UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
 FORM
10-K
 (Mark
one)
 
 [X]
              Annual
      Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934 for the fiscal year ended December 31, 2008,
  or
 
 [   ]
              Transition
      Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934 for the transition period from ______________ to
      _____________.
 
 Commission
File No. 0-23862
 Fonix
Corporation
 (Exact
name of registrant as specified in its charter)
 
 Delaware
                (State
      or other jurisdiction of incorporation or organization)
              22-2994719
                (I.R.S.  Employer
      Identification No.)
 
 387
South 520 West, Suite 110
 Lindon,
Utah 84042
 (Address
of principal executive offices with zip code)
 (801)
553-6600
 (Registrant's
telephone number, including area code)
 
 Securities
      registered pursuant to Section 12(b) of the Act:
              None
 Securities
      registered pursuant to Section 12(g) of the Act:
              Class
      A Common Stock ($0.0001 par value per
share)
 
 Indicate
by check mark if the registrant is a well-know seasoned issuer, as defined in
Rule 405 of the Securities Act
 Yes
[  ] No [X]
 
 Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d)
 Required
[X] Not Required [  ]
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days: Yes [X] No[  ].
 
 The
aggregate market value of the voting stock held by non-affiliates of the
registrant as of June 30, 2008, was approximately $2,000,393, calculated using a
closing price of $1.00 per share on June 30, 2008.  For purposes of
this calculation, the registrant has included only the number of shares directly
held by its officers and directors as of (and not counting shares beneficially
owned on that date), in determining the shares held by
non-affiliates.
 
 As of
March 16, 2009, there were issued and outstanding 5,818,536 shares of our Class
A common stock.
 
 Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of the registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  [  ]
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer, or a smaller reporting
company.  See definition of “accelerated filer and large accelerated
filer,”  and “smaller reporting company” in Rule 12b-2 of the Exchange
Act.  (Check one):
 Large
accelerated filer [  ]  Accelerated filer
[  ]  Non-accelerated filer
[  ]  Smaller reporting company [X]
 
 Indicate
by check mark whether the registrant is a shell company (as defined in rule
12b-2 of the Exchange Act).  Yes [  ]  No
[X].
  
  Fonix
Corporation
 
 2008 FORM
10-K ANNUAL REPORT
 
 
 TABLE OF
CONTENTS
 
 Part
I
 PageItem
      1.
                                                        Business
                                                        3Item
      1A.
                                                        Risk
      Factors
                                                        13Item
      2.
                                                        Properties
                                                        19Item
      3.
                                                        Legal
      Proceedings
                                                        20Item
      4.
                                                        Submission
      of Matters to a Vote of Security Holders
                                                        20Part
      IIItem
      5.
                                                        Market
      for Registrant's Common Equity, Related Stockholder Matters and Issuer
      Purchases
      of Equity Securities
                                                        21Item
      7.
                                                        Management's
      Discussion and Analysis of Financial Condition and Results
      of Operations
                                                        24Item
      8.
                                                        Financial
      Statements and Supplementary Data
                                                        38Item
      9A.
                                                        Controls
      and Procedures
                                                        38Part
      IIIItem
      10.
                                                        Directors,
      Executive Officers and Corporate Governance
                                                        40Item
      11.
                                                        Executive
      Compensation
                                                        42Item
      12.
                                                        Security
      Ownership of Certain Beneficial Owners and Management and
      Related Stockholder Matters
                                                        46Item
      13.
                                                        Certain
      Relationships and Related Transactions, and Director
      Independence
                                                        47Item
      14.
                                                        Principal
      Accountant Fees and Services
                                                        48Part
      IVItem
      15.
                                                        Exhibits
      and Financial Statement Schedules
                                                        49
 
 
  2
  FORWARD
LOOKING STATEMENTS
 
 THIS
ANNUAL REPORT ON FORM 10-K CONTAINS, IN ADDITION TO HISTORICAL INFORMATION,
FORWARD-LOOKING STATEMENTS THAT INVOLVE SUBSTANTIAL RISKS AND
UNCERTAINTIES.  OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE
RESULTS ANTICIPATED BY FONIX AND DISCUSSED IN THE FORWARD-LOOKING
STATEMENTS.  FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH
DIFFERENCES ARE DISCUSSED BELOW IN THE SECTION “MANAGEMENT’S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS,” IN THE SECTION
ENTITLED “FORWARD-LOOKING STATEMENTS,” AND ELSEWHERE IN THIS ANNUAL
REPORT.  WE DISCLAIM ANY INTENTION OR OBLIGATION TO UPDATE OR REVISE
ANY FORWARD-LOOKING STATEMENT, WHETHER AS A RESULTOF NEW INFORMATION, FUTURE
EVENTS, OR OTHERWISE.  THE FOLLOWING DISCUSSION SHOULD BE READ
TOGETHER WITH OUR FINANCIAL STATEMENTS AND RELATED NOTES THERETO INCLUDED
ELSEWHERE IN THIS DOCUMENT.
 
 
 PART
I
 
 ITEM
1.                      BUSINESS
 
 History and Development of
the Company
 
 Fonix
Corporation (the “Company,” “Fonix,” or “we”) was incorporated in Delaware in
1985, and, pursuant to a merger transaction in 1994, the Company’s name was
changed to Fonix Corporation. The Company’s operations are managed through its
two wholly owned subsidiaries, Fonix Speech, Inc. (“Fonix Speech”) and Fonix GS
Acquisition Co., Inc. (“Fonix GS”).
 
 Fonix
Speech
 
 Fonix
Speech provides value-added speech-enabling technologies, speech interface
development tools, and speech solutions and applications, including automated
speech recognition (“ASR”) and text-to-speech (“TTS”, together with ASR, the
“Core Technologies”) that empower consumers to interact conversationally with
information systems and devices.  We offer our speech-enabling
technologies to markets for personal software for consumer applications
including video games, e.Dictionaries and mobile navigation devices with GPS,
wireless and mobile devices, computer telephony, and server solutions. The
Company’s Speech Products enhance user productivity, ease of use and efficiency
in a broad range of market segments, including mobile and wireless devices;
videogame consoles; electronic devices for the assistive and language learning
markets, robots, appliances; automotive telematics, computer telephony and
server applications.
 
 We have
received various patents for certain elements of our Core Technologies and have
filed applications for other patents covering various aspects of our
technologies. We seek to develop relationships and strategic alliances with
third-party developers and vendors in telecommunications, computers, electronic
devices and related industries, including producers of application software,
operating systems, computers and microprocessor chips. Revenues are generated
through licensing of speech-enabling technologies, unit royalties, maintenance
contracts and services.
 
 Prior to
2002, the Company focused on research and development (“R&D”) projects for
customized applications.  R&D and prototype development used the
Core Technologies to develop applications and engines marketed for multiple
operating systems and hardware platforms.  Today, Fonix Speech serves
markets that are adopting speech-enabled interfaces, solutions and
applications.  As memory requirements, noise robustness, speech
recognition accuracy and efficiency of speech interface solutions become
increasingly critical, Fonix Speech anticipates that its Core Technologies and
solutions will meet customer demand for simple, convenient user
interfaces.
 
 Fonix GS
 
 Fonix GS
was formed on June 27, 2008 to facilitate the acquisition of Shanghai Gaozhi
Software Systems Limited (“GaozhiSoft”).  GaozhiSoft is a leading
Chinese software developer and solutions provider in 2G (second-generation) and
3G (third-generation) telecommunication operation support systems in China and
throughout the Asian Pacific region. Gaozhisoft is a qualified competitor
for telecommunication operation supports systems.
 GaozhiSoft’s
products are designed to increase data transferring speed, reduce
telecommunications data loss and provide network management, billing accuracy
and improved implementation techniques to telecom carriers.
  3
  
 GaozhiSoft’s
software products are divided into two main categories: (1) MOSS series and (2)
MDtrac series. MOSS products provide service providers with integrated
electronic management platforms for peer-to-peer business operation and
automatic management.  MDtrac products provide data collection
solutions.  GaozhiSoft has received various copyrights and patents for
certain of its products and has filed applications for other copyrights and
patents covering various aspects of its products.
 
 Gaozhisoft
has an outstanding management team with extensive industrial knowledge and
experience with system developing, marketing and sales.  Since
completion of the acquisition of GaozhiSoft, Fonix GS, through its wholly owned
foreign entities, has been working with the management team to transition the
business with a focus on creating synergies among the Company’s existing
technologies and GoazhiSoft’s products.  Upon completion of the
transition, we expect GaozhiSoft to continue its rapid growth and market
penetration based on the implementation of the 3G mobile network service with
these professional partners.
 
 Fonix
Corporation
 
 We are
continually developing new product offerings utilizing our Core Technologies in
an effort to increase our revenue stream, and we are continuing to work with our
existing customers to increase sales. We have also experienced operating expense
decreases through headcount reductions and overall cost reduction measures.
Through the combination of increased recurring revenues, operating cost
reduction strategies and accretive acquistions, we hope to achieve positive cash
flow from operations within the next 2-3 years. . However, there can be no
assurance that we will be able to achieve positive cash flow from operations
within this time frame.
 
 Our cash
resources, limited to loans, collections from customers and sales of our
equity and debt securities, have not been sufficient to cover operating
expenses.  We periodically engage in discussions with various sources of
financing to facilitate our cash requirements including buyers of both debt and
equity securities. To date, no additional sources of funding offering terms
superior to those available under equity lines and convertible debentures have
been implemented, and we rely on, first, cash generated from operations and
second, convertible debt financing arrangements.  In addition to
anticipated revenues generated from current and future customers, we will need
to generate approximately $2 to $3 million to continue operations for the next
twenty-four months.  There can be no assurance that we will be able to
obtain such financing or that the terms will be favorable to the
Company.
 
 The
acquisition of GaozhiSoft provides the Company a significant platform for growth
which we expect will eventually provide a gateway to the Chinese market for our
Core Technologies.  Additionally, we envision that through our foreign
subsidiaries we will pursue opportunities to expand in Asia and pursue
additional accretive acquisitions.
 
 Company
Internet addresses are as follows:
 Fonix Corporation – www.fonix.com
 Fonix Speech, Inc. – www.fonixspeech.com
 Shanghai GaozhiSoft Co. Ltd -- www.gaozhisoft.com
 
 
 VALUE-ADDED
SPEECH TECHNOLOGIES
 
 Fonix Speech,
Inc.
 
 On
January 1, 2006, Fonix Speech, was incorporated and now operates as a wholly
owned subsidiary of Fonix Corporation.  Fonix Speech provides
value-added embedded speech technology development tools, applications and
solutions for multiple market segments comprising mobile and wireless devices,
video game consoles, electronic devices for the assistive and language learning
markets, robots, appliances, automotive telematics, computer telephony and
server applications.
  4
  
 Original
Equipment Manufacturers (“OEMs”) or Original Design Manufacturers (“ODMs”) of
consumer electronics devices and products, software developers, wireless
operators, telephony distributors, system integrators and value-added resellers
(“VARs”) can simplify the use and increase the functionality of their electronic
products and services by integrating Fonix speech interfaces, resulting in
broader market opportunities and significant competitive
advantages.  Fonix Speech development tools and solutions support
multiple hardware and software platforms, are environment and speaker
independent, optimize cost and power efficiencies, are easily integrated with
relatively small memory requirements for embedded applications, and enhance
scalability for high channel capacity for computer telephony and server-based
systems.
 
 Fonix
Speech Market Focus
 
 Fonix
Speech delivers speech solutions in the following markets:
 
 §
              Electronic
      Devices
 Fonix
speech solutions make everyday life easier for people who are blind or have
visual, vocal or mobility impairments, and for non-English speakers who are
learning the English language.  FonixTalk® and  Fonix
DECtalk®, recognized TTS technology for the assistive market, transforms
ordinary text into highly intelligible speech.  Fonix VoiceInTM is
Fonix Speech’s proprietary neural network-based ASR technology.  Fonix
Speech has taken its intuitive Core Technologies and applied them to everyday
speech solutions for PCs and other consumer devices such as cordless phones,
electronic dictionaries, MP3s and toys.
  Fonix Speech Solutions for
Electronic Devices
 
 Fonix
      Speech offers a variety of speech solutions for the assistive and language
      learning markets.
 
 o
              The Assistive
      Market
 Fonix
speech solutions make everyday life easier for people who are blind, have
visual, vocal or mobility impairments or have learning
disabilities.  Fonix DECtalk is the assistive industry’s premier
text-to-speech engine, offering nine highly intelligible TTS voices and six
languages.  Many users rely on Fonix DECtalk to read their email, the
daily news or other documents, or to function as their voice to the outside
world.  Current OEM partners in the assistive market include Dynavox,
GW Micro, Prentke-Romich, Kurzweil Education Systems and Toby
Churchill.
  o
              PDA, PC and Electronic
      Devices
 Fonix
solutions apply speech interfaces to tasks that users perform
everyday.  Many of these solutions are appropriate for multiple
markets — assistive, mobile and wireless, and business and home
users.  The Speech Products enable users to listen to documents, have
email read aloud, access programs and launch applications with speech
commands.  Historical partners include Microsoft, Intel, Hitachi, O2,
Code Factory, Casio and HTC. Currently, the primary distribution of our Speech
Products for electronic  devices is Apple through their iTunes
AppStore for the iPhone 3G.
 
 o
              The Language Learning Market –
      e.Dictionaries
 Fonix
Speech solutions are particularly useful for non-English speakers who are
learning the language.  In the speech-enabled language learning (also
known as “language acquisition” ) market, Fonix has capitalized on (i)
FonixTalk and Fonix DECTalk’s small memory footprint and high intelligibility
and (ii) Fonix VoiceIn’s high-recognition-rate
capabilities.  Speech-enabled language learning is an emerging market,
especially in Asia.  Multiple OEMs currently sell handheld electronic
dictionaries in Japan and Korea that allow individuals to type a word in their
native language (like Japanese) and have the word read or spoken back to them in
English.  Non-English speakers can look up words in an English
dictionary and have the device speak the word correctly in
English.  Educational electronic dictionary devices are growing in
popularity in Japan and are expected to exceed a market volume of more than
500,000 units per quarter.  Fonix Speech’s goal is to become the
primary supplier of speech solutions for OEMs providing language learning
devices and systems.  Fonix Speech has partnered with Epson and other
chip manufacturers to provide an integrated solution including Fonix speech
technology. Current OEMs marketing e.Dictionary devices featuring Fonix
technology include Casio, Casio Soft, Canon, Huapu, Seiko Instruments, Inventec
Besta, AOne Pro and Brilliant Systems.
  5
  
 Speech
applications are also becoming increasingly popular for day-to-day
use.  Fonix Speech is working with OEM partners to capitalize on
market opportunities for toys, appliances and other devices where speech
applications may be applicable.  Fonix Speech has partnered with Epson
to provide an integrated chip with Fonix speech technology to various OEMs
manufacturing toys and appliances.
  Fonix
Speech’s primary competitors in the electronic device markets include Nuance,
Voice Signal, Premier Assistive Technology and others.
 
 
 §
              Video Game
      Consoles
 Fonix
VoiceIn®Game Edition is Fonix Speech’s award-winning software solution for voice
command and control in Xbox, Xbox 360, PlayStation2, PlayStation3 and PC video
games.  We believe that Fonix VoiceIn is the industry’s most
memory-efficient voice interface.  Game developers worldwide can now
build games that utilize a common version across Xbox, Xbox 360, PlayStation2,
PlayStation3 and PC platforms.  In 2006, Fonix added specialized tools
for game developers including Fonix VoiceIn Karaoke Edition and Fonix VoiceIn
Phonetic Edition. In 2008, Fonix completed Fonix VoiceIn 5.1 for the above
referenced consoles and added Apple 3G.  Fonix VoiceIn is optimized
for game development where memory and processing power are at a
premium.
 
 Fonix Speech Video Game
Solutions
 
 Fonix
Speech’s voice command software is available for cross-platform game developers
who wish to employ speech interfaces in videogames.  In March 2004,
Fonix Speech made Fonix VoiceIn Game Edition commercially available to
developers that produce videogames on multiple gaming
platforms.  Fonix voice command technology has been available in the
Microsoft Xbox developer’s kit (XDK) since February 2003.  In May
2005, Fonix announced a continuation of its agreement with Microsoft to deliver
Fonix VoiceIn in the new Microsoft Xbox 360 developer’s
kit.  Cross-platform game developers can use the same voice command
software for PlayStation2, PlayStation3, PC games and Apple 3G.  Game
developers worldwide can now build games that utilize a common application
program interface across Xbox, Xbox 360, PlayStation2, PlayStation3, Apple 3G
and PC platforms.  Fonix VoiceIn voice command software is available
to game developers in multiple languages, including English and UK English,
German, French, Spanish, Japanese and Italian.  Currently, Fonix
VoiceIn is included on more than 20 video game titles on retail
shelves.
 
 Fonix Speech Video Game
Market Opportunities
 
 In the
video games market, Fonix VoiceIn® Game Edition is a compelling feature for
today’s game developers.  Gamers seek enhancements that add
excitement, interaction and realism.  Fonix VoiceIn allows developers
to take voice command and control to a new level.  The product gives
players new access to games features, command and control functions and menu
navigation.  Fonix expects this exciting new interface to expand
market demand for videogames.  In November 2008 Ubisoft released
Endwar on PS/3 and Xbox, and in March 2009 EndWar was released for the
PC.  EndWar is a virtual video game that is played with FonixVoiceIn,
a first-to-market video game that is played with voice commands.
  Fonix
VoiceIn Karaoke Edition is a new Fonix speech solution specifically designed for
karaoke game developers. Fonix technology compares the timing, pitch and voice
of the karaoke singer to the reference song and reports on the accuracy of the
karaoke singing. Karaoke singers can better enjoy the experience, and improve
future performances, by accurately measuring their talent against a professional
song track.
   Fonix
VoiceIn Phonetic Edition is a new Fonix technology for videogame developers and
animators. Fonix VoiceInPE speech technology
aligns word phonetics with audio data, allowing animators to more precisely
synchronize an animated characters’ facial movements with the phonetic
components of speech. The technology utilizes input text to break down the
phonetic components of words. The result is more realistic facial movement as
animated characters “speak.”
  Fonix
Speech’s competitor in the video game market is primarily
Nuance,  Fonix Speech’s partners also have competitors.  For
example, Intel competes with IBM and Epson.  However, Fonix Speech is
not precluded from working with its partners’ competitors.
  6
  
 §
              Mobile /
      Wireless
 Fonix
Speech provides embedded speech interface solutions for mobile phones,
Smartphones, PDAs and wireless communication devices.  The
award-winning Fonix VoiceDialTM is a totally interactive, hands-free software
application that enables users to place calls and navigate device menus and
applications simply by speaking.  Fonix VoiceCentralTM is a hands-free
software application for Pocket PC that allows users to access Personal
Information Management (“PIM”) tools, navigate through the device software, and
access song and movie lists simply by speaking.  Fonix iSpeakTM is
embedded on the Apple 3G phone and is sold through Apple’s iTunes App
Store.  Fonix iSpeak is now available in English, Spanish, French,
German and Italian.
 
 Fonix Mobile/Wireless
Solutions:
 
 o
              Fonix
      VoiceDial
 Fonix
VoiceDialis a
totally interactive, hands-free software application for Windows Mobile Pocket
PC, Smartphone and Symbian devices that enables users to access mobile phone
contacts simply by speaking.  VoiceDial is speaker independent, so no
voice training is involved, including both contact names and digit
dialing.  Fonix speech recognition is highly accurate, even in noisy
environments like cars or airports.  VoiceDial offers several
prompting voices; users choose which voices to download to their
device.  All TTS voices are highly intelligible and will handle an
unlimited vocabulary, even with difficult contact names.  VoiceDial is
available in multiple languages — English, French, German and
Spanish.  Current phones supported by Fonix VoiceDial include:
Cingular (now AT&T Wireless) 2125, T-Mobile SDA, SDA II, Audiovox SMT 5600,
i-mate SP3, i-mate SP3i, i-mate SP5, Motorola i930, Motorola MPx220, SPV C500,
SPV C600, TSM 520, T-Mobile MDA, Cingular 8125, PPC 6700, Audiovox PPC 6600,
i-mate PDA2k, i-mate JASJAR, i-mate K-JAM, MDA Pro, SPV M5000, and Qtek
9100.
 
 o
              Fonix
      VoiceCentral
 Fonix
VoiceCentral is a totally interactive, hands-free software application for
Windows Mobile Pocket PC and Smartphone devices that enables users to access PIM
tools, navigate through the device software and access song and movie lists
simply by speaking.  VoiceCentral incorporates the award-winning Fonix
VoiceDial software, while adding several other significant
capabilities.  VoiceCentral allows users to manage email (listen to
email, then choose to delete, reply with a .wav file or save); access calendar
and tasks; launch or close any application simply by speaking; dial names
directly from the contact list (users do not have to navigate multiple menu
trees; they just say the name of the person they want to call); and dial a
number directly using a continuous string of numbers.
  
 o
              Fonix
    iSpeak
 Fonix
ISpeak is a voice dial application for the Apple 3G.  the user can
voice command the phone dialing by stating the contact name or telephone
number.  Fonix ISpeak is available in US Englsih, French, German,
Spanish and Italian.
 
 
 Fonix Mobile / Wireless
Market Opportunities:
 
 Fonix
      Speech’s partners, OEMs and ODMs provide significant potential to reach
      users in many market areas.  Fonix Speech has already seen
      significant market response to VoiceDial and expects to deliver in the
      following channels:
 
 o
              OEMs & ODMs: The
      first Fonix VoiceDial contract delivered the solution on the Hewlett
      Packard (HP) Journada ® 928 WDA.  To date, VoiceDial has shipped
      with these additional devices: Hitachi G1000, i-mate PDA2k, T-Mobile MDA
      III and the O2 XDA IIs.  Fonix also has partnerships with
      Microsoft, Intel, Texas Instruments, Hitachi, O2 and HTC and is
      aggressively pursuing additional OEM opportunities with Nokia, Motorola,
      Sony-Ericsson, Siemens, Palm and
Samsung.
 
 o
              Mobile Operators: Fonix
      markets VoiceDial and VoiceCentral through mobile operators such as
      AT&T Wireless (formerly Cingular), T-Mobile, Orange, Vodafone and
      Verizon. VoiceDial can be delivered several ways, including loading
      software directly on the device or over-the-air
  activation.
  7
  
 o
              EmbeddedSolutions: Other
      complementary solutions are also channels for distribution for the Speech
      Products. Companies like ALK CodeFactory have integrated Fonix
      Speech’s solutions into their applications.  Fonix Speech
      foresees partners shipping the full VoiceDial and VoiceCentral
      functionality as a complement to their applications and
      devices.  Fonix iSpeak is distributed through Apple iTunes
      AppStore.  Through the AppStore, the user downloads Fonix iSpeak
      which is embedded on the device.
 
 Fonix
Speech has several competitors offering a variety of speech technologies and
products.  Companies like Nuance, Voice Signal and Neuvoice deliver
speaker-dependent and speaker-independent solutions.  Other speech
companies like IBM may introduce competitive products.
 
 §
              Customer Self-Service Solutions
      for Computer Telephony
 Fonix
ConnectMeTM is an innovative solution for computer telephony integration and
server systems.  Fonix ConnectMe is a voice-automated telephone
operator that provides anefficient, professional
means of routing incoming, outgoing and internal calls.  Fonix also
offers a voice interface solution for 511 system integrators.  511 is
the designated three-digit phone number for national travel information within
the United States.  Fonix ASR and TTS products are designed to give
developers easy-to-use tools with which to build call center speech enabled
solutions that lower costs and increase customer satisfaction.
 
 Fonix Speech Customer
Self-Service Solutions
 
 Fonix
      Speech provides telephony and server-based solutions for automated phone
      directory and database information systems.  Fonix Speech
      believes that traditional operator systems and other means of accessing
      information are becoming antiquated.  Significant time is lost
      trying to access information through keypad directories or because calls
      are blocked after hours.  Also, information stored or
      transferred through servers, PBXs or databases may not easily be accessed
      through non-integrated platforms.  Voice-automated systems are
      capable of integrating these platforms and meeting customer expectations
      of competitive costs, easy installation with minimal change to their
      existing infrastructure and a simple user
  interface.
 
 o
              Fonix ConnectMe
 Fonix
ConnectMe is a voice-automated telephone operator that provides an efficient,
professional means of routing incoming, outgoing and internal
calls.  Customers and employees dial one number, speak the name of a
person or a department and are quickly connected to the person or department
they want to reach.  Whether during peak business hours or late at
night, ConnectMe’s 24-hour high-tech customer service capabilities ensure that
all calls reach their intended destinations.  ConnectMe handles all
incoming calls simultaneously, so callers are never put on
hold.  Employees can create, maintain and access their own phone lists
and can customize the delivery of calls.
 
 o
              511 Traffic Information
      System
 In July
2000, the FCC assigned “511” as the number for nationwide access to traveler
information. 511 was designated as a free service and when fully implemented
will cover the majority of roads in the U.S., helping travelers avoid congested
routes and safety hazards.  By dialing 5-1-1, callers can access
information about route-specific weather and road conditions.  Fonix
and partner Meridian Environmental Technology, Inc. provide a 511 system in
North Dakota, South Dakota, Nebraska, Kansas and Montana.  Other
states are scheduled to deploy the system in the near
future.  Competition in the 511 market includes TellMe and IBM’s
WebSphere.
 
 Fonix Speech Customer
Self-Service Market Opportunities
 
 Fonix
      Speech is well positioned to be a primary competitor in telephony products
      with ConnectMe.  Benefits of ConnectMe include increased
      customer satisfaction, immediate ROI, user convenience, easy installation
      and maintenance, and its ability to bring a professional “voice” to
      companies’ telephone operator systems.  Fonix Speech’s market
      strategy is to sell ConnectMe through VARs and
      distributors.  Potential competitors in the telephony/server
      market include Nuance and
Avaya.
  8
  Fonix
Speech Marketing and Sales Activities
  
 Fonix
Speech expects to expand sales through partners, OEMs, ODMs, VARs, direct sales
and existing sales channels, both domestically and
internationally.  Fonix Speech will focus on wireless and mobile
devices, telephony and server phone solutions, assistive and language learning
devices, the videogame market, robots and appliances.
 
 To
address global opportunities, Fonix Speech plans to develop and expand sales and
marketing teams in Asia, Europe and the United States.  Fonix has
partnered with companies like A.I. Corporation, a high-tech Japanese product
distributor and engineering company specializing in embedded system software, to
capitalize on sales and marketing efforts outside the United
States.
 
 Fonix
Speech Strategic Relationships
 
 Fonix
Speech currently has a number of strategic collaboration, distribution and
marketing arrangements with OEMs, software developers and VARs.  Fonix
Speech intends to expand such relationships and add similar relationships,
specifically in markets related to wireless and mobile devices, assistive and
language learning devices and customer self-service solutions.  When
Fonix Speech identifies “first mover” speech-enabling applications that can
integrate Fonix Speech Products and Core Technologies, Fonix Speech intends to
investigate investment opportunities to obtain preferred or priority
collaboration rights.
 
 
 Fonix
Speech Continued Development
 
 Fonix
Speech plans to continue to invest resources in the development and acquisition
of standard speech solutions and enhancements to its Core Technologies,
developer tools and development frameworks to maintain competitive
advantages.
 
 Fonix
Speech Platforms, Ports, and Processors
 
 Fonix
Speech supports multiple microprocessors ("Chips"); including Win32, WinCE, QNX,
Linux, Solaris Palm, Apple OS 10+, Symbian Nokia Series 60 (operating
systems).  Supported operating systems (“OSs”) (these are the chips)
include: Analog Devices’ Blackfin, ARM 7, ARM 9, Epson S1C33 Family, Renesas,
Intel, MIPS, Motorola, NeoMagic’s MiMagic3, MiMagic5, TI OMAP1510, Sun Sparc,
FreeScale iMXL, Samsung S3C, FreeScale mCore and Power PC.
 
 Types
      of Microprocessors
              Types
      of Operating SystemsWin32
              WinCE
              QNX
              Linux
              Solaris
              Apple
      OS 10+
              Symbian
      Nokia Series 60
              No
      OS Support RequiredAnalog
      Devices
                Blackfin
              
              
              
              
              
              
              
              XARM
      7
                ARM
      9
              
              X
                X
              
              X
              
              
              X
              XEpson
                S1C33
      Family
              
              
              
              
              
              
              
              XRenasas
                SH-3
                SH-4
              
              X
                X
              X
              
              
              
              
              XIntel
                SA-1110
                XScale
                X86
              X
              X
                X
              X
                X
              X
                XMIPS
                MIPS
      R4XXX
              
              XMotorola
                PPC
      5100/5200
              
              
              X
              XNeoMagic
                MiMagic3
      (NMS7210)
                MiMagic5
              
              XTI
      OMAP1510 (ARM core)
              
              XSun
      Sparc
              
              
              
              
              XFreescale
      iMXL (ARM)
              
              XSamsung
      S3C ARM
              
              XFreeScale
      mCore
              
              
              
              
              
              
              
              XPower
      PC
              
              
              
              
              
              X
 
  9
 
 RECENT
DEVELOPMENTS
 
 Exchange
Agreement
 
 In March
2009, the Company announced that it had closed a previously announced
transaction whereby its subsidiary Fonix GS Acquisition Corporation, Inc.
(“Fonix GS”) acquired 80% of the issued and outstanding shares of G-Soft
Limited, a Hong Kong corporation (“G-Soft”), which is the ultimate parent of
Shanghai Gaozhi Software Systems Limited ("GaozhiSoft"), a Chinese software
developer and solutions provider in 2G (second-generation) and 3G
(third-generation) mobile networks in China and throughout the Asian Pacific
region.
 
 In a
Current Report filed with the SEC on August 12, 2008, the Company announced that
it had formed Fonix GS for the purpose of acquiring the GaozhiSoft
shares.
 
 On June
27, 2008, the Company and Fonix GS entered into an exchange agreement (the
“Exchange Agreement”), with Southridge LLC, a Connecticut limited liability
company (“Southridge”), G-Soft and the shareholders of G-Soft (the
“Sellers”).  G-Soft, through its wholly owned subsidiary, owns 100% of
the outstanding equity of GaozhiSoft. Pursuant to the Exchange Agreement, Fonix
GS agreed to purchase 80% of the issued and outstanding shares of G-Soft from
the Sellers, and Southridge agreed to purchase the remaining 20% of the issued
and outstanding G-Soft shares, thereby making Fonix GS and Southridge the
ultimate shareholders of GaozhiSoft.
 
 The
Exchange Agreement was amended by that certain First Amendment to the Exchange
Agreement, dated as of December 12, 2008 (the “First Amendment”), modifying the
consideration for the purchase of the G-Soft shares and certain other closing
conditions, as set forth therein.  Pursuant to the Exchange Agreement,
as amended, in exchange for 20% of the outstanding shares of G-Soft, Southridge
agreed to transfer shares of the Company’s Series L Convertible Preferred Stock
(the “Series L Preferred Stock”) in the amounts set forth in the First
Amendment.  In return for the purchase of 80% of the outstanding
shares of G-Soft, the Company agreed to issue an aggregate of one hundred and
twenty shares (120) of a new series of preferred stock (the “Series P Preferred
Stock”) to the Sellers.  Additionally, subject to the terms of the
First Amendment, the Sellers are entitled to annual earn-out payments equal to
fifty percent (50%) of the prior year’s net income of GaozhiSoft, to be paid in
the form of Series P Preferred Stock (the “Earn-Out Payments”).  The
aggregate of the Earn-Out Payments is limited to three hundred and eighty (380)
shares of Series P Preferred.  The First Amendment also amended and
restated section 6.1 of the Exchange Agreement, relating to additional closing
conditions, and section 8.2 of the original agreement relating to
indemnification.
 
 The
Sellers and Fonix entered into an Escrow Agreement (the “Escrow Agreement”) with
Adam L. Goldberg, whereby Mr. Goldberg agreed to act as escrow agent and hold
the Series P Preferred Stock issued or issuable to the Sellers to purchase their
interests in G-Soft.  The Escrow Agreement outlined Mr. Goldberg’s
duties and obligations as Escrow Agent.
 
 The First
Amendment and the Escrow Agreement were described in more detail in, and
attached as exhibits to, the Current Report on Form 8K, filed with the SEC on
December 19, 2008.
  10
  
 Additionally,
Fonix GS and the Sellers entered into a side letter agreement, dated February
18, 2009 (the “Side Letter”), attached hereto as an exhibit, modifying certain
closing conditions of the Exchange Agreement, as amended by the First
Amendment.  The Side Letter establishes certain conditions regarding:
(1) management and directorships of GaozhiSoft; (2) filing of certain
administrative government documents in China; and (3) operations of
GaozhiSoft.
 
 The final
closing conditions have been met, and the share exchange transaction closed as
of March 27, 2009.
 
 The
foregoing summaries of the terms and conditions of the Exchange Agreement, First
Amendment, Escrow Agreement and Side Letter do not purport to be complete and
are qualified in their entirety by reference to the full text of the Exchange
Agreement, First Amendment, Escrow Agreement and Side Letter, which were filed
as exhibits to Current Reports previously filed with the SEC.
 
