on the awards’grant date, based on the estimated number of awards that are expected to vestthat

 

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will result in a charge to operations. This statement is effective forpublic entities that do not file as small business issuers—as of the beginningof the first annual reporting period that begins after June 15, 2005. TheCompany began implementing this policy for the three-month period endedSeptember 30, 2005.

 

In December 2004, the FASBissued Statement of Financial Accounting Standard (“SFAS”) No. 153 “Exchanges of Nonmonetary Assets”. ThisStatement amends Opinion No. 29 to eliminate the exception for nonmonetaryexchanges of similar productive assets and replaces it with a general exceptionfor exchanges of nonmonetary assets that do not have commercial substance. Anonmonetary exchange has commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange. Theprovisions of this Statement, which is to be applied prospectively  are effective for nonmonetary asset exchangesoccurring in fiscal periods beginning after June 15, 2005. Earlierapplication is permitted for nonmonetary asset exchanges occurring in fiscalperiods beginning after June 15, 2004. The adoption of this pronouncementis not expected to have material effect on the Company’s financial statements.

 

Emerging Issues Task Force (“EITF”)Issue 04-8, “The Effect of Contingently Convertible Instruments on DilutedEarnings per Share.”  The EITF reached aconsensus that contingently convertible instruments, such as contingentlyconvertible debt, contingently convertible preferred stock, and other suchsecurities should be included in diluted earnings per share (if dilutive)regardless of whether the market price trigger has been met. The consensus iseffective for reporting periods ending after December 15, 2004. Theadoption of this pronouncement is not expected to have material effect on theCompany’s financial statements.

 

**ITEM3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Market risk associated withadverse changes in financial and commodity market prices and rates could impactour financial position, operating results or cash flows. The company does nothave any variable rate debt instruments and we are not exposed to market riskdue to changes in interest rates such as the prime rate and LIBOR.

 

We have operated primarily inthe United States. Accordingly, we have not had any significant exposure toforeign currency rate fluctuations.

 

**ITEM4. CONTROLS AND PROCEDURES**

 

An evaluation as of the end ofthe period covered by this quarterly report was performed under the supervisionand with the participation of the Company’s management, including its ChiefExecutive Officer, President and Chief Financial Officer, regarding theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures. Based on that evaluation, the Company’s Chief Executive Officerand President and Chief Financial Officer, have concluded that the Company’sdisclosure controls and procedures are effective to ensure that the informationrequired to be disclosed in the Company filings or which it submits under theSecurities Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in the Securities and Exchange Commission’srules and forms. There have been no changes in the Company’s internalcontrols over financial reporting that occurred during the nine months ended March31, 2006 that have materially affected, or are reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

**PART II - OTHER INFORMATION**

 

**ITEM 1A.RISK FACTORS**

 

Potential risks and uncertaintiesinclude, among other things, those factors discussed in Item 1 (Business) ofPart I and Item 7 (Management’s Discussion and Analysis of FinancialCondition and Results of Operations) of Part II of our Annual Report onForm 10-K filed on September 29, 2005, Item 2 (Management’sDiscussion and Analysis of Financial Condition and Results of Operations) ofPart I of this Quarterly Report on Form 10-Q, and as set forth belowin this Item IA. Readers should carefully review those risks, as well asadditional risks described in other documents we file from time to time withthe Securities and Exchange Commission. 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 onSeptember 29, 2005, but are not a complete list of all of our riskfactors.

 

***We will need additional capitalin the future, or we will need to scale back operations***.

 

We will need capital in thefuture, and if it is not available on terms acceptable to us, or at all, and wecannot generate enough cash through existing operations, we would have to scaleback operations and/or personnel costs. As of March 31, 2006, we had cashand cash equivalents of approximately $1,958,000. We have taken steps toconserve our capital resources, including a reduction of our general and administrativeexpenses, and reduced the current portion of our debt burden by completing ourrecapitalization in March 2006, including canceling certain debt obligationsthrough equity

 

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conversion and debt settlement agreements. Additionalfinancing transactions may be necessary if we are not able to generatesufficient cash flow from operations through revenue growth and overhead reductionto meet our requirements. New financing transactions could include issuingadditional equity and/or debt securities where appropriate. We would anticipateusing the proceeds of any future financing transactions (if any) to fund eitherexpansion of operations or our working capital needs. In the event of anyadditional financing, any equity financing would likely result in dilution to manyof our existing stockholders and any debt financing may include restrictivecovenants. We currently have no binding commitments for new financing in placenor can we provide any assurance that we will be successful in our efforts toraise additional capital in the future. If we are unable sustain operationsthrough internally generated cash flow or financing transactions, we will needto scale back our operations and personnel and/or divest assets to continueoperations. Any such reductions or divestitures would materially impact ouroperations. There can be no assurance that we will be successful in generatingcash from operattions, reducing expenses as planned, selling assets, or raisingadditional capital and these matters raise substantial doubt about our abilityto continue as a going concern.

