UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549FORM 10-Q(Mark One)x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended September 30, 2009oro
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934For the transition period from _________________ to _______________________Commission file number: 000-31121AVISTAR COMMUNICATIONS CORPORATION(Exact name of registrant as specified in its charter)DELAWARE
88-0463156(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification Number)1875 South Grant Street,
10THFloor, San Mateo, CA
94402(Address of principal executive offices)
(Zip Code))Registrant's telephone number, including area code: (650) 525-3300Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90
days.Yes xNooIndicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was
required to submit and post such files).Yes o  No oIndicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of "accelerated filer," "large accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.  (check one):Large accelerated filer o
Non-accelerated filer o
(Do not check if a small reporting company)
Accelerated filer o
Smaller reporting company xIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes oNo xAt October 27, 2009, 38,976,591 shares of common stock of the Registrant were outstanding.


















AVISTAR COMMUNICATIONS CORPORATION




INDEX





PART I.
FINANCIAL INFORMATION
3Item 1.
Financial Statements (unaudited)
3Condensed Consolidated Balance Sheets
3Condensed Consolidated Statements of Operations
4Condensed Consolidated Statements of Cash Flows
5Notes to Condensed Consolidated Financial Statements
6Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
19Item 3.
Omitted
24Item 4T.
Controls and Procedures
25PART II.
OTHER INFORMATION
25Item 1.
Legal Proceedings
25Item 1A.
Risk Factors
25Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
34Item 3.
Defaults Upon Senior Securities
34Item 4.
Submissions of Matters to a Vote of Security Holders
34Item 5.
Other Information
34Item 6.
Exhibits
34SIGNATURES

35





2





PART I - FINANCIAL INFORMATION




Item 1.                      Financial Statements







AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARY




CONDENSED CONSOLIDATED BALANCE SHEETS




as of September 30, 2009 and December 31, 2008




(in thousands, except share and per share data)





September 30,
2009


December 31,
2008(unaudited)Assets:Current assets:Cash and cash equivalents

$
382


$
4,898Accounts receivable, net of allowance for doubtful accounts of $13 and $20 at September 30, 2009 and December 31, 2008, respectively


1,161



2,701Inventories


136



307Deferred settlement and patent licensing costs


145



1,100Prepaid expenses and other current assets


252



320Total current assets


2,076



9,326Property and equipment, net


175



310Other assets


157



157Total assets

$
2,408


$
9,793Liabilities and Stockholders’ Equity (Deficit):Current liabilities:Line of credit

$
6,651


$
7,000Convertible debt


4,060



—Accounts payable


677



579Deferred income from settlement and patent licensing


626



4,751Deferred services revenue and customer deposits


1,228



3,687Accrued liabilities and other


1,654



1,382Total current liabilities


14,896



17,399Long-term liabilities:Long-term convertible debt


—



7,000Other liabilities


72



23Total liabilities


14,968



24,422Commitments and contingencies (Note 9)Stockholders’ equity (deficit):Common stock, $0.001 par value; 250,000,000 shares authorized at September 30, 2009 and December 31, 2008; 40,159,466 and 35,750,680 shares issued including treasury shares at September 30, 2009 and December 31, 2008, respectively


40



36Less: treasury common stock, 1,182,875 shares at September 30, 2009 and December 31, 2008, at cost


(53
)


(53
)Additional paid-in-capital


102,022



97,506Accumulated deficit


(114,569
)


(112,118
)Total stockholders’ equity (deficit)


(12,560
)


(14,629
)Total liabilities and stockholders’ equity (deficit)

$
2,408


$
9,793







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


3


AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARY




CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS




for the three and nine months ended September 30, 2009 and 2008




(in thousands, except per share data)






Three Months Ended September 30,


Nine Months Ended September 30,2009


2008


2009


2008(unaudited)