 Issuance
of Series P 9% Convertible Preferred Stock in G-Soft Transaction
 
 As
disclosed in a Current Report filed with the Commission on March 27, 2009, Fonix
Corporation (the “Company”) issued an aggregate of one hundred and twenty shares
(120) of the Company’s Series P 9% Convertible Preferred Stock (the “Series P
Preferred Stock”) to G-Soft Limited, a Hong Kong corporation (“G-Soft”), which
is the ultimate parent of Shanghai Gaozhi Software Systems Limited
("GaozhiSoft"), and the shareholders of G-Soft (collectively, the
“Sellers”).  The Shares of Series P Preferred Stock were issued
pursuant to an exchange agreement (the “Exchange Agreement”), with Southridge
LLC, a Connecticut limited liability company (“Southridge”), and the
Sellers.  Additionally, subject to the terms of the amended agreement
with the Sellers, the Sellers are entitled to annual earn-out payments equal to
fifty percent (50%) of the prior year’s net income of GaozhiSoft, to be paid in
the form of Series P Preferred Stock (the “Earn-Out Payments”).  The
aggregate of the Earn-Out Payments is limited to three hundred and eighty (380)
shares of Series P Preferred, which were issued into an escrow
account.
 
 The
Series P Preferred Stock entitles the holders to receive dividends in an amount
equal to 9% of the then-outstanding balance of shares of Series P Preferred
Stock.  The dividends are payable in cash or shares of our Class A
common stock, at the Company’s option.
 
 The
Series P Preferred Stock may be converted into the Company’s common stock at the
option of the holder by using a conversion price which shall be 80% of the
average of the two (2) lowest closing bid prices for the twenty-day trading
period prior to the conversion date.
 
 Redemption
of the Series P Preferred Stock, whether at the Company’s option or that of the
holder, requires the Company to pay, as a redemption price, the stated value of
the outstanding shares of Series P Preferred Stock to be redeemed, together with
any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).
 
 On
September 26, 2008, the Company filed with the State of Delaware a Certificate
of Designation and Series P 9% Convertible Stock Terms (the “Series P Terms”),
which become a part of the Company’s Certificate of Incorporation, as
amended.
  11
  Under the
G-Soft Agreement and the Series P Terms, the holders of the Series P Preferred
Stock may convert shares of Series P Preferred Stock into shares of the
Company’s common stock.  The Company’s issuances of shares of common
stock upon any conversion of the Series P Preferred Stock will be made without
registration under the Securities Act of 1933 (the “1933 Act”) in reliance on
Section 4(2) of the 1933 Act and the rules and regulations promulgated
thereunder.  The Company’s sale and issuance of the Series P Preferred
Stock to the Sellers was made without registration under the 1933 Act in
reliance on Section 4(2) of the 1933 Act and the rules and regulations
promulgated thereunder.
 
 Issuance
of Shares of Series P 9% Convertible Preferred Stock to Acquire Remaining 20% of
G-Soft
 
 In
connection with the G-Soft transaction described above, on March 27, 2009, the
Company entered into a Series P Convertible Preferred Stock Purchase Agreement
(the “Preferred Stock Purchase Agreement”), with Southridge Partners LP
(“Southridge”).  Pursuant to the Preferred Stock Purchase Agreement,
the Company issued 189 shares of Series P Preferred Stock in exchange for the
20% of G-Soft shares which Southridge had purchased in the G-Soft Transaction
described above.
 
 The
Series P Preferred Stock issued to Southridge has the same terms as described
above.
 
 Under the
Preferred Stock Purchase Agreement and the Series P Terms, Southridge may
convert shares of Series P Preferred Stock into shares of the Company’s common
stock.  The Company’s issuances of shares of common stock upon any
conversion of the Series P Preferred Stock will be made without registration
under the Securities Act of 1933 (the “1933 Act”) in reliance on Section 4(2) of
the 1933 Act and the rules and regulations promulgated
thereunder.  The Company’s sale and issuance of the Series P Preferred
Stock to Southridge was made without registration under the 1933 Act in reliance
on Section 4(2) of the 1933 Act and the rules and regulations promulgated
thereunder.
 
 The foregoing summaries of the terms
and conditions of the Exchange Agreement and the Preferred Stock Purchase
Agreement do not purport to be complete and are qualified in their entirety by
reference to the full text of the Exchange Agreement and the Preferred Stock
Purchase Agreement, filed previously with the Commission.
 
 Reverse
Stock Split
 
 On
December 19, 2008, Fonix Corporation (the “Company”) filed an amendment (the
“Amendment”) to its Certificate of Incorporation, as amended to date, to provide
for a reverse stock split (the “Reverse Split”) of the Company’s Class A common
stock at a ratio of one new share for each 5,000 old shares, or
one-for-5,000.  The Reverse Stock Split had previously been approved
by the shareholders of the Company at the Company’s Annual Meeting on December
2, 2008.
 
 The Amendment provided that the Reverse
Stock Split would take effect on December 23, 2008.  However, due to
scheduling issues between the Company’s transfer agent and FINRA, the effective
date of the Reverse Stock Split was delayed.  The market effective
date of the Reverse Stock Split will be as of the open of business on December
26, 2008.
 
 Beginning December 26, 2008, Fonix's
common stock trades under the symbol FNXC.
   12
  ITEM
1A.                           RISK
FACTORS
 
 The
short- and long-term success of Fonix is subject to certain risks, many of which
are substantial in nature and outside the control of Fonix.  You
should consider carefully the following risk factors, in addition to other
information contained herein.  When used in this Report, words such as
“believes,” “expects,” “intends,” “plans,” “anticipates,” “estimates,” and
similar expressions are intended to identify forward-looking statements,
although there may be certain forward-looking statements not accompanied by such
expressions.  Additionally, statements that relate to future business
development, financial projections, capital raising, capital requirements,
growth of markets or customer bases, or future business combinations may also
include forward-looking statements.  You should understand that
several factors govern whether any forward-looking statement contained herein
will or can be achieved.  Any one of those factors could cause actual
results to differ materially from those projected herein.  These
forward-looking statements include plans and objectives of management for future
operations, including the strategies, plans and objectives relating to the
products and the future economic performance of Fonix and its subsidiaries
discussed above.  In light of the significant uncertainties inherent
in the forward-looking statements included herein, the inclusion of any such
statement should not be regarded as a representation by Fonix or any other
person that the objectives or plans of Fonix will be achieved.  Fonix
disclaims any intention or obligation to update any forward-looking statement
contained herein.
 
 Our
substantial and continuing losses since inception, coupled with significant
ongoing operating expenses, raise doubt about our ability to continue as a going
concern.
 
 Since
inception, we have sustained substantial losses. Such losses continue due to
ongoing operating expenses and a lack of revenues sufficient to offset operating
expenses. We have raised capital to fund ongoing operations by private sales of
our securities, some of which sales have been highly dilutive and involve
considerable expense. In our present circumstances, there is substantial doubt
about our ability to continue as a going concern absent significant sales of our
products and telecommunication services, substantial revenues from new licensing
or co-development contracts, or continuing large sales of our
securities.
 
 We had
net loss of $6,169,000 for December 31, 2008, and net income of $14,959,000 for
the year ended December 31, 2007 and a net loss of $21,943,000 for the year
ended December 31, 2006, respectively. As of December 31, 2008, we had an
accumulated deficit of $286,367,000, negative working capital of $44,471,000,
derivative liabilities of $34,582,000 related to the issuance of Series L
Preferred Stock, Series M Preferred Stock, Series N Preferred Stock, Series O
Preferred Stock, Series P Preferred Stock and Series B Preferred Stock of our
subsidiary, accrued liabilities of $6,510,000, accounts payable of $1,801,000
and deferred revenues of $445,000.
 
 We expect
to continue to spend significant amounts to enhance our Speech Products and
technologies and fund further Product development. As a result, we will need to
generate significant additional revenue to achieve profitability. Even if we do
achieve profitability, we may not be able to sustain or increase profitability
on a quarterly or annual basis. If we do not achieve and maintain profitability,
the market price for our common stock may further decline, perhaps
substantially, and we may have to curtail or cease our operations.
 
 Continuing
debt obligations could impair our ability to continue as a going
concern.
 
 As of
December 31, 2008, we had debt obligations of $917,000, accrued liabilities of
$6,510,000 and vendor accounts payable of approximately
$1,801,000.  At present, our revenues from existing licensing
arrangements and Speech Product sales are not sufficient to offset our ongoing
operating expenses or to pay in full our current debt obligations.
 
 There is
substantial risk, therefore, that the existence and extent of the debt
obligations described above could adversely affect our business, operations and
financial condition, and we may be forced to curtail our operations, sell part
or all of our assets, or seek protection under bankruptcy laws. Additionally,
there is substantial risk that the current or former employees or our vendors
could bring lawsuits to collect the unpaid amounts. In the event of lawsuits of
this type, if we are unable to negotiate settlements or satisfy our obligations,
we could be forced to seek protection under the bankruptcy
laws.
  13
   Holders
of Fonix Class A common stock are subject to the risk of additional and
substantial dilution to their interests as a result of the issuances of Class A
common stock in connection with conversions of the outstanding series of
preferred stock.
 
 The
following table describes the number of shares of Class A common stock that
would be issuable, assuming that the full principal amount of the various series
of preferred stock listed were converted into shares of our Class A common stock
as of March 16, 2009 (irrespective of the availability of registered shares or
conversion limitations imposed by the applicable certificates of designation),
and further assuming that the applicable conversion price at the time of such
put were the following amounts:
 
 Hypothetical
      Conversion Price
              Shares
      issuable upon
                Conversion
      of Series L Preferred Stock
                (1,494
      shares outstanding)
              Shares
      issuable upon
                Conversion
      of Series M Preferred Stock
                (150
      shares outstanding)
              Shares
      issuable upon
                Conversion
      of Series N Preferred Stock
                (1,755
      shares outstanding)
              Shares
      issuable upon
                Conversion
      of Series O Preferred Stock
                (730
      shares outstanding)
              Shares
      issuable upon
                Conversion
      of Series P Preferred Stock
                (1,305
      shares outstanding)
              Shares
      issuable upon
                Conversion
      of Fonix Speech Series B Preferred Stock*
                (125
      shares outstanding)
              Total
      shares issuable upon conversion of outstanding Preferred
    Stock$0.01
              1,494,000,000
              150,000,000
              175,500,000
              73,000,000
              13,005,000,000
              125,000,000
              3,322,500,000$0.02
              747,000,000
              75,000,000
              87,750,000
              36,500,000
              652,500,000
              62,500,000
              1,661,250,000$0.03
              498,000,000
              50,000,000
              58,500,000
              24,333,333
              435,000,000
              41,666,666
              1,107,500,000$0.05
              298,800,000
              30,000,000
              35,100,000
              14,600,000
              261,000,000
              25,000,000
              664,500,000$0.10
              149,400,000
              15,000,000
              17,550,000
              7,300,000
              130,500,000
              12,500,000
              332,250,000$0.20
              74,700,000
              7,500,000
              8,775,000
              3,650,000
              65,250,000
              6,250,000
              166,125,000$0.50
              29,880,000
              3,000,000
              3,510,000
              1,460,000
              26,100,000
              2,500,000
              66,450,000
 
 *           The
Fonix Speech Series B Preferred Stock is convertible into shares of Fonix
Corporation Class A common stock.
 
 Given the formulas for calculating the
shares to be issued in connection with conversions of the various series of
preferred stock, there effectively is no limitation on the number of shares of
Class A common stock which may be issued in connection with conversions of the
outstanding shares of preferred stock, except for the number of shares available
for issuance under the Company’s Certificate of Incorporation.  As
such, shareholders are subject to the risk of substantial dilution to their
interests as a result of our issuance of shares in connection with conversions
of the series of preferred stock listed above.
 
 We
have no dividend history and have no intention to pay dividends in the
foreseeable future.
 
 We have never paid dividends on or in
connection with any class of our common stock and do not intend to pay any
dividends to common stockholders for the foreseeable future.
 
 Competition
from other industry participants and rapid technological change could impede our
ability to achieve profitable operations.  Additionally, our current
and potential competitors, some of whom have greater resources and experience
than we do, may develop products and technologies that may cause a decline in
demand for, and the prices of, our Speech Products.
 
 The speech-enabled technologies market
sector and telecommunications industry are characterized by rapid technological
change.  Competition in the speech-enabled technologies market is
based largely on marketing ability and resources, distribution channels,
technology and product superiority and product service and support.  A
number of companies have developed, or are expected to develop, products that
compete with our Speech Products and Core Technologies.  Competitors
in the speech technology software market include IBM, SpeechWorks International,
Nuance, and VoiceSignal.  We expect additional competition from other
companies, including Microsoft.  Furthermore, our competitors may
combine with each other, and other companies may enter our markets by acquiring
or entering into strategic relationships with our
competitors.  Current and potential competitors have established, or
may establish, cooperative relationships among themselves or with third parties
to increase the abilities of their speech and language technology products to
address the needs of our prospective customers.
  14
  
 Many of our current and potential
competitors have competitive advantages over us, including substantially greater
financial, technical, personnel and other resources, including brand name
recognition and long-standing relationships with customers.  These
resources may place us at competitive disadvantage in our existing speech and
telecommunications markets and may impair our ability to expand into new
markets, which could adversely affect our business.  If we fail to
grow rapidly or obtain additional capital we may not be able to compete with
larger, more well established companies.  There can be no assurance
that we will be able to successfully compete in our existing markets or in new
markets.
 
 We
may incur a variety of costs to engage in future acquisitions of companies,
products or technologies to grow our customer base, to expand into new markets,
or to provide new services.  As such, the anticipated benefits of
those acquisitions may never be realized.
 
 We may acquire other businesses to grow
our customer base, to expand into new markets, or to provide new
services.  We may make acquisitions of, or significant investments in,
complementary companies, products or technologies, although no additional
material acquisitions or investments are currently
pending.  Acquisitions may be accompanied by risks such
as:
 
 •
              difficulties
      in assimilating the operations and employees of acquired
      companies;
 
 •
              diversion
      of our management's attention from ongoing business
    concerns;
 
 •
              our
      potential inability to maximize our financial and strategic position
      through the successful incorporation of acquired technology and rights
      into our products and services;
 
 •
              additional
      expense associated with amortization of acquired
  assets;
 
 •
              additional
      expense associated with understanding and development of acquired
      business;
 
 •
              maintenance
      and implementation of uniform standards, controls, procedures and
      policies; and
 
 •
              impairment
      of existing relationships with employees, suppliers and customers as a
      result of the integration of new management
  employees.
 
 We
must attract and retain skilled personnel.  If we are unable to hire
and retain technical, sales and marketing and operational employees, our
business could be harmed.
 
 Our ability to manage our growth will
be particularly dependent on our ability to develop and retain an effective
sales force and qualified technical and managerial personnel.  We
intend to hire additional employees, including software engineers, sales and
marketing employees and operational employees.  The competition for
qualified sales, technical, and managerial personnel in the communications
industry, as well as the speech technology industry, is intense, and we may not
be able to hire and retain sufficient qualified personnel.  In
addition, we may not be able to maintain the quality of our operations, control
our costs, maintain compliance with all applicable regulations, and expand our
internal management, technical, information and accounting systems in order to
support our desired growth, which could have an adverse impact on our
operations.
 
 We
are subject to the risk that certain key personnel, including key scientific
employees named below, on whom we depend, in part, for our operations, will
cease to be involved with us.
 
 We are dependent on the knowledge,
skill and expertise of several key scientific and business development
employees, including Dale Lynn Shepherd and Ron Lowe; and executive officers,
including Roger D. Dudley.  The loss of any of the key personnel
listed above could materially and adversely affect our future business
efforts.  Although we have taken reasonable steps to protect our
intellectual property rights including obtaining non-competition and
non-disclosure agreements from all of our employees and independent contractors,
if one or more of our key scientific employees, executive employees or
independent contractors resigns from Fonix to join a competitor, to the extent
not prohibited by such person's non-competition and non-disclosure agreement,
the loss of such personnel and the employment of such personnel by a competitor
could have a material adverse effect on us.  We do not presently have
any key man life insurance on any of our employees.
  15
  
 As
of the date of this Report, our board of directors consisted of one individual,
and we had only one executive officer.  As such, management of the
Company is consolidated in one individual.
 
 On Wednesday, March 5, 2008, Thomas A.
Murdock resigned as Chairman of the Board, President, and Chief Executive
Officer of the Company.  Mr. Murdock also resigned all officer and
director positions he held with Fonix Speech, Inc., Fonix/AcuVoice, Inc.,
Fonix/Papyrus Corporation, Fonix UK, Ltd., and Fonix Sales, Korea Group, Ltd.,
all subsidiaries of the Company.  Additionally, on Wednesday, March 5,
2008, William A. Maasberg resigned as director of the Company, although he
continued to serve as our Chief Operating Officer until March 31,
2008.  In connection with the resignation of Messrs. Murdock and
Maasberg, the Company appointed Roger D. Dudley, who was serving as the
Company’s Executive Vice President and Chief Financial Officer, as the Company’s
Chairman, President, and Chief Executive Officer.  Mr. Dudley will
continue to serve as Chief Financial Officer.  Following the
resignations of Messrs. Murdock and Maasberg, Mr. Dudley is the sole director of
the Company.
 
 Although our bylaws and Delaware
corporate law permit the continuation of business with a sole director, this
situation results in an absence of the typical checks and balances that are
present where a board of directors consists of even two
individuals.  Additionally, although we have in place controls and
procedures relating to the operation of the Company, the positions of Chief
Executive Officer (principal executive officer) and Chief Financial Officer
(principal accounting officer) are held by one individual, again resulting in
the absence of checks and balances.  Such consolidation of management
roles may also subvert certain of our operational controls and
procedures.
 
 An
inability to market and develop additional services may adversely affect our
ability to retain existing customers or attract new customers.
 
 Through Fonix Speech, we offer speech
technology solutions and products.  In order to address the future
needs of our customers, we will be required to market and develop additional
products and services.  We may not be able to continue to provide the
range of speech products or telecommunication services that our customers need
or desire.  We may lose some of our customers or be unable to attract
new customers if we cannot offer the products and services our customers need or
desire.
 
 Our
common stock is considered a penny stock.  Penny stocks are subject to
special regulations, which may make them more difficult to trade on the open
market.
 
 Securities in the OTC market are
generally more difficult to trade than those on the NASDAQ National Market, the
NASDAQ SmallCap Market or the major stock exchanges.  In addition,
accurate price quotations are also more difficult to obtain.  The
trading market for our common stock is subject to special regulations governing
the sale of penny stock.
 
 A “penny stock” is defined by
regulations of the Securities and Exchange Commission as an equity security with
a market price of less than $5.00 per share.  The market price of our
Class A common stock has been less than $5.00 for several years.
 
 If you buy or sell a penny stock, these
regulations require that you receive, prior to the transaction, a disclosure
explaining the penny stock market and associated risks.  Furthermore,
trading in our common stock would be subject to Rule 15g-9 of the Exchange Act,
which relates to non-NASDAQ and non-exchange listed securities.  Under
this rule, broker-dealers who recommend our securities to persons other than
established customers and accredited investors must make a special written
suitability determination for the purchaser and receive the purchaser's written
agreement to a transaction prior to sale.  Securities are exempt from
this rule if their market price is at least $5.00 per share.
  16
  
 Penny
stock regulations will tend to reduce market liquidity of our common stock,
because they limit the broker-dealers' ability to trade, and a purchaser's
ability to sell the stock in the secondary market.  The low price of
our common stock will have a negative effect on the amount and percentage of
transaction costs paid by individual shareholders.  The low price of
our common stock may also limit our ability to raise additional capital by
issuing additional shares.  There are several reasons for these
effects.  First, the internal policies of many institutional investors
prohibit the purchase of low-priced stocks.  Second, many brokerage
houses do not permit low-priced stocks to be used as collateral for margin
accounts or to be purchased on margin.  Third, some brokerage house
policies and practices tend to discourage individual brokers from dealing in
low-priced stocks.  Finally, broker's commissions on low-priced stocks
usually represent a higher percentage of the stock price than commissions on
higher priced stocks.  As a result, our shareholders will pay
transaction costs that are a higher percentage of their total share value than
if our share price were substantially higher.
 
 We
have a limited Speech Product offering, and many of our key technologies are
still in the product development stage.
 
 Presently, there are a limited number
of commercially available Speech Products incorporating our Core
Technologies.  For Fonix to be ultimately successful, sales from these
Speech Products must be substantially greater.  An additional element
of our business strategy is to achieve revenues through strategic alliances,
co-development arrangements, and license arrangements with third
parties.  For example, we have entered into licensing and
joint-marketing agreements with Sony, Electronic Arts, Microsoft, Epson, Casio,
Canon, Ubisoft, OC3, Harmonix, and others.  These agreements provide
for joint marketing and application development for end-users or
customers.  To date, these agreements have not produced significant
revenues.  There can be no assurance that these collaboration
agreements will produce license or other agreements which will generate
significant revenues for us.
 
 The
market for many of our Core Technologies and Speech Products is largely unproven
and may never develop sufficiently to allow us to capitalize on our Core
Technology and Speech Products.
 
 The market for speech-enabled Speech
Products is rapidly evolving.  Additionally, our Speech Products are
new and, in many instances, represent a significant departure from technologies
which already have found a degree of acceptance in the speech-enabled
technologies marketplace.  Our financial performance will depend, in
part, on the future development, growth and ultimate size of the market for
speech-enabled applications and Speech Products generally, and applications and
products incorporating our Speech Products.  If the potential users of
speech-enabled software in general and our products in particular do not
perceive appropriate benefits, or if speech-enabled software platforms do not
achieve commercial acceptance, our business could be harmed or even
fail.
 
 The Speech Products which incorporate
our Core Technologies will be competing with more conventional means of
information processing such as data entry, access by keyboard, mouse or
touch-tone telephone.  We believe that there is a substantial
potential market for applications and products incorporating advanced
speech-enabled technologies.  Nevertheless, such a market for our
Speech Products may never develop to the point that profitable operations can be
achieved or sustained.
 
 Our
Speech Products may not achieve widespread acceptance by businesses or
telecommunications carriers, which could limit our ability to grow our
business.
 
 Our ability to increase revenue in the
future depends on the acceptance of speech-enabling products and applications by
both our customers and end users.  The adoption and integration of
speech-enabling products and applications could be hindered by the perceived
costs of these new products and applications, as well as the reluctance of
enterprises that have invested substantial resources in existing applications to
replace their current systems with these new products and
applications.  Accordingly, in order to achieve commercial acceptance,
we will have to educate prospective customers, including large, established
companies, about the uses and benefits of speech-enabling products and
applications in general and our Speech Products in particular.  If
these efforts fail, or if speech-enabling products and technology platforms do
not achieve commercial acceptance, our business will not develop or may
subsequently fail.
 
 Continued development of the market for
our Speech Products also will depend upon the following factors over which we
have little or no control:
  17
  
 •
              widespread
      deployment of speech-enabling applications by third parties, which is
      driven by consumer demand for services having a voice user
      interface;
 
 •
              demand
      for new uses and applications of speech-enabling technology, including
      adoption of speech-enabled interfaces by companies that operate web
      sites;
 
 •
              adoption
      of industry standards for speech-enabling and related technologies;
      and
 
 •
              continuing
      improvements in hardware technology that may reduce the costs of
      speech-enabling technology
solutions.
 
 In
many cases, the delivery of our Speech Products to end users is dependent upon
third-party integration and may be subject to delays and cancellations that are
beyond our control.
 
 Generally, we are pursuing third-party
integration of our Speech Products into mass market, general business, personal
electronics products, and computing solutions.  Thus, lead time to
revenue recognition will be longer than software products directly released into
consumer channels.  Purchase of our Speech Products often requires a
significant expenditure by a customer.  Accordingly, the decision to
purchase our Speech Products typically requires significant pre-purchase
evaluation.  We spend significant time educating and providing
information to prospective customers regarding the use and benefits of our
Speech Products.  During this evaluation period, we may expend
substantial sales, marketing and management resources.
 
 Further, our Speech Products sold and
integrated into customer applications and products are subject to both customer
production schedules and customer success in marketing their own products and
generating product sales.  Our revenues are thus subject to delays and
possible cancellation resulting from customer integration risks and
delays.
 
 In cases where our contract with our
customers specifies milestones or acceptance criteria, we may not be able to
recognize license or services revenue until these conditions are
met.  We have in the past and may in the future experience unexpected
delays in recognizing revenue.  Consequently, the length of our sales
and implementation cycles and the varying order amounts for our Speech Products
make it difficult to predict the quarter in which revenue recognition may occur
and may cause license and services revenue and operating results to vary
significantly from period to period.  These factors could cause our
stock price to be volatile or to decline.
 
 Our
Speech Products can have a long sales cycle and, as a result, our quarterly
operating results and our stock price may fluctuate.
 
 The sales cycles for our Speech
Products are generally six to twelve months but may be shorter or longer
depending on the size and complexity of the order, the amount of services to be
provided and whether the sale is made directly by us or indirectly through an
OEM, VAR, or systems integrator.  The length of the sales cycles could
adversely impact our operating results.
 
 Our
failure to respond to rapid change in the speech-enabled technologies market
could cause us to lose revenue and could harm our business.
 
 Our success will depend substantially
upon our ability to enhance our existing Speech Products and to develop and
introduce, on a timely and cost-effective basis, new technologies, Speech
Products and features that meet changing end-user requirements and incorporate
technological advancements.  If we are unable to develop new Speech
Products and enhanced functionalities or technologies to adapt to these changes,
or if we cannot offset a decline in revenue from existing Speech Products with
sales of new Speech Products, our business will suffer.
 
 Commercial acceptance of our Speech
Products will depend, among other things, on:
 
 •
              the
      ability of our Speech Products to meet and adapt to the needs of our
      target markets;
 
 •
              the
      performance and price of our Speech Products and our competitors'
      products; and
 
 •
              our
      ability to deliver customer services directly and through our resellers,
      VARs and OEM partners.
 
  18
  
 In
order to increase our international sales, we must increase the foreign language
capacities of our Speech Products.  If we are unable to do so, we may
be unable to grow our revenue and execute our business strategy.
 
 We intend to expand our international
sales, which requires a significant investment to create and refine different
language models for each particular language or dialect.  These
language models are required to create versions of products that allow end users
to speak the local language or dialect and be understood.  If we fail
to develop additional foreign language capacity of our Speech Products, our
ability to benefit from international market opportunities and to grow our
business will be limited.
 
 Our
operations and financial condition could be adversely affected by our failure or
inability to protect our intellectual property or if our technologies are found
to infringe the intellectual property of a third party.
 
 Dependence on proprietary
technology
 
 Our success is heavily dependent upon
our proprietary technology.  Certain elements of our Core Technologies
are the subject of nine patents issued and allowed by the United States Patent
and Trademark Office and seven other patent applications which are
pending.  In addition to our patents, we rely on a combination of
copyright and trademark laws, trade secrets, confidentiality procedures and
contractual provisions to protect our proprietary rights.  Such means
of protecting our proprietary rights may not be adequate because such laws
provide only limited protection.  Despite precautions that we take, it
may be possible for unauthorized third parties to duplicate aspects of our
technologies or the current or future products or technologies of our business
units or to obtain and use information that we regard as
proprietary.  Additionally, our competitors may independently develop
similar or superior technology.  Policing unauthorized use of
proprietary rights is difficult, and some international laws do not protect
proprietary rights to the same extent as United States
laws.  Litigation periodically may be necessary to enforce our
intellectual property rights, to protect our trade secrets or to determine the
validity and scope of the proprietary rights of others.
 
 
 Risks of our infringement upon the
technology of unrelated parties or entities
 
 We are not aware and do not believe
that any of our technologies or products infringe the proprietary rights of
third parties.  Nevertheless, third parties may claim infringement
with respect to our current or future technologies or products or products
manufactured by others and incorporating our technologies.  We expect
that developers of speech-enabled technologies increasingly will be subject to
infringement claims as the number of products and competitors in the industry
grows and the functionality of products in different industry segments
overlaps.  Responding to any such claims, whether or not they are
found to have merit, could be time consuming, result in costly litigation, cause
development delays, or require us to enter into royalty or license
agreements.  Royalty or license agreements may not be available on
acceptable terms or at all.  As a result, infringement claims could
have a material adverse affect on our business, operating results, and financial
condition.
 
 There
may be additional unknown risks, which could have a negative effect on our
business.
 
 The risks and uncertainties described
in this section are not the only ones facing us.  Additional risks and
uncertainties not presently known to us or that we currently deem immaterial may
also impair our business operations.  If any of the foregoing risks
actually occur, our business, financial condition, or results of operations
could be materially adversely affected.
 
 ITEM
      2.
              PROPERTIES
 
 We own no real property.  We
lease approximately 3,900 square feet of office space in Lindon, Utah, where
Fonix Speech conducts its principal scientific research, product development and
sales and marketing activities.  Our lease of that facility expires
April 30, 2013.  The average base monthly lease payment over the
five-year life of the lease is $6,000.
  19
  
 ITEM
      3.
              LEGAL
      PROCEEDINGS
 
 
 Hite Development Corporation v. Fonix
Corporation,Third District Court, Salt Lake County (Civil No.
070900883).  In January 2007, Hite Development Corporation (“Hite”)
brought a lawsuit against the Company claiming breach of contract and breach of
the covenant of good faith and fair dealing, alleging that the Company failed to
make certain payments under a settlement agreement with Hite dating from March
2005.  The complaint seeks approximately $33,000 plus
interest.  The Company filed its answer in May 2007.  On
October 2, 2008, a judgment was entered against the Company in the amount of
$28,050.
 
 RR Donnelley Receivables Inc. v.
Fonix Corporation,Third District Court, Salt Lake County (Civil No.
070412088).  In July 2007, RR Donnelley Receivables Inc. (“Donnelly”)
brought a lawsuit against the Company for alleged failure to pay for services
provided.  The complaint seeks approximately $21,000 plus
interest.  The Company filed its answer in August 2007, and filed a
motion to dismiss the action in December 2007.  That motion is
currently pending before the court.  If the Company’s motion to
dismiss is denied, the Company intends to defend against the claims in the
complaint.
 
 ITEM
4.                  SUBMISSION
OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
 Annual
Meeting of Shareholders
 
 Annual Shareholder Meeting
Results
 
 On
December 2, 2008, Fonix Corporation held its Annual Meeting of Shareholders in
Salt Lake City, Utah.  The record date for the meeting was October 20,
2008, on which date there were 14,963,757,642 pre-split shares of our class A
common stock outstanding.
 
 The first
matter voted upon at the meeting was the election of a director.  The
following director was elected:
 
 DIRECTOR
                
                SHARES
                  VOTED
      IN FAVOR
                
                SHARES
                  WITHHELDRoger
      D. Dudley
                
                7,679,501,871
                
                1,211,813,436
 
 The
second matter voted upon at the meeting was the approval of the Board of
Directors’ selection of Hansen, Barnett & Maxwell as the Company’s
independent registered public accounting firm for the fiscal year ending
December 31, 2008.  The results of the voting were 7,834,674,657
shares in favor, 582,334,490 shares against, and 474,306,159 shares
abstaining.
 
 The third
matter voted upon at the meeting was the approval of an amendment to the
Company’s Certificate of Incorporation to provide for a reverse stock split at
one of the following ratios: 1-for-1,000; 1-for-2,500; 1-for-5,000; or
1-for-7,500.  The results of the voting were 5,394,860,190 common
shares in favor, 3,450,924,914 shares against and 45,530,202 shares
abstaining.  There were also an additional 39,500,000,000 votes from
the holders of the Company’s Series O Preferred Stock, which was entitled to
vote on this issue, which were voted in favor of this proposal.  By
way of background, the Company’s Series O Preferred Stock granted its holders
the right to vote on certain limited matters that could be proposed to the
shareholders of the Company, including the proposed reverse stock
split.  The Series O Preferred Stock certificate of designation
provided that the holders of the Series O Preferred Stock would be entitled to
that number of votes equal to the number of shares of common stock into which
the preferred stock would be converted, multiplied by five.
 
 The
Company’s Board of Directors and management determined that it was in the best
interest of the Company to implement a reverse stock split at a ratio of
1-for-5,000, or one (1) new share for each 5,000 old shares, which took effect
in December 2008.
 
  20
  
 PART
II
 
 ITEM
      5.
              MARKET
      FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
      PURCHASES OF EQUITY SECURITIES
 
 Market information
 
 Our Class A common stock is listed on
the OTC Bulletin Board under the trading symbol FNIX.  The following
table shows the range of high and low sales price information for our Class A
common stock as quoted on the OTC Bulletin Board for the calendar years 2007 and
2008 and for the first quarter of 2009.  The quotations reflect
inter-dealer prices, without retail mark-up, mark-down or commissions and may
not represent actual transactions.  As noted above, in December 2008,
we implemented a 1 for 5000 share reverse stock split.  The prices
below have been adjusted to reflect the effect of the reverse
split.
 
