**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

**ý****        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES AND EXCHANGE ACT OF 1934**

 

**For the quarterly period ended June 30, 2005**

 

**OR**

 

**o****        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES AND EXCHANGE ACT OF 1934**

 

**For the transition period from                to**

 

**Commission file number:  000-31121**

 

**AVISTAR COMMUNICATIONS CORPORATION**

(Exact name of registrant asspecified in its charter)

 
| **DELAWARE**                                                                 | ** ** | **88-0463156**                           |
|------------------------------------------------------------------------------|------------|------------------------------------------|
| (State or other jurisdiction                                                 |       | (I.R.S. Employer Identification  Number) |
| of incorporation or  organization)                                           |       |                                     |
| ** **                                                                   | ** ** | ** **                               |
| **555 TWIN DOLPHIN DRIVE, SUITE 360, REDWOOD  SHORES, CA 94065**             |
| (Address of Principal Executive  Offices) (Zip Code)                         |
| ** **                                                                   | ** ** | ** **                               |
| Registrant’s telephone number,  including area code: **(650) 610-2900** |

 

**Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities and Exchange Act of 1934during the preceding 12 months (or for shorter period that the registrant wasrequired to file such reports); and (2) has been subject to such filingrequirements for the past 90 days.**

 

**Yes ****ý      No ****o**

 

**Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Act).**

 

**Yes ****o      No ****ý**

 

**AtJune 30, 2005, 33,602,693 shares of common stock of the Registrant wereoutstanding.**

 

 

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** **

**AVISTAR COMMUNICATIONS CORPORATION**

**INDEX**

 
| PART I.    |   | FINANCIAL  INFORMATION                                                                      | 3      |
|------------|--------|---------------------------------------------------------------------------------------------|--------|
|       |   |                                                                                        |   |
| Item 1.    |   | Financial  Statements (unaudited)                                                           | 3      |
|       |   | Condensed Consolidated Balance Sheets                                                       | 3      |
|       |   | Condensed Consolidated Statements of  Operations                                            | 4      |
|       |   | Condensed Consolidated Statements of Cash  Flows                                            | 5      |
|       |   | Notes to Condensed Consolidated Financial  Statements                                       | 6      |
| Item 2.    |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 13     |
|       |   | Factors Affecting Future Operating Results                                                  | 20     |
| Item 3.    |   | Quantitative  and Qualitative Disclosures About Market Risk                                 | 28     |
| Item 4.    |   | Controls  and Procedures                                                                    | 28     |
|       |   |                                                                                        |   |
| PART  II.  |   | OTHER  INFORMATION                                                                          | 29     |
|       |   |                                                                                        |   |
| Item 1.    |   | Legal Proceedings                                                                           | 29     |
| Item  6.   |   | Exhibits                                                                                    | 29     |
|       |   |                                                                                        |   |
| SIGNATURES | 30     |

 

2

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**PART I - FINANCIAL INFORMATION**

 

**Item 1. *Financial Statements***

 

**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED BALANCE SHEETSas of June 30, 2005 and December 31, 2004(in thousands, except share and per share data)**

 
| ** **                                                                                                                                                                                                      | ** ** | **June 30,**    | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                      | ** ** | **2005**        | ** ** | **2004**              | ** ** |
| ** **                                                                                                                                                                                                      | ** ** | **(unaudited)** | ** ** |
| ** **                                                                                                                                                                                                      | ** ** | ** **      | ** ** |
| **Assets:**                                                                                                                                                                                                     | ** ** | ** **      | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                                 |       |            |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                       |       | $               | 17,624     |                  | $          | 21,656 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $75 and $22 at June 30, 2005 and December 31,  2004, respectively                                                                     |       | 868             |       | 886                   |       |
| Inventories, including inventory shipped to  customers’ sites, not yet installed of $45 and $34 at June 30, 2005 and  December 31, 2004, respectively                                                 |       | 752             |       | 737                   |       |
| Prepaid expenses and other current assets                                                                                                                                                                       |       | 432             |       | 454                   |       |
| Total current assets                                                                                                                                                                                            |       | 19,676          |       | 23,733                |       |
| Property and equipment, net                                                                                                                                                                                     |       | 347             |       | 192                   |       |
| Other assets                                                                                                                                                                                                    |       | 284             |       | 286                   |       |
| Total assets                                                                                                                                                                                                    |       | $               | 20,307     |                  | $          | 24,211 |   |
|                                                                                                                                                                                                            |       |            |       |                  |       |
| **Liabilities and Stockholders’ Equity  (Deficit):**                                                                                                                                                       |       |            |       |                  |       |
| Current liabilities:                                                                                                                                                                                            |       |            |       |                  |       |
| Accounts payable                                                                                                                                                                                                |       | 474             |       | 1,105                 |       |
| Deferred license revenue                                                                                                                                                                                        |       | 4,264           |       | 4,226                 |       |
| Deferred services revenue and customer  deposits                                                                                                                                                                |       | 1,008           |       | 748                   |       |
| Accrued liabilities and other                                                                                                                                                                                   |       | 1,148           |       | 1,287                 |       |
| Total current liabilities                                                                                                                                                                                       |       | 6,894           |       | 7,366                 |       |
| Long-term liabilities:                                                                                                                                                                                          |       |            |       |                  |       |
| Long-term deferred license revenue                                                                                                                                                                              |       | 14,217          |       | 16,331                |       |
| Total liabilities                                                                                                                                                                                               |       | 21,111          |       | 23,697                |       |
| Stockholders’ equity:                                                                                                                                                                                      |       |            |       |                  |       |
| Common stock, $0.001 par value; 250,000,000  shares authorized at June 30, 2005 and December 31, 2004; 34,784,318 and  34,542,334 shares issued at June 30, 2005 and December 31, 2004,  respectively |       | 35              |       | 35                    |       |
| Less: treasury common stock, 1,181,625  shares at June 30, 2005 and December 31, 2004, at cost                                                                                                             |       | (53             | )          | (53                   | )          |
| Additional paid-in-capital                                                                                                                                                                                      |       | 90,334          |       | 90,005                |       |
| Accumulated deficit                                                                                                                                                                                             |       | (91,120         | )          | (89,473               | )          |
| Total stockholders’ equity (deficit)                                                                                                                                                                       |       | (804            | )          | 514                   |       |
| Total liabilities and stockholders’ equity  (deficit)                                                                                                                                                      |       | $               | 20,307     |                  | $          | 24,211 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

3

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**AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**for the three and six months ended June 30, 2005 and 2004**

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

 
| ** **                                                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                        | ** ** | **June 30,**           | ** ** | **June 30,**         | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                                        | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                        | ** ** | **(unaudited)**        | ** ** | **(unaudited)**      | ** ** |
|                                                                              |       |                   |       |                 |       |   |   |   |   |
| Revenue:                                                                          |       |                   |       |                 |       |   |   |   |   |
| Product                                                                           |       | $                      | 535        |                 | $          | 914 |   | $ | 1,662 |   | $ | 1,476 |   |
| Licensing                                                                         |       | 1,057                  |       | —               |       | 2,114 |   | — |   |
| Services, maintenance and support                                                 |       | 811                    |       | 762                  |       | 1,606 |   | 1,604 |   |
| Total revenue                                                                     |       | 2,403                  |       | 1,676                |       | 5,382 |   | 3,080 |   |
| Cost of revenue:                                                                  |       |                   |       |                 |       |   |   |   |   |
| Product                                                                           |       | 318                    |       | 364                  |       | 768 |   | 656 |   |
| Services, maintenance and support                                                 |       | 525                    |       | 461                  |       | 972 |   | 943 |   |
| Total cost of revenue                                                             |       | 843                    |       | 825                  |       | 1,740 |   | 1,599 |   |
| Gross margin                                                                      |       | 1,560                  |       | 851                  |       | 3,642 |   | 1,481 |   |
| Operating Expenses:                                                               |       |                   |       |                 |       |   |   |   |   |
| Research and development                                                          |       | 706                    |       | 632                  |       | 1,347 |   | 1,256 |   |
| Sales and marketing                                                               |       | 819                    |       | 669                  |       | 1,517 |   | 1,277 |   |
| General and administrative                                                        |       | 1,362                  |       | 1,794                |       | 2,635 |   | 3,299 |   |
| Total operating expenses                                                          |       | 2,887                  |       | 3,095                |       | 5,499 |   | 5,832 |   |
| Loss from operations                                                              |       | (1,327                 | )          | (2,244               | )          | (1,857 | ) | (4,351 | ) |
| Other income (expense):                                                           |       |                   |       |                 |       |   |   |   |   |
| Interest income                                                                   |       | 73                     |       | 16                   |       | 221 |   | 29 |   |
| Other income (expense), net                                                       |       | (6                     | )          | (5                   | )          | (11 | ) | 1 |   |
| Total other income (expense), net                                                 |       | 67                     |       | 11                   |       | 210 |   | 30 |   |
| Net loss                                                                          |       | $                      | (1,260     | )                    | $          | (2,233 | ) | $ | (1,647 | ) | $ | (4,321 | ) |
|                                                                              |       |                   |       |                 |       |   |   |   |   |
| Net loss per share - basic and diluted                                            |       | $                      | (0.04      | )                    | $          | (0.07 | ) | $ | (0.05 | ) | $ | (0.14 | ) |
| Weighted average shares used in calculating  basic and diluted net loss per share |       | 33,547                 |       | 33,277               |       | 33,486 |   | 31,864 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

4

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**AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**for the six months ended June 30, 2005 and 2004**

**(in thousands)**

 
| ** **                                                                   | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                   | ** ** | **June 30,**         | ** ** | **June 30,** | ** ** |
| ** **                                                                   | ** ** | **2005**             | ** ** | **2004** | ** ** |
| ** **                                                                   | ** ** | **(unaudited)**      | ** ** |
|                                                                         |       |                 |       |   |   |
| Cash Flows from Operating Activities:                                        |       |                 |       |   |   |
| Net loss                                                                     |       | $                    | (1,647     | ) | $ | (4,321 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                 |       |   |   |
| Depreciation                                                                 |       | 88                   |       | 141 |   |
| Compensation on options issued to  consultants                               |       | 49                   |       | 12 |   |
| Provision for doubtful accounts                                              |       | 53                   |       | 25 |   |
| Changes in assets and liabilities:                                           |       |                 |       |   |   |
| Accounts receivable                                                          |       | (35                  | )          | (94 | ) |
| Inventories                                                                  |       | (15                  | )          | 206 |   |
| Prepaid expenses and other current assets                                    |       | 22                   |       | 190 |   |
| Other assets                                                                 |       | 2                    |       | — |   |
| Accounts payable                                                             |       | (631                 | )          | 173 |   |
| Deferred license revenue                                                     |       | (2,076               | )          | — |   |
| Deferred services revenue and customer  deposits                             |       | 260                  |       | 411 |   |
| Accrued liabilities and other                                                |       | (139                 | )          | 207 |   |
| Net cash used in operating activities                                        |       | (4,069               | )          | (3,050 | ) |
|                                                                         |       |                 |       |   |   |
| Cash Flows from Investing Activities:                                        |       |                 |       |   |   |
| Purchase of property and equipment                                           |       | (243                 | )          | (135 | ) |
| Net cash used in investing activities                                        |       | (243                 | )          | (135 | ) |
|                                                                         |       |                 |       |   |   |
| Cash Flows from Financing Activities:                                        |       |                 |       |   |   |
| Proceeds from issuance of common stock                                       |       | 280                  |       | 3,643 |   |
| Net cash provided by financing activities                                    |       | 280                  |       | 3,643 |   |
| Net increase (decrease) in cash and cash  equivalents                        |       | (4,032               | )          | 458 |   |
| Cash and cash equivalents, beginning of  year                                |       | 21,656               |       | 5,438 |   |
| Cash and cash equivalents, end of year                                       |       | $                    | 17,624     |   | $ | 5,896 |   |
|                                                                         |       |                 |       |   |   |
| Supplemental Cash Flow Information:                                          |       |                 |       |   |   |
| Cash paid for income taxes                                                   |       | $                    | 315        |   | $ | 14 |   |

 

The accompanying notes are an integral partof these financial statements.

 

5

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**AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIESNOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS(UNAUDITED)**

 

**1.  Business, Basis of Presentation, and Risksand Uncertainties**

 

# **Business**

# ** **

AvistarCommunications Corporation (“Avistar” or the “Company”) provides theAvistar vBusiness integrated suite of video-enabled applications, including networked video communications software andhardware products and services. Avistar’s products include applications forinteractive video calling, content creation and publishing, broadcast video andvideo-on-demand, as well as data sharing, directory services and networkmanagement. Avistar designs, develops, markets, sells, manufactures and/orassembles and installs and supports its products. Avistar’s real-time andnon-real-time products are based upon its architecture and Video OperatingSystem (AvistarVOS) platform, which facilitates distribution over local andwide area networks using telephony or Internet services as appropriate.  Avistar’s services include softwaredevelopment, consulting, implementation, training, maintenance andsupport.  In addition, Avistar seeks toprosecute, maintain, support and license the intellectual property developed bythe Company through its wholly-owned subsidiary, Collaboration Properties, Inc.(CPI), a Nevada corporation.

 

# **Basis of Presentation**

# ** **

The unauditedbalance sheet as of June 30, 2005 presents the consolidated financial positionof Avistar and its two wholly-owned operating subsidiaries, Avistar SystemsU.K. Limited (ASUK) and CPI, after elimination of all intercompany accounts andtransactions.  The consolidated resultsare referred to, collectively, as those of Avistar or the Company in thesenotes.