(unaudited)Revenue:Product

$
289


$
1,313


$
3,235


$
2,115Licensing


350



367



572



674Services, maintenance and support


790



1,025



3,130



2,857Total revenue


1,429



2,705



6,937



5,646Costs and expenses:Cost of product revenue*


263



720



926



1,644Cost of services, maintenance and support revenue*


737



584



2,400



1,706Income from settlement and patent licensing


(1,057
)


(1,057
)


(3,171
)


(3,171
)Research and development*


891



1,122



2,777



3,932Sales and marketing*


629



634



1,992



2,752General and administrative*


1,709



1,369



4,143



4,683Total costs and expenses


3,172



3,372



9,067



11,546Loss from operations


(1,743
)


(667
)


(2,130
)


(5,900
)Other (expense) income:Interest income


-



15



8



82Other expense, net


(142
)


(122
)


(329
)


(335
)Total other expense, net


(142
)


(107
)


(321
)


(253
)Net loss

$
(1,885
)

$
(774
)

$
(2,451
)

$
(6,153
)Net loss per share - basic and diluted

$
(0.05
)

$
(0.02
)

$
(0.07
)

$
(0.18
)Weighted average shares used in calculatingbasic and diluted net loss per share


38,970



34,561



36,759



34,546*Including stock based compensation of:Cost of products, services, maintenance and support revenue

$
53


$
54


$
175


$
80Research and development


110



160



435



311Sales and marketing


48



72



155



(24
)General and administrative


218



298



642



567
  
 The accompanying notes are an integral part of these financial statements.







4







AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARY




CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS




for the nine months ended September 30, 2009 and 2008




(in thousands)







Nine Months EndedSeptember 30,


September 30,2009


2008(unaudited)Cash Flows from Operating Activities:Net loss

$
(2,451
)

$
(6,153
)Adjustments to reconcile net loss to net cash used in operating activities:Depreciation


182



404Stock based compensation for options issued to consultants and employees


1,407



934Provision for doubtful accounts


(7
)


19Changes in assets and liabilities:Accounts receivable


1,547



(2,704
)Inventories


171



(6
)Prepaid expenses and other current assets


68



229Deferred settlement and patent licensing costs


955



955Other assets


—



81Accounts payable


98



(395
)Deferred income from settlement and patent licensing and other liabilities


(4,076
)


(4,202
)Deferred services revenue and customer deposits


(2,459
)


1,494Accrued liabilities and other


272



17Net cash used in operating activities


(4,293
)


(9,327
)Cash Flows from Investing Activities:Maturities of short-term investments


—



799Sale of property and equipment


—



8Purchase of property and equipment


(47
)


(87
)Net cash (used in) provided by investing activities


(47
)


720Cash Flows from Financing Activities:Line of credit payments


(5,049
)


(5,100
)Proceeds from line of credit


4,700



7,000Proceeds from convertible debt issuance


—



7,000Net proceeds from issuance of common stock


173



74Net cash (used in) provided by financing activities


(176
)


8,974Net (decrease) increase in cash and cash equivalents


(4,516
)


367Cash and cash equivalents, beginning of period


4,898



4,077Cash and cash equivalents, end of period

$
382


$
4,444Non-cash financing activities:Debt converted to equity

$
2,940


$
—









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


5







AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(UNAUDITED)




1. Business, Basis of Presentation, and Risks and Uncertainties




Business




Avistar Communications Corporation (Avistar or the Company) was founded as a Nevada limited partnership in 1993. The Company filed articles of incorporation in Nevada in December 1997 under the name Avistar Systems Corporation. The Company reincorporated in Delaware in March 2000 and changed the Company name to Avistar Communications Corporation
in April 2000. The operating assets and liabilities of the business were then contributed to the Company’s wholly owned subsidiary, Avistar Systems Corporation, a Delaware corporation. In July 2001, the Company’s Board of Directors and the Board of Directors of Avistar Systems approved the merger of Avistar Systems with and into Avistar Communications Corporation. The merger was completed in July 2001.   In October 2007, the Company merged Collaboration Properties, Inc., the Company's
wholly-owned subsidiary, with and into the Company, with the Company being the surviving corporation.  Avistar has one wholly-owned subsidiary, Avistar Systems U.K. Limited (ASUK).