 Calendar
Year
 2009
                2008
                2007High
                Low
                High
                Low
                High
                LowFirst
      Quarter
                $0.21
                $0.026
                $2.00
                $0.50
                $14.00
                $6.50Second
      Quarter
                
                
                $1.50
                $0.50
                $12.50
                $4.50Third
      Quarter
                
                
                $1.50
                $0.50
                $6.50
                $2.00Fourth
      Quarter
                
                
                $1.00
                $0.18
                $8.00
                $1.00
 
 The high and low sales prices for our
Class A common stock on March 31, 2009, were $0.085 and $0.07,
respectively.  As of March 16, 2009, there were 5,818,536 shares of
Fonix Class A common stock outstanding, held by approximately 1,400 holders of
record and approximately 26,000 beneficial holders.  This number of
beneficial holders represents an estimate of the number of actual holders of our
stock, including beneficial owners of shares held in "nominee" or "street"
name.  The actual number of beneficial owners is not known to
us.
 
 We have never declared any dividends on
our Class A common stock and it is expected that earnings, if any, in future
periods will be retained to further the development and sale of our Core
Technologies and products.  No dividends can be paid on our common
stock until such time as all accrued and unpaid dividends on our preferred stock
have been paid.
 
 Recent
Sales of Unregistered Equity Securities
 
 Series L
Preferred
Stock                                           On
September 7, 2006, we entered into a Series L 9% Convertible Preferred Stock
Exchange Agreement (the "Exchange Agreement") with McCormack and Kenzie
Financial (“Kenzie”), a British Virgin Islands company.  Pursuant to
the Exchange Agreement, McCormack and Kenzie exchanged all of the shares of
Series H Preferred Stock that they acquired from sale of LTEL Holdings, for
1,960.8 and 39.2 shares, respectively, of our Series L 9% Convertible Preferred
Stock (the "Series L Preferred Stock").
 
 For the
year ended December 31, 2008, we issued 705,696 shares of our
Class A common stock upon conversion of 37 shares of our Series L Preferred
Stock
 
 Subsequent
to December 31, 2008 and through March 16, 2009, we issued 1,078,393 shares of
our Class A common stock upon conversion of 4 shares of our Series L Preferred
Stock.
 
 As of
December 31, 2008, there were 1,498 shares of Series L Preferred Stock
outstanding.
 
 Series M
Preferred Stock – On April 4, 2007, the Company entered into a Series M
9% Convertible Preferred Stock Exchange Agreement (the “Exchange Agreement”)
with Sovereign Partners, LP (“Sovereign”). Pursuant to the Exchange Agreement,
Sovereign exchanged 150 shares of the Company’s Series L Preferred Stock for 150
shares of the Company’s Series M 9% Convertible Preferred Stock (the “Series M
Preferred Stock”).
  21
  
 The
Series M Preferred Stock entitles Sovereign or its assignees to receive
dividends in an amount equal to 9% of the then-outstanding balance of shares of
Series M Preferred Stock. The dividends are payable in cash or shares of the
Company’s Class A common stock, at the Company’s option.
 
 The
Series M Preferred Stock may be converted into common stock of the Company at
the option of the holder by using a conversion price which is the lower of (A)
80% of the average of the two (2) lowest closing bid prices for the twenty-day
trading period prior to the conversion date, or (B) $0.004.
 
 Because
the shares of Series M were issued in exchange for the outstanding shares of
Series L Preferred Stock, we did not receive any proceeds in connection with the
issuance of the Series M Preferred Stock.
 
 Under the
Exchange Agreement and the Series M Terms, Sovereign or its assignees may
convert shares of Series M Preferred Stock into shares of our common stock. The
Company’s issuances of shares of common stock upon any conversion of the Series
M Preferred Stock will be made without registration under the securities Act of
1933 (the “1933 Act”) in reliance on Section 4(2) of the 1933 Act and the rules
and regulations promulgated thereunder.
 
 During
the year ended December 31, 2008 and through March 31, 2009 there were no
conversions of Series M Preferred Stock.
 
 As of
December 31, 2008, there were 150 shares of Series M Preferred Stock
outstanding.
 
 Series N
Preferred Stock – On August 24, 2007, the Company entered into a
Securities Purchase Agreement (the “Purchase Agreement”) by and among the
Company, Trillium Partners, LP (“Trillium”), and other unnamed future investors
relating to the purchase and sale of the Company’s Series N 9% Convertible
Preferred Stock (the “Series N Preferred Stock”) in the amount of
$2,400,000.
 
 Pursuant
to the Purchase Agreement, the Company agreed to sell up to 2,400 shares of the
Preferred Stock at a per share price of $1,000, to the various
investors.  The gross proceeds to the Company, if all shares of the
Series N Preferred Stock are sold, will be $2,400,000.  Trillium
purchased 1,755 shares between August 24, 2007 and December 31, 2008 of
Preferred Stock pursuant to the Purchase Agreement, yielding gross proceeds to
the Company of $1,755,000.  The Company anticipates that there will be
additional sales to various investors of the Preferred Stock pursuant to the
Purchase Agreement.
 
 The
shares of Preferred Stock are convertible into shares of the Company’s Class A
common stock.  The shares may be converted into common stock of the
Company at the option of the holder by using a conversion price which shall be
eighty percent (80%) of the two (2) lowest closing bid prices over the twenty
trading days prior to the conversion date.
 
 The sale
of the Preferred Stock was made without registration under the Securities Act of
1933 (the “1933 Act”) in reliance on Section 4(2) of the 1933 Act and the rules
and regulations promulgated thereunder.  The Company’s issuances of
shares of common stock upon any conversion of the Preferred Stock will be made
without registration under the 1933 Act in reliance on Section 4(2) of the 1933
Act and the rules and regulations promulgated thereunder.
 
 During the year ended December 31,
2008, there were no conversions of Series N Preferred
Stock.  Subsequent to December 31, 2008 and through March 31, 2009,
there were no conversions of our Series N Preferred Stock.
 
 As of December 31, 2008, there were
1,755 shares of Series N Preferred Stock outstanding.
 
 Series O
Convertible Preferred Stock – Between January 25, 2008, and December 31,
2008, the Company received advances from three entities in connection with the
purchase agreements related to the Company’s Series O 9% Convertible Preferred
Stock (“Series O Preferred Stock”). On May 20, 2008, the Company entered into
Securities Purchase Agreements with Southridge Partners LP, Southshore Capital
Fund LTD, Sovereign Partners LP (collectively, the “Series O Purchasers”) for
the sale of an aggregate of 730 shares of Series O Preferred Stock for gross
proceeds of $730,000.  The material terms of the purchase agreements
had been agreed upon prior to receipt of the advances.  Therefore, the
Series O Preferred Stock was accounted for as discussed below on the dates cash
proceeds were received by the Company.  The Company also began
accruing dividends upon receiving the advances.
  22
  
 The
Series O Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series O
Preferred Stock. The dividends are payable in cash or shares of the Company's
Class A common stock, at the Company's option.
 
 The
shares of Preferred Stock are convertible into shares of the Company’s Class A
common stock.  The shares may be converted into common stock of the
Company at the option of the holder by using a conversion price which shall be
eighty percent (80%) of the two (2) lowest closing bid prices over the twenty
trading days prior to the conversion date.
 
 The sale
of the Preferred Stock was made without registration under the Securities Act of
1933 (the “1933 Act”) in reliance on Section 4(2) of the 1933 Act and the rules
and regulations promulgated thereunder.  The Company’s issuances of
shares of common stock upon any conversion of the Preferred Stock will be made
without registration under the 1933 Act in reliance on Section 4(2) of the 1933
Act and the rules and regulations promulgated thereunder.
 
 During
the year ended December 31, 2008, there were no conversions of Series O
Preferred Stock.  Subsequent to December 31, 2008 and through March
31, 2009, there were no conversions of our Series O Preferred
Stock.
 
 As of December 31, 2008, there were 730
shares of Series O Preferred Stock outstanding.
 
 Series P
Convertible Preferred Stock – On September 30, 2008, Fonix Corporation
(the “Company”) entered into a Series P 9% Convertible Preferred Stock Exchange
Agreement (the “Exchange Agreement”) with Sovereign Partners, LP (“Sovereign”),
and McCormack Avenue Ltd. (“McCormack”).  Pursuant to the Exchange
Agreement, Sovereign and McCormack exchanged certain debt obligations, discussed
more fully below, for shares of the Company’s Series P 9% Convertible Preferred
Stock (the “Series P Preferred Stock”).
 
 The Series P Preferred Stock entitles
the holders to receive dividends in an amount equal to 9% of the
then-outstanding balance of shares of Series P Preferred Stock.  The
dividends are payable in cash or shares of the Company’s Class A common stock,
at the Company’s option.
 
 The
shares of Preferred Stock are convertible into shares of the Company’s Class A
common stock.  The shares may be converted into common stock of the
Company at the option of the holder by using a conversion price which shall be
eighty percent (80%) of the two (2) lowest closing bid prices over the twenty
trading days prior to the conversion date.
 
 Redemption of the Series P Preferred
Stock, whether at our option or that of the holder, requires us to pay, as a
redemption price, the stated value of the outstanding shares of Series P
Preferred Stock to be redeemed, together with any accrued but unissued dividends
thereon, multiplied by one hundred ten percent (110%).
 
 Because the shares of Series P were
issued in exchange for certain outstanding debt obligations of the Company, we
did not receive any proceeds in connection with the issuance of the Series P
Preferred Stock to McCormack and Sovereign.
 
 In connection with the issuance of the
Series P Preferred Stock, on September 26, 2008, we filed with the State of
Delaware a Certificate of Designation and Series P 9% Convertible Stock Terms
(the “Series P Terms”), which become a part of our Certificate of Incorporation,
as amended.
 
 During
the year ended December 31, 2008, there were no conversions of Series P
Preferred Stock.  Subsequent to December 31, 2008 and through March
31, 2009, there were no conversions of our Series P Preferred
Stock.
 
 As of December 31, 2008, there were
1,305 shares of Series P Preferred Stock outstanding.
  23
  
 Fonix Speech,
Inc., Series B Convertible Preferred Stock – On April 4, 2007, the
Company entered into a Securities Purchase Agreement (the “FSI Agreement”) by
and among the Company, Fonix Speech, Inc. (“FSI”), and Sovereign. FSI is a
wholly owned subsidiary of the Company.
 
 Pursuant
to the FSI Agreement, FSI sold 125 shares of its Series B 9% Convertible
Preferred Stock (the “FSI Preferred Stock”), at a per share price of $10,000, to
Sovereign. The gross proceeds to FSI were $1,250,000.
 
 The
shares of FSI Preferred Stock are convertible into shares of the Company’s Class
A common stock. The FSI Preferred Stock may be converted into common stock of
the Company at the option of the holder by using a conversion price which is the
lower of (A) 80% of the average of the two (2) lowest closing bid prices for the
twenty-day trading period prior to the conversion date, or (B)
$0.004.
 
 The
Company’s issuances of shares of common stock upon any conversion of the FSI
Series B Preferred Stock will be made without registration under the securities
Act of 1933 (the “1933 Act”) in reliance on Section 4(2) of the 1933 Act and the
rules and regulations promulgated thereunder.
 
 During
the year ended December 31, 2008, there were no conversions of FSI Series B
Preferred Stock.  Subsequent to December 31, 2008, and through March
31, 2009, there were no conversions of FSI Series B Preferred
Stock.
 
 As of December 31, 2008, there were 125
shares of FSI Series B Preferred Stock outstanding.
 
 
 ITEM
      7.
              MANAGEMENT'S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS
 
 THIS
REPORT ON FORM 10-K CONTAINS, IN ADDITION TO HISTORICAL INFORMATION,
FORWARD-LOOKING STATEMENTS THAT INVOLVE SUBSTANTIAL RISKS AND
UNCERTAINTIES.  ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE
RESULTS ANTICIPATED BY FONIX AND DISCUSSED IN THE FORWARD-LOOKING
STATEMENTS.  WHEN USED IN THIS ANNUAL REPORT, WORDS SUCH AS
"BELIEVES," "EXPECTS," "INTENDS," "PLANS," "ANTICIPATES," "ESTIMATES," AND
SIMILAR EXPRESSIONS ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS,
ALTHOUGH THERE MAY BE CERTAIN FORWARD-LOOKING STATEMENTS NOT ACCOMPANIED BY SUCH
EXPRESSIONS.  ADDITIONALLY, STATEMENTS THAT RELATE TO THE FUTURE
BUSINESS DEVELOPMENT, FINANCIAL PROJECTIONS, CAPITAL RAISING, CAPITAL
REQUIRMENTS, GROWTH OF MARKETES OR CUSTOMER BASES, OR FUTURE BUSINESS
COMBINATIONS MAY ALSO INCLUDE FORWARD-LOOKING STATEMENTS.FACTORS THAT COULD
CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES ARE DISCUSSED BELOW IN THE SECTION
ENTITLED "INFORMATION CONCERNING FORWARD-LOOKING STATEMENTS" AND UNDER THE
HEADING "CERTAIN SIGNIFICANT RISK FACTORS," ABOVE.  FONIX CORPORATION
SPECIFICALLY DISCLAIMS ANY OBLIGATION OR INTENTION TO UPDATE ANY FORWARD LOOKING
STATEMENT.
 
 The following Management’s discussion
and Analysis of financial Condition and Results of Operations (“MD&A”) is
intended to help the reader understand Fonix Corporation, our operations and our
present business environment.  MD&A is provided as a supplement
to, and should be read in conjunction with, our consolidated financial
statements and the accompanying notes thereto contained in Item 8 of this
report.  This overview summarizes MD&A, which includes the
following sections:
 
 ·
              Overview – a general
      description of our business and the markets in which we operate; our
      objective; our areas of focus; and challenges and risks of our
      business.
 
 ·
              Significant Accounting
      Policies– a discussion of accounting policies that require
      critical judgments and
estimates.
  24
  
 ·
              Results of Operations–
      an analysis of our Company’s consolidated results of operations for the
      three years presented in our consolidated financial
      statements.  Except to the extent that differences among our
      operating segments are material to an understanding of our business as a
      whole, we present the discussion in the MD&A on a consolidated
      basis.
 
 ·
              Liquidity and Capital
      Resources– an analysis of cash flows; off-balance sheet
      arrangements and aggregate contractual obligations; the impact of
      foregoing exchange; an overview of financial position; and the impact of
      inflation and changing prices.
 
 We intend
for this discussion to provide the reader with information that will assist in
understanding our financial statements, the changes in certain key items in
those financial statements from year to year, and the primary factors that
accounted for those changes, as well as how certain accounting principles affect
our financial statements.  The discussion also provides information
about the financial results of the various segments of our business to provide a
better understanding of how those segments and their results affect the
financial condition and results of operations of the Company as a
whole.  This discussion should be read in conjunction with our
financial statements as of December 31, 2008, and the year then ended and the
notes accompanying those financial statements.
 
 Overview
 
 We are engaged in providing value-added
speech technologies through Fonix Speech, Inc. (“Fonix Speech”).  We
offer speech-enabling technologies including automated speech recognition
(“ASR”) and text-to-speech (“TTS”) through Fonix Speech.  We offer our
speech-enabling technologies to markets for wireless and mobile devices,
computer telephony, server solutions and personal software for consumer
applications.  We have received various patents for certain elements
of our core technologies and have filed applications for other patents covering
various aspects of our technologies.  We seek to develop relationships
and strategic alliances with third-party developers and vendors in
telecommunications, computers, electronic devices and related industries,
including producers of application software, operating systems, computers and
microprocessor chips.  Revenues are generated through licensing of
speech-enabling technologies, maintenance contracts and services.
 
 For the years ended December 31, 2008,
2007 and 2006, we generated revenues of $1,265,000, $1,838,000 and $1,329,000,
respectively; with net loss of $6,169,000 in 2008, net income of $14,959,000 in
2007 and  net loss of $21,943,000 in 2006, and had negative cash flows
from operating activities of $266,000, $2,312,000 and $4,048,000,
respectively.  As of December 31, 2008,  we had an
accumulated deficit of $286,367,000; negative working capital of $44,471,000;
derivative liabilities of $34,582,000 related to the issuance of Series L
Preferred Stock,  Series M Preferred Stock, Series N Preferred Stock,
Series O Preferred Stock , Series P Preferred Stock and Series B Preferred Stock
of our subsidiary; accrued liabilities of $6,510,000; accounts payable of
$1,801,000; and deferred revenues of $445,000.We expect to continue to incur
significant losses and negative cash flows from operating activities at least
through December 31, 2009, primarily due to expenditure requirements associated
with continued marketing and development of our speech-enabling
technologies.
 
 We are continually developing new
product offerings in the ASR businesses in an effort to increase our revenue
stream, and we are continuing to work with our existing customers to increase
sales.  We have also experienced operating expense decreases through
headcount reductions and overall cost reduction measures.  Through the
combination of increased recurring revenues and the overall operating cost
reduction strategies we have implemented, we hope to achieve positive cash flow
from operations in the next 18-24 months.  However, there can be no
assurance that we will be able to achieve positive cash flow from operations
within this time frame.
 
 Historically, our cash resources,
limited to collections from customers, draws on equity lines of credit and
loans, have not been sufficient to cover operating expenses.  We
periodically engage in discussions with various sources of financing to
facilitate our cash requirements including buyers of both debt and equity
securities.  To date, no additional sources of funding offering terms
superior to those available under equity lines have been implemented, and we
rely on first, cash generated from operations, and second, cash provided through
convertible debt financing arrangements.  We will need to generate
approximately $2 to $3 million to continue operations for the next twenty-four
months.  There can be no assurance that we will be able to obtain such
financing or that, if we can obtain such financing, it will be on terms
favorable to us.
  25
  
 Significant
Accounting Policies
 
 The discussion and
analysis of our financial condition and results of operations are based upon our
consolidated financial statements, which have been prepared in accordance with
accounting principles generally accepted in the United States.  The
preparation of these financial statements requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of sales and expenses during the reporting
period.  Significant accounting policies and areas where substantial
judgments are made by management include:
 
 Accounting
estimates-The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
the disclosures of contingent assets and liabilities at the date of the
financial statements, and the reported amounts of revenues and expenses during
the reporting period.  Actual results could differ from those
estimates.
 
 Valuation of
long-lived assets - The carrying values of our long-lived assets are
reviewed for impairment whenever events or changes in circumstances indicate
that they may not be recoverable.  When such an event occurs, we
project undiscounted cash flows to be generated from the use of the asset and
its eventual disposition over the remaining life of the asset.  If
projections indicate that the carrying value of the long-lived asset will not be
recovered, the carrying value of the long-lived asset, other than software
technology, is reduced by the estimated excess of the carrying value over the
projected discounted cash flows.
 
 Goodwill
–
Goodwill represents the excess of the cost over the fair value of net assets of
acquired businesses. Goodwill is not amortized, but is tested for impairment
quarterly or when a triggering event occurs.  The testing for
impairment requires the determination of the fair value of the asset or entity
to which the goodwill relates (the reporting unit).  The fair value of
a reporting  unit is determined based upon a weighting of the quoted
market price of our common stock and present value techniques based upon
estimated future cash flows of the reporting unit, considering future revenues,
operating costs, the risk-adjusted discount rate and other
factors.  Impairment is indicated if the fair value of the reporting
unit is allocated to the assets and liabilities of that unit, with the excess of
the fair value of the reporting unit over the amounts assigned to its assets and
liabilities assigned to the fair value of goodwill.  The amount of
impairment of goodwill is measured by the excess of the goodwill’s carrying
value over its fair value.  At December 31, 2007, we tested the
carrying value of goodwill and determined that it was fully
impaired.
 
 Revenue
recognition – We recognize revenue when pervasive evidence of an
arrangement exists, services have been rendered or products have been delivered,
the price to the buyer is fixed and determinable and collectibility is
reasonable assured.  Revenues are recognized by us based on the
various types of transactions generating the revenue.  For software
sales, we recognize revenues in accordance with the provisions of Statement of
Position No. 97-2, “Software Revenue Recognition” and related
interpretations.We generate
revenues from licensing the rights to its software products to end users and
from royalties.  For telecommunications services, revenue is
recognized in the period that the service is provided.
 
 For Fonix Speech, revenue of all types
is recognized when acceptance of functionality, rights of return, and price
protection are confirmed or can be reasonably estimated, as
appropriate.  Revenues from development and consulting services are
recognized on a completed-contract basis when the services are completed and
accepted by the customer.  The completed-contract method is used
because our contracts are typically either short-term in duration or we are
unable to make reasonably dependable estimates of the costs of the
contracts.  Revenue for hardware units delivered is recognized when
delivery is verified and collection assured.
 
 Revenue for products distributed
through wholesale and retail channels and through resellers is recognized upon
verification of final sell-through to end users, after consideration of rights
of return and price protection.  Typically, the right of return on
such products has expired when the end user purchases the product from the
retail outlet.  Once the end user opens the package, it is not
returnable unless the medium is defective.
 
 When arrangements to license software
products do not require significant production, modification or customization of
software, revenue from licenses and royalties are recognized when persuasive
evidence of a licensing arrangement exists, delivery of the software has
occurred, the fee is fixed or determinable, and collectibility is
probable.  Post-contract obligations, if any, generally consist of one
year of support including such services as customer calls, bug fixes, and
upgrades.  Related revenue is recognized over the period covered by
the agreement.  Revenues from maintenance and support contracts are
also recognized over the term of the related contracts.
  26
  
 Revenues applicable to multiple-element
fee arrangements are bifurcated among the elements such as license agreements
and support and upgrade obligations using vendor-specific objective evidence of
fair value.  Such evidence consists primarily of pricing of multiple
elements as if sold as separate products or arrangements.  These
elements vary based upon factors such as the type of license, volume of units
licensed, and other related factors.
 
 Deferred revenue as of December 31,
2008, consisted of the following:
  Description
                Criteria
      for Recognition
                December
      31, 2008Deferred
      unit royalties and license fees
                Delivery
      of units to end users or expiration of contract
                $       445,000
 
 Cost of
revenues-  Cost of revenues from license, royalties, and maintenance
consists of costs to distribute the product, installation and support personnel
compensation, amortization and impairment of capitalized speech software costs,
licensed technology, and other related costs.  Cost of service
revenues consists of personnel compensation and other related
costs.
 
 Software
Technology Development and Production Costs- All costs incurred to
establish the technological feasibility of speech software technology to be
sold, leased, or otherwise marketed are charged to product development and
research expense.  Technological feasibility is established when a
product design and a working model of the software product have been completed
and confirmed by testing.  Costs to produce or purchase software
technology incurred subsequent to establishing technological feasibility are
capitalized.  Capitalization of software costs ceases when the product
is available for general release to customers.  Costs to perform
consulting or development services are charged to cost of revenues in the period
in which the corresponding revenues are recognized.  Costs of
maintenance and customer support are charged to expense when related revenue is
recognized or when these costs are incurred, whichever occurs
first.
 
 Capitalized software technology costs
were amortized on a product-by-product basis.  Amortization was
recognized from the date the product was available for general release to
customers as the greater of (a) the ratio that current gross revenue for a
product bears to total current and anticipated future gross revenues for that
product or (b) the straight-line method over the remaining estimated economic
life of the products.  Amortization was charged to cost of
revenues.
 
 We assessed unamortized capitalized
software costs for possible write down on a quarterly basis based on net
realizable value of each related product.  Net realizable value was
determined based on the estimated future gross revenues from a product reduced
by the estimated future cost of completing and disposing of the product,
including the cost of performing maintenance and customer
support.  The amount by which the unamortized capitalized costs of a
software product exceeded the net realizable value of that asset was written
off.
 
 Stock-Based
Employee Compensation The Company has outstanding stock options to
directors and employees, which are described more fully in Note
10.  The Company accounts for its stock options in accordance with
Statements of Financial Standards 123R, Share-Based Payment (SFAS 123R). SFAS
123R requires the recognition of the cost of employee services received in
exchange for an award of equity instruments in the financial statements and is
measured based on the grant date fair value of the award. SFAS 123R also
requires the stock option compensation expense to be recognized over the period
during which an employee is required to provide service in exchange for the
award (the vesting period).
 
 The
Company has not recognized any stock-based employee compensation expense for the
years ended December 31, 2008, 2007, and 2006.
 
  27
  
 Imputed Interest
Expense and Income - Interest is imputed on long-term debt obligations
and notes receivable where management has determined that the contractual
interest rates are below the market rate for instruments with similar risk
characteristics.
 
 Foreign Currency
Translation-The
functional currency of our Korean subsidiary is the South Korean
won.  Consequently, assets and liabilities of the Korean operations
are translated into United States dollars using current exchange rates at the
end of the year.  All revenue is invoiced in South Korean won and
revenues and expenses are translated into United States dollars using
weighted-average exchange rates for the year.
 
 Comprehensive
Income-Other
comprehensive income presented in the accompanying consolidated financial
statements consists of cumulative foreign currency translation
adjustments.
 
 New Accounting
Policies–In
September 2006, the FASB issued SFAS No. 157, “Fair Value
Measurement.” This statement defines fair value, establishes a framework for
measuring fair value in generally accepted accounting principles and expands
disclosures about fair value measurements. SFAS No. 157 does not require
any new fair value measurements but provides guidance on how to measure fair
value by providing a fair value hierarchy used to classify the source of the
information. We adopted SFAS No. 157 effective January 1, 2008 and the
adoption did not have a significant effect on our consolidated results of
operations, financial position or cash flows. In February 2008, the FASB
issued FSP SFAS No. 157-2 which delays the effective date of SFAS
No. 157 for all non-financial assets and non-financial liabilities except
those that are recognized or disclosed at fair value in the financial statements
on a recurring basis (at least annually). We are currently evaluating the impact
of the pending adoption in 2009 of SFAS No. 157 non-recurring fair value
measures.
 
 In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities, including an amendment of FASB
Statement No. 115,” effective on January 1, 2008, and permits
companies to choose, at specified dates, to measure certain eligible financial
instruments at fair value. The provisions of SFAS No. 159 apply only to
entities that elect to use the fair value option and to all entities with
available-for-sale and trading securities. At the effective date, companies may
elect the fair value option for eligible items that exist at that date, and the
effect of the first remeasurement to fair value must be reported as a
cumulative-effect adjustment to the opening balance of retained earnings. The
adoption of SFAS No. 159 has not had a material impact on the Company’s
financial position or results of operations.
 
 Effective
January 1, 2007, the Company adopted FASB Interpretation No. 48,
“Accounting for Uncertainty in Income Taxes — an interpretation of FASB
Statement No. 109” (FIN 48), which clarifies the accounting and
disclosure for uncertainty in tax positions. The Company has analyzed its filing
positions in all jurisdictions where it is required to file income tax returns
for the open tax years in such jurisdictions. The Company’s federal income tax
returns for the years ended December 31, 2005 through 2007 remain subject
to examination.  The Company currently believes that all significant
filing positions are highly certain and that all of its significant income tax
filing positions and deductions would be sustained upon audit. Therefore, the
Company has no significant reserves for uncertain tax positions and no
adjustments to such reserves were required upon adoption of
FIN 48.  No interest or penalties have been levied against the
Company and none are anticipated, therefore interest or penalty has been
included in our provision for income taxes in the consolidated statements of
operations.
 
 Recent Accounting
Pronouncements–In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities—an amendment of FASB Statement No. 133, which
changes the disclosure requirements for derivative instruments and hedging
activities. Enhanced disclosures are required to provide information about (a)
how and why an entity uses derivative instruments, (b) how derivative
instruments and related hedged items are accounted for under Statement 133 and
its related interpretations, and (c) how derivative instruments and related
hedged items affect an entity’s financial position, financial performance, and
cash flows. This Statement is effective for financial statements issued for
fiscal years and interim periods beginning after November 15, 2008, with early
application encouraged. This Statement will require the additional disclosures
described above.  The Company does not expect the adoption of SFAS 161
to have a material impact on its results of operations or financial
condition.
  28
  
 In April
2008, FASB issued FASB Staff Position SFAS No. 142-3, Determination of the
Useful Life of Intangible Assets (“FSP SFAS No. 142-3”). FSP SFAS
No. 142-3 amends the factors that should be considered in developing
renewal or extension assumptions used to determine the useful life of a
recognizable intangible asset under SFAS No. 142, “Goodwill and Other
Intangible Assets” (“SFAS No. 142”). The intent of FSP SFAS No. 142-3
is to improve the consistency between the useful life of a recognizable
intangible asset under SFAS No. 142 and the period of expected cash flows
used to measure the fair value of the asset under SFAS 141(R), “Business
Combinations” and other U.S. generally accepted accounting principles. FSP SFAS
No. 142-3 is effective for financial statements issued for fiscal years
beginning after December 15, 2008, and interim periods within those fiscal
years. Early adoption is prohibited. The Company does not anticipate that the
adoption of FSP SFAS No. 142-3 will have an impact on its financial
position or results of operations.
 
 In
November 2007, the FASB issued SFAS No. 160, Noncontrolling Interests
in Consolidated Financial Statements, an amendment of ARB No. 51
(FAS 160).  FAS 160 will change the accounting and reporting
for minority interests, which will be recharacterized as noncontrolling
interests and classified as a component of equity.  FASB 160 is
effective for fiscal years beginning on or after December 15,
2008.  FASB 160 requires retroactive adoption of the presentation
and disclosure requirements for existing minority interests.  All other
requirements of FAS 160 will be applied prospectively.  Early adoption
is prohibited.  The Company does not anticipate that the adoption of
FASB 160 will have an impact on its financial position or results of
operations.
 
 Results
of Continued Operations
 
 Fiscal
Year 2008 Compared to 2007
 
 During 2008, we recorded revenues of
$1,265,000, a decrease of $573,000 from $1,838,000 in 2007.  The
decrease was primarily due to decreased royalties of $506,000, decreased
licensing revenue of $87,000, and decreased non-recurring engineering speech
revenues of $20,000.
 
 Cost of revenues was $54,000, a
decrease of $87,000 from $141,000 in 2007.  The decrease is primarily
due to the decreased costs of third-party royalty fees.
 
 Selling, general and administrative
expenses were $2,238,000 in 2008, a decrease of $241,000 from $2,479,000 in
2007.  The decrease is primarily due to decreased salary and wage
expenses of $177,000, decreased other operating expense of $85,000,
decreased occupancy related expenses of $41,000, decreased investor
relations expenses of $38,000, decreased legal and accounting fees of $18,000,
decreased taxes, licenses and permits of $13,000, decreased depreciation
expenses of $9,000, partially offset by increased consulting expenses of
$136,000, increased travel expenses of $2,000 and decreased promotions of
$2,000.
 
 We incurred research and product
development expenses of $1,925,000 in 2008, an increase of $353,000 from
$1,572,000 in 2007.  The increase was primarily due to an overall
increase in salaries and wage-related expenses of $540,000, partially offset by
decreased occupancy related expenses of $51,000, decreased consulting expenses
of $51,000, decreased travel expenses of $37,000, decreased operating
expenses of $31,000 and decreased depreciation expenses of $11,000.
 
 Other income (expense) was a loss of
$3,217,000 for 2008, an decrease of $23,161,000 from the gain of $19,944,000 for
2007.  The overall decrease was due to the gain on forgiveness of
liabilities of $21,018,000 in 2007, primarily resulting from the bankruptcy of
the discontinued subsidiaries of $20,819,000, and a loss on derivative liability
of $512,000 in 2008, compared to the gain on derivative liability of $813,000 in
2007 and the increase in interest expense of $865,000.
 
 Fiscal
Year 2007 Compared to 2006
 
 During 2007, we recorded revenues of
$1,838,000, an increase of $509,000 from $1,329,000 in 2006.  The
increase was primarily due to increased licensing revenue of $287,000, increased
royalties of $324,000, partially offset by decreased non-recurring engineering
speech revenues of $102,000.
 
 Cost of revenues was $141,000, an
increase of $123,000 from $18,000 in 2006.  The increase is primarily
due to the increased costs of third party royalty fees.
  29
  
 Selling, general and administrative
expenses were $2,479,000 in 2007, a decrease of $2,877,000 from $5,356,000 in
2006.  The decrease is primarily due to the decreased bad debt expense
of $1,214,000, decreased salary and wage expenses of $912,000, decreased other
operating expense of $328,000, decreased legal and accounting fees of $213,000,
decreased travel expenses of $206,000, decreased promotions of $27,000,
decreased investor relations expenses of $23,000 and decreased depreciation
expenses of $12,000 partially offset by increased occupancy related expenses of
$43,000, increased taxes, licenses and permits of $10,000 and increased
consulting expenses of $5,000.
 
 We incurred research and product
development expenses of $1,572,000 in 2007, a decrease of $571,000 from
$2,143,000 in 2006.  The decrease was primarily due to an overall
decrease in salaries and wage-related expenses of $489,000, decreased occupancy
related expenses of $67,000, decreased travel expenses of $22,000, depreciation
expenses of $15,000, partially offset by increased consulting expenses of
$11,000 and increased other operating expenses of $11,000.
 
 Other income (expense) was a gain of
$19,944,000 for 2007, an increase of $24,452,000 from the expense of $4,508,000
for 2006.  The overall decrease was due to the gain on forgiveness of
liabilities of $21,018,000, primarily resulting for the bankruptcy of the
discontinued subsidiaries of $20,819,000, and a gain on derivative liability of
$813,000 compared to the loss on derivative liability of $2,771,000, increased
gain on forgiveness of liabilities of $199,000, partially offset
by  an increase in interest expense of $150,000.
 