 

The functional currency of ASUK is the United Statesdollar. Accordingly, all gains and losses resulting from those transactionsdenominated in currencies other than the United States dollar are included inthe statements of operations.

 

The Company’sfiscal year end is December 31.

 

# **Risks and Uncertainties**

# ** **

The markets for the Company’s products and servicesare in the early stages of development. Some of the Company’s products utilize changing and emergingtechnologies. As is typical in industries of this nature, demand and marketacceptance are subject to a high level of uncertainty. Acceptance of theCompany’s products over time is critical to the Company’s success.  The Company’s prospects must be evaluated inlight of difficulties encountered by it and its competitors in furtherdeveloping this evolving marketplace. The Company has generated losses sinceinception and had an accumulated deficit of $91.1 million as of June 30,2005.  The Company’s operating resultsmay fluctuate significantly in the future as a result of a variety of factors,including, but not limited to, the economic environment, the adoption ofdifferent distribution channels, and the timing of new product announcements bythe Company or its competitors.

 

The Company’s future liquidity and capitalrequirements will depend upon numerous factors, including, but not limited to,the costs and timing of its expansion of product development efforts and thesuccess of these development efforts, the costs and timing of its expansion ofsales and marketing activities, the extent to which its existing and newproducts gain market acceptance, competing technological and marketdevelopments, the costs involved in maintaining, enforcing and defending patentclaims and other intellectual property rights, the level and timing of revenuefrom both product and services sales, and licensing, as well as other factors.

 

**2.  Summary of Significant Accounting Policies**

 

# **Unaudited InterimFinancial Information**

# ** **

The financial statements filed in this reporthave been prepared by the Company, without audit, pursuant to the rules andregulations of the Securities and Exchange Commission. Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to such rules andregulations. The December 31, 2004 Condensed Consolidated Balance Sheetwas derived from audited financial statements, but does not include alldisclosures required by accounting principles generally accepted in the UnitedStates of America.

 

6

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In the opinionof management, the unaudited financial statements furnished in this reportreflect all adjustments (consisting of normal recurring adjustments) necessaryfor a fair presentation of the results of operations for the interim periodscovered and of the Company’s financial position as of the interim balance sheetdate. The results of operations for the interim periods are not necessarilyindicative of the results for the entire year. These financial statementsshould be read in conjunction with the Company’s audited consolidated financialstatements and the accompanying notes for the year ended December 31,2004, included in the Company’s annual report on Form 10-K filed with theSecurities and Exchange Commission on March 28, 2005.

 

**Reclassifications**

 

Certainreclassifications, none of which affected the net loss, have been made to prioryear amounts to conform to the current year presentation.

 

**Use of Estimates**

 

The preparationof financial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the period.  Actual results could differ from thoseestimates.

 

# **Cash and Cash Equivalentsand Short Term Investments**

# ** **

The Company considers all investment instrumentspurchased with an original maturity of three months or less to be cashequivalents. Investment securities with original or remaining maturities ofmore than three months but less than one year are considered short-terminvestments. Investment securities with original or remaining maturities of oneyear or more are considered long-term investments. The Company classifies itsshort-term investments as available for sale with unrealized gains or lossesreported as a separate component of stockholders’ equity. The fair valueof the Company’s investments was determined based on quoted market prices atthe reporting date for those instruments.

 

The Company’scash equivalents at June 30, 2005 and December 31, 2004 consisted of moneymarket funds and short term commercial paper.  At June 30, 2005 and December 31,2004, all investments had an original remaining maturity of three months orless and are therefore classified as cash and cash equivalents in theaccompanying balance sheets.

 

# **SignificantConcentrations**

# ** **

A relativelysmall number of customers accounted for a significant percentage of the Company’snet sales. Sales to these customers as a percentage of total sales were asfollows for the three and six months ended June 30, 2005 and 2004:

 
| ** ** | ** ** | **THREE MONTHS ENDED****JUNE 30,** | ** ** | **SIX MONTHS ENDED****JUNE 30,** | ** ** |
|------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** ** | ** ** | **2005**                           | ** ** | **2004**                         | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** ** | ** ** | **(UNAUDITED)**                    | ** ** | **(UNAUDITED)**                  | ** ** |
| Customer A |       | 44                                 | %          |                             | *          | 39 | % |   | * |
| Customer B |       | 26                                 | %          | 51                               | %          | 24 | % | 55 | % |
| Customer C |       | 20                                 | %          | 11                               | %          | 24 | % | 13 | % |

 

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* Less than 10%

 

Any change inthe relationship with these customers could have a potentially adverse effecton the Company’s financial position.

 

Financial instruments that potentially subject theCompany to concentrations of credit risk consist primarily of temporary cashinvestments and trade receivables. The Company has cash and investment policiesthat limit the amount of credit exposure to any one financial institution andrestrict placement of these investments to financial institutions evaluated ashighly credit worthy.  Concentration ofcredit risk with respect to trade receivables relate to those trade receivablesfrom both United States and foreign customers of Avistar.  As of June 30, 2005, approximately 93% ofaccounts receivable were concentrated with three customers, each of whomrepresented more than 10% of the Company’s total accounts receivable balance.As of December 31, 2004, approximately

 

7

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81% of accounts receivable wereconcentrated with one customer. No other customers individually accounted forgreater than 10% of total accounts receivable as of December 31, 2004.

 

# **Inventories**

 

Inventories are stated at the lower of cost (first-in,first-out method) or market. When required, provisions are made to reduceexcess and obsolete inventories to their estimated net realizable value.Inventories consisted of the following (in thousands):

 
| ** **                                              | ** ** | **JUNE 30,  2005** | ** ** | **DECEMBER 31,  2004** | ** ** |
|---------------------------------------------------------|------------|--------------------|------------|-----------------------------|------------|
| ** **                                              | ** ** | **(UNAUDITED)**    | ** ** |
| Raw materials and subassemblies                         |       | $                  | 55         |                        | $          | 35 |   |
| Finished goods                                          |       | 652                |       | 668                         |       |
| Inventory shipped to customer sites, not  yet installed |       | 45                 |       | 34                          |       |
|                                                    |       |               |       |                        |       |
|                                                    |       | $                  | 752        |                        | $          | 737 |   |

 

Inventory shipped to customersites, not yet installed, represents product shipped to customer sites pendingcompletion of the installation process by the Company. As of June 30, 2005 and December 31, 2004, the Company hadbilled approximately $51,000 and $25,000, respectively, to customersrelated to these shipments, but did not record the revenue, as theinstallations had not been completed and confirmed by the customer.  Although customers are billed in accordancewith customer agreements, these deferred revenue amounts are netted againstaccounts receivable until the customer confirms installation.

 

**Revenue Recognition andDeferred Revenue**

 

The Companyrecognizes revenue in accordance with Statement of Position (SOP) 97-2,Software Revenue Recognition (SOP 97-2), as amended by SOP 98-9, Modificationof SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions(SOP 98-9). In connection with each transaction involving product, the Companymust evaluate whether: (i) persuasive evidence of an arrangement exists, (ii)delivery has occurred, (iii) the fee is fixed or determinable, and (iv)collectibility is probable. The Company applies these criteria as discussedbelow:

 

•                  *Persuasive evidence of an arrangement exists*. The Company requires a written contract, signedby both the customer and the Company, or a purchase order from those customersthat have previously negotiated a standard end-user license arrangement orvolume purchase agreement, prior to recognizing revenue on an arrangement.

 

•                  *Delivery has occurred*. The Company delivers software and hardware to customers physically. Thestandard delivery terms are FOB shipping point.

 

•                  *The fee is fixed or determinable*. The Company’s determination that an arrangementfee is fixed or determinable depends principally on the arrangement’s paymentterms. The Company’s standard payment terms generally require the arrangementfee to be paid within a negotiated, but standard, period of time – frequently30 days from the date of invoice. Where these terms apply, the Company regardsthe fee as fixed or determinable, and recognizes revenue upon delivery(assuming other revenue recognition criteria are met). If the payment terms donot meet this standard, referred to as “extended payment terms,” the fee maynot be considered to be fixed or determinable and the revenue would then berecognized when customer installments are due and payable.

 

•                  *Collectibility is probable*. To recognize revenue, the Company judgescollectibility of the arrangement fees on a customer-by-customer basis pursuantto a credit review policy. The Company typically sells to customers with ahistory of successful collection. For new customers, the Company evaluates thecustomer’s financial position and ability to pay. If the Company determinesthat collectibility is not probable based upon the credit review process or thecustomer’s payment history, revenue is recognized when cash is collected.

 

When the Companyprovides installation services, the product and installation revenue isrecognized upon completion of the installation process and receipt of customerconfirmation, subject to the satisfaction of the revenue recognition criteriadescribed above.  When the customer or athird party provides installation services, the product revenue is recognizedupon shipment, subject to satisfaction of the revenue recognition criteriadescribed above.  Payment for product isdue upon shipment, subject to specific payment terms.  Payment for installation and professionalservices are due upon providing the services, subject to specific payment terms.  If payments for systems are made in advanceof the completion of installation, such amounts are deferred and recorded as

 

8

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deferred services revenue and customerdeposits in the accompanying balance sheets until installation has occurred andthe customer has provided confirmation. Reimbursements received for out-of-pocket expenses incurred during installation and supportservices, which have not been significant to date, are recognized as revenue inaccordance with Emerging Issues Task Force (EITF) Issue No. 01-14 (EITF 01-14),“Income Statement Characterization of Reimbursements Received for “Out ofPocket” Expenses Incurred.”

 

The price chargedfor maintenance and/or support is defined in the contract, and is based on afixed price for both hardware and software components as stipulated in thecustomer agreement.  Customers have theoption to renew the maintenance and/or support arrangement in subsequentperiods at the same rate as paid in the initial year.  Revenue from maintenance and support servicesis deferred and recognized pro-rata over the maintenance and/or support term,which is typically one year in length. Payments for services made in advance of the provision of services arerecorded as deferred services revenue and customer deposits in the accompanyingbalance sheets.  Training services areoffered together with and independently of the purchase of product.  The value of these training services isdetermined based on the price charged when such services are sold separately,and training revenue is recognized upon performance of the service.

 

The Companyrecognizes service revenue from software development contracts in accordancewith SOP 81-1, “Accounting for Performance of Construction-Type and CertainProduction-Type Contracts.” Revenue related to contracts for softwaredevelopment is recognized using the percentage of completion method, when allof the following conditions are met: a contract exists with the customer at afixed price, the Company has fulfilled all of its material contractualobligations to the customer for each deliverable of the contract, verificationof completion of the deliverable has been received, and collection of thereceivable is probable.  The amountsbilled to customers in excess of revenues recognized to date are deferred andrecorded as deferred services revenue and customer deposits in the accompanyingbalance sheets.  Assumptions used forrecording revenue and earnings are adjusted in the period of change to reflectrevisions in contract value and estimated costs to complete the contract.  Any anticipated losses on contracts inprogress are charged to earnings when identified.

 

The Companyrecognizes revenue from the licensing of its intellectual property portfoliobased on the terms of the royalty, partnership and cross-licensing agreementsinvolved.  Revenue from licensing ofintellectual property, to date, has consisted entirely of payment from Polycom,Inc. pursuant to a settlement agreement and a cross-license agreement dated November 12,2004, and has been recognized as revenue in accordance with Section 48 and49 of SOP 97-2, which discusses multiple-element arrangements and the futuredelivery of unspecified additional software products. As part of the settlementand cross-license agreements with Polycom, Inc., the Company granted to Polycoma non-exclusive, fully paid-up license to its entire patent portfolio. Thecross-license agreement includes a five year capture period from the date ofthe settlement, adding all new patents with a priority date extending up tofive years from the date of execution of the cross-license agreement. Sections48 and 49 of SOP 97-2 provide that a vendor may agree to deliver softwarecurrently and to deliver unspecified additional software products in thefuture. The software elements of the kinds of arrangements discussed inparagraph 48 should be accounted for as subscriptions. No allocation of revenueshould be made among any of the software products, and all softwareproduct-related revenue from the arrangement should be recognized ratably overthe term of the arrangement beginning with delivery of the first product.Accordingly, the net $21.1 million license fee paid to the Company by Polycom,Inc. has been deferred and is being recognized as licensing revenue ratablyover the five year period beginning November 12, 2004.