The Company’s principal executive offices are located at 1875 South Grant Street, 10th Floor, San Mateo, California, 94402. The Company’s telephone number is (650) 525-3300. The Company’s trademarks include Avistar and the Avistar logo, AvistarVOS, Shareboard, vBrief and The Enterprise Video Company. This Quarterly Report
on Form 10-Q also includes Avistar and other organizations’ product names, trade names and trademarks. The Company’s corporate website is www.avistar.com.




The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, are available free of charge on the Avistar website when such reports are available on the U.S. Securities and
Exchange Commission (SEC) website (see “Company—Investor Relations—SEC Information”). The public may read and copy any materials filed by Avistar with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers
that file electronically with the SEC at http://www.sec.gov. The contents of these websites are not incorporated into this filing.




Basis of Presentation




The unaudited condensed consolidated balance sheet as of September 30, 2009, the unaudited condensed consolidated results of operations for the three and nine months ended September 30, 2009 and 2008 and the unaudited condensed consolidated cash flows for the nine months ended September 30, 2009 and 2008 present the consolidated financial
position of Avistar and ASUK after the elimination of all intercompany accounts and transactions. The unaudited condensed consolidated balance sheet of Avistar as of December 31, 2008 was derived from audited financial statements, but does not contain all disclosures required by accounting principles generally accepted in the United States of America, and certain information and footnote disclosures normally included have been condensed or omitted pursuant to the rules and regulations of the SEC.  The consolidated
results are referred to, collectively, as those of Avistar or the Company in these notes.




The functional currency of ASUK is the United States dollar. All gains and losses resulting from transactions denominated in currencies other than the United States dollar are included in the statements of operations and have not been material.




The Company’s fiscal year end is December 31.




Risks and Uncertainties




The markets for the Company’s products and services are in the early stages of development. Some of the Company’s products utilize changing and emerging technologies. As is typical in industries of this nature, demand and market acceptance are subject to a high level of uncertainty, particularly when there are adverse conditions
in the economy. Acceptance of the Company’s products, over time, is critical to the Company’s success. The Company’s prospects must be evaluated in light of difficulties encountered by it and its competitors in further developing this evolving marketplace. The Company has generated losses since inception and had an accumulated deficit of $114.6 million as of September 30, 2009. The Company’s operating results may fluctuate significantly in the future as a result of a variety of factors,
including, but not limited to, the economic environment, the adoption of different distribution channels, and the timing of new product announcements by the Company or its competitors.




The Company’s future liquidity and capital requirements will depend upon numerous factors, including, but not limited to, the ability to become profitable or generate positive cash flow from operations, current discussions with the remaining holders of the convertible debt (Notes) to convert the Notes into shares of common stock
at or prior to maturity in January 2010 or extend the term of the Notes, the Company’s cost reduction efforts, Dr. Burnett’s personal guarantee to Avistar to support an extension of the revolving line of credit through March 31, 2010, the Company’s ability to obtain a renewal or extension of its existing line of credit or a new line of credit with another bank, the costs and timing of its expansion of product development efforts and the success of these development efforts, the costs and timing
of its expansion of sales and marketing activities, the extent to which its existing and new products gain market acceptance, competing technological and market developments, the costs involved in maintaining, enforcing and defending patent claims and other intellectual property rights, the level and timing of revenue, and other factors. If adequate funds are not available on acceptable terms or at all, the Company’s ability to achieve or sustain positive cash flows, maintain current operations, fund any
potential expansion, take advantage of unanticipated opportunities, develop or enhance products or services, or otherwise respond to competitive pressures would be significantly limited.




6




2. Summary of Significant Accounting Policies




Unaudited Interim Financial Information




The financial statements filed in this report have been prepared by the Company, without audit, pursuant to the rules and regulations of the SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been
condensed or omitted pursuant to such rules and regulations.