 Selected
Quarterly Operations Data
 
 The following tables set forth selected
unaudited statement of operations data for each of the quarters in the years
ended December 31, 2008 and 2007.  This data has been derived from our
unaudited financial statements that have been prepared on the same basis as the
audited financial statements and, in the opinion of management, include all
adjustments, consisting of normal recurring adjustments, necessary for a fair
presentation of the information when read in connection with the financial
statements and the related notes.  Our quarterly operating results
have varied substantially in the past and may vary substantially in the
future.  Conclusions about our future results for any period should
not be drawn from the selected unaudited statement of operations data, either
for any particular quarter or taken as a whole.
 
 For
      the Quarter EndedMar
      31, 2008
                      
                      
                      Jun
      30, 2008
                      
                      
                      Sep
      30, 2008
                      
                      
                      Dec
      31, 2008(Unaudited)Net
      sales
                      
                      $
                      286,000
                      
                      
                      $
                      560,000
                      
                      
                      $
                      223,000
                      
                      
                      $
                      196,000Gross
      profit
                      
                      
                      261,000
                      
                      
                      
                      535,000
                      
                      
                      
                      220,000
                      
                      
                      
                      195,000Net
      gain/loss from continuing operations
                      
                      
                      (1,046,000
                      )
                      
                      
                      (1,293,000
                      )
                      
                      
                      (1,701,000
                      )
                      
                      
                      (2,129,000
                      )Preferred
      stock dividends
                      
                      
                      (578,000
                      )
                      
                      
                      (447,000
                      )
                      
                      
                      (466,000
                      )
                      
                      
                      (764,000
                      )Net
      gain/loss attributable to common stockholders
                      
                      
                      (1,624,000
                      )
                      
                      
                      (1,740,000
                      )
                      
                      
                      (2,167,000
                      )
                      
                      
                      (2,893,000
                      )Basic
      gain (loss) per common share
                      
                      $
                      (1.68
                      )
                      
                      $
                      (1.35
                      )
                      
                      $
                      (0.85
                      )
                      
                      $
                      (0.01
                      )Diluted
      gain per common share
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
                      
                      
                      
                      --
 
 
 For
      the Quarter EndedMar
      31, 2007
                        
                        
                        Jun
      30, 2007
                        
                        
                        Sep
      30, 2007
                        
                        
                        Dec
      31, 2007(Unaudited)Net
      sales
                        
                        $
                        360,000
                        
                        
                        $
                        644,000
                        
                        
                        $
                        339,000
                        
                        
                        $
                        495,000Gross
      profit
                        
                        
                        353,000
                        
                        
                        
                        572,000
                        
                        
                        
                        285,000
                        
                        
                        
                        487,000Net
      gain/loss from continuing operations
                        
                        
                        (787,000
                        )
                        
                        
                        (1,061,000
                        )
                        
                        
                        (585,000
                        )
                        
                        
                        17,392,000Preferred
      stock dividends
                        
                        
                        (410,000
                        )
                        
                        
                        (431,000
                        )
                        
                        
                        (434,000
                        )
                        
                        
                        (427,000
                        )Net
      gain/loss attributable to common stockholders
                        
                        
                        (1,197,000
                        )
                        
                        
                        (1,492,000
                        )
                        
                        
                        (1,019,000
                        )
                        
                        
                        16,965,000Basic
      gain (loss) per common share
                        
                        $
                        (3.93
                        )
                        
                        $
                        (3.81
                        )
                        
                        $
                        (2.03
                        )
                        
                        $
                        23.27Diluted
      gain per common share
                        
                        
                        --
                        
                        
                        
                        --
                        
                        
                        
                        --
                        
                        
                        $
                        0.83
 
  30
  
 Liquidity
and Capital Resources
 
 We must raise additional funds to be
able to satisfy our cash requirements during the next 12 months.  It
is anticipated that we will need to raise approximately $2 to $3 million over
the next 12 months to meet obligations and continue our product development,
corporate operations and marketing expenses.  Because we presently
have only limited revenue from operations, we intend to continue to rely
primarily on financing through the sale of our equity and debt securities to
satisfy future capital requirements until such time as we are able to enter into
additional third-party licensing, collaboration, or co-marketing arrangements
such that we will be able to finance ongoing operations from license, royalty,
and sales revenue.  We are working with game developers and other
potential licensors of our speech product offerings to develop additional
revenue streams for our speech technologies.  There can be no
assurance that we will be able to enter into such
agreements.  Furthermore, the issuance of equity or debt securities
which are or may become convertible into equity securities of Fonix in
connection with such financing could result in substantial additional dilution
to the stockholders of Fonix.
 
 Our cash resources are limited to
collections from customers, proceeds from the issuance of preferred stock, and
loan proceeds, and are only sufficient to cover current operating expenses and
payments of current liabilities.  At December 31, 2008, we had
negative working capital of $44,471,000; derivative liabilities of $34,582,000
related to the issuance of Series L Preferred Stock,  Series M
Preferred Stock, Series N Preferred Stock,  Series O Preferred Stock,
Series P Preferred Stock and Fonix Speech Series B Preferred Stock; accrued
liabilities of $6,510,000; accounts payable of $1,801,000; and deferred revenues
of $445,000.
 
 We had $1,265,000 in revenue and net
loss of $6,169,000 for the year ended December 31, 2008.  Net cash
used in operating activities of $266,000 for the year ended December 31, 2008,
resulted principally from the net loss incurred of
$6,169,000,  partially offset by the non-cash accretion of the
discount on notes payable of $2,124,000, increased other accrued liabilities of
$1,663,000, issuance of shares for employee grants of $911,000, the loss on
derivative liability of $512,000, increased accounts payable of $393,000,
decreased prepaid expenses and other current assets of $194,000, decreased other
assets of $96,000, and depreciation expense of $10,000.  Net cash used
in investing activities was $20,000 for the year ended December 31,
2008.  Net cash provided by financing activities of $262,000
consisting primarily of the receipt of $730,000 in cash related to the sale of
shares of Series O preferred stock and $72,000 in proceeds from related
party notes, partially offset by payments on accrued settlement obligation of
$540,000.
 
 We had negative working capital of
$44,471,000 at December 31, 2008, compared to negative working capital of
$34,384,000 at December 31, 2007.  Current assets decreased by $85,000
to $2,000 from $87,000 from December 31, 2008, to December 31,
2007.  Current liabilities increased by $10,002,000 to $44,473,000
from $38,027,000 during the same period.  The change in working
capital from December 31, 2007, to December 31, 2008, reflects, in part, the
derivative related to the issuance of Series L Preferred Stock, Series M
Preferred Stock, Series N Preferred Stock,  Series O Preferred Stock ,
Series P Preferred Stock  and Fonix Speech Series B Preferred Stock;
and increases in accrued liabilities and accounts payable, partially offset by
decreases in accrued settlement obligation due to payments made during the year
ended December 31, 2008.  Total assets were $40,000 at December 31,
2008, compared to $211,000 at December 31, 2007.
 
 Notes
Payable Related Parties
 
 During 2002, two executive officers of
the Company (the “Lenders”) sold shares of the Company’s Class A common stock
owned by them and advanced the resulting proceeds amounting to $333,000 to the
Company under the terms of a revolving line of credit and related promissory
note.  The funds were advanced for use in Company
operations.  The advances bear interest at 12 percent per annum, which
interest is payable on a semi-annual basis.  The entire principal,
along with unpaid accrued interest and any other unpaid charges or related fees,
was originally due and payable on June 10, 2003.  The Company and the
Lenders have agreed to postpone the maturity date on several
occasions.  The note was due September 30, 2006.  All or
part of the outstanding balance and unpaid interest may be converted at the
option of the Lenders into shares of Class A common stock of the Company at any
time.  The conversion price was the average closing bid price of the
shares at the time of the advances.  To the extent the market price of
the Company’s shares is below the conversion price at the time of conversion,
the Lenders are entitled to receive additional shares equal to the gross dollar
value received from the original sale of the shares.  A beneficial
conversion option of $15,000 was recorded as interest expense in connection with
this transaction.  The Lenders may also receive additional
compensation as determined appropriate by the Board of
Directors.
  31
  
 During the year ended December 31,
2005, the Company received an additional advance of $50,000 against the
promissory note.  The balance due at December 31, 2005 was
$486,000.  During the year ended December 31, 2006, the Company
received additional advances and other consideration from the Lenders in the
aggregate amount of $419,000 and made principal payments to the Lenders against
the note of $105,000.  For the year ended December 31, 2007, the
Company received additional advances of $102,000. For the year ended December
31, 2008, the Company received additional advances of $91,000 and made principal
payments to the Lenders against the note of $19,000. The balance due at December
31, 2008, was $917,000.
 
 The balance due of $917,000 is secured
by the Company’s intellectual property rights and common stock of Fonix
Speech.  For the year ended December 31, 2008, the Lenders converted
$56,000 of the principal balance into 113,194 shares common stock, and also
converted $111,000 of accrued interest into 146,426 shares of common stock for
the benefit of one of the Lenders, Thomas A. Murdock, a former officer and
director of the Company.
 
 Notes
Payable
 
 In connection with the acquisition of
the capital stock of LTEL Holdings in 2004, the Company issued a 5%,
$10,000,000, secured, six-year note (the “Note”) payable to McCormack Avenue,
Ltd. (“McCormack”).  Under the terms of the Note, quarterly
interest-only payments were required through January 15, 2005, with quarterly
principal and interest payments of $319,000 beginning April 2005 and continuing
through January 2010.  Interest on the Note is payable in cash or, at
the Company’s option, in shares of the Company’s Class A common
stock.  The Note is secured by the capital stock and all of the assets
of LTEL Holdings and its subsidiaries.  The Note was originally valued
at $4,624,000 based on an imputed interest rate of 25 percent per
annum.
 
 On September 8, 2006, the Company
received a default notice (the “Default Notice”) from McCormack in respect of
the Note  In the Default Notice, McCormack stated that it intended to
exercise its rights, including any and all rights set forth in the Note, as
amended.  McCormack has taken no action to collect amounts due under
the Note.
 
 During the fourth quarter of 2006, the
Company entered into two promissory notes with McCormack Avenue, Ltd., in the
aggregate amount of $330,000. These notes accrue interest at 10% annually and
were due and payable during the second quarter of 2007.  These
promissory notes were exchanged for shares of the Company’s Series P Preferred
Stock.  See table below.
 
 During the quarter ended March 31,
2007, the Company entered into five promissory notes with McCormack Avenue, Ltd.
and Sovereign Partners LP., in the aggregate amount of
$450,000.  These notes accrue interest at 10% annually and were due
and payable during the third quarter of 2007.  These promissory notes
were exchanged for shares of the Company’s Series P Preferred
Stock.  See table below.
 
 On September 30, 2008, the Company
entered into a Series P 9% Convertible Preferred Stock Exchange Agreement (the
“Exchange Agreement”) with McCormack and Sovereign Partners, LP (“Sovereign”),
whereby McCormack exchanged the Note, along with other promissory notes and the
Series E debenture (discussed in Note 5), and Sovereign exchanged two promissory
notes, for shares of the Company’s Series P 9% Convertible Preferred Stock (the
Series P Preferred Stock”).  A table listing the obligations exchanged
and the number of shares of Series P Preferred Stock issued is included
below.
 
  32
  
 Purchaser
                Nature
      of Obligation Exchanged
                Amount
      of Obligation Exchanged
                Number
      of Series P Preferred Shares to be IssuedSovereign
      Partners LP
                Promissory
      Note, dated February 22, 2007, in the principal amount of $100,000, and
      interest of $16,278
                $116,278
                11.6278Sovereign
      Partners LP
                Promissory
      Note, dated March 13, 2007, in the principal amount of $100,000, and
      interest of $15,750
                $115,750
                11.575McCormack
      Avenue, Ltd.
                Promissory
      Note, dated January 11, 2007, in the principal amount of $50,000, and
      interest of $8,722
                $58,722
                5.8722McCormack
      Avenue, Ltd.
                Promissory
      Note, dated January 19, 2007, in the principal amount of $100,000, and
      interest of $17,222
                $117,222
                11.7222McCormack
      Avenue, Ltd.
                Promissory
      Note, dated January 26, 2007, in the principal amount of $100,000, and
      interest of $17,028
                $117,028
                11.7028McCormack
      Avenue, Ltd.
                Promissory
      Note, dated December 28, 2006, in the principal amount of $95,000, and
      16,942
                $111,942
                11.1942McCormack
      Avenue, Ltd.
                Promissory
      Note, dated December 15, 2006, in the principal amount of $235,000, and
      interest of $42,701
                $277,701
                27.7701McCormack
      Avenue, Ltd.
                Note
      Payable, dated February, 2004, in the principal amount of $8,732,620, and
      interest of $1,311,105
                $10,043,725
                1,004.3725McCormack
      Avenue, Ltd.
                Series
      E Debenture, dated December 7, 2007, in the principal amount of
      $1,754,464, and interest of $291,763
                $2,046,227
                204.6227
 
 
 Series
D Debentures
 
 On October 11, 2002, we issued
$1,500,000 of Series D 12% Convertible Debentures (the "Debentures"), due April
9, 2003, and 194,444 shares of Class A common stock to Breckenridge Fund, LLC
("Breckenridge"), an unaffiliated third party, for $1,500,000 before offering
costs of $118,000.  The outstanding principal amount of the Debentures
was convertible at any time at the option of the holder into shares of our
common stock at a conversion price equal to the average of the two lowest
closing bid prices of our Class A common stock for the twenty trading days
immediately preceding the conversion date, multiplied by 90%.
 
 We determined that Breckenridge had
received a beneficial conversion option on the date the Debentures were
issued.  The net proceeds of $1,382,000, were allocated to the
Debentures and to the Class A common stock based upon their relative fair values
and resulted in allocating $524,000 to the Debentures, $571,000 to the related
beneficial conversion option, $373,000 to the 194,444 shares of Class A common
stock, less $86,000 of deferred loan costs.  The resulting $976,000
discount on the Debentures and the deferred loan costs were amortized over the
term of the Debentures as interest expense.
 
 The Debentures were originally due
April 9, 2003.  However, Fonix and Breckenridge agreed in January 2003
to modify the terms of the Debentures requiring the following principal payments
plus accrued interest: $400,000 in January 2003; $350,000 in February 2003;
$250,000 in March 2003; $250,000 in April 2003; and $250,000 in May
2003.  Additionally, we agreed to release 237,584 of the Collateral
Shares to Breckenridge as consideration (the "Released Shares") for revising the
terms of the purchase agreement.  The additional shares were accounted
for as an additional discount of $285,000.  The value of the shares
was amortized over the modified term of the Debentures as interest
expense.  We did not make the last three payments as
scheduled.  Breckenridge asserted its rights under the Debenture
agreement for penalties as we did not meet the prescribed payment
schedule.  Breckenridge asserted a claim of $379,000 which we
disputed.  Both parties subsequently agreed to satisfy the claim in
full through the issuance of 1,550,000 shares of our Class A common stock with a
value of $225,000.  We transferred the shares to Breckenridge on
October 20, 2003, in full satisfaction of the claim and recorded the penalty as
interest expense.
  33
   In connection with the issuance of the
Debentures, we entered into a registration rights agreement in which we agreed
to register the resale of the shares underlying the Debentures, the Collateral
Shares, and the Released Shares.  We filed a registration statement on
Form S-2, which became effective February 14, 2003.  Additionally, we
filed another registration statement on July 2, 2003, which was declared
effective on July 7, 2003, which included shares issuable to Breckenridge in
connection with the Debentures.  We were obligated to file such
post-effective amendments as necessary to keep the registration statements
effective as required by the registration rights agreement.
 
 Through December 31, 2003, we had paid
$650,000 of the outstanding principal, together with $54,000 in accrued
interest.  Additionally, through December 31, 2003, the holder of the
Debentures converted the remaining $850,000 principal amount and $41,000 in
interest into 7,359,089 shares of Fonix Class A common stock.
 
 As part of the Debenture agreement, we
were required to pay Breckenridge a placement fee in the amount of $350,000
payable in stock at the conclusion of the Debenture.  We satisfied the
obligation through the issuance of 2,000,000 shares of our Class A common stock
valued at $358,000, or $0.179 per share and 377,717 shares of our Class A common
stock valued at $59,000, or $0.157 per share.  We recorded the expense
as interest expense.
 
 In March 2004, we discovered that
during 2003 an aggregate of 2,277,777 shares of Class A common stock (the
"Unauthorized Shares") were improperly transferred to the Debenture holder as a
result of (i) the unauthorized release from escrow of the Collateral Shares (net
of the Released Shares), and (ii) the transfer to the Debenture holder of a
duplicate certificate for 194,445 shares where the original certificate was not
returned to the transfer agent for cancellation.  The Unauthorized
Shares were, therefore, in excess of the shares the Debenture holder was
entitled to receive.  No consideration was paid to or received by us
for the Unauthorized Shares during 2003; therefore, we did not recognize the
Unauthorized Shares as being validly issued during 2003.
 
 Upon discovering in March 2004 that the
Unauthorized Shares had been improperly transferred to the Debenture holder, we
attempted to settle the matter with the Debenture holder but was unable to reach
a settlement.  Accordingly, on May 3, 2004, we filed a lawsuit against
the Debenture holder, alleging the improper transfer to and subsequent sale of
the Unauthorized Shares by the Debenture holder.  The lawsuit was
subsequently dismissed without prejudice and refiled on October 12,
2004.  The complaint sought (i) a declaratory judgment that we may set
off the fair value of the Unauthorized Shares against the value we owed to the
Debenture holder in connection with the Series I Preferred Stock transaction,
(ii) judgment against the Debenture holder for the fair value of the
Unauthorized Shares, and (iii) punitive damages from the Debenture holder for
improper conversion of the Unauthorized Shares.
 
 On September 27, 2005, we agreed with
Breckenridge to settle and discontinue the three pending legal actions between
us and Breckenridge.  The three actions pending in the Supreme Court
of New York, Nassau County, involved (i) the Company’s claims against
Breckenridge for the improper transfer to and subsequent sale of shares of the
Company’s common stock by Breckenridge; (ii) Breckenridge’s claims against the
Company for failure to honor conversion notices or properly issue shares upon
conversion of the Company’s Series I 8% Convertible Preferred Stock (the “Series
I Preferred”) by Breckenridge; and (iii) Breckenridge’s claims that the Company
breached agreements in connection with the Series I Preferred, and that pursuant
to a security agreement, Breckenridge was entitled to damages and possession of
the pledged collateral (collectively, the “Breckenridge Lawsuits”).
 
 Pursuant to the Settlement of the
Breckenridge Lawsuits, we entered into a Mutual Release of Claims Agreement (the
“Mutual Release”), pursuant to which we and Breckenridge agreed to settle and
dismiss the Breckenridge Lawsuits, and to release any and all claims against
each other relating to any prior transactions between us and
Breckenridge.  Pursuant to the Mutual Release, Breckenridge agreed to
assign the remaining shares of Series I Preferred to Southridge Partners, LP, to
release its security interest in the Company’s intellectual property, and to
stipulate to the discontinuance with prejudice of the Breckenridge
Lawsuits.  We agreed to pay to Breckenridge installment payments (the
“Periodic Payments”) consisting of monthly payments of $130,000 from November
2005 through April 2006, and monthly payments of $165,000 from May 2006 through
December 2006, as well as approximately $397,000 which we had previously paid
into an escrow account in connection with the Breckenridge
Lawsuits.
  34
  
 On June 6, 2006, Breckenridge filed a
complaint against the Company in the Supreme Court of the State of New York,
County of Nassau (the “Court”), in connection with a settlement agreement
between the Company and Breckenridge entered into in September 2005. In the
Complaint, Breckenridge alleged that the Company failed to pay certain amounts
due under the settlement agreement in the amount of $450,000. The Company denied
the allegations of Breckenridge’s complaint and filed a motion for summary
judgment.  Breckenridge also filed for summary judgment on its
complaint.
 
 On February 2, 2007, the Court granted
Breckenridge’s motion for summary judgment, denied the Company’s summary
judgment motion, and directed that a hearing be held to determine the amount
owed by the Company to Breckenridge.  The Company and Breckenridge
entered into a stipulation that the Company owed Breckenridge $1,530,000 plus
interest at a rate of 9% from September 15, 2006 to the date of entry of
judgment.
 
 The
Court’s judgment dated as of March 15, 2007, states that the Company owes an
aggregate of $1,602,000 to Breckenridge.  The Company has accrued for
this settlement in the accompanying financial statements.
 
 In
February 2008, the Company entered into an amended settlement agreement with
Breckenridge under which the Company agreed to pay Breckenridge
$540,000.  The Company has paid Breckenridge the full amount . No
further obligations are required by the Company to Breckenridge.
 
 Equity
Lines of Credit
 
 We have previously entered into several
equity lines of credit with Queen, LLC (the “Equity Line
Investor”).
 
 Seventh Equity
Line of Credit - On May 27, 2005, we entered into a seventh private
equity line agreement (the "Seventh Equity Line Agreement") with the Equity Line
Investor, on terms substantially similar to those of the Sixth Equity Line
between Queen and us dated November 15, 2004.
 
 Under the
Seventh Equity Line Agreement, we had the right to draw up to $20,000,000
against an equity line of credit (the "Seventh Equity Line") from the Equity
Line Investor.  We were entitled under the Seventh Equity Line
Agreement to draw certain funds and to put to the Equity Line Investor shares of
the Company's Class A common stock in lieu of repayment of the
draw.  We were limited as to the amount of shares we may put to the
Equity Line Investor in connection with each put; we could not put shares which
would cause the Equity Line Investor to own more than 4.99% of our outstanding
common stock on the date of the put notice.  The number of shares to
be issued in connection with each draw was determined by dividing the amount of
the draw by 93% of the average of the two lowest closing bid prices of our Class
A common stock over the ten trading days after the put notice is
tendered.  The Equity Line Investor was required under the Seventh
Equity Line Agreement to tender the funds requested by us within two trading
days after the ten-trading-day period used to determine the market
price.
 
 We granted registration rights to the
Equity Line Investor and filed three registration statements which cover the
resales of the shares to be issued under the Seventh Equity Line.  All
of the shares registered by the first registration statement had been sold as of
October 24, 2005.  The second registration statement filed in
connection with the Seventh Equity Line was declared effective by the SEC on
February 10, 2006.  All of the shares registered by the second
registration statement had been sold as of July 26, 2006.  We filed a
third registration statement on June 26, 2006, to register additional shares
under the Seventh Equity Line.  However, that registration statement
was not declared effective, and no shares were sold under that registration
statement.
 
 For the
year ended December 31, 2006, we received $3,378,000 in funds drawn under the
Seventh Equity Line, less commissions and fees of $114,000.  We issued
300,000,000 shares of Class A common stock to the Equity Line Investor as puts
under the Seventh Equity Line totaling $3,378,000.
 
 In January 2007, we terminated the
Seventh Equity Line, and we have withdrawn the third registration statement
related to the Seventh Equity Line.  As such, as of the date of this
report, we did not have an equity line of credit financing available to
us.
  35
   Stock Options and
Warrants
 
 During 2006, we granted options to
purchase 12 shares of Class A common stock in addition to the option granted in
connection with the option exchange program described above.  The
options were granted at exercise price of $50.00.  All options were
granted at the quoted market price on the date of grant.  All options
granted vest over three years following issuance.  If not exercised,
all options expire within ten years from the date of grant.
 
 As of December 31, 2007, we had
warrants to purchase a total of 3 shares of Class A common stock outstanding
that expire through 2010.
 
 For the year ended December 31, 2008,
we granted no options to employees to purchase.  As of December 31,
2008, we had a total of 40 options to purchase Class A common stock
outstanding.
 
 Summary
of Contractual Obligations
 
 The following summary reflects payments
due under long-term obligations as of December 31, 2008:
 
 Total
                        
                        
                        Less Than
      One
                        
                        
                        One to
      Three
                        
                        
                        Three to
      Five
                        
                        
                        More than
      FiveNotes
      payable
                        
                        $
                        917,000
                        
                        
                        $
                        917,000
                        
                        
                        $
                        --
                        
                        
                        $
                        --
                        
                        
                        
                        --Operating
      lease obligations
                        
                        
                        299,000
                        
                        
                        
                        71,000
                        
                        
                        
                        150,000
                        
                        
                        
                        78,000
                        
                        
                        
                        --Preferred
      stock dividends
                        
                        
                        8,900,000
                        
                        
                        
                        1,780,000
                        
                        
                        
                        3,560,000
                        
                        
                        
                        3,560,000
                        
                        
                        
                        **Total
      contractual cash obligations
                        
                        $
                        10,116,000
                        
                        
                        $
                        2,768,000
                        
                        
                        $
                        3,710,000
                        
                        
                        $
                        3,638,000
  **  Preferred
stock dividends do not have a definite life, therefore dividend payment
requirements greater than five years cannot reasonably be
estimated.
  
 Other
 
 We presently have no plans to purchase
new research and development or office facilities.
 
 Corporate
Outlook
 
 Fonix’s
focus on providing competitive and value-added solutions for customers and
partners requires a broad set of technologies, service offerings and channel
capabilities.  Management anticipates and expects further development
of complementary technologies, added product and application developments,
access to market channels and additional opportunities for strategic alliances
in other industry segments.
 
 We will
continue to leverage our research and development of speech technologies to
deliver software applications and engines to device manufacturers looking to
incorporate speech interfaces into end-user products.  Fonix Speech’s
award-wining technologies provide competitive embedded speech solutions for
mobile/wireless devices, videogames, telephony systems and products for the
assistive market based on Fonix’s proprietary and patented TTS and ASR
technologies.
 
 As we proceed to implement our strategy
and to reach our objectives, we anticipate further development of complementary
technologies, added product and applications development expertise, access to
market channels and additional opportunities for strategic alliances in other
industry segments.  The strategy adopted by us has significant risks,
and shareholders and others interested in Fonix and our Class A common stock
should carefully consider the risks set forth below and under the heading
“Certain Significant Risk Factors” in Item 1, Part I, of this
report.
  36
  
 As noted above, as of December 31,
2008, we had an accumulated deficit of $286,367,000, negative working capital of
$44,471,000, derivative liabilities of $34,582,000 related to the issuance of
Series L Preferred Stock, Series M Preferred Stock, Series N Preferred Stock,
Series O Preferred Stock, , Series P Preferred Stock and Series B Preferred
Stock of our subsidiary, accrued liabilities of $6,510,000, accounts payable of
$1,801,000 deferred revenues of $445,000.  Sales of products and
revenue from licenses based on our technologies have not been sufficient to
finance ongoing operations.  These matters raise substantial doubt
about our ability to continue as a going concern.  Our continued
existence is dependent upon several factors, including our success in (1)
increasing speech license, royalty and services revenues, (2) raising sufficient
additional funding, and (3) minimizing operating costs.  Until
sufficient revenues are generated from operating activities, we expected to
continue to fund our operations through debt instruments.  We are
currently pursuing additional sources of liquidity in the form of traditional
commercial credit, asset based lending, or additional sales of our equity
securities to finance our ongoing operations.  Additionally, we are
pursuing other types of commercial and private financing, which could involve
sales of our assets or sales of one or more operating divisions.  Our
sales and financial condition have been adversely affected by our reduced credit
availability and lack of access to alternate financing because of our
significant ongoing losses and increasing liabilities and
payables.  As we have noted in our previous annual reports and other
public filings, if additional financing is not obtained in the near future, we
will be required to more significantly curtail our operations or seek protection
under bankruptcy laws.
 
 Information
Concerning Forward-Looking Statements
 
 Certain of the statements contained in
this report (other than the historical financial data and other statements of
historical fact) are forward-looking statements.  These statements
include, but are not limited to our expectations with respect to the development
of a diversified revenue base; delivery of our VoiceDial application; the market
volume of educational electronic dictionary devices; our ability to capitalize
in markets including toys, appliances, and other devices; the market demand for
videogames; our growth strategies and the implementation of our Core
Technologies and potential results; our payment of dividends on our common
stock; our ability to meet customer demand for speech technologies and
solutions; development of complementary technologies, products, marketing, and
strategic alliance opportunities; profitability of language learning tools; the
status of  traditional operator systems; our ability to continue
operations in the event we do not receive approval to amend our articles of
incorporation; the comparability of our speech-enabled Speech Products to other
products; our intentions with respect to strategic collaborations and marketing
arrangements; our intentions with respect to use of licenses; our plans with
respect to development and acquisition of speech solutions; our goals with
respect to supplying speech solutions for OEMs; our expectations with respect to
continued financial losses; and our intentions with respect to financing our
operations in the future.  Additional forward-looking statements may
be found in the “Certain Significant Risk Factors” Section of this Report,
together with accompanying explanations of the potential risks associated with
such statements.
 
 Forward-looking statements made in this
Report are made based upon management’s good faith expectations and beliefs
concerning future developments and their potential effect upon
Fonix.  There can be no assurance that future developments will be in
accordance with such expectations, or that the effect of future developments on
Fonix will be those anticipated by management.  Forward-looking
statements may be identified by the use of words such as “believe,” “expect,”
“plans,” “strategy,” “prospects,” “estimate,” “project,” “anticipate,” “intends”
and other words of similar meaning in connection with a discussion of future
operating or financial performance.
 
 You are cautioned not to place undue
reliance on these forward looking statements, which are current only as of the
date of this Report.  We disclaim any intention or obligation to
update or revise any forward-looking statements, whether as a result of new
information, future events, or otherwise.  Many important factors
could cause actual results to differ materially from management’s expectations,
including those listed in the “Certain Significant Risk Factors” Section of this
report, as well as the following:
 
 •              unpredictable
difficulties or delays in the development of new products and
technologies;
 
 •
              changes
      in U.S. or international economic conditions, such as inflation, interest
      rate fluctuations, foreign exchange rate fluctuations or recessions in
      Fonix's markets;
  37
  •
              pricing
      changes to our supplies or products or those of our competitors, and other
      competitive pressures on pricing and
sales;
 
 •
              difficulties
      in obtaining or retaining the management, engineering, and other human
      resource competencies that we need to achieve our business
      objectives;
 
 •
              the
      impact on Fonix or a subsidiary from the loss of a significant customer or
      a significant number of customers;
 
 •
              risks
      generally relating to our international operations, including
      governmental, regulatory or political
changes;
 
 •
              transactions
      or other events affecting the need for, timing and extent of our capital
      expenditures; and
 
 •        
      the extent to which we reduce outstanding
debt.
 
 
 ITEM
8.                 FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA
 
 Index
      to Consolidated Financial
Statements:
 
 Report
      of Independent Registered Public Accounting Firm
                      F-2CONSOLIDATED
      FINANCIAL STATEMENTS:Consolidated
      Balance Sheets as of December 31, 2008 and 2007
                      F-3Consolidated
      Statements of Operations and Comprehensive Loss for the Years
      EndedDecember
      31, 2008, 2007 and 2006
                      F-4Consolidated
      Statements of Stockholders’ Deficit for the Years EndedDecember
      31, 2006, 2007 and 2008
                      F-5Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2008, 2007 and
      2006
                      F-6Notes
      to Consolidated Financial Statements
                      F-8
 
 
 ITEM
      9.
              CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE.
 
 None.
 
 ITEM
9A.              CONTROLS
AND PROCEDURES
  Management's
Report on Internal Control Over Financial Reporting
  Our
management, currently consisting of one individual, is responsible for
establishing and maintaining effective internal control over financial
reporting. Internal control over financial reporting is defined in
Rule 13a-15(f) or Rule 15d-(f) promulgated under the Exchange Act as a
process designed by, or under the supervision of, a company's principal
executive officer and principal financial officer and effected by the company's
board of directors, management and other personnel, to provide reasonable
assurance regarding the reliability of financial reporting and the preparation
of financial statements for external purposes in accordance with generally
accepted accounting principles. A company's internal control over financial
reporting includes those policies and procedures that:
   38
   
  •
              pertain
      to the maintenance of records that, in reasonable detail, accurately and
      fairly reflect the transactions and dispositions of the assets of the
      company;
 •
              provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the company
      are being made only in accordance with authorizations of management and
      directors of the company; and
 •
              provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use or disposition of the company's assets that
      could have a material effect on the financial
  statements.
  Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
  Our Chief
Executive Officer assessed the effectiveness of our internal control over
financial reporting as of December 31, 2008. In making its assessment, he
used the criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission. Based on his assessment, management determined that, as of
December 31, 2008, we maintained effective internal control over financial
reporting based on those criteria.
  Based on
his assessment, our Chief Executive Officer determined that, as of
December 31, 2008, our internal controls over financial reporting, based on
those criteria, were not effective.  This was due to deficiencies that
existed in the design or operation of our internal control over financial
reporting, or the implementation and staffing of such controls and procedures,
that adversely affected our internal controls and that may be considered to be
material weaknesses.
  The
matters involving internal controls and procedures that the Company's management
considered to be material weaknesses under COSO and SEC rules were:
  (1)lack
      of segregation of duties, due to management being consolidated in one
      individual;
  (2)lack
      of a functioning audit committee, resulting in ineffective oversight in
      the establishment and monitoring of required internal controls and
      procedures; and
  (3)ineffective
      implementation of controls over period end financial disclosure and
      reporting processes, due in part to the consolidation of management in one
      individual.
  The
aforementioned material weaknesses were identified by the Company's Chief
Executive Officer in connection with the preparation of our financial statements
as of December 31, 2008.
  The
Company’s Chief Executive Officer believes that the material weaknesses set
above did not have an effect on the Company's financial results. However,
management believes that the lack of a functioning audit committee, resulting in
ineffective oversight in the establishment and monitoring of required internal
controls and procedures, can impact the Company's financial statements for the
future years.
  We are
committed to improving our financial organization. As part of this commitment,
and as resources permit, we intend to hire additional management personnel and
to create positions to segregate duties consistent with control objectives and
to increase our personnel resources and technical accounting expertise within
the accounting function when funds are available to the Company, by: i)
appointing one or more additional directors of our board of directors to an
audit committee of the Company resulting in a fully functioning audit committee
who will undertake the oversight in the establishment and monitoring of required
internal controls and procedures; and ii) preparing and implementing sufficient
written policies and checklists which will set forth procedures for accounting
and financial reporting with respect to the requirements and application of US
GAAP and SEC disclosure requirements.
   39
   Our Chief
Executive Officer believes that the appointment of one or more additional
directors to a fully functioning audit committee, will remedy the lack of a
functioning audit committee. In addition, management believes that preparing and
implementing sufficient written policies and checklists will remedy the
following material weaknesses: (i) insufficient written policies and procedures
for accounting and financial reporting with respect to the requirements and
application of US GAAP and SEC disclosure requirements; and (ii) ineffective
controls over period end financial close and reporting processes. Further,
management believes that the hiring of additional personnel, as well as
additional executive officers, who have the technical expertise and knowledge
will result proper segregation of duties and provide more checks and balances
within the department. Additional personnel will also provide the cross training
needed to support the Company if personnel turn over issues within the
department occur. Our Chief Executive Officer believes that these steps, coupled
with the appointment of additional directors, will greatly decrease any control
and procedure weaknesses or deficiencies the Company may encounter in the
future.
  We will
continue to monitor and evaluate the effectiveness of our internal controls and
procedures and our internal controls over financial reporting on an ongoing
basis and are committed to taking further action and implementing additional
enhancements or improvements, as necessary and as funds allow.]
  Evaluation of Disclosure
Controls and Procedures.  Our Chief Executive Officer, after
evaluating the effectiveness of the Company’s “disclosure controls and
procedures” (as defined in the Securities Exchange Act of 1934 (Exchange Act)
Rules 13a-15(e) or 15d-15(e)) as of the end of the period covered by this
annual  report, has concluded that our disclosure controls and
procedures are effective based on their evaluation of these controls and
procedures required by paragraph (b) of Exchange Act Rules 13a-15 or
15d-15.
 