 

***We have a history of operatinglosses and may not be able to achieve long-term profitability.***

 

Since our inception inMay 1989, we have incurred substantial operating losses, and as of March 31,2006, there was substantial doubt about our ability to continue as a goingconcern. During the nine months ended March 31, 2006, we generated a netloss of $21,634,000. At March 31, 2006, we had an accumulated deficit of$119,280.00. There can be no assurance that our revenues will exceed ouroperating expenses and cost of revenues in the future.

 

***Dilution in ownership of ourshares from the exercise or conversion of options, warrants, and convertiblesecurities.***

 

There are a significant numberof outstanding options, warrants, and convertible securities to acquire sharesof our common stock and we may grant additional rights in the future. Theholders of such options, warrants, and convertible securities can be expectedto exercise them at a time when our Common Stock is trading at a price higherthan the exercise price of these outstanding options, warrants, and convertiblesecurities. If these options or warrants to purchase our common stock areexercised, convertible debt is converted or other equity interests are grantedunder our 2001 or 2005 stock option plans or under other plans or agreementsadopted in the future, such equity interests will have a dilutive effect onyour ownership of common stock. The existence of such options, warrants, andconvertible securities may also adversely affect the terms on which we canobtain additional financing.

 

We intend to raise capitalthrough offerings of our common stock, securities convertible into our common stock,or rights to acquire such securities or our common stock. Such other rights toacquire our common stock may be issued at exercise prices or conversion ratesthat are significantly lower than the price at which you may have paid for ourshares. In addition, the shares issuable upon exercise of certain of thewarrants and upon conversion of our convertible debt may increase subject toanti-dilutive rights, which we granted to warrant and debt holders. We may alsoissue a significant number of new options to purchase shares of our common stock,as the number of authorized shares under our 2005 option plan was increased to30,000,000 by approval of the stockholders at our Annual Meeting onDecember 13, 2005.

 

***Lloyd I. Miller, IIIbeneficially owns a majority of our outstanding common stock, which may enablehim to control many significant stockholder matters and corporate actions andmay prevent a change in control that would otherwise be beneficial to otherstockholders.***

 

According to aSchedule 13D filed with the Securities and Exchange Commission by Lloyd I.Miller, III, Mr. Miller and his affiliates own 7,787,984 shares of ouroutstanding shares of common stock.  Inaddition, Mr. Miller may be deemed to beneficially own a total of 375,683,968shares of our common stock, or 64.71%, after taking into account shares to beissued to Mr. Miller as a result of the conversion of the Bridge Notepreviously held by him, shares issuable upon conversion of the Junior Note andshares issuable upon exercise of warrants held by Mr. Miller and hisaffiliates.  The foregoing does not takeinto account the exercise or conversion of other outstanding convertible orexercisable securities of the Company, which would have the effect of reducingthe percentage beneficial ownership of Mr. Miller.  Because of his high percentage of beneficialownership, Mr. Miller may be able to control matters requiring the vote of thestockholders, including the election of our board of directors and certainother significant corporate actions. This control could delay, defer or preventothers from initiating a potential merger, takeover or other change in ourcontrol, even if these actions would benefit our other stockholders and us.This control could adversely affect the voting and other rights of our otherstockholders and could depress the market price of our common stock.

 

***Our product margins are subjectto competitive pricing pressures.***

 

Our product margins are subjectto competitive pricing pressures and fluctuate from quarter to quarter dependingon the mix of products we provide. We believe that current product margins aremore reflective of the present marketplace and likely to continue at or near presentlevels into the foreseeable future.  Weintend to meet the challenges of aggressive price

 

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reductions and discount pricing by certainproduct suppliers by focusing our offerings around relatively higher marginpractice areas, including security solutions, VOIP, and access infrastructure.There can be no assurance, however, that we will be able to improve profitmargins and compete profitably in all areas, given the intense competition thatexists in the IT industry.