In the opinion of management, the unaudited financial statements furnished in this report reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the results of operations for the interim periods covered and of the Company’s financial position as of the interim balance sheet date. The
results of operations for the interim periods are not necessarily indicative of the results for the entire year. These financial statements should be read in conjunction with the Company’s audited consolidated financial statements and the accompanying notes for the year ended December 31, 2008, included in the Company’s annual report on Form 10-K filed with the SEC on March 31, 2009.




Use of Estimates




The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues
and expenses during the period. Actual results could differ from those estimates.




Cash and Cash Equivalents and Short and Long-term Investments




The Company considers all investment instruments purchased with an original maturity of three months or less to be cash equivalents. Investment securities with original or remaining maturities of more than three months but less than one year are considered short-term investments. Auction rate securities with original or remaining maturities
of more than three months are considered short-term investments even if they are subject to re-pricing within three months.  The Company was not invested in any auction rate securities as of September 30, 2009 and December 31, 2008. Investment securities held with the intent to reinvest or hold for longer than a year, or with remaining maturities of one year or more, are considered long-term investments. The Company’s cash equivalents at September 30, 2009 and December 31, 2008 consisted of money
market funds with original maturities of three months or less, and are therefore classified as cash and cash equivalents in the accompanying balance sheets.




The Company accounts for its short-term and long-term investments in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 320, Investments – Debt and Equity Securities. The Company’s short and long-term investments in securities
are classified as available-for-sale and are reported at fair value, with unrealized gains and losses, net of tax, recorded in other comprehensive income (loss). Realized gains or losses and declines in value judged to be other than temporary, if any, on available- for-sale securities are reported in other income, net. The Company reviews the securities for impairments considering current factors including the economic environment, market conditions and the operational performance and other specific factors relating
to the business underlying the securities. The Company records impairment charges equal to the amount that the carrying value of its available-for-sale securities exceeds the estimated fair market value of the securities as of the evaluation date. The fair value for publicly held securities is determined based on quoted market prices as of the evaluation date. In computing realized gains and losses on available-for-sale securities, the Company determines cost based on amounts paid, including direct costs such
as commissions, to acquire the security using the specific identification method. The Company did not have any short or long-term investments at September 30, 2009 and December 31, 2008.




Cash and cash equivalents consisted of cash and money market funds of $382,000 and $4.9 million at September 30, 2009 and December 31, 2008, respectively.




See Note 3 for further information on fair value.




7







Significant Concentrations




A relatively small number of customers accounted for a significant percentage of the Company’s revenues for the three and nine months ended September 30, 2009 and 2008. Revenues from these customers as a percentage of total revenues were as follows for the three and nine months ended September 30, 2009 and 2008:




Three Months Ended September 30,


Nine Months Ended September 30,2009


2008


2009


2008(unaudited)


(unaudited)Customer A


31
%


28
%


15
%


46
%Customer B


31
%


*
%


18
%


*
%Customer C


25
%


13
%


*
%


12
%Customer D


*
%


18
%


38
%


*
%Customer E


*
%


30
%


*
%


23
%







* Less than 10%




Any change in the relationship with these customers could have a potentially adverse effect on the Company’s financial position.




Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of temporary cash investments and trade receivables. The Company has cash and investment policies that limit the amount of credit exposure to any one financial institution, or restrict placement of these investments to financial institutions
evaluated as highly credit worthy. As of September 30, 2009, the Company had cash and cash equivalents on deposit with a major financial institution that were above the FDIC insured limits. Concentrations of credit risk with respect to trade receivables relate to those trade receivables from both United States and foreign entities. As of September 30, 2009, approximately 82% of the Company’s gross accounts receivable was concentrated with two customers, each of whom represented more than 10% of the total
gross accounts receivable. As of December 31, 2008, approximately 98% of the Company’s gross accounts receivable was concentrated with four customers, each of whom represented more than 10% of the total gross accounts receivable. No other customer individually accounted for greater than 10% of total accounts receivable as of September 30, 2009 and December 31, 2008.