 

**Stock-Based Compensation**

 

The Company applies the intrinsic-value-based methodof accounting prescribed by Accounting Principles Board (APB) Opinion No. 25,Accounting for Stock Issued to Employees, and related interpretations includingFASB Interpretation No. 44, Accounting for Certain Transactions involving StockCompensation, an interpretation of APB Opinion No. 25, to account for its fixed-planstock options. Under this method, compensation expense is recorded on the dateof grant only if the current market price of the underlying stock exceeded theexercise price. Statement of Financial Accounting Standard No. 123, Accountingfor Stock-Based Compensation (“SFAS No. 123”), and Statement of FinancialAccounting Standard No. 148, Accounting for Stock-BasedCompensation - Transition and Disclosure – An Amendment of FASB Statement No.123 (“SFAS No. 148”), established accounting and disclosure requirementsusing a fair-value-based method of accounting for stock-based employeecompensation plans. As allowed by SFAS No. 123 and No. 148, the Company haselected to continue to apply the intrinsic-value-based method of accountingdescribed above, and has adopted only the disclosure requirements of SFAS No.123 and 148. The following table illustrates the effect on net loss if the fair-value-basedmethod had been applied to all outstanding and unvested awards in each period(in thousands, except per share data):

 

9

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| ** **                                                                                                                   | ** ** | **Three Months**   | ** ** | **Six Months**     | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                                                                                   | ** ** | **Ended June 30,** | ** ** | **Ended June 30,** | ** ** |
| ** **                                                                                                                   | ** ** | **2005**           | ** ** | **2004**           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss, as reported                                                                                                        |       | $                  | (1,260     | )                  | $          | (2,233 | ) | $ | (1,647 | ) | $ | (4,321 | ) |
| Deduct total stock-based  employee compensation expense determined under fair-value-based method for  all awards, net of tax |       | (625               | )          | (471               | )          | (1,110 | ) | (922 | ) |
| Pro forma net loss                                                                                                           |       | $                  | (1,885     | )                  | $          | (2,704 | ) | $ | (2,757 | ) | $ | (5,243 | ) |
|                                                                                                                         |       |               |       |               |       |   |   |   |   |
| Basic and diluted loss per  share                                                                                            |       |               |       |               |       |   |   |   |   |
| As reported                                                                                                                  |       | $                  | (0.04      | )                  | $          | (0.07 | ) | $ | (0.05 | ) | $ | (0.14 | ) |
| Pro forma                                                                                                                    |       | $                  | (0.06      | )                  | $          | (0.08 | ) | $ | (0.08 | ) | $ | (0.16 | ) |

 

The Company has adopted SFAS No. 123 and SFAS No. 148for disclosure purposes.  The weightedaverage fair value of options granted during the six months ended June 30, 2005and 2004, estimated on the date of grant using the Black-Scholes option pricingmodel was $2.78 and $1.13, respectively. The Black-Scholes option-pricing model was developed for use inestimating the fair value of traded options that have vesting restrictions andare fully transferable.  In addition,option-pricing models require the input of highly subjective assumptions,including a factor to represent expected stock price volatility.  Because the Company’s employee stock optionshave characteristics significantly different from those of traded options, andbecause changes in the subjective input assumptions can materially affect thefair value estimate, in management’s opinion, the existing models do notnecessarily provide a reliable single measure of the fair value of the Company’soptions.  The fair value of optionsgranted for the three and six months ended June 30, 2005 and 2004 is estimatedon the date of grant using the following assumptions:

 

**Employee Stock Option Plan**

** **
| ** **                      | ** ** | **Three and Six Months Ended  June 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
| Expected dividend               |       | 0                                             | %          | 0 | % |
| Average risk-free interest rate |       | 3.9                                           | %          | 3.5 | % |
| Expected volatility             |       | 224                                           | %          | 237 | % |
| Expected term (years)           |       | 4                                             |       | 4 |   |

 

**Employee Stock Purchase Plan**

 
| ** **                      | ** ** | **Three and Six Months Ended  June 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
| Expected dividend               |       | 0                                             | %          | 0 | % |
| Average risk-free interest rate |       | 3.0                                           | %          | 1.2 | % |
| Expected volatility             |       | 96                                            | %          | 479 | % |
| Expected term (months)          |       | 6                                             |       | 6 |   |

 

**RecentAccounting Pronouncements**

 

In December 2004, the FASB revised SFAS No. 123(revised 2004) (“SFAS 123(R)”), Share-Based Payment, which requires companiesto expense the estimated fair value of employee stock options and similarawards. The accounting provisions of SFAS 123(R) will be effective for theCompany beginning on January 1, 2006. The Company expects to adopt theprovisions of SFAS 123(R) using a modified prospective application. Under amodified prospective application, SFAS 123(R) will apply to new awards and toawards that are outstanding on the effective date and are subsequently modifiedor cancelled. Compensation expense for outstanding awards for which therequisite service had not been rendered as of the effective date will berecognized over the remaining service period using the compensation costcalculated for pro forma disclosure purposes under SFAS 123. The Company is inthe process of determining how the new method of valuing stock-basedcompensation as prescribed in SFAS 123(R) will be applied to valuingstock-based awards granted after the effective date and the impact therecognition of compensation expense related to such awards will have on itsfinancial statements.

 

In March 2005, the SEC staff issued guidance onSFAS 123(R). Staff Accounting Bulletin No. 107 (“SAB 107”) was issued toassist preparers by simplifying some of the implementation challenges of SFAS123(R) while enhancing the information that investors receive. SAB 107 createsa framework that is premised on two overarching themes: (a) considerablejudgment will be required by preparers to successfully implement SFAS 123(R),specifically when valuing employee stock options; and (b) reasonableindividuals, acting in good faith, may conclude differently on the fair valueof employee stock options. Key topics covered by SAB 107 include: (a) valuationmodels – SAB 107 reinforces the flexibility allowed by SFAS 123(R) to choose anoption-pricing model that meets the standard’s fair value measurementobjective; (b) expected volatility – SAB 107 provides guidance on when itwould be appropriate to rely exclusively on either historical or impliedvolatility in estimating expected volatility; and (c) expected term – thenew guidance includes examples and some simplified approaches to determiningthe expected term under certain circumstances. The Company expects to apply theprinciples of SAB 107 in conjunction with its adoption of SFAS 123(R).

 

In March 2005,the FASB issued FIN 47 as an interpretation of FASB Statement No. 143,Accounting for Asset Retirement Obligations (FASB No. 143). Thisinterpretation clarifies that the term conditional asset retirement obligationas used in FASB No. 143, refers to a legal obligation to perform an assetretirement activity in which the timing and/or method of settlement areconditional on a future event that may or may not be within the control of theentity. The obligation to perform the asset retirement activity isunconditional even though uncertainty exists about the timing and/or method ofsettlement. Accordingly, an entity is required to recognize a liability for thefair value of a conditional asset retirement obligation if the fair value ofthe liability can be reasonably estimated. This interpretation also clarifieswhen an entity would have sufficient information to reasonably estimate the fairvalue of an asset retirement obligation. FIN 47 is effective no later than theend of fiscal years ending after December 15, 2005. The Company iscurrently assessing the impact of the adoption of FIN 47.

 

In May 2005, the FASB issuedSFAS No. 154, *Accounting Changes andError Corrections* (“SFAS 154”) which replaces APB OpinionNo. 20 *Accounting Changes*and SFAS No. 3, *Reporting AccountingChanges in Interim Financial Statements—An Amendment of APB Opinion No. 28*. SFAS 154 requires retrospective application to prior periods’ financialstatements of a voluntary change in accounting principle unless it is notpracticable.  SFAS 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005 and is required to be adopted by us in the first quarter of fiscal 2006.Although the Company will continue to evaluate the application of SFAS 154,management does not currently believe adoption will have a material impact onour results of operations or financial position.

 

**3.  Line of Credit**

 

On February 27,2002, the Company entered into a Loan and Security Agreement with a financialinstitution to borrow up to $4.5 million under a revolving line of credit. On December 15,2002, the Company entered into an amendment to the Loan and Security Agreementto increase the maximum funds available under the line of credit to $6.0million and extend the term of the agreement. The amended Loan and Security Agreement, as further amended in March 2003,had an expiration date of February 27, 2004.  The agreement, as amended, included a firstpriority security interest in all the Company’s assets, excluding intellectualproperty.  Gerald Burnett, the Company’sChairman and Chief Executive Officer, had provided a collateralized guaranteeto the financial institution, assuring payment of the Company’s obligationsunder the agreement and as a consequence, a number of restrictive covenantsfrom the original Loan and Security Agreement had been deleted, except forquick ratio and loan to value covenants, allowing the Company greater access tothe full amount of the facility.  On February 27,2004, the Loan and Security Agreement was amended to change the maximumborrowings thereunder to $3.5 million, subject to certain quick ratio and loanto value covenants, and to extend the term of

 

10

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the Loanand Security Agreement to February 27, 2005.  In connection with this amendment, Dr.Burnett’s collateralized guarantee was amended to reduce the amount of suchguarantee to $3.5 million.  The Loan andSecurity Agreement expired by its terms on February 27, 2005 with nooutstanding borrowings thereunder.

 

**4. Related Party Transactions**

 

Robert P. Latta,a member of the law firm Wilson Sonsini Goodrich & Rosati, ProfessionalCorporation (WSGR), has served as a director of the Company since February 2001.  Mr. Latta and WSGR have represented theCompany and its predecessors as corporate counsel since 1997.  During the six months ended June 30, 2005and 2004, payments of approximately $65,000 and $51,000, respectively, weremade to WSGR for legal services provided to the Company.

 

**5.  Legal Proceedings**

 

On May 11, 2005, CPI, the Company’swholly-owned patent prosecution and licensing subsidiary, commenced a patentinfringement lawsuit against Tandberg ASA and Tandberg, Inc. alleging thatseveral Tandberg videoconferencing products infringe three patents held by CPI.The suit was filed in the United States District Court for the NorthernDistrict of California.  The threepatents involved are U.S. Patent Nos. 5,867,654; 5,896,500; and 6,212,547.  These patents cover technologies relating tovideo and data conferencing over unshielded twisted pair (UTP) networks,distributed call-state management and separate monitors for simultaneouscomputer-based data sharing and videoconferencing. These technologies are corecomponents of the AvistarVOS video operating system.  In this action, CPI has requested injunctiverelief, damages to compensate for past and present infringement, trebledamages, costs associated with the litigation and such further relief as theCourt deems just and proper. Both of the Tandberg entities answered theComplaint on July 15, 2005, at which time they asserted that they did not infringethe patents and that the patents were invalid and unenforceable.  Theprosecution of this lawsuit may require the Company and CPI to expendsignificant financial and managerial resources, and therefore may have amaterial negative impact on the Company and CPI.  The duration andultimate outcome of this litigation are uncertain.

 

**6.  Net Loss Per Share**

 

Basic anddiluted net loss per share of common stock is presented in conformity with SFASNo. 128 (“SFAS 128”), “Earnings Per Share,” for all periods presented.

 

In accordancewith SFAS 128, basic net loss per share has been computed using the weightedaverage number of shares of common stock outstanding during the period, lessshares subject to repurchase.  Dilutednet loss per share is computed on the basis of the weighted average number ofshares and potential common shares outstanding during the period. Potentialcommon shares result from the assumed exercise of outstanding stock optionsthat have a dilutive effect when applying the treasury stock method.  The Company has excluded all outstandingstock options and shares subject to repurchase from the calculation of dilutednet loss per share for the three and six months ended June 30, 2005 and 2004,because all such securities are antidilutive (owing to the fact that theCompany is in a loss position). Accordingly, diluted net loss per share is equal to basic net loss pershare for all periods presented.

 

The total number ofshares excluded from the calculations of diluted net loss per share were 5,272,936and 4,218,749 for the three months ended June 30, 2005 and 2004, respectively,and 4,417,208 and 3,760,880 for the six months ended June 30, 2005 and 2004,respectively.

 

The followingtable presents the calculation of basic and diluted net loss per share (inthousands, except per share data):

 
| ** **                                                                    | ** ** | **Three Months ended  June 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Net loss                                                                      |       | $                                     | (1,260     | ) | $ | (2,233 | ) |
| Weighted average shares of  common stock used in computing net loss per share |       | 33,547                                |       | 33,277 |   |
| Net loss per share basic and  diluted                                         |       | $                                     | (0.04      | ) | $ | (0.07 | ) |

 
| ** **                                                                    | ** ** | **Six Months ended June 30,** |       |
|-------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                      | ** ** | **2004** |   |
| Net loss                                                                      |       | $                             | (1,647     | ) | $ | (4,321 | ) |
| Weighted average shares of  common stock used in computing net loss per share |       | 33,486                        |       | 31,864 |   |
| Net loss per share basic and  diluted                                         |       | $                             | (0.05      | ) | $ | (0.14 | ) |

 

11

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**7. Segment Reporting**

 

Disclosure of segments is presented inaccordance with SFAS No. 131 (“SFAS 131”), “Disclosures About Segments of anEnterprise and Related Information.” SFAS 131 establishes standards for disclosures regarding operatingsegments, products and services, geographic areas and major customers. The Company is organized and operates as twooperating segments: (1) the design, development, manufacturing, sale andmarketing of networked video communications products (Avistar) and (2) theprosecution, maintenance, support and licensing of the intellectual propertyused in the Company’s products (CPI).  Service revenue relates mainly to themaintenance, support, training, software development and installation ofproducts and is included in Avistar for purposes of reporting anddecision-making.  Avistar alsoengages in the corporate functions and provides financing and services to itssubsidiaries. The Company’s chief operating decision maker, its Chief ExecutiveOfficer, monitors the Company’s operations based upon the information reflectedin the following table (in thousands):