 Changes in Internal Control
Over Financial Reporting.  Other than as discussed above, there
were no changes in our internal control over financial reporting identified in
connection with the evaluation required by paragraph (d) of Exchange Act Rules
13a-15 or 15d-15 that occurred during our last fiscal quarter that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.
 
 Limitations on Effectiveness
of Controls.  A system of controls, however well designed and
operated, can provide only reasonable, and not absolute, assurance that the
system will meet its objectives.  The design of a control system is
based, in part, upon the benefits of the control system relative to its
costs.  Control systems can be circumvented by the individual acts of
some persons, by collusion of two or more people, or by management override of
the control.  In addition, over time, controls may become inadequate
because of changes in conditions, or the degree of compliance with the policies
or procedures may deteriorate.  In addition, the design of any control
system is based in part upon assumptions about the likelihood of future
events.
 
 No Attestation
Report.  This annual report does not include an attestation
report of the Company's registered public accounting firm regarding internal
control over financial reporting. Management's report was not subject to
attestation by the Company's registered public accounting firm pursuant to
temporary rules of the  Securities and Exchange Commission that permit
the company to provide only management's report in this annual
report.
 
 PART
III
 
 ITEM
      10.
              DIRECTORS,
      EXECUTIVE OFFICERS, AND CORPORATE
GOVERNANCE
 
 The following table sets forth
certain information concerning the executive officers and directors of Fonix as
of March 31, 2008:
 
 Name
              Age
              PositionRoger
      D.  Dudley
              57
              Director,
      Chief Executive Officer & Chief
  Financial Officer
 
 All directors hold office until the
next annual meeting of the stockholders of Fonix or until their successors have
been elected and qualified.  Our officers are elected annually and
serve at the pleasure of the Board of Directors.
 
 As noted elsewhere in this report,
Thomas A. Murdock served as President, Chief Executive Officer, and Chairman of
the Company during 2007 and through his resignation on March 5,
2008.
  40
   As noted elsewhere in this Report,
William A. Maasberg, Jr., served as a Director and Chief Operating Office of the
Company during 2007 and through his resignation as a Director on March 5, 2008,
and as Chief Operating Office on March 31, 2008.  Since the
resignations of Mr. Murdock and Mr. Maasberg, Mr. Dudley has been the sole
officer and director of the Company.
 
 ROGER
D.  DUDLEY is a co-founder of Fonix and has served as an executive
officer and member of our board of directors since June 1994.  Mr.
Dudley currently serves as the Company’s sole Director, chief executive officer
and chief financial officer.  After several years at IBM in marketing
and sales, he began his career in the investment banking industry.  He
has extensive experience in corporate finance, equity and debt private
placements and asset management.
 
 Audit
Committee Financial Expert
 
 The Board of Directors has determined
that we do not have an audit committee financial expert.  We have been
seeking to add an individual with these qualifications to our Board of Directors
but have been unable to find a suitable individual.  We continue to
search for someone who meets the qualifications of an audit committee financial
expert.
 
 
 
 Compliance
With Section 16(a) of the Exchange Act
 
 Section 16(a) of the Securities
Exchange Act of 1934 requires our officers and directors, and persons who
beneficially own more than 10% of a registered class of our equity securities,
to file reports of ownership and changes in ownership with the Securities and
Exchange Commission.  Officers, directors and greater than 10%
shareholders are required by regulation of the Securities and Exchange
Commission to furnish us with copies of all Section 16(a) forms which they
file.  Based solely on its review of the copies of such forms
furnished to us during the fiscal year ended December 31, 2008, we are aware of
the following untimely filings:
 
 Mr. Dudley filed a late Form
5.
 
 Code
of Ethics Disclosure
 
 In March 2004, our Board of Directors
adopted a Code of Ethics (the “Code”) that applies to it and our executive
officers, including, among others, our chief executive officers and senior
financial officers, as well as all of our employees at all levels, including our
subsidiaries.  The Code is designed to deter wrongdoing and to matters
of business ethics including, but not limited to:
 
 •
              Business
      Ethics - The Code states that it is the policy of the Company that each
      employee should conduct his or her affairs with uncompromising honesty and
      integrity.
 
 •
              Public
      Reports - The Code notes that Fonix is a public reporting company, and
      expresses the policy that any employee who has a responsibility for
      assisting in preparation of public reports or other public filings must
      assure that the information contained in the report or filing is complete,
      accurate, and true in every
respect.
 
 •
              Conflicts
      of Interest - The Code discusses possible situations of conflicts of
      interest, and requires that potential conflicts of interest be cleared
      through the Company's Audit
Committee.
 
 •
              The
      Code prohibits gifts, bribes, or kickbacks being given or received by
      Fonix employees.  Additionally, the Code prohibits: loans to
      officers or directors; improper use or theft of Company property;
      falsifying records; abuse of Company, customer, associate, or vendor
      information; gathering information regarding competitors of the Company;
      defamation or misstatements; and improper use of Company or third-party
      software.
  41
  
 
 A copy of our Code of Ethics was an
exhibit to the annual report filed for 2003.  Additionally, we
undertake to provide to any person without charge, upon request, a copy of our
Code of Ethics.  Such request may be made in writing to the Board of
Directors at our address listed on the first page of this report.
 
 
 ITEM
11.                      EXECUTIVE
COMPENSATION
 
 Compensation
Discussion and Analysis
 
 The following is a discussion of the
Company’s program for compensation of its named executive officers and
directors.  During 2008, the compensation committee of the Board of
Directors was responsible for determining the Company’s compensation
program.  On March 5, 2008 Messrs. Murdock and Maasberg resigned as
directors of the Company, and as such, Mr. Dudley, as the sole director during
the period covered by this Report was responsible for the Company’s compensation
program.
 
 Compensation
Program Objectives
 
 The
Company’s compensation program is designed to encompass several factors in
determining the compensation of the Company’s named executive
officers.  The following are the main objectives of the compensation
program for the Company’s named executive officers:
 
 -              Retain
qualified officers.
 -
              Provide
      overall corporate direction for the officers and also to provide direction
      that is specific to officer’s respective areas of
      authority.  The level of compensation amongst the officer group,
      in relation to one another, is also considered in order to maintain a high
      level of satisfaction within the leadership group. We consider the
      relationship that the officers maintain to be one of the most important
      elements of the leadership group.
 -           
  Provide a performance incentive for the officers.
 
 The
Company’s compensation program is designed to reward the officers in the
following areas:
 
 -             
achievement of specific goals;
 -             
professional education and development;
 -
              creativity
      in the form of innovative ideas and analysis for new programs and
      projects;
 -             
new program implementation;
 -             
attainment of company goals, budgets, and objectives;
 -             
results oriented determination and organization;
 -            
 positive and supportive direction for company personnel; and
 -            
 community involvement.
 
 As of the
date of this Report, there were three principal elements of named executive
officer compensation.  The Compensation Committee determines the
portion of compensation allocated to each element for each individual named
executive officer.  The discussions of compensation practices and
policies are of historical practices and policies.  Our Compensation
Committee is expected to continue these policies and practices, but will
reevaluate the practices and policies as it considers advisable.
 
 The elements of the compensation
program include:
 
 -           Base
salary;
 -           Stock
options and stock awards;
 -           Employee
benefits in the form of:
 -           health
and dental insurance;
 -           auto
reimbursement
 -           Other
de minimis benefits.
 
  42
  
 Base
salary
 
 Base
salary is intended to provide competitive compensation for job performance and
to attract and retain qualified named executive officers.  The base
salary level is determined by considering several factors inherent in the market
place such as: the size of the company; the prevailing salary levels for the
particular office or position; prevailing salary levels in a given geographic
locale; and the qualifications and experience of the named executive
officer.
 
 Stock
options and stock awards
 
 Stock
ownership is provided to enable named executive officers and directors to
participate in the success of the Company.  The direct or potential
ownership of stock will also provide the incentive to expand the involvement of
the named executive officer to include, and therefore be mindful of, the
perspective of stockholders of the Company.
 
 Employee
benefits
 
 Several
of the employee benefits for the named executive officers are selected to
provide security for the named executive officers.  Most notably,
health insurance coverage is intended to provide a level of protection to that
will enable the named executive officers to function without having the
distraction of having to manage undue risk.  The health insurance also
provides access to preventative medical care which will help the named executive
officers function at a high energy level, to manage job related stress, and
contribute to the overall well being of the named executive officers, all of
which contribute to an enhanced job performance.
 
 Other de minimis benefits
 
 Other de
minimis employee benefits such as cell phones and auto usage reimbursements are
directly related to job functions but contain a personal use element which is
considered to be a goodwill gesture that contributes to enhanced job
performance.
 
 As
discussed above, the Compensation Committee determines the portion of
compensation allocated to each element for each individual named executive
officer.  As a general rule, base salary is competitively based while
giving consideration to employee retention, qualifications, performance, and
general market conditions.  Typically, stock options are based on the
current market value of the option and how that will contribute to the overall
compensation of the named executive officer.  Consideration is also
given to the fact that the option has the potential for an appreciated future
value.  As such this future value may in fact be the most significant
factor of the option, but it is also more difficult to quantify as a benefit to
the named executive officer.
 
 Accordingly,
in determining the compensation program for the Company, as well as setting the
compensation for each named executive officer, the Compensation Committee of the
Board of Directors attempts to attract the interest of the named executive
officer within in the constraints of a compensation package that is fair and
equitable to all parties involved.
 
 EXECUTIVE
COMPENSATION
 
 SUMMARY COMPENSATION
TABLE
 Name
      and Principal Position
              Year
              Salary
                ($)
              Bonus
                ($)
              Stock
      Awards
                ($)
              Option
      Grants
                ($)
              Non-Equity
      Incentive Plan Compensation
                ($)
              Change
      in Pension Value and Nonqualified Deferred Compensation
      Earnings
                ($)
              All
      Other Compensation
              Total
                ($)Roger D. Dudley
                Executive vice President & Chief
                Financial
      Officer (2)
              2008
              $
      309,400 (1)
              --
              --
              $25,330
              --
              --
              $ 5,742(3)
              $
      340,472
  (1)
              Due
      to cash flow difficulties, Mr. Dudley was not paid his full contracted
      rate of $309,400 for 2008, but was paid
$68,024.
 
 (2)
              We
      have an executive employment agreement Mr.Dudley.  The
      expiration date is December 31, 2010.  The material terms of the
      executive employment agreement with Mr. Dudley are as follows: the annual
      base salary is $309,400 and may be adjusted upward in future years as
      deemed appropriate by the board of
directors.
 
 Mr.
Dudley also is entitled to customary insurance benefits, office and support
staff and an automobile allowance.  In addition, if Mr. Dudley is
terminated without cause during the contract term, then all salary then and
thereafter due and owing under the executive employment agreement shall, at the
executive’s option, be immediately paid in a lump sum payment to the executive
officer, and all stock options, warrants and other similar rights granted by us
and then vested or earned shall be immediately granted to the executive officer
without restriction or limitation of any kind.
 
 The
executive employment agreement contains a non-disclosure, confidentiality,
non-solicitation and non-competition clause.  Under the terms of the
non-competition clause, Mr. Dudley has agreed that for a period of one year
after termination of his employment
 with us
the executive will not engage in any capacity in a business which competes with
or may compete with Fonix.
 
 (3)
              These
      amounts relate to expenses paid by the Company for the use of automobiles
      for the named executive
officer.
  43
  GRANTS
OF PLAN-BASED AWARDS
 For
Fiscal Year Ended December 31, 2008
 
 Name
              Grant
      Date
              Estimated
      Future Payouts Under Non-Equity Incentive Plan Awards
              Estimated
      Future Payouts Under Equity Incentive Plan Awards
              All
      Other Stock Awards: Number of Shares of Stock or Units
                (#)
              All
      Other Option Awards: Number of Securities Underlying Options
                (#)
              Exercise
      Price or Base Price of Option Awards
                ($/Sh)Threshold
                ($)
              Target
                ($)
              Maximum
                ($)
              Threshold
                (#)
              Target
                (#)
              Maximum
                (#)Roger
      D. Dudley
              N/A
              --
              --
              --
              --
              --
              --
              --
              --
              --
 
 For the
year ended December 31, 2008, there were no grants of plan based
awards.
 
 OUTSTANDING
EQUITY AWARDS AT FISCAL 2008 YEAR-END
 
 Option
      Awards
                Stock
      AwardsName
                Number
      of Securities Underlying Unexercised Options (#) Exercisable
                Number
      of Securities Underlying Unexercised Options
                  (#)
                  Unexercisable
                Equity
      Incentive Plan Awards: Number of Securities Underlying Unexercised
      Unearned Options
                  (#)
                Option
      Exercise Price ($)
                Option
      Expiration Date
                Number
      of Shares or Units of Stock That Have Not Vested (#)
                Market
      Value of Shares or Units of Stock That Have Not Vested ($)
                Equity
      Incentive Plan Awards: Number of Unearned Shares, Units, or Other Rights
      That Have Not Vested
                  (#)
                Equity
      Incentive Plan Awards: Market or Payout Value of Unearned Shares, Units,
      or Other Rights That Have Not Vested
                  ($)Roger D. Dudley
                20
                --
                --
                $200.00
                2010
                --
                $19
                --
                --
 
 This
table lists the securities underlying unexercised options as of December 31,
2008, and related information.
  44
  
 OPTION
EXERCISES AND STOCK VESTED
 For
Fiscal Year Ended December 31, 2008
 
 Option
      Awards
                Stock
      AwardsName
      of Executive Officer
                Number
      of Shares Acquired on Exercise
                  (#)
                Value
      Realized on Exercise
                  ($)
                Number
      of Shares Acquired on Vesting
                  (#)
                Value
      Realized on Vesting
                  ($)Roger D. Dudley
                --
                --
                --
                --
 
 For the
year ended December 31, 2008, there were no option exercises.
 
 PENSION
BENEFITS
 For
Fiscal Year Ended December 31, 2008
 
 Name
              Plan
      Name
              Number
      of Years Credited Service
                (#)
              Present
      Value of Accumulated Benefit ($)
              Payments
      During Last Fiscal Year
                ($)Roger D. Dudley
              N/A
              --
              --
              --
 
 For the
year ended December 31, 2008, there were no pension benefits paid.  We
do not currently have a pension plan.
 
 
 NONQUALIFIED
DEFERRED COMPENSATION
 For
Fiscal Year Ended December 31, 2008
 
 Name
              Executive
      Contributions in Last FY
                ($)
              Registrant
      Contributions in Last FY
                ($)
              Aggregate
      Earnings in Last FY
                ($)
              Aggregate
      Withdrawals/
                Distributions
                ($)
              Aggregate
      Balance at Last FYE
                ($)Roger D. Dudley
              --
              --
              --
              --
              --
 
 For the
year ended December 31, 2008, there was no non-qualified
compensation.
 
 
 DIRECTOR
COMPENSATION
 For
Fiscal Year Ended December 31, 2008
 
 Name
              Fees
      Earned or Paid in Cash
                ($)
              Stock
      Awards
                ($)
              Option
      Awards
                ($)
              Non-Equity
      Incentive Plan Compensation
                ($)
              Change
      in Pension Value and Nonqualified Deferred Compensation
      Earnings
                ($)
              All
      Other Compensation
                ($)
              Total
                ($)Roger D. Dudley
              --
              --
              --
              --
              --
              --
              --
 
 For the
year ended December 31, 2008, no compensation was paid to the directors for
their service as directors.
  45
  
 Board
of Directors Meetings, Committees and Director Compensation
 
 Our board of directors took action
at2 duly noticed meetings of the board during
2008.  Each director attended (in person or telephonically) all of the
meetings of Fonix’s board of directors.  On March 5, 2008, Messrs.
Murdock and Maasberg resigned as directors of the Company.  Because
Mr. Dudley is the sole remaining director, as of the date of this Report the
Company had no board committees.
 
 Compensation
of Directors
 
 Prior to April 1996, our directors
received no compensation for their service.  We historically have
reimbursed our directors for actual expenses incurred in traveling to and
participating in directors’ meetings, and we intend to continue that policy for
the foreseeable future.  On March 30, 1996, our board of directors
adopted, and our shareholders subsequently approved, our 1996 Directors’ Stock
Option Plan (the “Directors’ Plan”).  Under the Directors’ Plan,
members of the Board as constituted on the date of adoption received options to
purchase 5,000 shares of our Class A common stock for each year (or any portion
thereof consisting of at least six months) during which such persons had served
on the board for each of fiscal years 1994 and 1995 and were granted 5,000
shares for each of fiscal years 1996 through 2002, which options vested after
completion of at least six months’ service on the board during those fiscal
years.  These options have terms of ten years.  No options
were granted to our directors under the Directors’ Plan during
2008.  Similar grants have been made to our under our 1998 Stock
Option Plan, as set forth elsewhere in this report.
 
 ITEM 12.
              SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS
 
 The following table sets forth, as of
March  16, 2009, the number of shares of Common Stock of Fonix
beneficially owned by all persons known to be holders of more than five percent
of our Common Stock and by the executive officers and directors of Fonix
individually and as a group.    Unless indicated otherwise,
the address of the stockholder is our principal executive offices, 387 South 520
West, Suite 110, Lindon, Utah 84042.
 
 Name
      and Address of 5% Beneficial Owners, Executive Officers, and
      Directors
              Number
      of Shares
                Beneficially
      Owned
              Percent
      of Class (1)Roger
      D.  Dudley
                Chairman
      of the Board, Chief Executive Officer, Chief Financial Officer,
      Director
              5,430,455(3)
              48.79%Thomas
      A.  Murdock (2)
                Former
      Chairman of the Board & Former Chief Executive Officer
              1,328,049(4)
              18.53%Officer
      and Director as a Group
                (1
      persons)
              6,758,504
              54.25%
 
 
 (1)           Percentages
rounded to nearest 1/100th of one percent.  Except as indicated in the
footnotes below, each of the persons listed exercises sole voting and investment
power over the shares of Common Stock listed for each such person in the
table.
 
 (2)           On
March 5, 2008, Mr. Murdock resigned as the Company’s Chairman, President, and
Chief Executive Officer.
 
 (3)           Includes
8 shares of Common Stock deposited in a voting trust (the “Voting Trust”) as to
which Mr. Dudley is the sole trustee and 5,292,926 shares of Common Stock
issuable as of March 31, 2008, into the Voting Trust under a convertible
promissory note (the “Convertible Note”) held by Mr. Murdock and Mr.
Dudley.  Persons who have deposited their shares of Common Stock into
the Voting Trust have dividend and liquidation rights (“Economic Rights”) in
proportion to the number of shares of Common Stock they have deposited in the
Voting Trust, but have no voting rights with respect to such
shares.  All voting rights associated with the shares deposited into
the Voting Trust are exercisable solely and exclusively by the Trustee of the
Voting Trust.  The voting trust expires, unless extended according to
its terms, upon the earlier to occur of (i)(a) the sale of all of the shares of
common stock of the Company issued and issuable to the Shareholders upon
conversion of the entire unpaid of the Note in accordance with the terms and
conditions of the Note and the LOC Agreement; and (b) sale or distribution of
the Shares Certificates to the Shareholders; or (ii)(a)the payment in full of
the Note in accordance with the terms and conditions of the Note and the LOC
Agreement; and (b) sale or distribution of the Shares Certificates to the
Shareholders.  Although as the sole trustee of the Voting Trust Mr.
Dudley exercises the voting rights of all of the shares deposited into the
Voting Trust, and accordingly has listed all shares in the table above, he has
no economic or pecuniary interest in any of the shares deposited into the Voting
Trust except for 3,964,957 shares issuable as of March 16, 2009, under the
Convertible Note as to which he will directly own Economic Rights when
issued.  Also, (iv) includes 71 shares owned directly by Mr. Dudley,
(v) options to purchase 20 shares of the Company’s Common Stock, and (vi) 4
shares held in the Voting Trust.
 
 (4)           Includes
(i) 1,328,049 common Stock issuable as of March 16, 2008, under the Convertible
Note which will be deposited into the Voting Trust when issued,  (ii)
20 shares held in the Voting Trust.
  46
 
 
 Plan
      Category
              Number
      of securities to be issued upon exercise of outstanding options, warrants,
      and rights
              Weighted
      average exercise price of outstanding options, warrants, and
      rights
              Number
      of securities remaining available for future issuance under equity
      compensation plansEquity
      compensation plans approved by shareholders
              40
              $800.00
              3,887Equity
      compensation plans not approved by shareholders
              --
              --
              --Total
              40
              $800.00
              3,887
 
 ITEM
      13.
              CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
      INDEPENDENCE
 
 Loans
from Senior Management to Company
 
 During
2002, two of our executive officers (the “Lenders”) sold shares of our Class A
common stock owned by them and advanced the resulting proceeds amounting to
$333,000 to us under the terms of a revolving line of credit and related
promissory note.  The funds were advanced for use in our
operations.  The advances bear interest at 12 percent per annum, which
interest is payable on a semi-annual basis.  The entire principal,
along with unpaid accrued interest and any other unpaid charges or related fees,
was originally due and payable on June 10, 2003.  Fonix and the
Lenders have agreed to postpone the maturity date on several
occasions.  The note was due September 30, 2006.  As of
March 19, 2008, we had not made payment against the outstanding balance due on
the note. All or part of the outstanding balance and unpaid interest may be
converted at the option of the Lenders into shares of Class A common stock of
Fonix at any time.  The conversion price was the average closing bid
price of the shares at the time of the advances.  To the extent the
market price of our shares is below the conversion price at the time of
conversion, the Lenders are entitled to receive additional shares equal to the
gross dollar value received from the original sale of the shares.  The
Lenders may also receive additional compensation as determined appropriate by
the Board of Directors.
 
 In October 2002, the Lenders pledged
30,866 shares of the Company's Class A common stock to the Equity Line Investor
in connection with an advance of $183,000 to us under the Third Equity
Line.  The Equity Line Investor subsequently sold the pledged shares
and applied $82,000 of the proceeds as a reduction of the
advance.  The value of the pledged shares of $82,000 was treated as an
additional advance from the Lenders.
 
 During the fourth quarter of 2003, we
made a principal payment of $26,000 against the outstanding balance of the
promissory note.  During 2004, we entered into an agreement with the
holders of the promissory note to increase the balance of the note payable by
$300,000 in exchange for a release of the $1,443,000 of accrued liabilities
related to prior indemnity agreements between us and the note
holders.  We classified the release of $1,143,000 as a capital
contribution in the Consolidated Financial Statements during the fourth quarter
of 2004.  We made principal payments against the note of $253,000
during the year ended December 31, 2004.  During the year ended
December 31, 2005, we received an additional advance of $50,000 under the note
from the Lenders.  The balance due the Lenders at December 31, 2005
was $486,000.  For the year ended December 31, 2006 we received
additional advances and other consideration from the Lenders in the aggregate
amount of $419,000 and made principal payments to the Lenders against the note
of $105,000.  For the year ended December 31, 2007, the Company
received additional advances of $102,000. For the year ended December 31, 2008,
the Company received additional advances of $72,000. The balance due at December
31, 2008, was $917,000.
  47
   The balance due of $940,000 is secured
by the Company’s intellectual property rights and common stock of Fonix
Speech.  For the year ended December 31, 2008, the Lenders converted
$56,000 of the principal balance into 113,194 shares common stock, and also
converted $111,000 of accrued interest into 96,425 shares of common stock for
the benefit of one of the Lenders, Thomas A. Murdock, a former officer and
director of the Company.
  As of
December 31, 2008, our director was not an “independent director” as he was
employed by the Company as an executive officer, as discussed
above.
 
 ITEM
      14.
              PRINCIPAL
      ACCOUNTANT FEES AND SERVICES
 
 (1) AUDIT
FEES
 
 The aggregate fees billed for the
fiscal years ended December 31, 2008 and 2007, for professional services
rendered by Hansen Barnett & Maxwell P.C., for the audit of the registrant's
annual financial statements and review of the financial statements included in
the registrant's Form 10-Q or services that are normally provided by the
accountant in connection with statutory and regulatory filings or engagements
for fiscal year 2007 and 2006 were $70,000 and $59,000,
respectively.
 
 
 (2)
AUDIT-RELATED FEES
 
 The aggregate fees billed for the
fiscal year ended December 31, 2008 and 2007 for assurance and related services
by Hansen Barnett & Maxwell P.C., that are reasonably related to the
performance of the audit or review of the registrant's financial statements for
fiscal year 2008 and 2007 were $0 and $0, respectively.
 
 (3)
TAX FEES
 
 The aggregate fees billed for each of
the fiscal years ended December 31, 2008 and 2007, for professional services
rendered by Hansen Barnett & Maxwell P.C. for tax compliance, tax advice,
and tax planning, for those fiscal years were $1,000 and $1,000,
respectively.  Services provided included preparation of federal and
state income tax returns.
 
 (4) ALL
OTHER FEES
 
 The aggregate fees billed in each of
the fiscal years ended December 31, 2008 and 2007, for products and services
provided by Hansen Barnett & Maxwell P.C. other than those services reported
above, for those fiscal years were $0 and $10,000.  The other fees
billed in 2007 related to Hansen Barnett & Maxwell’s participation in an
audit of the Company’s 401K plan.  This participation was approved by
the Board of Directors prior to commencement.  Hansen Barnett &
Maxwell made no management decisions.
 
 (5) AUDIT
COMMITTEE POLICIES AND PROCEDURES
 
 Not applicable.
 
 (6) If
greater than 50 percent, disclose the percentage of hours expended on the
principal accountant's engagement to audit the registrant's financial statements
for the most recent fiscal year that were attributed to work performed by
persons other than the principal accountant's full-time, permanent
employees.
 
 Not applicable.
  48
  
 PART
IV
 
 ITEM
      15.
              EXHIBITS
      AND FINANCIAL STATEMENT SCHEDULES
 
 (A)
              Documents
      filed as part of this Form 10-K:
 
 1.
              Consolidated
      Financial Statements (included in Part II, Item
  8)
 
 Consolidated Balance Sheets as of
December 31, 2008 and 2007
 
 Consolidated
Statements of Operations for the Years Ended December 31, 2008, 2007 and
2006
 
 Consolidated
      Statements of Stockholders’ Deficit for the Years Ended December 31, 2008,
      2007 and 2006
 
 Consolidated
Statements of Cash Flows for the Years Ended December 31, 2008, 2007 and
2006
 
 Notes to Consolidated Financial
Statements
 
 
 2.
              Financial
      Statement Schedules: None
 
 
 3.
              Exhibits:
      The following Exhibits are filed with this Form 10-K pursuant to Item
      601(a) of Regulation S-K:
 
 Exhibit
      No.
              Description of
      Exhibit
 
 22
              Subsidiaries
      of Registrant
 
 31
              Certification
      of President and Chief Financial
Officer
 
 32
              Certification
      of President and Chief Financial Officer Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.
 
 
  49
  SIGNATURES
 
 Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.
 
 Fonix
      CorporationDate:
      April 15, 2009
                By:
                /s/  Roger
      D.DudleyRoger
      D.  Dudley, President, Chief Executive
Officerand
      Chief Financial Officer(Principal  Executive
      Officer, Principal Financial and Accounting
  Officer)
 
 
 In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated:
 
 
 
 /s/  Roger
      D.Dudley
 Roger
      D.  Dudley, Executive Vice
President,
 Chief Financial Officer, and
Director
 
 April15, 2009
 Date
  50
   FONIX
CORPORATION AND SUBSIDIARIES
 
 
 INDEX
TO FINANCIAL STATEMENTS
 
 
 Report
      of Independent Registered Public Accounting Firm
                        F-2CONSOLIDATED
      FINANCIAL STATEMENTS:Consolidated
      Balance Sheets as of December 31, 2008 and 2007
                        F-3Consolidated
      Statements of Operations and Comprehensive Loss for the Years
      EndedDecember
      31, 2008, 2007 and 2006
                        F-4Consolidated
      Statements of Stockholders’ Deficit for the Years EndedDecember
      31, 2006, 2007 and 2008
                        F-5Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2008, 2007 and
      2006
                        F-6Notes
      to Consolidated Financial Statements
                        F-8
 
 
 
 
  F-1
  
 HANSEN, BARNETT& MAXWELL,
      P.C.A
      Professional Corporation
              
              Registered
      with the Public CompanyCERTIFIED
      PUBLIC ACCOUNTANTS
              
              Accounting
      Oversight Board5
      Triad Center, Suite 750Salt
      Lake City, UT 84180-1128Phone:
      (801) 532-2200
                Fax:
      (801) 532-7944www.hbmcpas.com
              
              A
      Member of the Forum of Firms
 
 
 REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 
 To the
Board of Directors and the Stockholders
 Fonix
Corporation
 
 We have
audited the accompanying consolidated balance sheets of Fonix Corporation and
subsidiaries as of December 31, 2008 and 2007, and the related consolidated
statements of operations and comprehensive loss, stockholders’ deficit, and cash
flows for each of the three years in the period ended December 31, 2008. These
consolidated financial statements are the responsibility of the Company’s
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audits to obtain reasonable assurance about whether the
consolidated financial statements are free of material misstatement. The Company
is not required to have, nor were we engaged to perform, and audit of its
internal control over financial reporting.  Our audit included
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Company’s
internal control over financial reporting. Accordingly, we express no such
opinion. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the consolidated financial statements. An audit also
includes assessing the accounting principles used and significant estimates made
by management, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis
for our opinion.
 
 In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Fonix Corporation and
subsidiaries as of December 31, 2008 and 2007, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2008, in conformity with accounting principles generally accepted
in the United States of America.
 
 The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern.  As discussed in Note 1
to the consolidated financial statements, the Company has incurred significant
operating losses and negative cash flows from operating activities during each
of the three years in the period ended December 31, 2008. As of December 31,
2008, the Company had an accumulated deficit of $286,367,000, and negative
working capital of $44,471,000. These matters raise substantial doubt about the
Company’s ability to continue as a going concern. Management’s plans with
respect to these matters are also described in Note 1. The accompanying
consolidated financial statements do not include any adjustments that might
result from the outcome of this uncertainty.
 