Allowance for Doubtful Accounts




The Company uses estimates in determining the allowance for doubtful accounts based on historical collection experience, historical write-offs, current trends and the credit quality of the Company’s customer base, and the characteristics of accounts receivable by aging category. Accounts are generally considered delinquent when they
are thirty days past due. Uncollectible accounts are written off directly to the allowance for doubtful accounts. If the allowance for doubtful accounts was understated, operating income could be significantly reduced. The impact of any such change or deviation may be increased by the Company’s reliance on a relatively small number of customers for a large portion of its total revenue.




Fair Value of Financial Instruments




The carrying amounts of the Company’s financial assets and liabilities, including cash and cash equivalents, accounts receivable, line of credit, and accounts payable at September 30, 2009 and December 31, 2008, approximate fair value because of the short maturity of these instruments.




The convertible debt was stated at cost at September 30, 2009 and December 31, 2008 since there were no unamortized discounts and the Company did not elect to measure the instrument at fair value in accordance with the Fair Value Option subsection of ASC 825, Financial Instruments. As
of September 30, 2009, the carrying amount of the convertible debt is $4.1 million and the estimated fair value is $5.2 million.  As of December 31, 2008, the carrying amount of the convertible debt was $7.0 million, and the estimated fair value was $11.2 million. The fair value is estimated as the sum of the present value of future interest and principal payments of the debt based on rates available to the Company for debt with similar terms
and remaining maturities, and the fair value of the conversion feature calculated based on the Black-Scholes method.See Note 8 for further details on the terms of the convertible debt.




8




Inventories




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




September 30,
2009


December 31,
2008(unaudited)Raw materials and subassemblies

$
1


$
10Finished goods


135



297Total Inventories

$
136


$
307





Revenue Recognition and Deferred Revenue




The Company recognizes product and services revenue in accordance with ASC 985-605, Revenue Recognition - Software,or ASC 605-25, Revenue Recognition – Multiple-Element
Arrangements. The Company derives product revenue from the sale and licensing of a set of desktop (endpoint) products (hardware and software) and infrastructure products (hardware and software) that combine to form an Avistar video-enabled collaboration solution. Services revenue includes revenue from post-contract customer support, training and software development. The fair value of all product, post-contract customer support and training offered to customers is determined based on the price charged
when such products or services are sold separately




Arrangements that include multiple product and service elements may include software and hardware products, as well as post-contract customer support and training. Pursuant to ASC 985-605, the Company recognizes revenue when all of the following criteria are met: (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 discussed below:




·
Persuasive evidence of an arrangement exists. The Company requires a written contract, signed by both the customer and the Company, or a purchase order from those customers that have previously negotiated a standard end-user license arrangement or volume purchase agreement, prior to recognizing revenue on an arrangement.




·
Delivery has occurred.  The Company delivers software and hardware to customers either electronically or physically and the Company has no further obligations with respect to the agreement. The standard delivery terms are FOB shipping point.




·
The fee is fixed or determinable. The Company’s determination that an arrangement fee is fixed or determinable depends principally on the arrangement’s payment terms. The Company’s standard terms generally require payment within 30 to 90 days of the date of invoice. Where these terms apply, the Company regards the fee as fixed or determinable,
and recognizes revenue upon delivery (assuming other revenue recognition criteria are met). If the payment terms do not meet this standard, but rather, involve “extended payment terms,” the fee may not be considered to be fixed or determinable, and the revenue would then be recognized when customer installments are due and payable.




·
Collectibility is probable. To recognize revenue, the Company judges collectibility of the arrangement fees on a customer-by-customer basis pursuant to a credit review policy. The Company typically sells to customers with which it has had a history of successful collections. For new customers, the Company evaluates the customer’s financial position and ability
to pay. If the Company determines that collectibility is not probable based upon the credit review process or the customer’s payment history, revenue is recognized when cash is collected.