 

| ** **                       | ** ** | **Avistar** | ** ** | **CPI** | ** ** | **Total** | ** ** |
|----------------------------------|------------|-------------|------------|---------|------------|-----------|------------|
|                             |       |        |       |    |       |      |       |
| Three Months Ended June 30, 2005 |       |        |       |    |       |      |       |
| Revenue                          |       | $           | 1,346      |    | $          | 1,057     |       | $ | 2,403 |   |
| Gross margin                     |       | 503         |       | 1,057   |       | 1,560     |       |
| Depreciation expense             |       | (52         | )          | —  |       | (52       | )          |
| Total operating expenses         |       | (2,486      | )          | (401    | )          | (2,887    | )          |
| Interest income                  |       | 73          |       | —  |       | 73        |       |
| Net loss                         |       | (1,915      | )          | 655     |       | (1,260    | )          |
| Total Assets                     |       | 20,245      |       | 62      |       | 20,307    |       |
|                             |       |        |       |    |       |      |       |
| Three Months Ended June 30, 2004 |       |        |       |    |       |      |       |
| Revenue                          |       | $           | 1,676      |    | $          | —    |       | $ | 1,676 |   |
| Gross margin                     |       | 851         |       | —  |       | 851       |       |
| Depreciation expense             |       | (73         | )          | —  |       | (73       | )          |
| Total operating expenses         |       | (2,128      | )          | (967    | )          | (3,095    | )          |
| Interest income                  |       | 16          |       | —  |       | 16        |       |
| Net loss                         |       | (1,266      | )          | (967    | )          | (2,233    | )          |
| Total Assets                     |       | 8,344       |       | 9       |       | 8,353     |       |
|                             |       |        |       |    |       |      |       |
| Six Months Ended June 30, 2005   |       |        |       |    |       |      |       |
| Revenue                          |       | $           | 3,268      |    | $          | 2,114     |       | $ | 5,382 |   |
| Gross margin                     |       | 1,528       |       | 2,114   |       | 3,642     |       |
| Depreciation expense             |       | (88         | )          | —  |       | (88       | )          |
| Total operating expenses         |       | (4,600      | )          | (899    | )          | (5,499    | )          |
| Interest income                  |       | 221         |       | —  |       | 221       |       |
| Net loss                         |       | (2,861      | )          | 1,214   |       | (1,647    | )          |
|                             |       |        |       |    |       |      |       |
| Six Months Ended June 30, 2004   |       |        |       |    |       |      |       |
| Revenue                          |       | $           | 3,080      |    | $          | —    |       | $ | 3,080 |   |
| Gross margin                     |       | 1,481       |       | —  |       | 1,481     |       |
| Depreciation expense             |       | (141        | )          | —  |       | (141      | )          |
| Total operating expenses         |       | (4,120      | )          | (1,712  | )          | (5,832    | )          |
| Interest income                  |       | 29          |       | —  |       | 29        |       |
| Net loss                         |       | (2,609      | )          | (1,712  | )          | (4,321    | )          |

 

International revenue, which consists ofsales to customers with operations principally in Western Europe and Asia,comprised 59% and 52% of total product and services revenue for the threemonths ended June 30, 2005 and 2004, respectively.  International revenue comprised 58% and 53%of total product and services revenue for the six months ended June 30, 2005and 2004, respectively. For the three months ended June 30, 2005 and 2004,international revenues from customers in the United Kingdom accounted for 35%and 28%, respectively, of total product and services revenue.  For the six months ended June 30, 2005 and2004, international revenues from customers in the United Kingdom accounted for30% and 34%, respectively, of total product and services revenue. The Companyhad no significant long-lived assets in any country other than in the UnitedStates for any period presented.

 

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**Item 2. *Management’s Discussion and Analysis of FinancialCondition and Results of Operations***

 

The following discussion should be read inconjunction with the Unaudited Condensed Consolidated Financial Statements andthe Notes thereto included elsewhere herein, and the Audited ConsolidatedFinancial Statements contained in our Annual Report on Form 10-K for the yearended December 31, 2004, as filed with the Securities and ExchangeCommission on March 28, 2005.

 

Certainstatements in this “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” are forward looking statements. These statementsrelate to future events or our future financial performance and involve knownand unknown risks, uncertainties and other factors that may cause our or ourindustry’s actual results, levels of activity, performance or achievements tobe materially different from any future results, levels of activity,performance or achievements expressed or implied by the forward lookingstatements. These risks and other factors include those listed under “FactorsAffecting Future Operating Results” elsewhere in this Quarterly Report on Form10-Q. In some cases, you can identify forward looking statements by terminologysuch as “may”, “will”, “should”, “expects”, “intends”, “plans”, “anticipates”, “believes”,“estimates”, “predicts”, “potential”, “continue” or the negative of theseterms, or other comparable terminology. These statements are only predictions.Actual events or results may differ materially. In evaluating these statements,you should specifically consider various factors, including the risks outlinedunder “Factors Affecting Future Operating Results.”  These factors may cause our actual results todiffer materially from any forward looking statement.

 

Although we believe that the expectationsreflected in the forward looking statements are reasonable, we cannot guaranteefuture results, levels of activity, performance or achievements.  We are under no duty to update any of theforward-looking statements after the date of this report on Form 10-Q in orderto conform our prior statements to actual results.

 

**Overview**

 

We develop, market and support an integratedsuite of vBusiness – video-enabled eBusiness – applications, all powered by theAvistarVOSTM software. From the desktop, we deliver TV-quality interactive videocalling, content creation and publishing, broadcast origination anddistribution, video-on-demand, and integrated data sharing. The Avistar videoand data collaboration applications are all managed by the AvistarVOS videooperating system. By integrating video tightly into the way they work, ourcustomers can use our system to help reduce costs and improve productivity andcommunications within the enterprise and between enterprises, to enhancerelationships with customers, suppliers and partners.  Using AvistarVOS software and leveraging video,telephony and Internet networking standards, Avistar applications are designedto be scalable, reliable, cost effective, easy to use, and capable of evolvingwith communications networks as bandwidthincreases and as new standards and protocols emerge.  We currently sell our system directly toenterprises in selected strategic vertical markets, and have focused initiallyon the financial services industry. Our objective is to establish ourtechnology as the standard for networked video through direct sales, indirectchannel sales/partnerships and the licensing of our technology to others.

 

We operate on a 52-week fiscalyear ending December 31. We operate in two segments: AvistarCommunications Corporation engages in the design, development, manufacture,sale and marketing of networked video communications products and associatedsupport services. Collaboration Properties, Inc., or CPI, our wholly ownedsubsidiary, engages in the prosecution, maintenance, support and licensing ofthe intellectual property that we have developed, some of which is used in ourproducts.

 

Since inception, we have recognized the innovativevalue of our research and development efforts, and have invested in securingprotection for these innovations through domestic and foreign patentapplications and issuance. As of June 30, 2005, we hold 68 U.S. andforeign patents, which we look to license to others in the collaborationtechnology marketplace.

 

**CriticalAccounting Policies**

 

The preparation of our Condensed ConsolidatedFinancial Statements in accordance with accounting principles generallyaccepted in the United States requires us to make estimates and judgments thataffect the reported amounts of assets, liabilities, revenues and expenses, andrelated disclosure of contingent assets and liabilities. We base our estimateson historical experience and assumptions that we believe to be reasonable underthe circumstances, the results of which form the basis for making judgmentsabout the carrying values of assets and liabilities that are not readilyapparent from other sources. Actual results may differ from these estimates.

 

We believe the following critical accountingpolicies, among others, affect our more significant judgments and estimatesused in the preparation of our Condensed Consolidated Financial Statements:

 

13

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•                  Revenuerecognition;

•                  Valuationof accounts receivable; and

•                  Valuationof inventories.

 

Revenue Recognition

 

We derive product revenue principally fromthe sale and licensing of our video-enabled networked communications system,consisting of a suite of Avistar-designed software and hardware products,including third party components.  Wealso derive revenue from fees for installation, maintenance, support, trainingservices and software development. In addition, we derive revenue from thelicensing of our intellectual property portfolio.

 

We recognize revenue in accordance withStatement of Position (SOP) 97-2, Software Revenue Recognition (SOP 97-2), asamended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition,With Respect to Certain Transactions (SOP 98-9). In connection with eachtransaction involving our products, we must evaluate whether: (i) persuasiveevidence of an arrangement exists, (ii) delivery has occurred, (iii) our fee isfixed or determinable, and (iv) collectibility is probable. We apply thesecriteria as discussed below:

 

•                  *Persuasive evidence of an arrangement exists*. We require a written contract, signed by boththe customer and us, or a purchase order from those customers that havepreviously negotiated a standard end-user license arrangement or volumepurchase agreement with us prior to recognizing revenue on an arrangement.

 

•                  *Delivery has occurred*. We deliver software and hardware to our customers physically. Ourstandard delivery terms are FOB shipping point.

 

•                  *The fee is fixed or determinable*. Our determination that an arrangement fee isfixed or determinable depends principally on the arrangement’s payment terms. Ourstandard payment terms generally require the arrangement fee to be paid withina negotiated, but standard, period of time – frequently 30 days from the dateof invoice.  Where these terms apply, weregard the fee as fixed or determinable, and we recognize revenue upon delivery(assuming other revenue recognition criteria are met). If the payment terms donot meet this standard, which we refer to as “extended payment terms,” we maynot consider the fee to be fixed or determinable and would then recognizerevenue when customer installments are due and payable.

 

•                  *Collectibility is probable*. To recognize revenue, we must judgecollectibility of the arrangement fees, which we do on a customer-by-customerbasis pursuant to our credit review policy. We typically sell to customers withwhom we have a history of successful collection. For new customers, we evaluatethe customer’s financial position and ability to pay. If we determine thatcollectibility is not probable based upon our credit review process or thecustomer’s payment history, we recognize revenue when cash is collected.

 

When we provideinstallation services, the product and installation revenue is recognized uponcompletion of installation and receipt of customer confirmation, subject to thesatisfaction of the revenue recognition criteria described above.  When the customer or a third party providesinstallation services, the product revenue is recognized upon shipment, subjectto satisfaction of the revenue recognition criteria described above.  Payment for product is due upon shipment,subject to specific payment terms. Payment for installation and professional services are due uponproviding the services, subject to specific payment terms.  If payments for systems are made in advanceof the completion of installation, such amounts are deferred and recorded asdeferred services revenue and customer deposits in the accompanying balancesheets until installation has occurred and the customer has providedconfirmation.  Reimbursementsreceived for out-of-pocket expensesincurred during installation and support services, which have not beensignificant to date, are recognized as revenue in accordance with EmergingIssues Task Force (EITF) Issue No. 01-14 (EITF 01-14), “Income StatementCharacterization of Reimbursements Received for “Out of Pocket” ExpensesIncurred.”

 

The pricecharged for maintenance and/or support is defined in the product contract, andis based on a fixed price for both hardware and software components asstipulated in the customer agreement.  Customers have the option to renew the maintenance and/or supportservices in subsequent periods at the same rate as paid in the initial year.Revenue from maintenance and support is recognized pro-rata over themaintenance and/or support term, which is typically one year in length.  Training services are offered together withand independently of the purchase of product. The value of training services is determined based on the price chargedwhen such services are sold separately. Training revenue is recognized uponperformance of the service. We recognize service revenue from softwaredevelopment contracts using the percentage of completion method in accordancewith SOP 81-1, when all of

 

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the following conditions are met: a contractexists with the customer at a fixed price, we have fulfilled all of ourmaterial contractual obligations to the customer for a deliverable of thecontract, verification of completion of the deliverable has been received, andcollection of the receivable is probable. Reimbursements received for out-of-pocket expenses incurred during installation and supportservices have not been significant to date. These reimbursements are recognizedas revenue in accordance with Emerging Issues Task Force Issue No. 01-14 (EITF01-14), “Income Statement Characterization of Reimbursements Received for “Outof Pocket” Expenses Incurred.”

 

We recognizerevenue from the licensing of our intellectual property portfolio based on theterms of the royalty, partnership and cross-licensing agreements involved.  Revenue from licensing of our intellectualproperty, to date, has consisted entirely of payment from Polycom, Inc.pursuant to a settlement agreement and a cross-license agreement dated November 12,2004, and has been recognized as revenue in accordance with Section 48 and49 of SOP 97-2, which discusses multiple-element arrangements and the futuredelivery of unspecified additional software products. As part of the settlementand cross-license agreements with Polycom, Inc., we granted to Polycom anon-exclusive, fully paid-up, license to our entire patent portfolio. Thecross-license agreement includes a five year capture period from the date ofthe settlement, adding all our new patents with a priority date extending up tofive years from the date of execution of the cross-license agreement. Sections48 and 49 of SOP 97-2 provide that a vendor may agree to deliver softwarecurrently and to deliver unspecified additional software products in thefuture. The software elements of the kinds of arrangements discussed inparagraph 48 should be accounted for as subscriptions. No allocation of revenueshould be made among any of the software products, and all softwareproduct-related revenue from the arrangement should be recognized ratably overthe term of the arrangement beginning with delivery of the first product.Accordingly, the net $21.1 million license fee paid to us by Polycom, Inc. hasbeen deferred and is being recognized as licensing revenue ratably over thefive year period beginning November 12, 2004.

 

To date, a significant portion of our revenuehas resulted from sales to a limited number of customers, particularly DeutscheBank AG and UBS Warburg LLC and their affiliates. In addition, since November 12,2004, a significant portion of our revenue has come from our recognition oflicensing revenue associated with the licensing of our intellectual propertyportfolio to Polycom, Inc.  For the threemonths ended June 30, 2005, we recorded revenue of approximately $2.2 million,or 90% of total revenue, from Polycom, Inc., Deutsche Bank AG and UBS WarburgLLC and their affiliates, each of whom accounted for greater than 10% of ourtotal revenue for the three months ended June 30, 2005.  For the three months ended June 30, 2004, werecorded revenue of approximately $1.0 million, or 62% of total revenue, fromDeutsche Bank AG and UBS Warburg LLC and their affiliates, each of whomaccounted for greater than 10% of our total revenue for the three months ended June30, 2004.  For the six months ended June30, 2005, we recorded revenue of approximately $4.7 million, or 87% of totalrevenue, from Polycom, Inc., Deutsche Bank AG and UBS Warburg LLC and theiraffiliates, each of whom accounted for greater than 10% of our total revenuefor the six months ended June 30, 2005. For the six months ended June 30, 2004, we recorded revenue ofapproximately $2.1 million, or 68% of total revenue, from Deutsche Bank AG andUBS Warburg LLC and their affiliates, each of whom accounted for greater than10% of our total revenue for the six months ended June 30, 2004. We did notreceive licensing revenue from Polycom during the three or six months ended June30, 2004. We anticipate that our revenue, and therefore, our operating resultsfor any given period, will continue to depend to a significant extent on alimited number of customers.  As a result,the loss of or a reduction in sales to any one of these customers would have asignificant adverse impact on our operations and financial performance.