 HANSEN,
      BARNETT & MAXWELL. P.C.
 Salt Lake
City, Utah
 April 15,
2009
  F-2
 
 Fonix
Corporation
 CONSOLIDATED
BALANCE SHEETS
 December
      31,
                                                                  
                                                                  
                                                                  December
      31,2008
                                                                  
                                                                  
                                                                  2007ASSETSCurrent
      assetsCash
      and cash equivalents
                                                                  
                                                                  $
                                                                  2,000
                                                                  
                                                                  
                                                                  $
                                                                  26,000Prepaid
      expenses and other current assets
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  61,000Total
      current assets
                                                                  
                                                                  
                                                                  2,000
                                                                  
                                                                  
                                                                  
                                                                  87,000Property and equipment,
      net of accumulated depreciation of $1,303,000 and $1,293,000,
      respectively
                                                                  
                                                                  
                                                                  26,000
                                                                  
                                                                  
                                                                  
                                                                  16,000Deposits
      and other assets
                                                                  
                                                                  
                                                                  12,000
                                                                  
                                                                  
                                                                  
                                                                  108,000Total
      assets
                                                                  
                                                                  $
                                                                  40,000
                                                                  
                                                                  
                                                                  $
                                                                  211,000LIABILITIES
      AND STOCKHOLDERS' DEFICITCurrent
      liabilitiesAccrued
      liabilities
                                                                  
                                                                  $
                                                                  6,510,000
                                                                  
                                                                  
                                                                  $
                                                                  4,505,000Accounts
      payable
                                                                  
                                                                  
                                                                  1,801,000
                                                                  
                                                                  
                                                                  
                                                                  1,532,000Derivative
      liability
                                                                  
                                                                  
                                                                  34,582,000
                                                                  
                                                                  
                                                                  
                                                                  20,742,000Accrued
      payroll and other compensation
                                                                  
                                                                  
                                                                  211,000
                                                                  
                                                                  
                                                                  
                                                                  211,000Accrued
      settlement obligation
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  540,000Deferred
      revenues
                                                                  
                                                                  
                                                                  445,000
                                                                  
                                                                  
                                                                  
                                                                  445,000Notes
      payable - related parties
                                                                  
                                                                  
                                                                  917,000
                                                                  
                                                                  
                                                                  
                                                                  902,000Series
      E debentures
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  1,754,000Current
      portion of notes payable
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  3,833,000Deposits
      and other
                                                                  
                                                                  
                                                                  7,000
                                                                  
                                                                  
                                                                  
                                                                  7,000Total
      current liabilities
                                                                  
                                                                  
                                                                  44,473,000
                                                                  
                                                                  
                                                                  
                                                                  34,471,000Long-term
      notes payable, net of current portion
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  3,556,000Total
      liabilities
                                                                  
                                                                  
                                                                  44,473,000
                                                                  
                                                                  
                                                                  
                                                                  38,027,000Commitments
      and contingenciesStockholders'
      deficitPreferred
      stock, $0.0001 par value;  50,000,000 shares
      authorized;Series
      A, convertible; 166,667 shares outstanding (aggregate liquidation
      preference of $6,055,000)
                                                                  
                                                                  
                                                                  500,000
                                                                  
                                                                  
                                                                  
                                                                  500,000Series
      L, convertible; 1,498 shares and 1,535 shares outstanding ,
      respectively
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  -Common
      stock, $0.0001 par value; 20,000,000,000 shares
authorized;Class
      A voting, 3,447,501 shares and 857,423 shares outstanding,
      respectively
                                                                  
                                                                  
                                                                  1,000
                                                                  
                                                                  
                                                                  
                                                                  1,000Class
      B non-voting, none outstanding
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  -Additional
      paid-in capital
                                                                  
                                                                  
                                                                  240,949,000
                                                                  
                                                                  
                                                                  
                                                                  239,142,000Outstanding
      warrants to purchase Class A common stock
                                                                  
                                                                  
                                                                  474,000
                                                                  
                                                                  
                                                                  
                                                                  474,000Cumulative
      foreign currency translation adjustment
                                                                  
                                                                  
                                                                  10,000
                                                                  
                                                                  
                                                                  
                                                                  10,000Accumulated
      deficit
                                                                  
                                                                  
                                                                  (286,367,000
                                                                  )
                                                                  
                                                                  
                                                                  (277,943,000
                                                                  )Total
      stockholders' deficit
                                                                  
                                                                  
                                                                  (44,433,000
                                                                  )
                                                                  
                                                                  
                                                                  (37,816,000
                                                                  )Total
      liabilities and stockholders' deficit
                                                                  
                                                                  $
                                                                  40,000
                                                                  
                                                                  
                                                                  $
                                                                  211,000
 
 
 See
accompanying notes to consolidated financial statements.
  F-3
  Fonix
Corporation
 CONSOLIDATED
STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
 
 Years
      Ended December 31,2008
                                                          
                                                          
                                                          2007
                                                          
                                                          
                                                          2006RevenuesSpeech
      licenses, royalties and maintenance
                                                          
                                                          $
                                                          1,265,000
                                                          
                                                          
                                                          $
                                                          1,838,000
                                                          
                                                          
                                                          $
                                                          1,329,000Total
      Revenue
                                                          
                                                          
                                                          1,265,000
                                                          
                                                          
                                                          
                                                          1,838,000
                                                          
                                                          
                                                          
                                                          1,329,000Cost
      of revenuesSpeech
      licenses, royalties and maintenance
                                                          
                                                          
                                                          54,000
                                                          
                                                          
                                                          
                                                          141,000
                                                          
                                                          
                                                          
                                                          18,000Total
      cost of revenues
                                                          
                                                          
                                                          54,000
                                                          
                                                          
                                                          
                                                          141,000
                                                          
                                                          
                                                          
                                                          18,000Gross
      profit
                                                          
                                                          
                                                          1,211,000
                                                          
                                                          
                                                          
                                                          1,697,000
                                                          
                                                          
                                                          
                                                          1,311,000Operating
      expenses:Selling,
      general and administrative
                                                          
                                                          
                                                          2,238,000
                                                          
                                                          
                                                          
                                                          2,479,000
                                                          
                                                          
                                                          
                                                          5,356,000Impairment
      of goodwill
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          2,631,000
                                                          
                                                          
                                                          
                                                          -Product
      development and research
                                                          
                                                          
                                                          1,925,000
                                                          
                                                          
                                                          
                                                          1,572,000
                                                          
                                                          
                                                          
                                                          2,143,000Total
      operating expenses
                                                          
                                                          
                                                          4,163,000
                                                          
                                                          
                                                          
                                                          6,682,000
                                                          
                                                          
                                                          
                                                          7,499,000Other
      income (expense):Interest
      expense
                                                          
                                                          
                                                          (2,752,000
                                                          )
                                                          
                                                          
                                                          (1,887,000
                                                          )
                                                          
                                                          
                                                          (1,737,000
                                                          )Gain
      (loss) on derivative liability
                                                          
                                                          
                                                          (512,000
                                                          )
                                                          
                                                          
                                                          813,000
                                                          
                                                          
                                                          
                                                          (2,771,000
                                                          )Gain
      on forgiveness of liabilities
                                                          
                                                          
                                                          47,000
                                                          
                                                          
                                                          
                                                          21,018,000
                                                          
                                                          
                                                          
                                                          -Other
      income (expense), net
                                                          
                                                          
                                                          (3,217,000
                                                          )
                                                          
                                                          
                                                          19,944,000
                                                          
                                                          
                                                          
                                                          (4,508,000
                                                          )Income
      (loss) from continuing operations
                                                          
                                                          
                                                          (6,169,000
                                                          )
                                                          
                                                          
                                                          14,959,000
                                                          
                                                          
                                                          
                                                          (10,696,000
                                                          )Loss
      from discontinued operations
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          (11,247,000
                                                          )Net
      income (loss)
                                                          
                                                          
                                                          (6,169,000
                                                          )
                                                          
                                                          
                                                          14,959,000
                                                          
                                                          
                                                          
                                                          (21,943,000
                                                          )Preferred
      stock dividends
                                                          
                                                          
                                                          (2,255,000
                                                          )
                                                          
                                                          
                                                          (1,702,000
                                                          )
                                                          
                                                          
                                                          (18,735,000
                                                          )Income
      (loss) attributable to common stockholders
                                                          
                                                          $
                                                          (8,424,000
                                                          )
                                                          
                                                          $
                                                          13,257,000
                                                          
                                                          
                                                          $
                                                          (40,678,000
                                                          )Basic
      income (loss) per common share from continuing operations
                                                          
                                                          $
                                                          (3.02
                                                          )
                                                          
                                                          $
                                                          30.94
                                                          
                                                          
                                                          $
                                                          (73.22
                                                          )Basic
      and diluted income (loss) per common share from discontinued
      operations
                                                          
                                                          $
                                                          -
                                                          
                                                          
                                                          $
                                                          -
                                                          
                                                          
                                                          $
                                                          (69.63
                                                          )Diluted
      income per common share from continuing operations
                                                          
                                                          $
                                                          -
                                                          
                                                          
                                                          $
                                                          0.66
                                                          
                                                          
                                                          $
                                                          -Net
      income (loss)
                                                          
                                                          $
                                                          (6,169,000
                                                          )
                                                          
                                                          $
                                                          14,959,000
                                                          
                                                          
                                                          $
                                                          (21,943,000
                                                          )Other
      comprehensive income - foreign currency translation
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          8,000Comprehensive
      income (loss)
                                                          
                                                          $
                                                          (6,169,000
                                                          )
                                                          
                                                          $
                                                          14,959,000
                                                          
                                                          
                                                          $
                                                          (21,935,000
                                                          )
 
 See
accompanying notes to consolidated financial statements.
  F-4
  Fonix
Corporation
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ DEFICIT
 YEARS
ENDED DECEMBER 31, 2006, 2007 AND 2008
 Outstanding
                                            
                                            
                                            CumulativeWarrants
                                            
                                            
                                            ForeignAdditional
                                            
                                            
                                            to
      Purchase
                                            
                                            
                                            CurrencyPreferred
      Stock
                                            
                                            
                                            Common
      Stock
                                            
                                            
                                            Paid-in
                                            
                                            
                                            Common
                                            
                                            
                                            Translation
                                            
                                            
                                            AccumulatedShares
                                            
                                            
                                            Amount
                                            
                                            
                                            Shares
                                            
                                            
                                            Amount
                                            
                                            
                                            Capital
                                            
                                            
                                            Stock
                                            
                                            
                                            Adjustment
                                            
                                            
                                            Deficit
                                            
                                            
                                            TotalBALANCE,
      DECEMBER 31, 2005
                                            
                                            
                                            170,026
                                            
                                            
                                            $
                                            5,859,000
                                            
                                            
                                            
                                            78,586
                                            
                                            
                                            $
                                            1,000
                                            
                                            
                                            $
                                            228,943,000
                                            
                                            
                                            $
                                            474,000
                                            
                                            
                                            $
                                            18,000
                                            
                                            
                                            $
                                            (250,521,000
                                            )
                                            
                                            $
                                            (15,226,000
                                            )Issuance
      of common stock under equity lines of credit
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            60,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            3,280,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            3,280,000Shares
      issued for payment of dividends on Series H Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            568
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            65,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            65,000Series
      J Preferred Stock beneficial conversion dividend
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            1,587,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (1,587,000
                                            )
                                            
                                            
                                            -Series
      L Preferred Stock beneficial conversion dividend
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (4,000,000
                                            )
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (16,000,000
                                            )
                                            
                                            
                                            (20,000,000
                                            )Conversion
      of Series J Preferred into common stock
                                            
                                            
                                            (266
                                            )
                                            
                                            
                                            (266,000
                                            )
                                            
                                            
                                            3,006
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            266,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -Conversion
      of Series K Preferred into common stock
                                            
                                            
                                            (1,093
                                            )
                                            
                                            
                                            (1,093,000
                                            )
                                            
                                            
                                            21,860
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            1,093,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -Conversion
      of Series L Preferred into common stock
                                            
                                            
                                            (142
                                            )
                                            
                                            
                                            -
                                            
                                            
                                            
                                            97,974
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            1,832,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            1,832,000Cumulative
      foreign currency translation adjustment
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (8,000
                                            )
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (8,000
                                            )Dividend
      on Series H Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (693,000
                                            )
                                            
                                            
                                            (693,000
                                            )Dividend
      on Series J Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (5,000
                                            )
                                            
                                            
                                            (5,000
                                            )Dividend
      on Series K Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (11,000
                                            )
                                            
                                            
                                            (11,000
                                            )Dividend
      on Series L Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (440,000
                                            )
                                            
                                            
                                            (440,000
                                            )Net
      loss for year ended December 31, 2006
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (21,943,000
                                            )
                                            
                                            
                                            (21,943,000
                                            )BALANCE,
      DECEMBER 31, 2006
                                            
                                            
                                            168,525
                                            
                                            
                                            $
                                            500,000
                                            
                                            
                                            
                                            261,993
                                            
                                            
                                            $
                                            1,000
                                            
                                            
                                            $
                                            237,066,000
                                            
                                            
                                            $
                                            474,000
                                            
                                            
                                            $
                                            10,000
                                            
                                            
                                            $
                                            (291,200,000
                                            )
                                            
                                            $
                                            (53,149,000
                                            )Shares
      issued in conection with investor relations
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            40,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            62,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            62,000Conversion
      of Series L Preferred into common stock
                                            
                                            
                                            (173
                                            )
                                            
                                            
                                            -
                                            
                                            
                                            
                                            555,431
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            2,014,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            2,014,000Dividend
      on Series L Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (1,481,000
                                            )
                                            
                                            
                                            (1,481,000
                                            )Dividend
      on Series M Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (102,000
                                            )
                                            
                                            
                                            (102,000
                                            )Dividend
      on Series N Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (34,000
                                            )
                                            
                                            
                                            (34,000
                                            )Dividend
      on Series B Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (85,000
                                            )
                                            
                                            
                                            (85,000
                                            )Net
      income for year ended December 31, 2007
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            14,959,000
                                            
                                            
                                            
                                            14,959,000BALANCE,
      DECEMBER 31, 2007
                                            
                                            
                                            168,352
                                            
                                            
                                            $
                                            500,000
                                            
                                            
                                            
                                            857,424
                                            
                                            
                                            $
                                            1,000
                                            
                                            
                                            $
                                            239,142,000
                                            
                                            
                                            $
                                            474,000
                                            
                                            
                                            $
                                            10,000
                                            
                                            
                                            $
                                            (277,943,000
                                            )
                                            
                                            $
                                            (37,816,000
                                            )Shares
      issued to emploees
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            1,296,788
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            911,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            911,000Shares
      issued in connection with payment on related-party note
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            259,620
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            167,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            167,000Shares
      issued in conection with consulting services
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            145,225
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            133,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            133,000Shares
      issued in conection with accrued legal expenses
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            124,941
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            125,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            125,000Conversion
      of Series L Preferred into common stock
                                            
                                            
                                            (37
                                            )
                                            
                                            
                                            -
                                            
                                            
                                            
                                            705,696
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            400,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            400,000Conversion
      of Series L Preferred dividends into common stock
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            140,617
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            71,000
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            71,000Fractional
      shares canceled due to reverse stock split
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (82,810
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -Dividend
      on Series L Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (1,520,000
                                            )
                                            
                                            
                                            (1,520,000
                                            )Dividend
      on Series M Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (137,000
                                            )
                                            
                                            
                                            (137,000
                                            )Dividend
      on Series N Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (145,000
                                            )
                                            
                                            
                                            (145,000
                                            )Dividend
      on Series O Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (40,000
                                            )
                                            
                                            
                                            (40,000
                                            )Dividend
      on Series P Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (299,000
                                            )
                                            
                                            
                                            (299,000
                                            )Dividend
      on Series B Preferred
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (114,000
                                            )
                                            
                                            
                                            (114,000
                                            )Net
      income for year ended December 31, 2008
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (6,169,000
                                            )
                                            
                                            
                                            (6,169,000
                                            )BALANCE,
      DECEMBER 31, 2008
                                            
                                            
                                            168,315
                                            
                                            
                                            $
                                            500,000
                                            
                                            
                                            
                                            3,447,501
                                            
                                            
                                            $
                                            1,000
                                            
                                            
                                            $
                                            240,949,000
                                            
                                            
                                            $
                                            474,000
                                            
                                            
                                            $
                                            10,000
                                            
                                            
                                            $
                                            (286,367,000
                                            )
                                            
                                            $
                                            (44,433,000
                                            )
 See
accompanying notes to consolidated financial statements.
  F-5
  Fonix
Corporation
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 2008
                                    
                                    
                                    2007
                                    
                                    
                                    2006Cash
      flows from operating activitiesNet
      income (loss)
                                    
                                    $
                                    (6,169,000
                                    )
                                    
                                    $
                                    14,959,000
                                    
                                    
                                    $
                                    (21,943,000
                                    )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Discontinued
      operations
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    11,644,000Gain
      (loss) on derivative liability
                                    
                                    
                                    512,000
                                    
                                    
                                    
                                    (813,000
                                    )
                                    
                                    
                                    2,772,000Accretion
      of discount on notes payable
                                    
                                    
                                    2,124,000
                                    
                                    
                                    
                                    1,068,000
                                    
                                    
                                    
                                    832,000Issuance
      of shares for employee grants
                                    
                                    
                                    911,000
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Accretion
      of discount on legal settlement
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    117,000Impairment
      of goodwill
                                    
                                    
                                    -
                                    
                                    
                                    
                                    2,631,000
                                    
                                    
                                    
                                    -Write
      down of intercompany receivable
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,214,000Gain
      on forgiveness of liabilities
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (21,018,000
                                    )
                                    
                                    
                                    -Depreciation
                                    
                                    
                                    10,000
                                    
                                    
                                    
                                    32,000
                                    
                                    
                                    
                                    58,000Foreign
      exchange loss (gain)
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (8,000
                                    )Changes
      in assets and liabilitiesFunds
      held in escrow
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Accounts
      receivable
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,000Prepaid
      expenses and other current assets
                                    
                                    
                                    194,000
                                    
                                    
                                    
                                    5,000
                                    
                                    
                                    
                                    135,000Other
      assets
                                    
                                    
                                    96,000
                                    
                                    
                                    
                                    9,000
                                    
                                    
                                    
                                    (93,000
                                    )Accounts
      payable
                                    
                                    
                                    393,000
                                    
                                    
                                    
                                    28,000
                                    
                                    
                                    
                                    549,000Accrued
      payroll and other compensation
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (3,000
                                    )
                                    
                                    
                                    (9,000
                                    )Other
      accrued liabilities
                                    
                                    
                                    1,663,000
                                    
                                    
                                    
                                    805,000
                                    
                                    
                                    
                                    689,000Deferred
      revenues
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (15,000
                                    )
                                    
                                    
                                    (6,000
                                    )Net
      cash used in operating activities
                                    
                                    
                                    (266,000
                                    )
                                    
                                    
                                    (2,312,000
                                    )
                                    
                                    
                                    (4,048,000
                                    )Cash
      flows from investing activitiesPurchase
      of property and equipment
                                    
                                    
                                    (20,000
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (12,000
                                    )Net
      cash used in investing activities
                                    
                                    
                                    (20,000
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (12,000
                                    )Cash
      flows from financing activitiesProceeds
      from issuance of Class A common stock, net
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    3,504,000Proceeds
      from related party note payable
                                    
                                    
                                    72,000
                                    
                                    
                                    
                                    102,000
                                    
                                    
                                    
                                    419,000Proceeds
      from debentures
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    650,000Proceeds
      from credit advance
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    75,000Proceeds
      from Series B Preferred Stock
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,250,000
                                    
                                    
                                    
                                    -Proceeds
      from Series N Preferred Stock
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,350,000
                                    
                                    
                                    
                                    -Advance
      on Series N Preferred Stock
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Proceeds
      from issuance of Series O Preferred Stock
                                    
                                    
                                    730,000
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Proceeds
      from issuance of Series B Preferred Stock
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Proceeds
      from notes payable
                                    
                                    
                                    -
                                    
                                    
                                    
                                    450,000
                                    
                                    
                                    
                                    330,000Payments
      on accrued settlement obligation
                                    
                                    
                                    (540,000
                                    )
                                    
                                    
                                    (819,000
                                    )
                                    
                                    
                                    (440,000
                                    )Payments
      on related party note payable
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (105,000
                                    )Discontinued
      operations
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (536,000
                                    )Net
      cash provided by financing activities
                                    
                                    
                                    262,000
                                    
                                    
                                    
                                    2,333,000
                                    
                                    
                                    
                                    3,897,000Net
      increase (decrease) in cash and cash equivalents
                                    
                                    
                                    (24,000
                                    )
                                    
                                    
                                    21,000
                                    
                                    
                                    
                                    (163,000
                                    )Cash
      and cash equivalents at beginning of period
                                    
                                    
                                    26,000
                                    
                                    
                                    
                                    5,000
                                    
                                    
                                    
                                    168,000Cash
      and cash equivalents at end of period
                                    
                                    $
                                    2,000
                                    
                                    
                                    $
                                    26,000
                                    
                                    
                                    $
                                    5,000
 
 See
accompanying notes to consolidated financial statements.
  F-6
  Fonix
Corporation
 CONSOLIDATED
STATEMENTS OF CASH FLOWS (continued)
 
 
 Years Ended December 31,2008
                        
                        
                        2007
                        
                        
                        2006Supplemental
      Disclosure of Cash Flow InformationCash
      paid during the year for interest
                        
                        $
                        –
                        
                        
                        $
                        29,000
                        
                        
                        $
                        22,000Cash
      paid during the year for income taxes
                        
                        
                        –
                        
                        
                        
                        –
                        
                        
                        
                        –
 
 Supplemental
Schedule of Non-cash Investing and Financing Activities
 
 For
the Year Ended December 31, 2008
 
 Issued
705,696 shares of Class A common stock upon conversion of 37 shares of Series L
Convertible Preferred Stock.
 
 Issued  1,296,788
shares of Class A common stock for employee stock grants
 
 Issued
124,941 shares of Class A common stock for unpaid legal fees.
 
 Issued
145,225 shares of Class A common stock for consulting services.
 
 Issued
140,671shares of Class A common stock upon conversion of $71,000 in accrued
interest.
 
 Issued
259,620 shares of Class A common stock upon conversion of $167,000 in notes
payable – related parties.
 
 Accrued
$1,520,000 of dividends on Series L Preferred Stock.
 
 Accrued
$137,000 of dividends on Series M Preferred Stock.
 
 Accrued
$145,000 of dividends on Series N Preferred Stock.
 
 Accrued
$40,000 of dividends on Series O Preferred Stock.
 
 Accrued
$299,000 of dividends on Series P Preferred Stock.
 
 Accrued
$114,000 of dividends on Fonix Speech Series B Preferred Stock.
 
 
 For
the Year Ended December 31, 2007
 
 Issued
555,431 shares of Class A common stock upon conversion of 173 shares of Series L
Convertible Preferred Stock.
 
 Accrued
$1,481,000 of dividends on Series L Preferred Stock.
 
 Accrued
$102,000 of dividends on Series M Preferred Stock.
 
 Accrued
$34,000 of dividends on Series N Preferred Stock.
 
 Accrued
$85,000 of dividends on Fonix Speech Series B Preferred Stock.
 
 Issued
150 shares of Series M Convertible Preferred Stock with a face value of
$1,500,000 in exchange for 150 shares of Series L Preferred Stock with a face
value of $1,500,000.
 
 Issued
1,349.85 shares of Series N Convertible Preferred Stock with a face value of
$1,349,850.
 
 
 
 For
the Year Ended December 31, 2006
 
 Issued
3,006 shares of Class A common stock in conversion of 266 shares of Series J
Convertible Preferred Stock.
 
 Issued
21,860 shares of Class A common stock in conversion of 1,093 shares of Series K
Convertible Preferred Stock.
 
 Issued
568 shares of Class A common stock as payment of $65,000 of dividends on Series
H Preferred Stock.
 
 Accrued
$692,000 of dividends on Series H Preferred Stock.
 
 Issued
2,000 shares of Series L Convertible Preferred Stock with a face value of
$20,000,000 in exchange for 2,000 shares of Series H Preferred Stock with a face
value of $20,000,000.
 
 Issued
97,974 shares of Class A common stock in conversion of 142 shares of Series L
Preferred Stock.
 
 See
accompanying notes to consolidated financial statements.
 
 F-7
 
 Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 NOTE
1.  NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING
POLICIES
 
 Nature of
Operations -Fonix Corporation (“the Company”) provides value-added
speech technologies through its subsidiary, Fonix Speech, Inc. (“Fonix
Speech”).  The Company offers speech-enabling technologies including
automated speech recognition (“ASR”) and text-to-speech (“TTS”) through Fonix
Speech to markets for wireless and mobile devices, computer telephony, server
solutions and personal software for consumer applications.  The
Company has received various patents for certain elements of our core
technologies and have filed applications for other patents covering various
aspects of its technologies.  The Company seeks to develop
relationships and strategic alliances with third-party developers and vendors in
telecommunications, computers, electronic devices and related industries,
including producers of application software, operating systems, computers and
microprocessor chips.  Revenues are generated through licensing of
speech-enabling technologies, maintenance contracts and services.
 
 Reverse Stock
Split-
December 26, 2008 the Company effected a 1 for 5,000 reverse split of its common
stock, which reduced its issued and outstanding shares from 17,651,553,852 to
3,447,501  The accompanying financial statements have been presented
to retrospectively reflect this reverse stock split for all periods
 
 Business
Condition-For
the years ended December 31, 2008, 2007 and 2006, we generated revenues of
$1,265,000, $1,838,000 and $1,329,000, respectively; with net loss of $6,169,000
in 2008, net income of $14,959,000 in 2007 and  net loss of
$21,943,000 in 2006, and had negative cash flows from operating activities of
$266,000, $2,312,000 and $4,048,000, respectively.  As of December 31,
2008,  we had an accumulated deficit of $286,367,000, negative working
capital of $44,471,000, derivative liabilities of $34,582,000 related to the
issuance of Series L Preferred Stock,  Series M Preferred Stock,
Series N Preferred Stock, Series O Preferred Stock, Series P Preferred Stock and
Series B Preferred Stock of our subsidiary, accrued liabilities of $6,510,000,
accounts payable of $1,801,000 and deferred revenues of $445,000.We expect to
continue to incur significant losses and negative cash flows from operating
activities at least through December 31, 2009, primarily due to expenditure
requirements associated with continued marketing and development of our
speech-enabling technologies.
 
 These
factors, as well as the risk factors set out elsewhere in the Annual Report on
Form 10-K,  raise substantial doubt about the Company’s ability to
continue as a going concern.  The accompanying financial statements do
not include any adjustments that might result from the outcome of this
uncertainty.  Management plans to fund further operations of the
Company from cash flows from future license and royalty arrangements and with
proceeds from additional issuance of debt and equity
securities.  There can be no assurance that management’s plans will be
successful.
 
 Consolidation-The accompanying
consolidated financial statements include the accounts of the Company and its
wholly owned subsidiaries.  All significant intercompany balances and
transactions have been eliminated in consolidation.  The accompanying
footnotes do not include disclosures related to the operations of the
aforementioned companies and represent solely the operations of Fonix Speech,
Inc.
 
 Accounting
Estimates-The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
the disclosures of contingent assets and liabilities at the date of the
financial statements, and the reported amounts of revenues and expenses during
the reporting period.  Actual results could differ from those
estimates.
  F-8
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 Fair Value of
Financial Instruments - The carrying values of the Company’s liabilities
approximate their fair values.  The estimated fair values have been
determined using appropriate market information and valuation
methodologies.  The carrying values of the accrued settlement
obligation and note payable approximate fair value because the stated or imputed
interest rates approximate the Company’s borrowing rate.
 
 Concentration of
Credit Risks-The Company’s cash and cash equivalents are maintained in bank deposit
accounts which occasionally may exceed federally insured limits.  Cash
equivalents consist of highly liquid securities with maturities of three months
or less when purchased.  The Company has not experienced any losses
with respect to these deposits.  In the normal course of business, the
Company provides credit terms to its customers.  Accordingly, the
Company performs on-going credit evaluations of its customers and maintains
allowances for possible losses, which when realized, have been within the range
of management’s expectations.
 
 Valuation of
Long-lived Assets - The carrying values of the Company's long-lived
assets are reviewed for impairment whenever events or changes in circumstances
indicate that they may not be recoverable.  When such an event occurs,
the Company projects undiscounted cash flows to be generated from the use of the
asset and its eventual disposition over the remaining life of the
asset.  If projections indicate that the carrying value of the
long-lived asset will not be recovered, the carrying value of the long-lived
asset, other than software technology, is reduced by the estimated excess of the
carrying value over the projected discounted cash flows.  The
determination of whether the carrying value of software technology is
recoverable is discussed below in the section titled “Software Technology
Development and Production Costs” within this note.
 
 Goodwill –
Goodwill represents the excess of the cost over the fair value of net assets of
acquired businesses. Goodwill is not amortized, but is tested for impairment
quarterly or when a triggering event occurs.  The testing for
impairment requires the determination of the fair value of the asset or entity
to which the goodwill relates (the reporting unit).  The fair value of
a reporting  unit is determined based upon a weighting of the quoted
market price of the Company’s common stock and present value techniques based
upon estimated future cash flows of the reporting unit, considering future
revenues, operating costs, the risk-adjusted discount rate and other
factors.  Impairment is indicated if the fair value of the reporting
unit is allocated to the assets and liabilities of that unit, with the excess of
the fair value of the reporting unit over the amounts assigned to its assets and
liabilities assigned to the fair value of goodwill.  The amount of
impairment of goodwill is measured by the excess of the goodwill’s carrying
value over its fair value.  As of December 31, 2006, the fair value of
goodwill was greater than the carrying value.  At December 31, 2007,
the Company determined that the carrying value of goodwill was in excess of its
fair value and the balance of $2,631,000 was fully impaired.
 
 Revenue
Recognition – The Company recognizes revenue when pervasive evidence of
an arrangement exists; services have been rendered or products have been
delivered; the price to the buyer is fixed and determinable; and collectibility
is reasonably assured.  Revenues are recognized by the Company based
on the various types of transactions generating the revenue.  For
software sales, the Company recognizes revenues in accordance with the
provisions of Statement of Position No. 97-2, “Software Revenue Recognition,”
and related interpretations.The Company
generates revenues from licensing the rights to its software products to end
users and from royalties.  For telecommunications services, revenue is
recognized in the period that the service is provided.
 
 For Fonix
Speech, revenue of all types is recognized when acceptance of functionality,
rights of return, and price protection are confirmed or can be reasonably
estimated, as appropriate.  Revenues from development and consulting
services are recognized on a completed-contract basis when the services are
completed and accepted by the customer.  The completed-contract method
is used because the Company’s contracts are typically either short-term in
duration or the Company is unable to make reasonably dependable estimates of the
costs of the contracts.  Revenue for hardware units delivered is
recognized when delivery is verified and collection assured.
 
 Revenue
for products distributed through wholesale and retail channels and through
resellers is recognized upon verification of final sell-through to end users,
after consideration of rights of return and price
protection.  Typically, the right of return on such products has
expired when the end user purchases the product from the retail
outlet.  Once the end user opens the package, it is not returnable
unless the medium is defective.
  F-9
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 When
arrangements to license software products do not require significant production,
modification or customization of software, revenue from licenses and royalties
are recognized when persuasive evidence of a licensing arrangement exists,
delivery of the software has occurred, the fee is fixed or determinable, and
collectibility is probable.  Post-contract obligations, if any,
generally consist of one year of support including such services as customer
calls, bug fixes, and upgrades.  Related revenue is recognized over
the period covered by the agreement.  Revenues from maintenance and
support contracts are also recognized over the term of the related
contracts.
 
 Revenues
applicable to multiple-element fee arrangements are bifurcated among the
elements such as license agreements and support and upgrade obligations using
vendor-specific objective evidence of fair value.  Such evidence
consists primarily of pricing of multiple elements as if sold as separate
products or arrangements.  These elements vary based upon factors such
as the type of license, volume of units licensed, and other related
factors.
 
 Deferred
revenue as of December 31, 2008 and 2007, consisted of the
following:
 
 Description
              Criteria
      for Recognition
              AmountDeferred
      unit royalties and license fees
              Delivery
      of units to end users or expiration of contract
              $       445,000
 
 Cost of Revenues
-Cost of revenues from license, royalties, and maintenance consists of
costs to distribute the product, installation and support personnel
compensation, amortization and impairment of capitalized speech software costs,
licensed technology, and other related costs.  Cost of service
revenues consists of personnel compensation and other related
costs.
 
 Software
Technology Development and Production Costs- All costs incurred to
establish the technological feasibility of speech software technology to be
sold, leased, or otherwise marketed are charged to product development and
research expense.  Technological feasibility is established when a
product design and a working model of the software product have been completed
and confirmed by testing.  Costs to produce or purchase software
technology incurred subsequent to establishing technological feasibility are
capitalized.  Capitalization of software costs ceases when the product
is available for general release to customers.  Costs to perform
consulting or development services are charged to cost of revenues in the period
in which the corresponding revenues are recognized.  Costs of
maintenance and customer support are charged to expense when related revenue is
recognized or when these costs are incurred, whichever occurs
first.
 
 Capitalized
software technology costs were amortized on a product-by-product
basis.  Amortization was recognized from the date the product was
available for general release to customers as the greater of (a) the ratio that
current gross revenue for a product bears to total current and anticipated
future gross revenues for that product or (b) the straight-line method over the
remaining estimated economic life of the products.  Amortization was
charged to cost of revenues.
 
 The
Company assessed unamortized capitalized software costs for possible write down
on a quarterly basis based on net realizable value of each related
product.  Net realizable value was determined based on the estimated
future gross revenues from a product reduced by the estimated future cost of
completing and disposing of the product, including the cost of performing
maintenance and customer support.  The amount by which the unamortized
capitalized costs of a software product exceeded the net realizable value of
that asset was written off.
 
 Stock-Based
Employee Compensation–The Company has outstanding stock options to directors and employees,
which are described more fully in Note 10.  The Company accounts for
its stock options in accordance with Statements of Financial Standards 123R,
Share-Based Payment (SFAS 123R). SFAS 123R requires the recognition of the cost
of employee services received in exchange for an award of equity instruments in
the financial statements and is measured based on the grant date fair value of
the award. SFAS 123R also requires the stock option compensation expense to be
recognized over the period during which an employee is required to provide
service in exchange for the award (the vesting period).
 