If there are any undelivered elements, the Company defers revenue for those elements, as long as vendor specific objective evidence (VSOE) exists for the undelivered elements. Payment for product is due upon shipment, subject to specific payment terms. Payment for professional services is due in advance of providing the services, subject
to specific payment terms. Reimbursements received for out-of-pocket expenses and shipping costs, which have not been significant to date, are recognized as revenue in accordance with ASC 605-45, Revenue Recognition – Principal Agent Considerations.




The price charged for maintenance and/or support is defined in the contract, and is based on a fixed price for both hardware and software components as stipulated in the customer agreement. Customers have the option to renew the maintenance and/or support arrangement in subsequent periods at the same or similar rate as paid in the initial
year subject to contractual adjustments for inflation in some cases. Revenue from maintenance and support services is 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 are recorded as deferred revenue and customer deposits in the accompanying balance sheets. Training services are offered independently of the purchase of product. The value of these training services is determined based
on the price charged when such services are sold separately. Training revenue is recognized upon performance of the service.




9


The Company recognizes service revenue from software development contracts in accordance with ASC 605-35, Revenue Recognition – Construction-Type and Production-Type Contracts. Product and implementation revenue related to contracts for software development is recognized using
the percentage of completion method, in accordance with the “Input Method”, when all of the following conditions are met: a contract exists with the customer at a fixed price, the Company expects to fulfill all of its material contractual obligations to the customer for each deliverable of the contract, a reasonable estimate of the costs to complete the contract can be made, and collection of the receivable is probable. The amount of revenue recognized is based on the total project fee under the agreement
and the percentage of completion achieved.  The percentage of completion is measured by monitoring progress using records of actual time incurred to date in the project compared to the total estimated project requirements, which corresponds to the costs related to the earned revenues. Changes in estimates are recognized in the periods affected by the changes. Any anticipated losses on contracts in progress are charged to earnings when identified. The amounts billed to customers in excess of revenues
recognized to date are deferred and recorded as deferred revenue and customer deposits in the accompanying balance sheets.




The Company recognizes revenue from the licensing of its intellectual property portfolio according to ASC 985-605, Revenue Recognition – Software, based on the terms of the royalty, partnership and cross-licensing agreements involved. In the event that a license to the Company’s
intellectual property is granted after the commencement of litigation proceedings between the Company and the licensee, the proceeds of such transaction are recognized as licensing revenue only if sufficient historical evidence exists for the determination of fair value of the licensed patents to support the segregation of the proceeds between a gain on litigation settlement and patent license revenues consistent with Financial Accounting Standards Board (FASB) Concepts Statement No. 6, Elements
of Financial Statements (CON 6). As of September 30, 2009, these criteria for recognizing license revenue following the commencement of litigation had not been met.




In July 2006, Avistar entered into a Patent License Agreement with Sony Corporation (Sony) and Sony Computer Entertainment, Inc. (SCEI). Under the license agreement, Avistar granted Sony and its subsidiaries, including SCEI, a license to all of the Company’s patents with a filing date on or before January 1, 2006 for a specific field
of use relating to video conferencing. The license covers Sony’s video conferencing apparatus as well as other products, including video-enabled personal computer products and certain SCEI PlayStation products. Future royalties under this license are being recognized as estimated royalty-based sales occur in accordance with ASC 985-605, Revenue Recognition - Software.  The Company uses historical and forward looking sales forecasts provided
by SCEI and third party sources, in conjunction with past actual royalty reports provided periodically by SCEI directly to the Company, to develop an estimate of royalties recognized for each quarterly reporting period.  The royalty reporting directly from SCEI to the Company is delayed beyond the period in which the actual royalties are generated, and thus the estimate of current period royalties requires significant management judgment and is subject to corrections in a future period once actual royalties
become known.