 

International revenue, which consists ofsales to customers with operations principally in Western Europe and Asia,comprised 59% and 52% of total product and services revenue for the threemonths ended June 30, 2005 and 2004, respectively.  International revenue comprised 58% and 53%of total product and services revenue for the six months ended June 30, 2005and 2004, respectively.

 

Valuation of Accounts Receivable

 

Estimates are used in determining ourallowance for doubtful accounts and are based on our historical collectionexperience, historical write-offs, current trends and the credit quality of ourcustomer base and the characteristics of our accounts receivable by agingcategory.  If the allowance for doubtfulaccounts was understated, our operating income could be significantly reduced.The impact of any such change or deviation may be increased by our reliance ona relatively small number of customers for a large portion of our totalrevenue. As of June 30, 2005, approximately 93% of our accounts receivablebalance was concentrated with three customers. As of December 31, 2004, approximately 81% of our accountsreceivable were concentrated with one customer.

 

Valuation of Inventories

 

We record a provision for obsolete or excessinventory for systems and components that are no longer manufactured or are atrisk of being replaced with new versions of our product. In determining theallowance for obsolete or excess inventory, we look at our forecasted demandversus quantities on hand and commitments. Any significant unanticipated changes in demand or technologicaldevelopments could have a significant impact on the value of our inventory andcommitments and our reported results.  Ifactual market conditions are less favorable than those projected, additionalinventory write-downs, provision for purchase commitments and charges againstearnings may be required, which would negatively affect our operating resultsfor such period.

 

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**Results of Operations**

 

The followingtable sets forth data expressed as a percentage of total revenue for theperiods indicated.

 
| ** **                         | ** ** | **PERCENTAGE OF TOTAL REVENUE**    | ** ** |
|------------------------------------|------------|------------------------------------|------------|
| ** **                         | ** ** | **THREE MONTHS ENDED****JUNE 30,** | ** ** | **SIX MONTHS ENDED****JUNE 30,** | ** ** |
| ** **                         | ** ** | **2005**                           | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                           |       |                               |       |   |   |   |   |   |   |
| Product                            |       | 22                                 | %          | 55 | % | 31 | % | 48 | % |
| Licensing                          |       | 44                                 |       | — |   | 39 |   | — |   |
| Services, maintenance and  support |       | 34                                 |       | 45 |   | 30 |   | 52 |   |
| Total revenue                      |       | 100                                |       | 100 |   | 100 |   | 100 |   |
| Cost of revenue:                   |       |                               |       |   |   |   |   |   |   |
| Product                            |       | 13                                 |       | 22 |   | 14 |   | 21 |   |
| Services, maintenance and  support |       | 22                                 |       | 28 |   | 18 |   | 31 |   |
| Total cost of revenue              |       | 35                                 |       | 49 |   | 32 |   | 52 |   |
| Gross margin                       |       | 65                                 |       | 51 |   | 68 |   | 48 |   |
| Operating expenses:                |       |                               |       |   |   |   |   |   |   |
| Research and development           |       | 29                                 |       | 38 |   | 25 |   | 41 |   |
| Sales and marketing                |       | 34                                 |       | 40 |   | 28 |   | 41 |   |
| General and administrative         |       | 57                                 |       | 107 |   | 49 |   | 107 |   |
| Total operating expenses           |       | 120                                |       | 185 |   | 102 |   | 189 |   |
| Loss from operations               |       | (55                                | )          | (134 | ) | (34 | ) | (141 | ) |
| Other income (expense):            |       |                               |       |   |   |   |   |   |   |
| Interest income                    |       | 3                                  |       | 1 |   | 4 |   | 1 |   |
| Other income (expense), net        |       | —                             |       | — |   | — |   | — |   |
| Total other income                 |       | 3                                  |       | 1 |   | 4 |   | 1 |   |
| Net loss                           |       | (52                                | )%         | (133 | )% | (30 | )% | (140 | )% |

 

**COMPARISON OF THE THREE AND SIX MONTHS ENDED JUNE 30,2005 AND 2004**

 

## ***Revenue***

 

Total revenue increased by 43% to $2.4 million for thethree months ended June 30, 2005 from $1.7 million for the three months ended June30, 2004 and increased by 75% to $5.4 million for the six months ended June 30,2005 from $3.1 million for the six months ended June 30, 2004. The increase inthe three-month period ended June 30, 2005 was due primarily to the recognitionof $1.1 million of revenue related to the licensing of our intellectualproperty portfolio to Polycom, Inc., offset by decreased demand for Avistarequipment from new customers versus the three months ended June 30, 2004. Theincrease in the six-month period ended June 30, 2005 was due primarily to therecognition of $2.1 million of revenue related to the licensing of ourintellectual property portfolio to Polycom, Inc. and to a lesser degree,increased demand for Avistar equipment from existing customers in the firstquarter of 2005.  No licensing revenuewas recognized in periods prior to November 2004.

 

For the threemonths ended June 30, 2005, revenue from three customers accounted for 90% oftotal revenue, each of whom accounted for greater than 10% of total revenue.For the three months ended June 30, 2004, revenue from two customers accountedfor 62% of total revenue, each of whom accounted for greater than 10% of totalrevenue. For the six months ended June 30, 2005, revenue from three customersaccounted for 87% of total revenue, each of whom accounted for greater than 10%of total revenue. For the three months ended June 30, 2004, revenue from twocustomers accounted for 68% of total revenue, each of whom accounted forgreater than 10% of total revenue. The level of sales to any customer may varyfrom quarter to quarter.  We expect thatthere will be significant customer concentration in future quarters.  The loss of any one of those customers wouldhave a material adverse impact on our financial condition and operatingresults.

 

## ***Cost of Revenue***

 

The total cost of revenue remained level at $0.8million for the three months ended June 30, 2005 compared to the three monthsended June 30, 2004. The total cost of revenue increased by 9% to $1.7 millionfor the six months ended June 30, 2005 from $1.6 million for the six monthsended June 30, 2004. Cost of product revenue decreased by 13% to $0.3 millionfor the three months ended June 30, 2005 from $0.4 million for the three monthsended June 30, 2004.  This decrease incost of product revenue for the three month period ended June 30, 2005 wasprimarily due to the decrease in direct product costs related to the decreasein product sales compared to the three months ended June 30, 2004. Cost ofproduct revenue increased by 17% to $0.8 million for the six months ended June30, 2005 from $0.7 million for the six months ended June 30, 2004.  This increase in cost of product revenue forthe six month period ended June 30, 2005 was primarily due to the increase indirect product costs related to the increase in product sales compared to the sixmonths ended June 30, 2004. Cost of services revenue increased by 14% to approximately$525,000 for the three

 

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months ended June 30, 2005 fromapproximately $460,000 for the three months ended June 30, 2004. This increasein cost of service revenue for the three month period ended June 30, 2005 wasprimarily due to the increase in installation and professional servicesactivities. Cost of services revenue increased by 3% to approximately $1.0million for the six months ended June 30, 2005 from approximately $0.9 millionfor the six months ended June 30, 2004. This increase in cost of servicerevenue for the six month period ended June 30, 2005 was primarily due to theincrease in installation and professional services activities and offset by thereduction in software development costs associated with decreased softwaredevelopment contracts.

 

## ***Gross Margin***

 

Gross margin as a percentage of revenue increased to 65%for the three months ended June 30, 2005 from 51% for the three months ended June30, 2004. Gross margin as a percentage of revenue increased to 68% for the sixmonths ended June 30, 2005 from 48% for the six months ended June 30, 2004. Theincrease in gross margin as a percentage of revenue in the three and six month periodsended June 30, 2005 was due in large part to the revenue associated with thelicensing of our intellectual property portfolio, which began in the fourthquarter of 2004. Revenue generated from the licensing of our intellectualproperty portfolio does not have any associated cost of sales. Product grossmargin as a percentage of total product revenue decreased to 41% for the threemonths ended June 30, 2005 from 60% for the three months ended June 30, 2004.The decrease in product gross margin during the three months ended June 30,2005 was due to the decrease in product sales, resulting in reduced coverage ofthe fixed component of the cost of product revenue. Product gross margin as apercentage of total product revenue decreased slightly to 54% for the sixmonths ended June 30, 2005 from 56% for the six months ended June 30, 2004. Servicesgross margin as a percentage of total services revenue decreased to 35% for thethree month period ended June 30, 2005 compared to 40% for the three monthperiod ended June 30, 2004. The decrease in services gross margin during thethree months ended June 30, 2005 was due to the increased installation andprofessional services activities. Services gross margin as a percentage oftotal services revenue decreased slightly to 39% for the six month period endedJune 30, 2005 from 41% for the six month period ended June 30, 2004.

 

## ***Operating expenses***

 

*Researchand development.*****Research anddevelopment expenses increased by 12% to $0.7 million for the three monthsended June 30, 2005 from $0.6 million for the three months ended June 30, 2004.Research and development expenses increased by 7% to $1.35 million for the sixmonths ended June 30, 2005 from $1.26 million for the six months ended June 30,2004. The increase in the three and six month periods ended June 30, 2005 wasdue primarily to an increase in personnel and personnel related expenses.

 

*Salesand marketing.*Sales and marketing expenses increased by 22% to $0.8 million for the threemonths ended June 30, 2005 from $0.7 million for the three months ended June 30,2004. Sales and marketing expenses increased by 19% to $1.5 million for the sixmonths ended June 30, 2005 from $1.3 million for the six months ended June 30,2004. The increase in the three and six month periods ended June 30, 2005 wasdue primarily to an increase in personnel and personnel related expenses.

 

*Generaland administrative.*General and administrative expenses decreased by 24% to $1.4 million for thethree months ended June 30, 2005 from $1.8 million for the three months ended June30, 2004. General and administrative expenses decreased by 20% to $2.6 millionfor the six months ended June 30, 2005 from $3.3 million for the six monthsended June 30, 2004. The decrease in the three and six month periods ended June30, 2005 was due primarily to the cessation of legal fees associated with thesettlement of our litigation with Polycom, Inc. in November 2004, whichresulted in substantial reduction in our quarterly legal expenses.

 

## ***Other Income***

 

Other income, net increased by 509% to $67,000 for thethree months ended June 30, 2005 from $11,000 for the three months ended June30, 2004 and increased by 600% to $210,000 for the six months ended June 30,2005 from $30,000 for the six months ended June 30, 2004. The increase in thethree and six month periods ended June 30, 2005 was due to increased interestincome associated with our increased balances of cash, cash equivalents andshort-term investments.

 

**Liquidity and Capital Resources**

 

We have funded our operations since inceptionprimarily from product and services revenue, the net proceeds of $31.3 millionfrom our August 2000 initial public offering of common stock, lines ofcredit with related parties and financial institutions, the proceeds ofapproximately $6.4 million from the sale of Series B preferred stock in December 1999,the proceeds of approximately $5.7 million and $3.6 million from the privatesale of our common stock in October 2003 and March 2004,respectively, and the net proceeds of approximately $21.1 million from thesettlement and cross-license agreements signed with Polycom, Inc. on November 12,2004.

 

We had cash and cash equivalents of $17.6 million asof June 30, 2005 compared to cash and cash equivalents of $21.7 million as of December 31,2004.  For the six months ended June 30,2005 we had an overall net cash outflow of $4.0 million, resulting primarilyfrom net cash used in operations of $4.1 million. The net cash used inoperating activities of $4.1 million resulted from a net

 

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loss of $1.6 million, adecrease in deferred licensing revenue of $2.1 million, a decrease in accountspayable and accrued liabilities and other of $0.8 million, offset by anincrease in deferred services revenue and customer deposits of $0.3 million.

 

At June 30, 2005, we had open purchase orders andother contractual obligations of approximately $0.6 million, primarily relatedto inventory purchases. We also have commitments that consist of obligationsunder our operating leases. These purchase order commitments and contractualobligations are reflected in our financial statements once goods or serviceshave been received or payments related to the obligations become due.

 

The following table represents our futurecommitments under minimum annual operating lease payments as of June 30, 2005 (in thousands):

 

| **Year Ending December 31,** | ** ** | **Amount** | ** ** |
|-----------------------------------|------------|------------|------------|
| Third and fourth quarter of  2005 |       | $          | 412        |   |
| 2006                              |       | 546        |       |
| 2007                              |       | 88         |       |
| 2008                              |       | —     |       |
| 2009                              |       | —     |       |
| Thereafter                        |       | —     |       |
| Total minimum lease payments      |       | $          | 1,046      |   |

 

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In July 2003, we entered into a non-cancelableoperating lease to remain at our current office facility in Redwood Shores,California. The new operating lease commenced on October 1, 2003 andexpires on September 30, 2007. The commitments for this lease arereflected in the table above.

 

On February 27, 2002, we entered into aLoan and Security Agreement with a financial institution to borrow up to $4.5million under a revolving line of credit. The agreement, as amended, included afirst priority security interest in all our assets, excluding intellectualproperty.  On February 27, 2004, theLoan and Security Agreement was amended to change the maximum borrowingsthereunder to $3.5 million, subject to certain quick ratio and loan to valuecovenants, and to extend the term of the Loan and Security Agreement to February 27,2005.  The Loan and Security Agreementexpired by its terms on February 27, 2005 with no outstanding borrowings thereunder.

 

On March 26, 2004, we completed theprivate sale of a total of 3,000,000 shares of our common stock to Fuller &Thaler Avalanche Fund, L.P. and Fuller & Thaler Behavioral Finance Fund,Ltd. at a price per share of $1.20.  Thenet proceeds of this private financing after deducting expenses of thefinancing were approximately $3.6 million.