 The
Company has not recognized any stock-based employee compensation expense for the
years ended December 31, 2008, 2007, and 2006.
  F-10
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 Advertising Costs- Advertising costs are expensed when incurred.  Total
advertising expense was $15,000, $13,000 and $40,000 for the years ended
December 31, 2008, 2007 and 2006, respectively.
 
 Income
Taxes-The
Company recognizes deferred income tax assets or liabilities for the expected
future tax consequences of events that have been recognized in the financial
statements or tax returns.  Deferred income tax assets or liabilities
are determined based upon the difference between the financial and income tax
bases of assets and liabilities using enacted tax rates expected to apply when
differences are expected to be settled or realized.
 
 Net Loss Per
Common Share-Basic and diluted net loss per common share are calculated by dividing
net loss attributable to common stockholders by the weighted-average number of
shares of common stock outstanding during the year.  At December 31,
2008, 2007 and 2006, there were outstanding common stock equivalents to purchase
or receive 172,332,239, 19,642,337 and 1,129,549 and shares of common stock,
respectively. At December 31, 2008, 166,710 common stock equivalents were
excluded in the computation of diluted net income per common share as their
effect would have been anti-dilutive.  All common stock equivalents at
December 31, 2008 and 2007 were excluded in the computation of diluted net loss
per common share as their effect would have been anti-dilutive, thereby
decreasing the net loss per common share.
 
 The
following table is a reconciliation of the net income or loss numerator of basic
and diluted net income or loss per common share for the years ended December 31,
2008, 2007, and 2006:
 
 Years
      Ended December 31,2008
                    
                    2007
                    
                    2006Per
                    
                    
                    
                    Per
                    
                    
                    
                    
                    PerShare
                    
                    
                    
                    Share
                    
                    
                    
                    
                    ShareAmount
                    
                    Amount
                    
                    Amount
                    
                    Amount
                    
                    Amount
                    
                    
                    AmountNet
      income (loss) from continuing operations
                    
                    $
                    (6,169,000
                    )
                    
                    
                    $
                    14,959,000
                    
                    
                    
                    $
                    (10,696,000
                    )Net
      loss from discontinued operations
                    
                    
                    -
                    
                    
                    
                    
                    -
                    
                    
                    
                    
                    (11,247,000
                    )
                    
                    
                    $
      (73.22)Net
      income (loss)
                    
                    $
                    (6,169,000
                    )
                    
                    
                    
                    14,959,000
                    
                    
                    
                    
                    (21,943,000
                    )Preferred
      stock dividends
                    
                    
                    (2,255,000
                    )
                    
                    
                    
                    (1,702,000
                    )
                    
                    
                    
                    (18,735,000
                    )Net
      income (loss) attributable to common stockholders
                    
                    $
                    (8,424,000
                    )
                    
                    
                    $
                    13,257,000
                    
                    
                    
                    $
                    (40,678,000
                    )Basic
      weighted-average common shares outstanding
                    
                    
                    2,044,645
                    
                    $
      (4.12)
                    
                    
                    483,542
                    
                    $
      27.42
                    
                    
                    153,615
                    
                    
                    
                    $
      (264.80)Diluted
      weighted-average common shares outstanding
                    
                    
                    2,044,645
                    
                    $
      (4.12)
                    
                    
                    20,125,879
                    
                    $0.66
                    
                    
                    153,615
                    
                    
                    
                    $
      (264.80)
 
 Imputed Interest
Expense and Income-Interest is imputed on long-term debt obligations and notes receivable
where management has determined that the contractual interest rates are below
the market rate for instruments with similar risk characteristics.
 
 Foreign Currency
Translation-The
functional currency of the Company’s Korean subsidiary is the South Korean
won.  Consequently, assets and liabilities of the Korean operations
are translated into United States dollars using current exchange rates at the
end of the year.  All revenue is invoiced in South Korean won and
revenues and expenses are translated into United States dollars using
weighted-average exchange rates for the year.
 
 Comprehensive
Income-Other
comprehensive income presented in the accompanying consolidated financial
statements consists of cumulative foreign currency translation
adjustments.
  F-11
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 New Accounting
Policies–In
September 2006, the FASB issued SFAS No. 157, “Fair Value
Measurement.” This statement defines fair value, establishes a framework for
measuring fair value in generally accepted accounting principles and expands
disclosures about fair value measurements. SFAS No. 157 does not require
any new fair value measurements but provides guidance on how to measure fair
value by providing a fair value hierarchy used to classify the source of the
information. We adopted SFAS No. 157 effective January 1, 2008 and the
adoption did not have a significant effect on our consolidated results of
operations, financial position or cash flows. In February 2008, the FASB
issued FSP SFAS No. 157-2 which delays the effective date of SFAS
No. 157 for all non-financial assets and non-financial liabilities except
those that are recognized or disclosed at fair value in the financial statements
on a recurring basis (at least annually). We are currently evaluating the impact
of the pending adoption in 2009 of SFAS No. 157 non-recurring fair value
measures.
 
 In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities, including an amendment of FASB
Statement No. 115,” effective on January 1, 2008, and permits
companies to choose, at specified dates, to measure certain eligible financial
instruments at fair value. The provisions of SFAS No. 159 apply only to
entities that elect to use the fair value option and to all entities with
available-for-sale and trading securities. At the effective date, companies may
elect the fair value option for eligible items that exist at that date, and the
effect of the first remeasurement to fair value must be reported as a
cumulative-effect adjustment to the opening balance of retained earnings. The
adoption of SFAS No. 159 has not had a material impact on the Company’s
financial position or results of operations.
 
 Effective
January 1, 2007, the Company adopted FASB Interpretation No. 48,
“Accounting for Uncertainty in Income Taxes — an interpretation of FASB
Statement No. 109” (FIN 48), which clarifies the accounting and
disclosure for uncertainty in tax positions. The Company has analyzed its filing
positions in all jurisdictions where it is required to file income tax returns
for the open tax years in such jurisdictions. The Company’s federal income tax
returns for the years ended December 31, 2005 through 2007 remain subject
to examination.  The Company currently believes that all significant
filing positions are highly certain and that all of its significant income tax
filing positions and deductions would be sustained upon audit. Therefore, the
Company has no significant reserves for uncertain tax positions and no
adjustments to such reserves were required upon adoption of
FIN 48.  No interest or penalties have been levied against the
Company and none are anticipated, therefore interest or penalty has been
included in our provision for income taxes in the consolidated statements of
operations.
 
 Recent Accounting
Pronouncements–In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities—an amendment of FASB Statement No. 133, which
changes the disclosure requirements for derivative instruments and hedging
activities. Enhanced disclosures are required to provide information about (a)
how and why an entity uses derivative instruments, (b) how derivative
instruments and related hedged items are accounted for under Statement 133 and
its related interpretations, and (c) how derivative instruments and related
hedged items affect an entity’s financial position, financial performance, and
cash flows. This Statement is effective for financial statements issued for
fiscal years and interim periods beginning after November 15, 2008, with early
application encouraged. This Statement will require the additional disclosures
described above.  The Company does not expect the adoption of SFAS 161
to have a material impact on its results of operations or financial
condition.
 
 In April
2008, FASB issued FASB Staff Position SFAS No. 142-3, Determination of the
Useful Life of Intangible Assets (“FSP SFAS No. 142-3”). FSP SFAS
No. 142-3 amends the factors that should be considered in developing
renewal or extension assumptions used to determine the useful life of a
recognizable intangible asset under SFAS No. 142, “Goodwill and Other
Intangible Assets” (“SFAS No. 142”). The intent of FSP SFAS No. 142-3
is to improve the consistency between the useful life of a recognizable
intangible asset under SFAS No. 142 and the period of expected cash flows
used to measure the fair value of the asset under SFAS 141(R), “Business
Combinations” and other U.S. generally accepted accounting principles. FSP SFAS
No. 142-3 is effective for financial statements issued for fiscal years
beginning after December 15, 2008, and interim periods within those fiscal
years. Early adoption is prohibited. The Company does not anticipate that the
adoption of FSP SFAS No. 142-3 will have an impact on its financial
position or results of operations.
  F-12
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 In
November 2007, the FASB issued SFAS No. 160, Noncontrolling Interests
in Consolidated Financial Statements, an amendment of ARB No. 51
(FAS 160).  FAS 160 will change the accounting and reporting
for minority interests, which will be recharacterized as noncontrolling
interests and classified as a component of equity.  FASB 160 is
effective for fiscal years beginning on or after December 15,
2008.  FASB 160 requires retroactive adoption of the presentation
and disclosure requirements for existing minority interests.  All other
requirements of FAS 160 will be applied prospectively.  Early adoption
is prohibited.  The Company does not anticipate that the adoption of
FASB 160 will have an impact on its financial position or results of
operations.
 
 
 NOTE
2.  PROPERTY AND EQUIPMENT
 
 Property
and equipment are stated at cost.  Depreciation is computed on a
straight-line basis over the estimated useful lives of the assets as
follows:
 
 Computer
      equipment and software
                3
      to 5 yearsFurniture
      and fixtures
                5
      years
 
  Maintenance
and repairs are charged to expense as incurred and major improvements are
capitalized.  Gains or losses on sales or retirements are included in
the consolidated statements of operations in the year of
disposition.  Depreciation expense was $10,000, $32,000 and $58,000
for the years ended December 31, 2008, 2007, and 2006,
respectively.  Property and equipment consisted of the following at
December 31, 2008 and 2007:
 
 2008
                            
                            
                            2007Computer
      equipment
                            
                            $
                            990,000
                            
                            
                            $
                            980,000Software
                            
                            
                            201,000
                            
                            
                            
                            201,000Furniture
      and fixtures
                            
                            
                            138,000
                            
                            
                            
                            128,0001,329,000
                            
                            
                            
                            1,309,000Less
      accumulated depreciation and amortization
                            
                            
                            (1,303,000
                            )
                            
                            
                            (1,293,000
                            )Net
      Property and Equipment
                            
                            $
                            26,000
                            
                            
                            $
                            16,000
 
 NOTE
3.  GOODWILL AND INTANGIBLE ASSETS
 
 The
Company tested goodwill for impairment at December 31, 2007, and determined that
goodwill had been fully impaired.  The Company recorded an impairment
charge of $2,631,000 during 2007, which is reported in the accompanying
financial statements.
 
 NOTE
4.  NOTES PAYABLE
 
 In
connection with the acquisition of the capital stock of LTEL Holdings in 2004,
the Company issued a 5%, $10,000,000, secured, six-year note (the “Note”)
payable to McCormack Avenue, Ltd. (“McCormack”).  Under the terms of
the Note, quarterly interest-only payments were required through January 15,
2005, with quarterly principal and interest payments of $319,000 beginning April
2005 and continuing through January 2010.  Interest on the Note is
payable in cash or, at the Company’s option, in shares of the Company’s Class A
common stock.  The Note was secured by the capital stock and all of
the assets of LTEL Holdings and its subsidiaries.  The Note was
originally valued at $4,624,000 based on an imputed interest rate of 25 percent
per annum.
  F-13
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 On
September 8, 2006, the Company received a default notice (the “Default Notice”)
from McCormack in respect of the Note  In the Default Notice,
McCormack stated that it intended to exercise its rights, including any and all
rights set forth in the Note, as amended.  McCormack has taken no
action to collect amounts due under the Note.
 
 During
the fourth quarter of 2006, the Company entered into two promissory notes with
McCormack Avenue, Ltd., in the aggregate amount of $330,000. These notes accrue
interest at 10% annually and were due and payable during the second quarter of
2007.  These promissory notes were exchanged for shares of the
Company’s Series P Preferred Stock.  See table below.
 
 During
the quarter ended March 31, 2007, the Company entered into five promissory notes
with McCormack Avenue, Ltd. and Sovereign Partners LP., in the aggregate amount
of $450,000.  These notes accrue interest at 10% annually and were due
and payable during the third quarter of 2007.  These promissory notes
were exchanged for shares of the Company’s Series P Preferred
Stock.  See table below.
 
 On
September 30, 2008, the Company entered into a Series P 9% Convertible Preferred
Stock Exchange Agreement (the “Exchange Agreement”) with McCormack and Sovereign
Partners, LP (“Sovereign”), whereby McCormack exchanged the Note, along with
other promissory notes and the Series E debenture (discussed in Note 6), and
Sovereign exchanged two promissory notes, for shares of the Company’s Series P
9% Convertible Preferred Stock (the Series P Preferred Stock”).  The
obligations exchanged and the number of shares of Series P Preferred Stock
issued is as follows:
 
 Purchaser
                  Nature
      of Obligation Exchanged
                  Amount
      of Obligation Exchanged
                  Number
      of Series P Preferred Shares IssuedSovereign
      Partners LP
                  Promissory
      Note, dated February 22, 2007, in the principal amount of $100,000, and
      interest of $16,278
                  $116,278
                  11.6278Sovereign
      Partners LP
                  Promissory
      Note, dated March 13, 2007, in the principal amount of $100,000, and
      interest of $15,750
                  $115,750
                  11.575McCormack
      Avenue, Ltd.
                  Promissory
      Note, dated January 11, 2007, in the principal amount of $50,000, and
      interest of $8,722
                  $58,722
                  5.8722McCormack
      Avenue, Ltd.
                  Promissory
      Note, dated January 19, 2007, in the principal amount of $100,000, and
      interest of $17,222
                  $117,222
                  11.7222McCormack
      Avenue, Ltd.
                  Promissory
      Note, dated January 26, 2007, in the principal amount of $100,000, and
      interest of $17,028
                  $117,028
                  11.7028McCormack
      Avenue, Ltd.
                  Promissory
      Note, dated December 28, 2006, in the principal amount of $95,000, and
      $16,942
                  $111,942
                  11.1942McCormack
      Avenue, Ltd.
                  Promissory
      Note, dated December 15, 2006, in the principal amount of $235,000, and
      interest of $42,701
                  $277,701
                  27.7701McCormack
      Avenue, Ltd.
                  Note
      Payable, dated February, 2004, in the principal amount of $8,732,620, and
      interest of $1,311,105
                  $10,043,725
                  1,004.3725McCormack
      Avenue, Ltd.
                  Series
      E Debenture, dated December 7, 2007, in the principal amount of
      $1,754,464, and interest of $291,763
                  $2,046,227
                  204.6227
   F-14
 Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 NOTE
5.  RELATED-PARTY NOTES PAYABLE
 
 During
2002, two executive officers of the Company (the “Lenders”) sold shares of the
Company’s Class A common stock owned by them and advanced the resulting proceeds
amounting to $333,000 to the Company under the terms of a revolving line of
credit and related promissory note.  The funds were advanced for use
in Company operations.  The advances bear interest at 12 percent per
annum, which interest is payable on a semi-annual basis.  The entire
principal, along with unpaid accrued interest and any other unpaid charges or
related fees, was originally due and payable on June 10, 2003.  The
Company and the Lenders have agreed to postpone the maturity date on several
occasions.  The note was due September 30, 2006.  All or
part of the outstanding balance and unpaid interest may be converted at the
option of the Lenders into shares of Class A common stock of the Company at any
time.  The conversion price was the average closing bid price of the
shares at the time of the advances.  To the extent the market price of
the Company’s shares is below the conversion price at the time of conversion,
the Lenders are entitled to receive additional shares equal to the gross dollar
value received from the original sale of the shares.  A beneficial
conversion option of $15,000 was recorded as interest expense in connection with
this transaction.  The Lenders may also receive additional
compensation as determined appropriate by the Board of Directors.
 
 During
the year ended December 31, 2005, the Company received an additional advance of
$50,000 against the promissory note.  The balance due at December 31,
2005 was $486,000.  During the year ended December 31, 2006, the
Company received additional advances and other consideration from the Lenders in
the aggregate amount of $419,000 and made principal payments to the Lenders
against the note of $105,000.  For the year ended December 31, 2007,
the Company received additional advances of $102,000. For the year ended
December 31, 2008, the Company received additional advances of $91,000 and made
principal payments to the Lenders against the note of $19,000. The balance due
at December 31, 2008, was $917,000.
 
 The
balance due of $917,000 is secured by the Company’s intellectual property rights
and common stock of Fonix Speech.  For the year ended December 31,
2008, the Lenders converted $56,000 of the principal balance into 113,194 shares
common stock, and also converted $111,000 of accrued interest into 146,426
shares of common stock for the benefit of one of the Lenders, Thomas A. Murdock,
a former officer and director of the Company.
 
 NOTE
6.  DEBENTURES
 
 Series E
Debentures On December 7, 2006, the Company entered into a Securities
Purchase Agreement, dated as of December 1, 2006 (the “Agreement”), with
Southridge Partners, LP (“Southridge”) relating to the purchase and sale of a
Series E 9% Secured Subordinated Convertible Debenture (the “Debenture”) in the
principal amount of $850,000.
 
 Pursuant
to the Agreement, Southridge paid the purchase price by tendering a prior
debenture in the aggregate amount (including principal and interest) of
$641,000, and agreed that an advance to the Company in the amount of $75,000
made in November 2006 would also constitute part of the purchase
price.  Southridge agreed to fund the remaining $134,000 upon the
effectiveness of a registration statement, to be filed by the Company, to
register the resales of shares issuable to Southridge upon conversion of the
Debenture.  The Company received no new capital in connection with the
issuance and sale of the Debenture.
 
 The
Debenture is convertible into shares of our Class A common stock.  The
number of shares issuable is determined by dividing the amount of the Debenture
being converted by the conversion price, which is the average of the two lowest
per share market values for the twenty trading days immediately preceding the
conversion date multiplied by seventy percent. The conversion price is subject
to adjustment as set forth in the Debenture.  Southridge has agreed
not to convert the Debenture to the extent that such conversion would cause
Southridge to beneficially own in excess of 4.999% of the then-outstanding
shares of Class A common stock of the Company except in the case of a merger by
the Company or other organic change.
 
 The
Company also entered into a Registration Rights Agreement (the “Registration
Agreement”) with Southridge pursuant to which the Company agreed to file a
registration statement to register the resale by Southridge of shares of the
Company’s Class A common stock issuable upon conversion of the
Debenture.   As of the date of this Report, no registration
statement has been filed.
  F-15
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 In
addition to the Debenture issued to Southridge described above, on December 7,
2006, the Company entered into a Securities Purchase Agreement, dated as of
December 1, 2006 (the “McCormack Agreement”), with McCormack, relating to the
purchase and sale of a Series E 9% Secured Subordinated Convertible Debenture
(the “McCormack Debenture”) in the principal amount of $1,039,000.
 
 Pursuant
to the McCormack Agreement, McCormack paid the purchase price by tendering
outstanding promissory notes in the amounts of $300,000 and $350,000, together
with combined interest thereon of $64,000, and agreed that advances to the
Company in the amount of $325,000, made in September, October, and November
2006, would also constitute part of the purchase price.
 
 The
McCormack Debenture was convertible into shares of the Company’s Class A common
stock on the same terms as the Debenture.
 
 The
Company also entered into a Registration Rights Agreement (the “McCormack
Registration Agreement”) with McCormack pursuant to which the Company agreed to
file a registration statement to register the resale by McCormack of shares of
the Company’s common stock issuable upon conversion of the
Debenture.  As of the date of this Report, no registration statement
had been filed.
 
 This
debenture was exchanged for shares of the Company’s Series P Preferred
Stock.  See Note 4.
 
 NOTE
7.  PREFERRED STOCK
 
 The
Company’s certificate of incorporation allows for the issuance of preferred
stock in such series and having such terms and conditions as the Company’s board
of directors may designate.
 
 Series A
Convertible Preferred Stock - At December 31, 2008, there were 166,667
shares of Series A convertible preferred stock outstanding.  Holders
of the Series A convertible preferred stock have the same voting rights as
common stockholders, have the right to elect one person to the board of
directors and are entitled to receive a one time preferential dividend of $2.905
per share of Series A convertible preferred stock prior to the payment of any
dividend on any class or series of stock.  At the option of the
holders, each share of Series A convertible preferred stock is convertible into
one share of Class A common stock and in the event that the common stock price
has equaled or exceeded $10 per share for a 15 day period, the shares of Series
A convertible preferred stock will automatically be converted into Class A
common stock.  In the event of liquidation, the holders are entitled
to a liquidating distribution of $36.33 per share and a conversion of Series A
convertible preferred stock at an amount equal to .0375 shares of Class A common
stock for each share of Series A convertible preferred stock.
 
 Series J
Preferred Stock – On October 6, 2005, the Company entered into a Series J
5% Convertible Preferred Stock Exchange Agreement (the "Exchange Agreement")
with Southridge Partners, LP ("Southridge"), a Delaware limited
partnership.  Pursuant to the Exchange Agreement, Southridge exchanged
all of the shares of Series I Preferred Stock that it acquired from
Breckenridge, for 1,452 shares of the Company's Series J 5% Convertible
Preferred Stock (the "Series J Preferred Stock").
 
 Because
the shares of Series J were issued in exchange for the remaining outstanding
shares of Series I Preferred Stock, we did not receive any proceeds in
connection with the issuance of the Series J Preferred Stock.  The
Company issued 1,452 shares of Series J Preferred Stock in exchange for 1,172
shares of Series I Preferred Stock.  Of the 280 additional shares that
were issued to Southridge, 250 were issued as a placement fee and were accounted
for in the selling, general and administrative expense in the accompanying
financial statements.  The remaining 30 shares were issued as
additional litigation expense and were accounted for as legal settlement
expense.
  F-16
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 The
Series J Preferred Stock entitles Southridge to receive dividends in an amount
equal to 5% of the then-outstanding balance of shares of Series J Preferred
Stock.  The dividends are payable in cash or shares of the Company's
Class A common stock, at the Company's option.
 
 The
Series J Preferred Stock may be converted into common stock of the Company at
the option of the holder by using a conversion price which shall be 90% of the
average of the two (2) lowest closing bid prices for the twenty-day trading
period prior to the conversion date.
 
 Redemption
of the Series J Preferred Stock, whether at our option or that of Southridge,
requires us to pay, as a redemption price, the stated value of the outstanding
shares of Series J Preferred Stock to be redeemed, together with any accrued but
unissued dividends thereon, multiplied by one hundred ten percent
(110%).
 
 For the
year ended December 31, 2005, the Company issued 3,795,918 shares of its Class A
common stock upon conversion of 93 shares of its Series J Preferred
Stock.  For the year ended December 31, 2006, the Company issued
15,028,249 shares of its Class A common stock upon conversion of 266 shares of
Series J Preferred Stock.  As of December 31, 2007, no shares of
Series J Preferred Stock remained outstanding.
 
 Series K
Preferred Stock – On February 3, 2006, the Company’s Board of Directors
approved the designation and issuance of Series K 5% Convertible Preferred Stock
(the “Series K Preferred Stock”). The Series K Preferred Stock entitled the
holder to receive dividends in an amount equal to 5% of the stated value of the
then-outstanding balance of shares of Series K Preferred Stock.  The
dividends were payable in cash or shares of the Company’s Class A common stock,
at the Company’s option.
 
 The
shares of Series K Preferred Stock were issued pursuant to a Series K 5%
Convertible Preferred Stock Exchange Agreement (the “Series K Agreement”), in
connection with which Southridge exchanged 1,093 shares of Series J Convertible
Preferred Stock for 1,093 shares of Series K Convertible Preferred
Stock.
 
 The
Series K Preferred Stock were convertible into common stock of the Company at
the option of the holder by using a conversion price of $0.01 per
share.
 
 For year
ended December 31, 2006, the Company issued 109,300,000 shares of its Class A
common stock upon conversion of all 1,093 shares of its Series K Preferred
Stock.  As of December 31, 2007, no shares of Series K Preferred Stock
remained outstanding.
 
 Series L
Preferred Stock – On September 7, 2006, the Company entered into a Series
L 9% Convertible Preferred Stock Exchange Agreement (the "Exchange Agreement")
with McCormack and Kenzie Financial (“Kenzie”), a British Virgin Islands
company.  Pursuant to the Exchange Agreement, McCormack and Kenzie
exchanged all 2,000 shares of Series H Preferred Stock that
they  acquired from the sale of LTEL Holdings, for 1,960.8 and 39.2
shares, respectively,  of the Company's Series L 9% Convertible
Preferred Stock (the "Series L Preferred Stock").
 
 Because
the shares of Series L Preferred Stock were issued in exchange for the remaining
outstanding shares of Series H Preferred Stock, the Company did not receive any
proceeds in connection with the issuance of the Series L Preferred
Stock.
 
 The
Series L Preferred Stock entitles McCormack and Kenzie to receive dividends in
an amount equal to 9% of the then-outstanding balance of shares of Series L
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.
 
 The
Series L Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price which was 80% of the average of
the two (2) lowest closing bid prices for the twenty-day trading period prior to
the conversion date.
 
 Redemption
of the Series L Preferred Stock, whether at the Company’s option or that of
McCormack or Kenzie, requires the Company to pay, as a redemption price, the
stated value of the outstanding shares of Series L Preferred Stock to be
redeemed, together with any accrued but unissued dividends thereon, multiplied
by one hundred ten percent (110%).
  F-17
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 In
connection with the issuance of the Series L Preferred Stock, the Company filed
with the State of Delaware a Certificate of Designation and Series L 9%
Convertible Stock Terms (the “Series L Terms”), which become a part of the
Company’s Certificate of Incorporation, as amended.
 
 The
Company accounted for the exchange as redemption of the outstanding Series H
Preferred Stock as the Series H Preferred Stock was not convertible into shares
of common stock of the Company.  The Series L Preferred Stock is
convertible into shares of common stock of the Company.  The Company
followed the accounting treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the redemption of
$30,991,000 due to the value of the conversion feature of the Series L Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 140%, risk-free rate of 3.75% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
L Preferred Stock, no value was prescribed to the Series L Preferred
Stock.  Also in connection with the redemption, the Company recognized
a preferred stock dividend of $16,000,000, equal to the original discount the
Company had assigned to the Series H Preferred Stock.  At December 31,
2008 and 2007 the fair value of the Series L Preferred Stock derivative
liability was $15,838,000 and $16,148,000, respectively.
 
 For the
year ended December 31, 2006, the Company issued 97,974 shares of our Class A
common stock in conversion of 142 shares of its Series L Preferred
Stock.  For the year ended December 31, 2007, the Company issued
555,431 shares of our Class A common stock in conversion of 173 shares of its
Series L Preferred Stock. For the year ended December 31, 2008, the Company
issued 705,696 shares of our Class A common stock in conversion of 37 shares of
its Series L Preferred Stock. The Company exchanged 150 shares of Series L
Preferred Stock for 150 shares of Series M Preferred Stock as discussed
below.  At December 31, 2008, 1,498 shares of Series L Preferred Stock
remained outstanding.  Subsequent to December 31, 2008, the
Company issued 1,294,393 shares of our Class A common stock in conversion of 4
shares of Series L Preferred Stock and accrued dividends.
 
 Series M
Preferred Stock– On April 4, 2007, the Company entered into a Series M
9% Convertible Preferred Stock Exchange Agreement with Sovereign Partners, LP
(“Sovereign”).  Pursuant to the exchange agreement, Sovereign
exchanged 150 shares of the Company’s Series L Preferred Stock for 150 shares of
the Company’s Series M 9% Convertible Preferred Stock (the “Series M Preferred
Stock”).
 
 The
Series M Preferred Stock entitles Sovereign or its assignees to receive
dividends in an amount equal to 9% of the then-outstanding balance of shares of
Series M Preferred Stock.  The dividends are payable in cash or shares
of the Company’s Class A common stock, at the Company’s option.
 
 The
Series M Preferred Stock may be converted into common stock of the Company at
the option of the holder by using a conversion price which shall be the lower of
(i) 80% of the average of the two lowest closing bid prices for the twenty-day
trading period prior to the conversion date, or (ii) $0.004.
 
 Redemption
of the Series M Preferred Stock, whether at the Company’s option or that of
Sovereign, requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series M Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).
 
 Because
the shares of Series M were issued in exchange for the outstanding shares of
Series L Preferred Stock, the Company did not receive any proceeds in connection
with the issuance of the Series M Preferred Stock.
 
 The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the redemption of
$1,603,000 due to the value of the conversion feature of the Series M Preferred
Stock, which was previously recorded as part of the Series L Preferred Stock
derivative liability.  The liability was calculated using the
Black-Scholes valuation model with the following assumptions: dividend yield of
0%, expected volatility of 134%, risk-free rate of 5% and expected life of 4
years.  As the value of the derivative liability was greater than the
face value of the Series M Preferred Stock, no value was prescribed to the
Series M Preferred Stock.  At December 31, 2008 and 2007, the fair
value of the Series M Preferred Stock derivative liability was $1,542,000 and
$1,577,000, respectively.
 
 As of
December 31, 2008, there were 150 shares of Series M Preferred Stock
outstanding.
  F-18
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 
 Series N
Convertible Preferred Stock – On August 24, 2007, the Company entered
into a Securities Purchase Agreement with Trillium Partners, LP and other
unnamed future investors relating to the issuance and sale of the Company’s
Series N 9% Convertible Preferred Stock.
 
 Pursuant
to the agreement, the Company agreed to issue up to 2,400 shares of its Series N
9% Convertible Preferred Stock (the “Series N Preferred Stock”) at a per share
price of $1,000 to Trillium Partners, LP and other unnamed future investors, for
gross proceeds of up to $2,400,000.  As of the date of this report,
the Company had issued 1,755 shares of the Series N Preferred Stock, for cash
proceeds of $1,755,000.
 
 The
Series N Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series L
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.
 
 The
Series N Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price, equal to 80% of the average of
the two lowest closing bid prices for the twenty-day trading period prior to the
conversion date.
 
 Redemption
of the Series N Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series N Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).
 
 The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the redemption of
$957,000 due to the value of the conversion feature of the Series N Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 128%, risk-free rate of 5.0% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
N Preferred Stock, no value was prescribed to the Series N Preferred
Stock.  At December 31, 2008 and 2007, the fair value of the Series N
Preferred Stock derivative liability was $1,803,000 and $1,109,000,
respectively.
 
 As of
December 31, 2008, there were 1,755 shares of Series N Preferred Stock
outstanding.
 
 Series O
Convertible Preferred Stock – Between January 25, 2008, and December 31,
2008, the Company received advances from three entities in connection with the
purchase agreements related to the Company’s Series O 9% Convertible Preferred
Stock (“Series O Preferred Stock”). On May 20, 2008, the Company entered into
Securities Purchase Agreements with Southridge Partners LP, Southshore Capital
Fund LTD, Sovereign Partners LP (collectively, the “Series O Purchasers”) for
the sale of an aggregate of 730 shares of Series O Preferred Stock for gross
proceeds of $730,000.  The material terms of the purchase agreements
had been agreed upon prior to receipt of the advances.  Therefore, the
Series O Preferred Stock was accounted for as discussed below on the dates cash
proceeds were received by the Company.  The Company also began
accruing dividends upon receiving the advances.
 
 The
Series O Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series O
Preferred Stock. The dividends are payable in cash or shares of the Company's
Class A common stock, at the Company's option.
  F-19
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 The
Series O Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price, equal to 80% of the average of
the two lowest closing bid prices for the twenty-day trading period prior to the
conversion date.
 
 Redemption
of the Series O Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series O Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).
 
 The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity,” SFAS
133 “Accounting for Derivative Instruments and Hedging Activities” and EITF
00-19 “Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company’s Own Stock.” The Company recognized a
derivative liability upon the redemption of $290,000 due to the value of the
conversion feature of the Series O Preferred Stock. The liability was calculated
using the Black-Scholes valuation model with the following assumptions: dividend
yield of 0%, expected volatility of 128%, risk-free rate of 5.0% and expected
life of 4 years. As the value of the derivative liability was greater than the
face value of the Series O Preferred Stock, no value was prescribed to the
Series O Preferred Stock. At December 31, 2008, the fair value of the Series O
Preferred Stock derivative liability was $750,000.
 
 As of
December 31, 2008, there were 730 shares of Series O Preferred Stock
outstanding.
 
 Series P
Convertible Preferred Stock – On September 30, 2008, Fonix Corporation
(the “Company”) entered into a Series P 9% Convertible Preferred Stock Exchange
Agreement (the “Exchange Agreement”) with Sovereign Partners, LP (“Sovereign”),
and McCormack Avenue Ltd. (“McCormack”).  Pursuant to the Exchange
Agreement, Sovereign and McCormack exchanged certain debt obligations, discussed
more fully below, for shares of the Company’s Series P 9% Convertible Preferred
Stock (the “Series P Preferred Stock”).
 
 The
Series P Preferred Stock entitles the holders to receive dividends in an amount
equal to 9% of the then-outstanding balance of shares of Series P Preferred
Stock.  The dividends are payable in cash or shares of the Company’s
Class A common stock, at the Company’s option.
 
 The
Series P Preferred Stock may be converted into common stock of the Company at
the option of the holder by using a conversion price which shall be 80% of the
average of the two (2) lowest closing bid prices for the twenty-day trading
period prior to the conversion date.
 
 Redemption
of the Series P Preferred Stock, whether at our option or that of the holder,
requires us to pay, as a redemption price, the stated value of the outstanding
shares of Series P Preferred Stock to be redeemed, together with any accrued but
unissued dividends thereon, multiplied by one hundred ten percent
(110%).
 