On September 8, 2008 and on September 9, 2008, Avistar entered into a Licensed Works Agreement, Licensed Works Agreement Statement of Work and a Patent License Agreement with International Business Machines Corporation, or IBM, under which Avistar agreed to integrate its bandwidth management technology and related intellectual property into
future Lotus Unified Communications offerings by IBM, and to provide maintenance support services. An initial cash payment of $3.0 million was made by IBM to Avistar on November 7, 2008, and a second non-refundable payment of $1.5 million was made on August 31, 2009.   Avistar expects IBM to make one additional non-refundable payments of $1.5 million associated with scheduled phases of delivery.  IBM has agreed to make future royalty payments to Avistar equal to two percent of the world-wide
net revenue derived by IBM from Lotus Unified Communications products sold that exceeds a contractual base amount, and maintenance payments received from existing customers, which incorporate Avistar’s technology.  The agreements have a five year term and are non-cancelable except for material default by either party.  The agreements convey to IBM a non-exclusive world-wide license to Avistar’s patent portfolio existing at the time of the agreements and for all subsequent patents
issued with an effective filing date of up to five years from the date of the agreements.  The agreements also provide for a release of each party for any and all claims of past infringement.  In April 2009, the agreements were amended to extend the initial term from five years to six years.  The Company has determined the value of maintenance based on VSOE, and allocated the residual portion of the initial $6.0 million to the integration project.  The residual portion
is being recognized under the percentage of completion method, in accordance with the “Input Method”, and the maintenance revenue will be recognized over the future maintenance service period.  As the Company believes there are no future deliverables associated with the intellectual property patent licenses, no additional provision for this element has been made.  For the nine months ended September 30, 2009, the Company has recognized $2.1 million in product revenue and $453,000
in service revenue. The remaining $1.2 million is expected to be recognized in product and service revenue under the percentage of completion method over the remaining projected development time of six months. The estimate of current period percentage of completion requires significant management judgment and is subject to updates in future periods until the project is complete.




10


Income from Settlement and Patent Licensing




The Company recognizes the proceeds from settlement and patent licensing agreements based on the terms involved. When litigation has been filed prior to a settlement and patent licensing agreement, and insufficient historical evidence exists for the determination of fair value of the patents licensed to support the segregation of the proceeds
between a gain on litigation settlement and patent license revenues, the Company reports all proceeds in “income from settlement and patent licensing” within operating costs and expenses. The gain portion of the proceeds, when sufficient historical evidence exists to segregate the proceeds, would be reported according to ASC 450, Contingencies. When a patent license agreement is entered into prior to the commencement of litigation, the Company
reports the proceeds of such transaction as licensing revenue in the period in which such proceeds are received, subject to the revenue recognition criteria described above.




On November 12, 2004, the Company entered into a settlement and a patent cross-license agreement with Polycom, thus ending litigation against Polycom for patent infringement. As part of the settlement and patent cross-license agreement with Polycom, Avistar granted Polycom a non-exclusive, fully paid-up license to its entire patent portfolio.
The settlement and patent cross-license agreement includes a five year capture period from the date of the settlement, adding all new patents with a priority date extending up to five years from the date of execution of the agreement. Polycom, as part of the settlement and patent cross-licensing agreement, made a one-time payment to the Company of $27.5 million and Avistar paid $6.4 million in contingent legal fees to Avistar’s litigation counsel upon completion of the settlement and patent cross-licensing
agreement. The contingent legal fees were payable only in the event of a favorable outcome from the litigation with Polycom. The Company is recognizing the gross proceeds of $27.5 million from the settlement and patent cross-license agreement as income from settlement and patent licensing within operations over the five-year capture period, due to a lack of evidence necessary to apportion the proceeds between an implied punitive gain element in the settlement of the litigation, and software license revenues from
the cross-licensing of Avistar’s patented technologies for prior and future use by Polycom. Additionally, the $6.4 million in contingent legal fees was deferred and is being amortized to income from settlement and patent licensing over the five year capture period, resulting in a net of $21.1 million being recognized as income within operations over the five year capture period.