 

On November 12, 2004, we entered intoSettlement and Cross-License agreements with Polycom, Inc. Under theseagreements, CPI agreed to dismiss, with prejudice, its infringement suitagainst Polycom and both companies agreed to cross-license each other’s patentportfolios. The original litigation was initiated in September 2002, inthe Federal District Court for the Northern District of California and involvedthe following CPI patents: U.S. Patent Nos. 5,867,654; 5,896,500; 6,212,547;and 6,343,314. The agreements resulted in a payment, net of legal fees, to usfrom Polycom, Inc. in the amount of $21.1 million.

 

On May 11, 2005, CPI, our wholly-owned patentprosecution and licensing subsidiary, commenced a patent infringement lawsuitagainst Tandberg ASA and Tandberg, Inc. alleging that several Tandbergvideoconferencing products infringe three patents held by CPI. The suit wasfiled in the United States District Court for the Northern District ofCalifornia.  The three patents involvedare U.S. Patent Nos. 5,867,654; 5,896,500; and 6,212,547.  These patents cover technologies relating tovideo and data conferencing over unshielded twisted pair (UTP) networks, distributedcall-state management and separate monitors for simultaneous computer-baseddata sharing and videoconferencing. These technologies are core components ofthe AvistarVOS video operating system. In this action, CPI has requested injunctive relief, damages tocompensate for past and present infringement, treble damages, costs associatedwith the litigation and such further relief as the Court deems just and proper.Both of the Tandberg entities answered the Complaint on July 15, 2005, at whichtime they asserted that they did not infringe the patents and that the patentswere  invalid and unenforceable.  The prosecution of this lawsuit may requireus and CPI to expend significant financial and managerial resources, andtherefore may have a material negative impact.  The duration and ultimateoutcome of this litigation are uncertain.

 

We currently believe that existing cash andcash equivalents balances will provide us with sufficient funds to finance ouroperations for the next 12 months. We intend to continue to invest in thedevelopment of new products and enhancements to our existing products.  Our future liquidity and capital requirementswill depend upon numerous factors, including without limitation, generaleconomic conditions and conditions in the financial services industry inparticular, the level and timing of revenue, the costs and timing of ourproduct development efforts and the success of these development efforts, thecosts and timing of our sales and marketing activities, the extent to which ourexisting and new products gain market acceptance, competing technological andmarket developments, the costs involved in maintaining and enforcing patentclaims and other intellectual property rights, all of which may impact ourability to achieve and maintain profitability.

 

**Off-Balance Sheet Arrangements**

 

We have not entered into any transactionswith unconsolidated entities whereby we have financial guarantees, subordinatedretained interests, derivative instruments or other contingent arrangementsthat expose us to material continuing risks, contingent liabilities or anyother obligation under a variable interest in an unconsolidated entity thatprovides financing, liquidity, market risk or credit risk support to us.

 

**Recent Accounting Pronouncements**

 

In December 2004, the FASB revised SFAS No. 123(revised 2004) (“SFAS 123(R)”), Share-Based Payment, which requires companiesto expense the estimated fair value of employee stock options and similarawards. The accounting provisions of SFAS 123(R) will be effective for theCompany beginning on January 1, 2006. We expect to adopt the provisions ofSFAS 123(R) using a modified prospective application. Under a modifiedprospective application, SFAS 123(R) will apply to new awards and to awardsthat are outstanding on the effective date and are subsequently modified orcancelled. Compensation expense for outstanding awards for which the requisiteservice had not been rendered as of the effective date will be recognized overthe remaining service period using the compensation cost calculated for proforma disclosure purposes under SFAS 123. We are in the process of determininghow the new method of valuing stock-based compensation as prescribed in SFAS123(R) will be applied to valuing stock-based awards granted after theeffective date and the impact the recognition of compensation expense relatedto such awards will have on our financial statements.

 

In March 2005, the SEC staff issued guidance onSFAS 123(R). Staff Accounting Bulletin No. 107 (“SAB 107”) was issued toassist preparers by simplifying some of the implementation challenges of SFAS123(R) while enhancing the information that investors receive. SAB 107 createsa framework that is premised on two overarching themes: (a) considerablejudgment will be required by preparers to successfully implement SFAS 123(R),specifically when valuing employee stock options; and (b) reasonableindividuals, acting in good faith, may conclude differently on the fair valueof employee stock options. Key topics covered by SAB 107 include: (a) valuationmodels – SAB 107 reinforces the flexibility allowed by SFAS 123(R) to choose anoption-pricing model that meets the standard’s fair value measurementobjective; (b) expected volatility – SAB 107 provides guidance on when itwould be appropriate to rely exclusively on either historical or impliedvolatility in estimating expected volatility; and (c) expected term – thenew guidance includes examples and some simplified approaches to determiningthe expected term under certain circumstances. We expect to apply theprinciples of SAB 107 in conjunction with its adoption of SFAS 123(R).

 

In March 2005,the FASB issued FIN 47 as an interpretation of FASB Statement No. 143,Accounting for Asset Retirement Obligations (FASB No. 143). Thisinterpretation clarifies that the term conditional asset retirement obligationas used in FASB No. 143, refers to a legal obligation to perform an assetretirement activity in which the timing and/or method of settlement areconditional on a future event that may or may not be within the control of theentity. The obligation to perform the asset retirement activity isunconditional even though uncertainty exists about the timing and/or method ofsettlement. Accordingly, an entity is required to recognize a liability for thefair value of a conditional asset retirement obligation if the fair value ofthe liability can be reasonably estimated. This interpretation also clarifieswhen an entity would have sufficient information to reasonably estimate thefair value of an asset retirement obligation. FIN 47 is effective no later thanthe end of fiscal years ending after December 15, 2005. We are currentlyassessing the impact of the adoption of FIN 47.

 

In May 2005, the FASB issuedSFAS No. 154, *Accounting Changes andError Corrections* (“SFAS 154”) which replaces APB OpinionNo. 20 *Accounting Changes*and SFAS No. 3, *Reporting AccountingChanges in Interim Financial Statements—An Amendment of APB Opinion No. 28*. SFAS 154 requires retrospective application to prior periods’ financialstatements of a voluntary change in accounting principle unless it is notpracticable.  SFAS 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005 and is required to be adopted by us in the first quarter of fiscal 2006.Although we will continue to evaluate the application of SFAS 154, managementdoes not currently believe adoption will have a material impact on our resultsof operations or financial position.

 

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**Factors Affecting FutureOperating Results**

 

**Our market is in the earlystages of development, and our system may not be widely accepted.**

 

Our ability toachieve profitability depends in part on the widespread adoption of networkedvideo communications systems and the adoption of our video operating system inparticular.  If the market for our systemfails to grow or grows more slowly than we anticipate, we may not be able toincrease revenue or achieve profitability. The market for our system isrelatively dynamic.  We have to devotesubstantial resources to educating prospective customers about the uses andbenefits of our system.  Our efforts toeducate potential customers may not result in our system achieving broad marketacceptance.  In addition, businesses thathave invested or may invest substantial resources in other video products maybe reluctant or slow to adopt our system. Similarly, customers using existing information systems in which theyhave made significant investments may refuse to adopt our system if theyperceive that our offerings will not complement their existing systems.  Consequently, the conversion from traditionalmethods of communication to the extensive use of networked video may not occuras rapidly as we wish.

 

**We have incurred substantiallosses in the past and may not be profitable in the future.**

 

We incurred netlosses of $1.6 million for the six months ended June 30, 2005, $8.7 million forfiscal year 2004 and $8.6 million for fiscal year 2003.  As of June 30, 2005, our accumulated deficit was $91.1million.  Our revenue may not increase,or even remain at its current level.  Inaddition, our operating expenses may increase as we continue to develop ourbusiness in the future.  As a result, tobecome profitable, we will need to increase our revenue by increasing sales toexisting customers and by attracting additional customers.  If our expenses increase more rapidly thanour revenue, or if revenue and expense levels remain the same, we may neverbecome profitable.  If we do becomeprofitable, we may not be able to sustain or increase profitability on aquarterly or annual basis.  In addition,if we fail to reach profitability or to sustain or grow our profits within thetime frame expected by investors, the market price of our common stock may beadversely impacted.

 

**General economic conditions have and may continueto impact our revenues and harm our business.**

 

Theinternational economic slowdown and the downturn in the investment bankingindustry that began in the year 2000 negatively affected our business, and areoccurrence of a difficult economic environment may do so in the future.  During this most recent economic downturn,the investment banking industry suffered a sharp decline, which caused many ofour existing and potential customers to cancel or delay orders for ourproducts.  Although the U.S. economy hasimproved, our customers and potential customers may continue to delay orderingour products, and we could fall short of our revenue expectations for 2005 andbeyond. Slower growth among our customers, tightening of customers’ operatingbudgets, retrenchment in the capital markets and other general economic factorsall have had and could in the future have a materially adverse effect on ourrevenue, capital resources, financial condition and results of operations.

 

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**Our lengthy sales cycle toacquire new customers or large follow-on orders may cause our operating resultsto vary significantly and make it more difficult to forecast our revenue.**

 

We have generally experienced a product sales cycle offour to nine months for new customers or large follow-on orders from existingcustomers due to the time needed to educate customers about the uses andbenefits of our system, and the significant investment decisions that ourprospective customers must make when they decide to buy our system.  Many of our prospective customers have neitherbudgeted expenses for networked video communications systems, or for personnelspecifically dedicated to the procurement, installation or support of thesesystems.  As a result, our customersspend a substantial amount of time before purchasing our system in performinginternal reviews and obtaining capital expenditure approvals. Economicconditions over the last several years have contributed to additionaldeliberation and an associated delay in the sales cycle.

 

Our lengthysales cycle is one of the factors that has caused, and may in the futurecontinue to cause, our operating results to vary significantly from quarter toquarter and year to year.  This makes itdifficult for us to forecast revenue, and could cause volatility in the marketprice of our common stock.  A lost ordelayed order could result in lower revenue than expected in a particularquarter or year.

 

**Since a majority of our revenuehas come from follow-on orders, our financial performance could be harmed if wefail to obtain follow-on orders in the future.**

 

Our customerstypically place limited initial orders for our networked video communicationssystem, as they seek to evaluate its usefulness and value.  Our strategy is to pursue additional andlarger follow-on orders after these initial orders.  Revenue generated from follow-on orders,exclusive of license revenue, accounted for approximately 99% and 81% of ourrevenue for the six months ended June 30, 2005 and 2004, respectively.  Our future financial performance depends onsuccessful initial installations of our system and successful generation offollow-on orders as the Avistar network expands within a customerorganization.  If our system does notmeet the needs and expectations of customers, we may not be able to generatefollow-on orders.

 

**Because we depend on a few customers for amajority of our product revenue, the loss of one or more of them could cause asignificant decrease in our revenue.**

 

To date, a significant portion of our revenue hasresulted from sales to a limited number of customers, particularly Deutsche BankAG and UBS Warburg LLC and their affiliates. In addition, since November 12,2004, a significant portion of our revenue has come from our recognition oflicensing revenue associated with the licensing of our intellectual propertyportfolio to Polycom, Inc.  Collectively,Polycom, Inc., Deutsche Bank AG and UBS Warburg LLC and their affiliatesaccounted for approximately 90% of total revenue for the three months ended June30, 2005, each of whom individually accounted for greater than 10% of suchrevenue.  For the three months ended June30, 2004 Deutsche Bank AG and UBS Warburg LLC and their affiliates accountedfor 62% of our total revenue, each of whom individually accounted for greaterthan 10% of such revenue.  For the sixmonths ended June 30, 2005, Polycom, Inc., Deutsche Bank AG and UBS Warburg LLCand their affiliates accounted for approximately 87% of our total revenue, eachof whom individually accounted for greater than 10% of such revenue. For the sixmonths ended June 30, 2004 Deutsche Bank AG and UBS Warburg LLC and theiraffiliates accounted for 68% of our total revenue, each of whom individuallyaccounted for greater than 10% of such revenue. We expect to continue to dependupon a limited number of customers for a substantial portion of ourrevenue.  As of June 30, 2005,approximately 93% of our accounts receivable were concentrated with threecustomers, each of whom represented more than 10% of our total accountsreceivable.  As of December 31,2004, approximately 81% of our accounts receivable were concentrated with onecustomer.

 

The loss of amajor customer or the reduction, delay or cancellation of orders from one ormore of our significant customers could cause our revenue to decline and ourlosses to increase.  Because we currentlydepend on a limited number of customers with lengthy budgeting cycles andunpredictable buying patterns, our revenue from quarter to quarter or year toyear may be volatile.  Adverse changes inour revenue or operating results as a result of these budgeting cycles or anyother reduction in capital expenditures by our large customers couldsubstantially reduce the trading price of our common stock.

 

**We may not be able to modifyand improve our products in a timely and cost effective manner to respond totechnological change and customer demands.**

 

Future hardwareand software platforms embodying new technologies and the emergence of newindustry standards and customer requirements could render our systemnon-competitive or even obsolete.  Themarket for our system is characterized by:

 

•                  rapidtechnological change;

 

•                  theemergence of new competitors;

 

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•                       significant development costs;

 

•                       changes in the requirements of our customers and their communities ofusers;

 

•                       evolving industry standards; and

 

•                       transition to Internet protocol connectivity for video at the desktop,with increasing availability of bandwidth.