 

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

 

(a)   Exhibits.

 
| 10.1   |   | Note Purchase Agreement, dated as of March  8, 2006, by and among DynTek, Inc., SACC Partners, L.P. and Lloyd I. Miller,  III.                                           |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                     |
| 10.2   |   | Senior Note, dated as of March 8, 2006,  issued by DynTek, Inc. to each of SACC Partners, L.P. and Lloyd I. Miller,  III.                                                |
|   |   |                                                                                                                                                                     |
| 10.3   |   | Junior Note, dated as of March 8, 2006,  issued by DynTek, Inc. to Trust A-4 - Lloyd I. Miller.                                                                          |
|   |   |                                                                                                                                                                     |
| 10.4   |   | Security and Pledge Agreement, dated as of  March 8, 2006, by and among DynTek, Inc., DynTek Services, Inc., SACC Partners,  L.P. and Lloyd I. Miller III.               |
|   |   |                                                                                                                                                                     |
| 10.5   |   | Security and Pledge Agreement, dated as of  March 8, 2006, by and among DynTek, Inc., DynTek Services, Inc. and Trust A-4  - Lloyd I. Miller.                            |
|   |   |                                                                                                                                                                     |
| 10.6   |   | Form of Debt Financing Warrant issued to  each of SACC Partners, L.P. and Lloyd I. Miller, III.                                                                          |
|   |   |                                                                                                                                                                     |
| 10.7   |   | Securities Purchase Agreement, dated as of  March 8, 2006, by and among DynTek, Inc. and the accredited investors named  therein.                                        |
|   |   |                                                                                                                                                                     |
| 10.8   |   | Registration Rights Agreement, dated March  8, 2006, by and among DynTek, Inc. and the accredited investors named in the  Securities Purchase Agreement.                 |
|   |   |                                                                                                                                                                     |
| 10.9   |   | Form of Warrant issued by DynTek, Inc. to  each of the accredited investors named in the Securities Purchase Agreement  and Network 1 Financial Securities, Inc.         |
|   |   |                                                                                                                                                                     |
| 10.10  |   | Fifth Amended Warrant Agreement, dated as  of March 8, 2006, by and between DynTek, Inc. and American Stock Transfer  & Trust Company.                               |
|   |   |                                                                                                                                                                     |
| 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. |

 

35

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SIGNATURE

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 
|   | THE COMPANY, INC.       |                        |
|--------|-------------------------|-----------------------------|
|   |                    |
|   |                    |
|   | By:                     | /s/ Casper Zublin, Jr. |   |
|   |                    | Casper Zublin, Jr.     |
|   |                    | Chief Executive Officer     |
|   |                    |
|   | Date: May 19, 2006 |
|        |                         |                             |  |  |

 

36

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                          |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                     |
| 10.1                |       | Note Purchase Agreement, dated as of March  8, 2006, by and among DynTek, Inc., SACC Partners, L.P. and Lloyd I. Miller,  III.                                           |
|                |       |                                                                                                                                                                     |
| 10.2                |       | Senior Note, dated as of March 8, 2006,  issued by DynTek, Inc. to each of SACC Partners, L.P. and Lloyd I. Miller,  III.                                                |
|                |       |                                                                                                                                                                     |
| 10.3                |       | Junior Note, dated as of March 8, 2006,  issued by DynTek, Inc. to Trust A-4 - Lloyd I. Miller.                                                                          |
|                |       |                                                                                                                                                                     |
| 10.4                |       | Security and Pledge Agreement, dated as of  March 8, 2006, by and among DynTek, Inc., DynTek Services, Inc., SACC  Partners, L.P. and Lloyd I. Miller III.               |
|                |       |                                                                                                                                                                     |
| 10.5                |       | Security and Pledge Agreement, dated as of  March 8, 2006, by and among DynTek, Inc., DynTek Services, Inc. and Trust A-4  - Lloyd I. Miller.                            |
|                |       |                                                                                                                                                                     |
| 10.6                |       | Form of Debt Financing Warrant issued to  each of SACC Partners, L.P. and Lloyd I. Miller, III.                                                                          |
|                |       |                                                                                                                                                                     |
| 10.7                |       | Securities Purchase Agreement, dated as of  March 8, 2006, by and among DynTek, Inc. and the accredited investors named  therein.                                        |
|                |       |                                                                                                                                                                     |
| 10.8                |       | Registration Rights Agreement, dated March  8, 2006, by and among DynTek, Inc. and the accredited investors named in the  Securities Purchase Agreement.                 |
|                |       |                                                                                                                                                                     |
| 10.9                |       | Form of Warrant issued by DynTek, Inc. to  each of the accredited investors named in the Securities Purchase Agreement  and Network 1 Financial Securities, Inc.         |
|                |       |                                                                                                                                                                     |
| 10.10               |       | Fifth Amended Warrant Agreement, dated as  of March 8, 2006, by and between DynTek, Inc. and American Stock Transfer  & Trust Company.                               |
|                |       |                                                                                                                                                                     |
| 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. |

 

37

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