 Because
the shares of Series P were issued in exchange for certain outstanding debt
obligations of the Company, we did not receive any proceeds in connection with
the issuance of the Series P Preferred Stock to McCormack and
Sovereign.
 
 In
connection with the issuance of the Series P Preferred Stock, on September 26,
2008, we filed with the State of Delaware a Certificate of Designation and
Series P 9% Convertible Stock Terms (the “Series P Terms”), which become a part
of our Certificate of Incorporation, as amended.
 
 The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity,” SFAS
133 “Accounting for Derivative Instruments and Hedging Activities” and EITF
00-19 “Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company’s Own Stock.” The Company recognized a
derivative liability upon the redemption of $290,000 due to the value of the
conversion feature of the Series P Preferred Stock. The liability was calculated
using the Black-Scholes valuation model with the following assumptions: dividend
yield of 0%, expected volatility of 128%, risk-free rate of 5.0% and expected
life of 4 years. As the value of the derivative liability was greater than the
face value of the Series P Preferred Stock, no value was prescribed to the
Series P Preferred Stock. At December 31, 2008, the fair value of the
Series P Preferred Stock derivative liability was $13,365,000.
 
 As of
December 31, 2008, there were 1,305 shares of Series P Preferred Stock
outstanding.
 
  F-20
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 Fonix Speech,
Inc. Series B Convertible Preferred Stock – On April 4, 2007, the Company
entered into a Securities Purchase Agreement by and among the Company, Fonix
Speech, Inc. (“FSI”), and Sovereign Partners, LP (“Sovereign”).  FSI
is a wholly owned subsidiary of the Company.
 
 Pursuant
to the FSI agreement, FSI sold 125 shares of its Series B 9% Convertible
Preferred Stock (the “Series B Preferred Stock”) at a per share price of $10,000
to Sovereign, for gross proceeds of $1,250,000.
 
 The
shares of Series B Preferred Stock are convertible into shares of the Company’s
Class A common stock.  The Series B Preferred Stock may be converted
into common stock of the Company at the option of the holder by using a
conversion price which shall be the lower of (i) 80% of the average of the two
lowest closing bid prices for the twenty-day trading period prior to the
conversion date, or (ii) $0.004.
 
 The
Series B Preferred Stock entitles Sovereign or its assignees to receive
dividends in an amount equal to 9% of the then-outstanding balance of shares of
Series B Preferred Stock.  The dividends are payable in cash or shares
of the Company's Class A common stock, at the Company's option
 
 The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the issuance of
$1,336,207 due to the value of the conversion feature of the Series B Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 134%, risk-free rate of 5% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
B Preferred Stock, no value was prescribed to the Series B Preferred
Stock.  At December 31, 2008 and 2007, the fair value of the Series B
Preferred Stock derivative liability was $1,285,000 and $1,314,000,
respectively.
 
 As of
December 31, 2008, there were 125 shares of Series B Preferred Stock
outstanding.
 
 
 NOTE
8.  EQUITY LINES OF CREDIT
 
 Seventh Equity
Line of Credit - On May 27, 2005, the Company entered into a seventh
private equity line agreement (the "Seventh Equity Line Agreement") with the
Equity Line Investor, on terms substantially similar to those of the Sixth
Equity Line between Queen and the Company dated November 15, 2004.
 
 Under the
Seventh Equity Line Agreement, the Company had the right to draw up to
$20,000,000 against an equity line of credit (the "Seventh Equity Line") from
the Equity Line Investor.  The Company was entitled under the Seventh
Equity Line Agreement to draw certain funds and to put to the Equity Line
Investor shares of the Company's Class A common stock in lieu of repayment of
the draw.  The Company was limited as to the amount of shares it may
put to the Equity Line Investor in connection with each put; the Company could
not put shares which would cause the Equity Line Investor to own more than 4.99%
of its outstanding common stock on the date of the put notice.  The
number of shares to be issued in connection with each draw was determined by
dividing the amount of the draw by 93% of the average of the two lowest closing
bid prices of our Class A common stock over the ten trading days after the put
notice is tendered.  The Equity Line Investor was required under the
Seventh Equity Line Agreement to tender the funds requested by the Company
within two trading days after the ten-trading-day period used to determine the
market price.
 
 The
Company granted registration rights to the Equity Line Investor and filed three
registration statements which cover the resales of the shares to be issued under
the Seventh Equity Line.  All of the shares registered by the first
registration statement had been sold as of October 24, 2005.  The
second registration statement filed in connection with the Seventh Equity Line
was declared effective by the SEC on February 10, 2006.  All of the
shares registered by the second registration statement had been sold as of July
26, 2006.  The Company filed a third registration statement on June
26, 2006, to register additional shares under the Seventh Equity
Line.  However, that registration statement was not declared
effective, and no shares were sold under that registration
statement.
  F-21
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 For the
year ended December 31, 2006, the Company received $3,378,000 in funds drawn
under the Seventh Equity Line, less commissions and fees of
$114,000.  The Company issued 60,000 shares of Class A common stock to
the Equity Line Investor as puts under the Seventh Equity Line totaling
$3,378,000.
 
 In
January, 2007, the Company terminated the Seventh Equity Line, and the Company
has withdrawn the third registration statement related to the Seventh Equity
Line.  As such, as of the date of this Report, the Company did not
have an equity line of credit financing available to it.
 
 NOTE
9.  COMMON STOCK
 
 Common
Stock– As
described elsewhere in this Annual Report, in December 2008 the Company
implemented a 1 for 5000 share reverse stock split.  The share numbers
in these notes have been adjusted to reflect the reverse stock
split.  During 2008, the Company issued 2,672,887 shares of Class A
common stock.  Of such shares, 1,296,788 shares were issued as
employee stock grants, 259,620 shares were issued as payment on the related
party note, 145,225 shares were issued for consulting services, 124,941 shares
were issued as payment on legal expenses, 705,696 shares were issued in
conversion of 37 shares of Series L Preferred Stock and 140,617 shares were
issued as payment of accrued dividends of Series L Preferred Stock.
 
 During
2007, the Company issued 595,431 shares of Class A common stock.  Of
such shares, 555,431 shares were issued in conversion of 173 shares of Series L
Preferred Stock and 40,000 shares were issued for consulting
services.
 
 During
2006, the Company issued 183,407 shares of Class A common stock.  Of
such shares, 60,000 were issued in connection with draws on the Seventh Equity
Line, 3,006 shares were issued in conversion of 266 shares of Series J Preferred
Stock, 21,860 shares were issued in conversion of 1,093 shares of Series K
Preferred Stock, 568 shares were issued in payment of dividends on Series H
Preferred Stock and 97,974 shares were issued in conversion of 142 shares of
Series L Preferred Stock.
 
 NOTE
10.  STOCK OPTIONS AND WARRANTS
 
 Common Stock
Options - In 1998, the Company’s board of directors and shareholders
approved the 1998 Stock Option and Incentive Plan (“the “1998 Plan”) for
directors, employees and other persons acting on behalf of the Company, under
which the aggregate number of shares authorized for issuance was
50.  The Company subsequently determined that it had issued 51 options
in excess of the aggregate number authorized under the plan.  In 2004,
the Company’s board of directors approved an increase in the number of shares
under the Plan from 50 to 110 to cover the additional options
issued.  In November 2004, the Board of Directors again amended the
1998 Plan to increase the aggregate number of shares under the 1998 Plan from
110 to 4000.  The purpose of this amendment is to cover any additional
issuances of shares made in excess of the number authorized under the 1998 Plan
and to enable the Company to issue additional incentive stock options to key
employees and non-qualified stock options, stock appreciation rights, cash and
stock bonuses and other incentive grants to directors, employees and certain
non-employees who have important relationships with the Company or its
subsidiaries.  At a meeting of shareholders held on December 30, 2004,
the amendments to the 1998 Plan were approved.  As of December 31,
2008, there were 3,818 shares available for grant under this plan.
 
 In 1997,
the Company’s board of directors approved the 1997 Stock Option and Incentive
Plan for directors, employees and other persons acting on behalf of the Company,
under which the aggregate number of shares authorized for issuance is
38.  As of December 31, 2008, there were 38 shares available for grant
under this plan.
  F-22
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 In 1996,
the Company’s board of directors and shareholders approved the 1996 Directors’
Stock Option Plan, under which the aggregate number of shares of Class A common
stock authorized for issuance is 27.  The plan provides that each
director shall receive options to purchase 1 share of Class A common stock for
services rendered as a director during each entire calendar year or portion of a
calendar year in excess of six months.  The exercise price of such
options is the closing market price of the Class A common stock on the date the
options are granted.  The option term is 10 years from date of
grant.  As of December 31, 2008, shares available for grant under this
plan were 27.
 
 In 1996,
the Company’s board of directors approved a Long-Term Stock Investment and
Incentive Plan for officers, key employees and other persons acting on behalf of
the Company under which the aggregate number of shares authorized for issuance
is 5.  The exercise price of these options is the closing market price
of the Class A common stock on the date the options are granted.  The
term of the plan is 10 years and options are subject to a three-year vesting
schedule, pursuant to which one-third of the total number of options granted may
be exercised each year.  As of December 31, 2008, shares available for
grant under this plan were 5.
 
 During
2006, the Company granted options to purchase 12 shares of Class A common stock
at exercise price $50.00.  All options were granted at the quoted
market price on the date of grant.  All options granted vest over
three years following issuance.  If not exercised, all options expire
within ten years from the date of grant.
 
 During
2008 and2007, the Company granted no options to employees.
 
 A summary
of options granted under the Company’s various stock option plans for the years
ended December 31, 2008, 2007, and 2006, is presented below:
 
 2008
                  
                  
                  2007
                  
                  
                  2006Stock
                    Options
                  
                  
                  Weighted
                    Average
                    Exercise
                    Price
                  
                  
                  Stock
                    Options
                  
                  
                  Weighted
                    Average
                    Exercise
                    Price
                  
                  
                  Stock
                    Options
                  
                  
                  Weighted
                    Average
                    Exercise
                    PriceOutstanding
      at beginning of the year
                  
                  
                  75
                  
                  
                  $
                  500
                  
                  
                  
                  182
                  
                  
                  $
                  650
                  
                  
                  
                  266
                  
                  
                  $
                  660Granted
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  12
                  
                  
                  
                  50Exercised
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Forfeited
                  
                  
                  (35
                  )
                  
                  
                  750
                  
                  
                  
                  (107
                  )
                  
                  
                  750
                  
                  
                  
                  (96
                  )
                  
                  
                  650Outstanding
      at end of the year
                  
                  
                  40
                  
                  
                  
                  800
                  
                  
                  
                  75
                  
                  
                  
                  500
                  
                  
                  
                  182
                  
                  
                  
                  650Exercisable
      at the end of the year
                  
                  
                  40
                  
                  
                  $
                  800
                  
                  
                  
                  73
                  
                  
                  $
                  550
                  
                  
                  
                  155
                  
                  
                  $
                  650
 
 A summary
of options outstanding and options exercisable under the Company’s various stock
option plans at December 31, 2008, is presented below:
 
 
 Options
      Outstanding
                            
                            Options
      ExercisableRange
      of Exercise Prices
                            Number
      Outstanding
                            Weighted
      Average Remaining Contractual Life
                            Weighted
      Average Exercise Price
                            
                            Number
      Exercisable
                            Weighted
      Average Exercise Price$
      67 – 200
                            11
                            3.6
      years
                            $    174
                            
                            11
                            $    174200
      – 500
                            11
                            1.0
      years
                            175
                            
                            11
                            175720
      – 1,473
                            18
                            2.1
      years
                            485
                            
                            18
                            485
 
 The
weighted average fair value of options granted during the years ended December
31, 2006 were $50 per share.  The options outstanding at December 31,
2008 and December 31, 2007 had an aggregate intrinsic value of
zero.
  F-23
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 The fair
value of options and warrants is estimated on the date granted using the
Black-Scholes option pricing model with the following weighted-average
assumptions used for grants during 2006:
 
 2006Risk-free
      interest rate
                  3.75%Expected
      dividend yield
                  0.0%Expected
      exercise lives
                  5
      yearsExpected
      volatility
                  143%
 
 The
estimated fair value of options granted is subject to the assumptions made, and
if the assumptions were to change the estimated fair value amounts could be
significantly different.
 
 Warrants -
A summary of warrants granted by the Company during the years ended December 31,
2008, 2007, and 2006, is presented below:
  2008
                  
                  
                  2007
                  
                  
                  2006Shares
                  
                  
                  Weighted
                    Average
                    Exercise
                    Price
                  
                  
                  Shares
                  
                  
                  Weighted
                    Average
                    Exercise
                    Price
                  
                  
                  Shares
                  
                  
                  Weighted
                    Average
                    Exercise
                    PriceOutstanding
      at beginning of the year
                  
                  
                  3
                  
                  
                  $
                  200,000
                  
                  
                  
                  3
                  
                  
                  $
                  200,000
                  
                  
                  
                  196
                  
                  
                  $
                  550Granted
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —Forfeited
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  (193
                  )
                  
                  
                  2,550Outstanding
      at end of the year
                  
                  
                  3
                  
                  
                  
                  200,000
                  
                  
                  
                  3
                  
                  
                  
                  200,000
                  
                  
                  
                  3
                  
                  
                  
                  200,000Exercisable
      at end of the year
                  
                  
                  3
                  
                  
                  
                  200,000
                  
                  
                  
                  3
                  
                  
                  
                  200,000
                  
                  
                  
                  3
                  
                  
                  
                  200,000
 
 NOTE
11.  RELATED-PARTY TRANSACTIONS
 
 The
secretary of the Company is a partner in a law firm that the Company uses to
provide legal services.  During 2008, 2007 and 2006, the Company
incurred expenses of approximately $254,000, $207,000 and $368,000 respectively,
to the law firm for services provided to the Company.
 
 NOTE
12.  INCOME TAXES
 
 At
December 31, 2008 and 2007, net deferred income tax assets, before considering
the valuation allowance, totaled $61,032,000 and $58,731,000,
respectively.  The amount and ultimate realization of the benefits
from the deferred income tax assets are dependent, in part, upon the tax laws in
effect, the Company’s future earnings, and other future events, the effects of
which cannot be determined.  The Company has established a valuation
allowance for all deferred income tax assets not offset by deferred income tax
liabilities due to the uncertainty of their realization.  The net
change in the valuation allowance was and increase of $2,301,000 for 2008, a
decrease of $5,582,000 for 2007 and an increase of $8,187,000 for
2006.
 
 At
December 31, 2008, the Company has unused federal net operating loss
carryforwards available of approximately $150,494,000 and unused state net
operating loss carryforwards of approximately $141,774,000 which may be applied
against future taxable income, if any, and which expire in various years from
2011 through 2028.  The Internal Revenue Code contains provisions
which likely will reduce or limit the availability and utilization of these net
operating loss carryforwards.  For example, limitations are imposed on
the utilization of net operating loss carryforwards if certain ownership changes
have taken place or will take place.  The Company has not performed an
analysis to determine whether any such limitations have
occurred.
  F-24
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 The
temporary differences and carryforwards which give rise to the deferred income
tax assets as of December 31, 2008 and 2007 are as follows:
 
 Deferred
      income tax assets:
                      
                      2008
                      
                      
                      2007Net
      operating loss carryforwards:Federal
                      
                      $
                      51,167,904
                      
                      
                      $
                      48,614,944State
                      
                      
                      4,678,537
                      
                      
                      
                      4,430,748Research
      expenditures credits
                      
                      
                      2,537,005
                      
                      
                      
                      2,487,000Accrued
      liabilities
                      
                      
                      117,049
                      
                      
                      
                      86,000Deferred
      revenues
                      
                      
                      166,133
                      
                      
                      
                      172,000Amortization
      of intangible assets
                      
                      
                      2,365,295
                      
                      
                      
                      2,437,000Total
      deferred income tax assets
                      
                      
                      61,031,923
                      
                      
                      
                      64,313,000Valuation
      allowance
                      
                      
                      (61,031,923
                      )
                      
                      
                      (64,313,000
                      )Deferred
      income tax liability – intangible telecommunications
assets
                      
                      
                      –
                      
                      
                      
                      –Net
      deferred income tax assets
                      
                      $
                      –
                      
                      
                      $
                      –
 
 
 A
reconciliation of income taxes at the federal statutory rate to the Company’s
effective rate is as follows:
  Year
      Ended December 31,2008
                                  
                                  
                                  2007
                                  
                                  
                                  2006Federal
      statutory income tax rate
                                  
                                  
                                  34.0
                                  %
                                  
                                  
                                  34.0
                                  %
                                  
                                  
                                  34.0
                                  %State
      and local income tax rate, net of federal benefit
                                  
                                  
                                  3.3
                                  
                                  
                                  
                                  3.3
                                  
                                  
                                  
                                  3.3Non-deductible
      items
                                  
                                  
                                  (0.5
                                  )
                                  
                                  
                                  (0.5
                                  )
                                  
                                  
                                  (0.5
                                  )Valuation
      allowance
                                  
                                  
                                  (37.3
                                  )
                                  
                                  
                                  (37.2
                                  )
                                  
                                  
                                  (37.2
                                  )Effective
      income tax rate
                                  
                                  
                                  0.0
                                  %
                                  
                                  
                                  0.0
                                  %
                                  
                                  
                                  0.0
                                  %
 
 NOTE
13.  COMMITMENTS AND CONTINGENCIES
 
 Executive
Employment Agreements– As of December 31, 2008, the Company had employment agreements with two
executive officers that were initiated November 1, 1996, and amended effective
January 31, 2000, to extend the term of the agreements and reduce the base
compensation.  The current annual base salary for each executive
officer was $309,400.  During 2002, the executive officers agreed to
accept reduced cash compensation pursuant to the Company’s 2002 Employee
Compensation Plan.  The current expiration date of the agreements is
December 31, 2010.
 
 In the
event that, during the contract term, both a change of control occurs, and
within six months after such change in control occurs, the executive’s
employment is terminated by the Company for any reason other than cause, death,
or retirement, the executive shall be entitled to receive an amount in cash
equal to all base salary then and thereafter payable within 30 days of
termination.
 
 On March
5, 2008 Mr. Murdock resigned as President, Chairman, and Chief Executive
Officer.
 
 In
connection with his resignation from the Company and its subsidiaries, Mr.
Murdock entered into a Separation and Release of Claims Agreement (the
“Separation Agreement”) with the Company.  Under the Separation
Agreement, the parties agreed that the Company is not obligated to pay to Mr.
Murdock approximately $320,000 in deferred salary owed to Mr. Murdock unless and
until (i) the occurrence of a Liquidity Event (as defined in the Agreement), and
then in proportion to the amount that Mr. Dudley is paid for salary that he also
deferred during the deferred salary period or (ii) the Company begins to make
payments to Dudley for salary which he has deferred for the deferred salary
period, and then in proportion to the amount that Mr. Dudley is paid for salary
that he deferred during the deferred salary period, or (ii) the conversion by
Murdock into shares of the Company's Common Stock at any time or times on or
after the date of the Agreement, at Mr. Murdock’s sole option, any portion of
the outstanding and unpaid deferred salary into fully paid and nonassessable
shares of the Company’s Common Stock, with the number of shares issuable being
determined by dividing the salary amount being converted by the conversion price
(which is equal to the average of the closing bid prices over the ten (10)
trading days prior to the conversion date). Additionally, the parties agreed
that Mr. Murdock was not entitled to any severance under his Employment
Agreement, except that upon the occurrence of a Liquidity Event, then the
Company is required to pay to Mr. Murdock an amount which is equal to the lower
of (i) his annual base salary or (ii) the severance paid to Mr. Dudley in
connection with such Liquidity Event.
  F-25
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 The
Company also agreed (i) to provide COBRA medical coverage for Mr. Murdock
through December 31, 2009; (ii) that all of Mr. Murdock’s stock options,
warrants, and other similar rights would immediately vest; (iii) that the
Company would maintain life insurance, disability insurance, and 401(k) plan for
Mr. Murdock through December 31, 2009; (iv) to indemnify Mr. Murdock against
claims relating to his service as an officer and director of Fonix, as well as
in connection with the lawsuits by The Breckenridge Fund LLC; (v) that unpaid
expenses of approximately $25,000 owed to Mr. Murdock would be paid to Mr.
Murdock at the time of a Liquidity Event (as defined in the Agreement); and (vi)
to pay as and when due in regular monthly installments the balance of
approximately $24,000 under the terms a loan from the Company’s 401(k) plan, as
lender, to Mr. Murdock, as borrower.
 
 Under the
Separation Agreement, Mr. Murdock agreed, among other this, (i) to release the
Company and its officers, directors, and employees from any claims; and (ii)
that he would not make us of or disclose any proprietary business or trade
secret information.
 
 Mr.
Dudley’s executive employment agreement, as described above, remained in force
as the date of this Report.
 
 Operating Lease
Agreements - The Company leases certain facilities and equipment used in
its operations.  The amounts of commitments for non-cancelable
operating leases in effect at December 31, 2008, were as follows:
 
 Year
      ending December 31,2009
                        
                        $
                        71,0002010
                        
                        
                        74,0002011
                        
                        
                        76,000$
                        221,000
 
 The
Company incurred rental expense of $275,000, $382,000, $350,000 during 2008,
2007 and 2006, respectively, related to these leases.
 
 Forgiveness of
Trade Payables and Accrued Interest - The Company negotiated reductions
in amounts due various trade vendors amounting to $0, $199,000 and $0 during
2008, 2007 and 2006, respectively.
 
 NOTE
14.  LITIGATION
 
 Hite Development Corporation v. Fonix
Corporation,Third District Court, Salt Lake County (Civil No.
070900883).  In January 2007, Hite Development Corporation (“Hite”)
brought a lawsuit against the Company claiming breach of contract and breach of
the covenant of good faith and fair dealing, alleging that the Company failed to
make certain payments under a settlement agreement with Hite dating from March
2005.  The complaint seeks approximately $33,000 plus
interest.  The Company filed its answer in May 2007.  On
October 2, 2008, a judgment was entered against the Company in the amount of
$28,050.
 
 RR Donnelley Receivables Inc. v.
Fonix Corporartion,Third District Court, Salt Lake County (Civil No.
070412088).  In July 2007, RR Donnelley Receivables Inc. (“Donnelly”)
brought a lawsuit against the Company for alleged failure to pay for services
provided.  The complaint seeks approximately $21,000 plus
interest.  The Company filed its answer in August 2007, and filed a
motion to dismiss the action in December 2007.  That motion is
currently pending before the court.  If the Company’s motion to
dismiss is denied, the Company intends to defend against the claims in the
complaint.
  F-26
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
  NOTE
15.  EMPLOYEE PROFIT SHARING PLAN
 
 The
Company has a 401(k) profit sharing plan covering essentially all of its
full-time employees.  Under the plan, employees may reduce their
salaries, in amounts allowed by law, and contribute the salary reduction amount
to the plan on a pretax basis.  The plan also allows the Company to
make matching and profit sharing contributions as determined by the board of
directors.  To date, no matching or profit sharing contributions have
been made by the Company.
 
 NOTE
16.  SIGNIFICANT CUSTOMERS
 
 The
Company’s revenues by geographic region for the years ended December 31, 2008,
2007 and 2006 were:
 
 2008
                      
                      
                      2007
                      
                      
                      2006United
      States
                      
                      $
                      635,000
                      
                      
                      
                      50
                      %
                      
                      $
                      913,000
                      
                      
                      
                      50
                      %
                      
                      $
                      546,000
                      
                      
                      
                      41
                      %Asia
      Pacific
                      
                      
                      508,000
                      
                      
                      
                      40
                      %
                      
                      
                      830,000
                      
                      
                      
                      45
                      %
                      
                      
                      591,000
                      
                      
                      
                      44
                      %Other
                      
                      
                      122,000
                      
                      
                      
                      10
                      %
                      
                      
                      95,000
                      
                      
                      
                      5
                      %
                      
                      
                      192,000
                      
                      
                      
                      15
                      %$
                      1,265,000
                      
                      
                      
                      
                      
                      
                      $
                      1,838,000
                      
                      
                      
                      
                      
                      
                      $
                      1,329,000
 
 For the
year ended December 31, 2008 no one customer accounted for more than 10% of
total revenue.  For the year ended December 31, 2007, four customers
accounted for 20% of total revenues, 15%, 12% and 10% of total
revenues.  For the year ended December 31, 2006, one customer
accounted for 31% of total revenues and another customer accounted for 10% of
total revenues.
 
 NOTE
17.  SUBSEQUENT EVENTS
 
 Subsequent
to December 31, 2008, the Company has issued 1,078,393 shares of its Class A
common stock in conversion of 4 shares of Series L Preferred Stock.
 
 Subsequent
to December 31, 2008, the Company has issued 216,000 shares of its Class A
common stock in payment of accrued dividends on the Series L Preferred
Stock.
 
 Through
December 31, 2008, the Company has issued 909,621shares of its Class A common
stock in conversion of principle on the related party note.
 
 Through
December 31, 2008, the Company has issued 167,089 shares of its Class A common
stock in conversion of interest on the related party note.
 
 Exchange
Agreement
 
 In March
2009, the Company announced that it had closed a previously announced
transaction whereby its subsidiary Fonix GS Acquisition Corporation, Inc.
(“Fonix GS”) acquired 80% of the issued and outstanding shares of G-Soft
Limited, a Hong Kong corporation (“G-Soft”), which is the ultimate parent of
Shanghai Gaozhi Software Systems Limited ("GaozhiSoft"), a Chinese software
developer and solutions provider in 2G (second-generation) and 3G
(third-generation) mobile networks in China and throughout the Asian Pacific
region.
 
 In a
Current Report filed with the SEC on August 12, 2008, the Company announced that
it had formed Fonix GS for the purpose of acquiring the GaozhiSoft
shares.
 
 On June
27, 2008, the Company and Fonix GS entered into an exchange agreement (the
“Exchange Agreement”), with Southridge LLC, a Connecticut limited liability
company (“Southridge”), G-Soft and the shareholders of G-Soft (the
“Sellers”).  G-Soft, through its wholly owned subsidiary, owns 100% of
the outstanding equity of GaozhiSoft. Pursuant to the Exchange Agreement, Fonix
GS agreed to purchase 80% of the issued and outstanding shares of G-Soft from
the Sellers, and Southridge agreed to purchase the remaining 20% of the issued
and outstanding G-Soft shares, thereby making Fonix GS and Southridge the
ultimate shareholders of GaozhiSoft.
  F-27
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 The
Exchange Agreement was amended by that certain First Amendment to the Exchange
Agreement, dated as of December 12, 2008 (the “First Amendment”), modifying the
consideration for the purchase of the G-Soft shares and certain other closing
conditions, as set forth therein.  Pursuant to the Exchange Agreement,
as amended, in exchange for 20% of the outstanding shares of G-Soft, Southridge
agreed to transfer shares of the Company’s Series L Convertible Preferred Stock
(the “Series L Preferred Stock”) in the amounts set forth in the First
Amendment.  In return for the purchase of 80% of the outstanding
shares of G-Soft, the Company agreed to issue an aggregate of one hundred and
twenty shares (120) of a new series of preferred stock (the “Series P Preferred
Stock”) to the Sellers.  Additionally, subject to the terms of the
First Amendment, the Sellers are entitled to annual earn-out payments equal to
fifty percent (50%) of the prior year’s net income of GaozhiSoft, to be paid in
the form of Series P Preferred Stock (the “Earn-Out Payments”).  The
aggregate of the Earn-Out Payments is limited to three hundred and eighty (380)
shares of Series P Preferred.  The First Amendment also amended and
restated section 6.1 of the Exchange Agreement, relating to additional closing
conditions, and section 8.2 of the original agreement relating to
indemnification.
 
 The
Sellers and Fonix entered into an Escrow Agreement (the “Escrow Agreement”) with
Adam L. Goldberg, whereby Mr. Goldberg agreed to act as escrow agent and hold
the Series P Preferred Stock issued or issuable to the Sellers to purchase their
interests in G-Soft.  The Escrow Agreement outlined Mr. Goldberg’s
duties and obligations as Escrow Agent.
 
 The First
Amendment and the Escrow Agreement were described in more detail in, and
attached as exhibits to, the Current Report on Form 8K, filed with the SEC on
December 19, 2008.
 
 Additionally,
Fonix GS and the Sellers entered into a side letter agreement, dated February
18, 2009 (the “Side Letter”), attached hereto as an exhibit, modifying certain
closing conditions of the Exchange Agreement, as amended by the First
Amendment.  The Side Letter establishes certain conditions regarding:
(1) management and directorships of GaozhiSoft; (2) filing of certain
administrative government documents in China; and (3) operations of
GaozhiSoft.
 
 The final
closing conditions have been met, and the share exchange transaction closed as
of March 27, 2009.
 
 The
foregoing summaries of the terms and conditions of the Exchange Agreement, First
Amendment, Escrow Agreement and Side Letter do not purport to be complete and
are qualified in their entirety by reference to the full text of the Exchange
Agreement, First Amendment, Escrow Agreement and Side Letter, which were filed
as exhibits to Current Reports previously filed with the SEC.
 
 Issuance
of Series P 9% Convertible Preferred Stock in G-Soft Transaction
 
 As
disclosed in a Current Report filed with the Commission on March 27, 2009, Fonix
Corporation (the “Company”) issued an aggregate of one hundred and twenty shares
(120) of the Company’s Series P 9% Convertible Preferred Stock (the “Series P
Preferred Stock”) to G-Soft Limited, a Hong Kong corporation (“G-Soft”), which
is the ultimate parent of Shanghai Gaozhi Software Systems Limited
("GaozhiSoft"), and the shareholders of G-Soft (collectively, the
“Sellers”).  The Shares of Series P Preferred Stock were issued
pursuant to an exchange agreement (the “Exchange Agreement”), with Southridge
LLC, a Connecticut limited liability company (“Southridge”), and the
Sellers.  Additionally, subject to the terms of the amended agreement
with the Sellers, the Sellers are entitled to annual earn-out payments equal to
fifty percent (50%) of the prior year’s net income of GaozhiSoft, to be paid in
the form of Series P Preferred Stock (the “Earn-Out Payments”).  The
aggregate of the Earn-Out Payments is limited to three hundred and eighty (380)
shares of Series P Preferred, which were issued into an escrow
account.
 
 The
Series P Preferred Stock entitles the holders to receive dividends in an amount
equal to 9% of the then-outstanding balance of shares of Series P Preferred
Stock.  The dividends are payable in cash or shares of our Class A
common stock, at the Company’s option.
  F-28
  Fonix
Corporation and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 
 The
Series P Preferred Stock may be converted into the Company’s common stock at the
option of the holder by using a conversion price which shall be 80% of the
average of the two (2) lowest closing bid prices for the twenty-day trading
period prior to the conversion date.
 
 Redemption
of the Series P Preferred Stock, whether at the Company’s option or that of the
holder, requires the Company to pay, as a redemption price, the stated value of
the outstanding shares of Series P Preferred Stock to be redeemed, together with
any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).
 
 On
September 26, 2008, the Company filed with the State of Delaware a Certificate
of Designation and Series P 9% Convertible Stock Terms (the “Series P Terms”),
which become a part of the Company’s Certificate of Incorporation, as
amended.
 
 Under the
G-Soft Agreement and the Series P Terms, the holders of the Series P Preferred
Stock may convert shares of Series P Preferred Stock into shares of the
Company’s common stock.  The Company’s issuances of shares of common
stock upon any conversion of the Series P Preferred Stock will be made without
registration under the Securities Act of 1933 (the “1933 Act”) in reliance on
Section 4(2) of the 1933 Act and the rules and regulations promulgated
thereunder.  The Company’s sale and issuance of the Series P Preferred
Stock to the Sellers was made without registration under the 1933 Act in
reliance on Section 4(2) of the 1933 Act and the rules and regulations
promulgated thereunder.
 
 Issuance
of Shares of Series P 9% Convertible Preferred Stock to Acquire Remaining 20% of
G-Soft
 
 In
connection with the G-Soft transaction described above, on March 27, 2009, the
Company entered into a Series P Convertible Preferred Stock Purchase Agreement
(the “Preferred Stock Purchase Agreement”), with Southridge Partners LP
(“Southridge”).  Pursuant to the Preferred Stock Purchase Agreement,
the Company issued 189 shares of Series P Preferred Stock in exchange for the
20% of G-Soft shares which Southridge had purchased in the G-Soft Transaction
described above.
 
 The
Series P Preferred Stock issued to Southridge has the same terms as described
above.
 
 Under the
Preferred Stock Purchase Agreement and the Series P Terms, Southridge may
convert shares of Series P Preferred Stock into shares of the Company’s common
stock.  The Company’s issuances of shares of common stock upon any
conversion of the Series P Preferred Stock will be made without registration
under the Securities Act of 1933 (the “1933 Act”) in reliance on Section 4(2) of
the 1933 Act and the rules and regulations promulgated
thereunder.  The Company’s sale and issuance of the Series P Preferred
Stock to Southridge was made without registration under the 1933 Act in reliance
on Section 4(2) of the 1933 Act and the rules and regulations promulgated
thereunder.
 
 The
foregoing summaries of the terms and conditions of the Exchange Agreement and
the Preferred Stock Purchase Agreement do not purport to be complete and are
qualified in their entirety by reference to the full text of the Exchange
Agreement and the Preferred Stock Purchase Agreement, filed previously with the
Commission.
 
 F-29