 

Our system isdesigned to work with a variety of hardware and software configurations anddata networking infrastructures used by our customers.  The majority of these customer networks relyon Microsoft Windows servers.  However,our software may not operate correctly on other hardware and software platformsor with other programming languages, database environments and systems that ourcustomers use.  Also, we must constantlymodify and improve our system to keep pace with changes made to our customers’platforms, data networking infrastructures, and their evolving ability totransport video and other applications. This may result in uncertainty relating to the timing and nature of ournew release announcements, introductions or modifications, which in turn maycause confusion in the market, with a potentially harmful effect on ourbusiness.  If we fail to promptly modifyor improve our system in response to evolving industry standards or customers’demands, our system could become less competitive, which would harm ourfinancial condition and reputation.

 

**Difficulties or delays ininstalling our products could harm our revenue and margins.**

 

We recognizerevenue upon the installation of our system in those cases where we areresponsible for installation, which often entails working with sophisticatedsoftware and computing and communications systems. If we experiencedifficulties with installation or do not meet deadlines due to delays caused byour customers or ourselves, we could be required to devote more customersupport, technical and other resources to a particular installation.  If we encounter delays in installing ourproducts for new or existing customers or installation requires significantamounts of our professional services support, our revenue recognition could bedelayed, our costs could increase and our margins could suffer.

 

**Competition could reduce our market share anddecrease our revenue.**

 

Currently, ourcompetition comes from many other kinds of companies, including communicationequipment, integrated solution, broadcast video and stand-alone point solutionproviders. Within the video-enabled network communications market, we competeprimarily against Polycom, Tandberg Inc. and VCON Telecommunications Ltd. Webelieve we may face increasing competition in the future from alternative videocommunications solutions that employ new technologies or new combinations oftechnologies from companies such as Cisco Systems, Inc., Avaya, Inc., MicrosoftCorporation, Nortel Networks Corporation and WebEx Communications, Inc., thatenable web-based or network-based video communications with low-cost digitalcamera systems. The market in which we operate is highly competitive.  In addition, because our industry isrelatively new and one which is characterized by rapid technological change,evolving user needs, developing industry standards and protocols and theintroduction of new products and services, it is difficult for us to predictwhether or when new competing technologies or new competitors will enter ourmarket.

 

We expect competition to increase in the future fromexisting competitors and from new market entrants with products that may beless expensive than ours or that may provide better performance or additionalfeatures not currently provided by our products.  Many of our current and potential competitorshave substantially greater financial, technical, manufacturing, marketing,distribution and other resources, greater name recognition and market presence,longer operating histories, lower cost structures and larger customer basesthan we do.  As a result, they may beable to adapt more quickly to new or emerging technologies and changes incustomer requirements.

 

We may be required to reduce or restructure ourpricing or increase spending in response to competition in order to retain orattract customers, pursue new market opportunities or invest in additionalresearch and development efforts.  As aresult, our revenue, margins and market share may be harmed.  We cannot assure you that we will be able tocompete successfully against current and future competitors, or thatcompetitive pressures faced by us will not harm our business, financialcondition and results of operations.

 

**Infringement of our proprietaryrights could affect our competitive position, harm our reputation or cost usmoney.**

 

We regard oursystem as open but proprietary. In an effort to protect our proprietary rights,we rely primarily on a combination of patent, copyright, trademark and tradesecret laws, as well as licensing, non-disclosure and other agreements with ourconsultants,

 

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suppliers, customers and employees.  However, these laws and agreements provideonly limited protection of our proprietary rights. In addition, we may not havesigned agreements in every case and the contractual provisions that are inplace and the protection they produce may not provide us with adequateprotection in all circumstances. Although CPI holds patents and has filed patent applications coveringsome of the inventions embodied in our systems, our means of protecting ourproprietary rights may not be adequate. It may be possible for a third party tocopy or otherwise obtain and use our technology without authorization andwithout our detection.  Inthe event that we believe a third party is infringing our intellectual propertyrights, an infringement claim brought by us could, regardless of the outcome,result in substantial cost to us, divert our management’s attention andresources, be time consuming to prosecute and result in unpredictable damageawards.  A third party may also develop similar technology independently, withoutinfringing upon our patents and copyrights. In addition, the laws of some countries in which we sell our system maynot protect our software and intellectual property rights to the same extent asthe laws of the United States or other countries where we hold patents.  Unauthorized copying, use or reverseengineering of our system could harm our business, financial condition orresults of operations.

 

**We have filed acomplaint alleging patent infringement against Tandberg ASA and Tandberg,Inc.  The prosecution of this lawsuit could require us to expendsignificant financial and managerial resources and may have a material negativeimpact on our business.   If we do not prevail, we may be required topay monetary damages.**

 

On May 11, 2005, CPI, our wholly-owned patentprosecution and licensing subsidiary, commenced a patent infringement lawsuitagainst Tandberg ASA and Tandberg, Inc. alleging that several Tandbergvideoconferencing products infringe three patents held by CPI. The suit wasfiled in the United States District Court for the Northern District ofCalifornia.  The three patents involvedare U.S. Patent Nos. 5,867,654; 5,896,500; and 6,212,547.  These patents cover technologies relating tovideo and data conferencing over unshielded twisted pair (UTP) networks,distributed call-state management and separate monitors for simultaneouscomputer-based data sharing and videoconferencing. These technologies are corecomponents of the AvistarVOS video operating system.  In this action, CPI has requested injunctiverelief, damages to compensate for past and present infringement, trebledamages, costs associated with the litigation and such further relief as theCourt deems just and proper. Both of the Tandberg entities answered theComplaint on July 15, 2005, at which time they asserted that they did notinfringe the patents and that the patents were invalid and unenforceable.  The prosecution of this lawsuit may requireus and CPI to expend significant financial and managerial resources**,** and therefore may have a material negative impact. The duration and ultimate outcome of this litigation are uncertain.

 

**Others may bring infringementclaims against us, which could be time-consuming and expensive to defend.**

 

In recent years, there has been significantlitigation in the United States involving patents and other intellectualproperty rights and we have been a party to such litigation. We may be a partyto litigation in the future, to protect our intellectual property or as aresult of an alleged infringement of the intellectual property of others. Theseclaims and any resulting lawsuit, could subject us to significant liability fordamages and invalidation of proprietary rights. These lawsuits, regardless oftheir success, would likely be time-consuming and expensive to resolve andwould divert management’s time and attention. Any potential intellectualproperty litigation also could force us to do one or more of the following:

 

•stop selling, incorporating or using products or services that use thechallenged intellectual property;

•obtain from the owner of the infringed intellectual property a license to therelevant intellectual property, which may require us to license ourintellectual property to such owner, or may not be available on reasonableterms or at all; and

•redesign those products or services that use technology that is the subject ofan infringement claim.

 

If we are forced to take any of the foregoingactions, we may be unable to manufacture, use, sell, import and export ourproducts, which would reduce our revenues.

 

**Our system could have defectsfor which we could be held liable for, and which could result in lost revenue,increased costs, loss of our credibility or delay in the further acceptance ofour system in the market.**

 

Our system maycontain errors or defects, especially when new products are introduced or whennew versions are released.  Despiteinternal system testing, we have in the past discovered software errors in someof the versions of our system after their introduction.  Errors in new systems or versions could befound after commencement of commercial shipments, and this could result inadditional development costs, diversion of technical and other resources fromour other development efforts or the loss of credibility with current or futurecustomers.  Any of these events couldresult in a loss of revenue or a delay in market acceptance of our system andcould harm our reputation.

 

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In addition, wehave warranted to some of our customers that our software is free ofviruses.  If a virus infects a customer’scomputer software, the customer could assert claims against us, which,regardless of their merits, could be costly to defend and could require us topay damages and potentially harm our reputation.

 

Our licenseagreements with our customers typically contain provisions designed to limitour exposure to potential product liability and certain contract claims.  Our license agreements also typically limit acustomer’s entire remedy to either a refund of the price paid or modificationof our system to satisfy our warranty. However, these provisions vary as to their terms and may not beeffective under the laws of some jurisdictions. Although we maintain product liability (“errors and omissions”)insurance coverage, we cannot assure you that such coverage will beadequate.  A product liability, warrantyor other claim could harm our business, financial condition and/or results ofoperations.  Performance interruptions ata customer’s site could negatively affect the demand for our system or giverise to claims against us.

 

The third party software we license with our systemmay also contain errors or defects for which we do not maintain insurance.  Typically, our license agreements transferany warranty from the third party to our customers to the extentpermitted.  Product liability, warrantyor other claims brought against us with respect to such warranties could,regardless of their merits, harm our business, financial condition or resultsof operations.

 

**The loss of any of our outsidecontract manufacturers or third party equipment suppliers that produce keycomponents of our system could significantly disrupt our manufacturing and newproduct development process.**

 

We depend onoutside contract manufacturers to produce components of our systems, such ascameras, microphones, gateways, speakers and monitors that we install atdesktops and in conference rooms.  Onesupplier, Pacific Corporation, is a single source supplier for a key componentof our product.  Another supplier,Equator Technologies Inc., is our only current source of a component used inour IP gateway product. Our reliance on these third parties involves a numberof risks, including:

 

•                  the possible unavailability of critical servicesand components on a timely basis, on commercially reasonable terms or at all;

 

•                  if the components necessary for our system wereto become unavailable, the need to qualify new or alternative components forour use or reconfigure our system and manufacturing process could be lengthyand expensive;

 

•                  the likelihood that, if particular componentswere not available, we would suffer an interruption in the manufacture andshipment of our systems until these components or alternatives becomeavailable;

 

•                  reduced control by us over the quality and costof our system and over our ability to respond to unanticipated changes andincreases in customer orders, and conversely, price changes from suppliers ifcommitted volumes are not met; and

 

•                  the possible unavailability of, or interruptionin, access to some technologies due to infringement claims, production/supplyissues or other hindrances.

 

If thesemanufacturers or suppliers cease to provide us with the assistance or thecomponents necessary for the operation of our business, we may not be able toidentify alternate sources in a timely fashion. Any transition to alternate manufacturers or suppliers would likelyresult in operational problems and increased expenses and could cause delays inthe shipment of or otherwise limit our ability to provide our products.  We cannot assure you that we would be able toenter into agreements with new manufacturers or suppliers on commerciallyreasonable terms, or at all.  Anydisruption in product flow may limit our revenue, delay our productdevelopment, seriously harm our competitive position and/or result inadditional costs or cancellation of orders by our customers.

 

**If we are unable to expand ourdirect sales force and/or add distribution channels, our business will suffer.**

 

To increase ourrevenue, we must increase the size of our direct sales force and add indirectdistribution channels, such as systems integrators, product partners and/orvalue-added resellers, and/or effect sales through our customers.  If we are unable to maintain or increase ourdirect sales force or add indirect distribution channels due to our own costconstraints, limited availability of qualified personnel or other reasons, ourfuture revenue growth may be limited and our future operating results maysuffer.  We cannot assure you that wewill be successful in attracting, integrating, motivating and retaining salespersonnel.  Furthermore, it can takeseveral months before a new hire becomes a productive member of our salesforce.  The loss of existing salespeople,or the failure of new salespeople and/or indirect sales partners to develop thenecessary skills in a timely manner, could reduce our revenue growth.

 

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**We may not be able to retainour existing key personnel, or hire and retain the additional personnel that weneed to sustain and grow our business.**

 

Our products and technologies are complex, and tosuccessfully implement our business strategy and manage our business, anin-depth understanding of video communication and collaboration technologiesand their potential uses is required.  Wedepend on the continued services of our executive officers and other keypersonnel.  We do not have long-termemployment agreements with our executive officers or other key personnel and wedo not carry any “key man” life insurance. The loss of the services of any of our executive officers or keypersonnel could harm our business, financial condition and results ofoperations.

 

We need to attract and retain highly skilled technicaland managerial personnel for whom there is intense competition.  If we are unable to attract and retainqualified technical and managerial personnel due to our own cost constraints,limited availability of qualified personnel or other reasons, our results ofoperations could suffer and we may never achieve profitability.  The failure of new personnel to develop thenecessary skills in a timely manner could harm our business.

 

**Our plans call for growth inour business, and our inability to achieve or manage growth could harm ourbusiness.**

 

Failure toachieve or manage growth effectively will harm our business, financialcondition and operating results. Furthermore, in order to remain competitive or to expand our business,we may find it necessary or desirable in the future to acquire otherbusinesses, products or technologies. If we identify an appropriate acquisitioncandidate, we may not be able to negotiate the terms of the acquisitionsuccessfully, to finance the acquisition or to integrate the acquiredbusinesses, products or technologies into our existing business andoperations.  In addition, completing apotential acquisition and integrating an acquired business may strain ourresources and require significant management time.

 

**Our international operationsexpose us to potential tariffs and other trade barriers, unexpected changes inforeign regulatory requirements and laws and economic and politicalinstability, as well as other risks that could adversely affect our results ofoperations.**

 

Internationalrevenue, which consists of sales to customers with operations principally inWestern Europe and Asia, comprised 59% of total product and services revenuefor the three months ended June 30, 2005 and 52% for the three months endedJune 30, 2004. International revenue comprised 58% of total product andservices revenue for the three months ended June 30, 2005 and 53% for the threemonths ended June 30, 2004.  Some of therisks we may encounter in conducting international business activities includethe following:

 

•                  tariffs and other trade barriers;

•                  unexpected changes in foreign regulatoryrequirements and laws;

•                  economic and political instability;

•                  increased risk of infringement claims;

•                  protection of our intellectual property;

•                  restrictions on the repatriation of funds;

•                  potentially adverse tax consequences;

•                  timing, cost and potential difficulty of adaptingour system to the local language standards in those foreign countries that donot use the English language;

•                  fluctuations in foreign currencies; and

•                  limitations in communications infrastructures insome foreign countries.

 

Some of our products are subject to variousfederal, state and international laws governing substances and materials inproducts, including those restricting the presence of certain substances inelectronics products. We could incur substantial costs, including fines andsanctions, or our products could be enjoined from entering certain jurisdictions,if we were to violate environmental laws or if our products becomenon-compliant with environmental laws. We also face increasing complexity inour product design and procurement operations as we adjust to new and futurerequirements relating to the materials composition of our products, includingthe restrictions on lead and certain other substances that will apply tospecified electronics products put on the market in the European Union as of July 1,2006 (Restriction of Hazardous Substances Directive). The ultimate costs underenvironmental laws and the timing of these costs are difficult to predict.  Similar legislation has been or may beenacted in other regions, including in the United States, the cumulative impactof which could be significant. We are currently assessing the impact ofEuropean environmental regulations on our products and distribution.

 

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**International politicalinstability may increase our cost of doing business and disrupt our business.**

 

Increased international political instability,evidenced by the threat or occurrence of terrorist attacks, enhanced nationalsecurity measures and/or sustained military action may halt or hinder ourability to do business, may increase our costs and may adversely affect ourstock price. This increased instability has had and may continue to havenegative effects on financial markets, including significant price and volumefluctuations in securities markets. If this international political instabilitycontinues or escalates, our business and results of operations could be harmedand the market price of our common stock could decline.

 

**If our customers do notperceive our system or services to be effective or of high quality, our brandand name recognition would suffer.**

 

We believe that establishing and maintaining brand and name recognitionis critical for attracting and expanding our targeted customer base.  We also believe that the importance ofreputation and name recognition will increase as competition in our marketincreases.  Promotion and enhancement ofour name will depend on the success of our marketing efforts, and on ourability to continue to provide high quality systems and services, neither ofwhich can be assured.  If our customersdo not perceive our system or services to be effective or of high quality, ourbrand and name recognition will suffer, which would harm our business.

 

**We may not meet the continuedlisting criteria for the NASDAQ SmallCap Market, which could materiallyadversely affect the price and liquidity of our stock, our business and ourfinancial condition.**

 

For continued listing of ourcommon stock on The NASDAQ SmallCap Market, we are required to, amongother things (i) maintain stockholders’ equity of at least $2.5 million, or amarket value of listed securities of at least $35 million or annual net incomefrom continuing operations of at least $500,000, and (ii) maintain a minimumclosing bid price of our common stock of at least $1.00.  If we do notmeet the continued listing requirements, our common stock could be subject todelisting from trading on The NASDAQ SmallCap Market.  There can be noassurance that we will continue to meet all requirements for continued listingon The NASDAQ SmallCap Market.

 

If we are unable to continue to list our common stockfor trading on The NASDAQ SmallCap Market, there may be adverse impact on themarket price and liquidity of our common stock, and our stock may be subject tothe “penny stock rules” contained in Section 15(g) of the SecuritiesExchange Act of 1934, as amended, and the rules promulgated there under.  Delisting of our common stock from The NASDAQSmallCap Market could also materially adversely affect our business, including,among other things: our ability to raise additional financing to fund ouroperations; our ability to attract and retain customers; and our ability toattract and retain personnel, including management personnel.  In addition, if we were unable to list ourcommon stock for trading on NASDAQ, many institutional investors would nolonger be able to retain their interests in and/or make further investments inour common stock because of their internal rules and protocols.

 

**Our common stock has been andwill likely continue to be subject to substantial price and volume fluctuationsdue to a number of factors, many of which will be beyond our control, which mayprevent our stockholders from reselling our common stock at a profit.**

 

The trading price of our common stock has in the pastbeen and could in the future be subject to significant fluctuations in responseto:

 

•                  general trends in the equities market, and/ortrends in the technology sector;

•                  quarterly variations in our results ofoperations;

•                  announcements regarding our product developments;

•                  announcements of technological innovations or newproducts by us, our customers or competitors;

•                  announcements of competitive productintroductions by our competitors or our customers;

•                  sales or the perception in the market of possiblesales of a large number of shares of our common stock by our directors,officers, employees or principal stockholders; and

•                  developments or disputes concerning patents orproprietary rights, or other events.

 

If our revenue and results of operations are below theexpectations of public market securities analysts or investors, thensignificant fluctuations in the market price of our common stock couldoccur.  In addition, the securitiesmarkets have, from time to time, experienced significant price and volumefluctuations, which have particularly affected the market prices for hightechnology

 

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companies, and which often are unrelated anddisproportionate to the operating performance of those companies.  These broad market fluctuations, as well asgeneral economic, political and market conditions, may negatively affect themarket price of our common stock.

 

**If our share price is volatile, we may be thetarget of securities litigation, which is costly and time-consuming to defend.**

 

In the past,following periods of market volatility in the price of a company’s securities,security holders have often instituted class action litigation. Many technologycompanies have been subject to this type of litigation.  Our share price has, in the past, experiencedprice volatility, and may continue to do so in the future. If the market valueof our common stock experiences adverse fluctuations and we become involved inthis type of litigation, regardless of the merits or outcome, we could incursubstantial legal costs and our management’s attention could be diverted,causing our business, financial condition and operating results to suffer.

 

**Provisions of our certificateof incorporation, our bylaws and Delaware law may make it difficult for a thirdparty to acquire us, despite the possible benefits to our stockholders.**

 

Our certificateof incorporation, our bylaws and Delaware law contain provisions that mayinhibit changes in our control that are not approved by our Board ofDirectors.  For example, the Board ofDirectors has the authority to issue up to 10,000,000 shares of preferred stockand to determine the terms of this preferred stock, without any further vote oraction on the part of the stockholders.

 

These provisionsmay have the effect of delaying, deferring or preventing a change in ourcontrol despite possible benefits to our stockholders, may discourage bids at apremium over the market price of our common stock, and may adversely affect themarket price of our common stock and the voting and other rights of ourstockholders.

 

**Our principalstockholders can exercise a controlling influence over our business affairs andthey may make business decisions with which you disagree that will affect thevalue of your investment.**

** **

Our executive officers, directors and entities affiliated with them, inthe aggregate, beneficially owned approximately 65% of our common stock as of June30, 2005.  If they were to act together, thesestockholders would be able to exercise control over most matters requiringapproval by our stockholders, including the election of directors and approvalof significant corporate transactions. These actions may be taken even if they are opposed by other investors.  This concentration of ownership may also havethe effect of delaying or preventing a change in control of our company, whichcould cause the market price of our common stock to decline.

 

**Changes in stockoption accounting rules, if enacted as scheduled, will adversely impact ourreported operating results prepared in accordance with generally acceptedaccounting principles, which may in turn adversely impact our stock price andour ability to attract and retain employees.**

 

In December 2004, the FASB issued SFAS No. 123R, “Share-BasedPayment.” SFAS No. 123R requires employee stock options and rights to purchaseshares under stock participation plans to be accounted for under the fair valuemethod, and eliminates the ability to account for these instruments under theintrinsic value method prescribed by APB Opinion No. 25, and allowed under theoriginal provisions of SFAS No. 123. SFAS No. 123R requires the use of anoption pricing model for estimating fair value, which is amortized to expenseover the service periods. The requirements of SFAS No. 123R are effective beginningin the first quarter of an issuer’s first fiscal year commencing after June 15,2005, which for us would be our fiscal quarter beginning January 1,2006.  SFAS No. 123R allows for eitherprospective recognition of compensation expense or retrospective recognition,which may be back to the original issuance of SFAS No. 123 or only to interimperiods in the year of adoption. We plan to adopt the provisionsof SFAS 123R using a modified prospective application. Under a modifiedprospective application, SFAS 123R will apply to new awards and to awards thatare outstanding on the effective date and are subsequently modified orcancelled. Compensation expense for outstanding awards for which the requisiteservice had not been rendered as of the effective date are expected to berecognized over the remaining service period using the compensation costcalculated for pro forma disclosure purposes under SFAS 123. We are in theprocess of determining how the new method of valuing stock-based compensation asprescribed in SFAS 123R will be applied to valuing stock-based awards grantedafter the effective date and the impact the recognition of compensation expenserelated to such awards will have on our financial statements.

 

The pro forma impact of the adoption of SFAS 123 onour historical financial statements is included in the notes to the condensedconsolidated financial statements presented in Item 1 of this Form 10-Q.  We expect to continue to grant stock-basedcompensation to employees. This new standard may have a material adverse impacton our future results of operations.

 

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**Item 3. *Quantitative and Qualitative DisclosuresAbout Market Risk***

 

We develop products primarily in the United States and sell those products primarily in North America, Europe and Asia. International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 59% of total product and services revenue for the three months ended June 30, 2005 and 52% for the three months ended June 30, 2004. International revenue comprised 58% of total product and services revenue for the six months ended June 30, 2005 and 53% for the six months ended June 30, 2004. As a result, our financial condition could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets.  As all of our sales are currently made in United States dollars, a strengthening of the United States dollar could make our products less competitive in foreign markets.  We do not use derivative financial instruments for speculative or trading purposes, nor do we engage in any foreign currency hedging transactions.

 

Our interest income is sensitive to changes in the general level of United States interest rates, particularly since the majority of our investments are in short-term instruments.  There has not been a material change in our exposure to interest rate and foreign currency risk since the date of our annual report on Form 10-K for the year ended December 31, 2004 filed with the Securities and Exchange Commission on March 28, 2005.

 

**Cash and Cash Equivalents**

 

Cash equivalentsconsist primarily of commercial paper and money market and municipal bond fundsacquired with remaining maturity periods of three months or less and are statedat cost, plus accrued interest that approximates market value.  We would not expect our operating results orcash flow to be significantly impacted by the effect of sudden changes inmarket interest rates given the nature of our short-term investments.

 

The followingtable provides information about our investment portfolio.  For investment securities, the table presentscash and cash equivalents and related weighted average interest rates by categoryat June 30, 2005.

 
| ** **                                          | ** ** | **Amounts**        | ** ** | **Weighted Average****Interest Rate** | ** ** |
|-----------------------------------------------------|------------|--------------------|------------|---------------------------------------|------------|
| ** **                                          | ** ** | **(in thousands)** | ** ** | ** **                            | ** ** |
| **Description**                                     |       |               |       |                                  |       |
| Cash, cash equivalents and  short-term investments: |       |               |       |                                  |       |
| Cash                                                |       | $                  | 32         |                                  | —     |   |
| Commercial Paper                                    |       | 15,594             |       | 3.20                                  | %          |
| Other cash equivalents                              |       | 1,998              |       | 3.03                                  | %          |
| Fair Value at June 30, 2005                         |       | $                  | 17,624     |                                  |       |   |

 

# **Item4. *Controls and Procedures***

 

(a) Evaluation of disclosure controls and procedures: Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

 

(b) Changes in internal control over financial reporting: There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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**PART II - OTHER INFORMATION**

 

**Item 1. *LegalProceedings***

 

On May 11, 2005, CPI, our wholly-owned patentprosecution and licensing subsidiary, commenced a patent infringement lawsuitagainst Tandberg ASA and Tandberg, Inc. alleging that several Tandbergvideoconferencing products infringe three patents held by CPI. The suit wasfiled in the United States District Court for the Northern District ofCalifornia.  The three patents involvedare U.S. Patent Nos. 5,867,654; 5,896,500; and 6,212,547.  These patents cover technologies relating tovideo and data conferencing over unshielded twisted pair (UTP) networks,distributed call-state management and separate monitors for simultaneouscomputer-based data sharing and videoconferencing. These technologies are corecomponents of the AvistarVOS video operating system.  In this action, CPI has requested injunctiverelief, damages to compensate for past and present infringement, trebledamages, costs associated with the litigation and such further relief as theCourt deems just and proper. Both of the Tandberg entities answered theComplaint on July 15, 2005, at which time they asserted that they did notinfringe the patents and that the patents were invalid and unenforceable.  Theprosecution of this lawsuit may require us and CPI to expend significantfinancial and managerial resources, and therefore may have a material negativeimpact.  The duration and ultimate outcome of this litigation areuncertain.

 

**Item 6.*Exhibits***

(a)

 
| 31.1   |   | Rule 13a-14(a)/15d-14(a) Certification by the  Chief Executive Officer.                                                                                                               |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                       |
| 31.2   |   | Rule 13a-14(a)/15d-14(a) Certification by the  Chief Financial Officer.                                                                                                               |
|   |   |                                                                                                                                                                                       |
| 32.1   |   | Certification of Chief Executive Officer  and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities and Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized, on this 12th day of August 2005.

 
|   | AVISTAR  COMMUNICATIONS CORPORATION |
|--------|-------------------------------------|
|   |                                |   |
|   | By:                                 | /s/  GERALD J. BURNETT |   |
|   |                                | Gerald  J. Burnett |   |
|   |                                | Chief  Executive Officer, President and |   |
|   |                                | Chairman  (Principal Executive Officer) |   |
|   |                                |   |   |
|   | By:                                 | /s/  ROBERT J. HABIG |   |
|   |                                | Robert  J. Habig |   |
|   |                                | Chief  Financial Officer |   |
|   |                                | (Principal  Financial and Accounting |   |
|   |                                | Officer) |   |

 

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                            |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                                                       |
| 31.1            |       | Rule 13a-14(a)/15d-14(a) Certification by the  Chief Executive Officer.                                                                                                               |
|            |       |                                                                                                                                                                                       |
| 31.2            |       | Rule 13a-14(a)/15d-14(a) Certification by the  Chief Financial Officer.                                                                                                               |
|            |       |                                                                                                                                                                                       |
| 32.1            |       | Certification of Chief Executive Officer  and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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