The presentation within operating expenses is supported by a determination that the transaction is central to the activities that constitute Avistar’s ongoing major or central operations, but may contain a gain element related to the settlement, which is not considered as revenue under the FASB CON 6. The Company did not have sufficient
historical evidence to support a reasonable determination of value for the purposes of segregating the transaction into revenue related to the patent licensing and an operating or non-operating gain upon settlement of litigation, resulting in the determination that the entire transaction is more appropriately classified as “income from settlement and patent licensing” within operations, as opposed to revenue.




Taxes Collected from Customers and Remitted to Governmental Authorities




Taxes collected from customers and remitted to governmental authorities are recognized on a net basis in the accompanying statement of operations.




Warranty




The Company accrues the estimated costs of fulfilling the warranty provisions of its contracts over the warranty period, which is typically 90 days. There was no warranty accrual as of September 30, 2009 and December 31, 2008.




Research and Development




Research and development costs include engineering expenses, such as salaries and related benefits, depreciation, professional services and overhead expenses related to the general development of Avistar’s products, and are expensed as incurred. Software development costs are capitalized beginning when a product’s technological
feasibility has been established and ending when a product is available for general release to customers. For the three and nine months ended September 30, 2009, Avistar did not capitalize any software development costs since the period between establishing technological feasibility and general release of the product was relatively short, and these costs were not significant.




Stock-Based Compensation




Effective January 1, 2006, the Company adopted the provisions of ASC 718, Compensation – Stock Compensation (ASC 718), which establishes accounting for stock-based awards exchanged for employee services. Accordingly, stock-based compensation cost is measured at grant
date, based on the fair value of the award, and is recognized as an expense over the employee’s service period.




The effect of recording stock-based compensation for the three and nine months ended September 30, 2009 and 2008 was as follows (in thousands):




Three Months Ended September 30,


Nine Months Ended September 30,2009

2008


2009


2008(unaudited)


(unaudited)Stock-based compensation expense by type of award:Employee stock options

$
421


$
576


$
1,385


$
923Non-employee stock options


4



3



9



9Employee stock purchase plan


4



5



13



2Total stock-based compensation


429



584



1,407



934Tax effect of stock-based compensation


—



—



—



—Net effect of stock-based compensation on net loss

$
429


$
584


$
1,407


$
934




For the three and nine months ended September 30, 2009, the Company has recognized stock-based compensation expense of $131,000 associated with extension of exercise period for the vested stock options under the separation agreement entered by and between the Company and Simon Moss, former Chief Executive Officer in July 2009. The amount
was measured based upon the difference between the fair value of the vested options immediately before and after the modification.




11




As of September 30, 2009, the Company had an unrecognized stock-based compensation balance related to stock options of approximately $2.5 million before estimated forfeitures and after actual cancellations. ASC 718 requires forfeitures to be estimated at the time of grant and revised if necessary in subsequent periods if actual forfeitures
differ from those estimates. Based on the Company’s historical experience of option pre-vesting cancellations, the Company has assumed an annualized forfeiture rate of 32% for its executive options and 40% for non-executive options. Accordingly, as of September 30, 2009, the Company estimated that the stock-based compensation for the awards not expected to vest was approximately $1.7 million and therefore, the unrecognized deferred stock-based compensation balance related to stock options was adjusted to
approximately $836,000 after estimated forfeitures and after actual cancellations. This amount will be recognized over an estimated weighted average period of 2.9 years. For the three months ended September 30, 2009 and 2008, the Company granted 1,507,500 and 46,000 stock options to employees, with an estimated total grant-date fair value of $886,000 and $56,000, or $0.59 and $1.22 per share, respectively.  For the nine months ended September 30, 2009 and 2008, the Company granted 2,842,928 and 2,449,318
stock options with an estimated total grant-date fair value of $1.8 million and $1.3 million, or $0.64 and $0.54 per share, respectively.




Valuation Assumptions




The Company estimated the fair value of stock options granted during the three and nine months ended September 30, 2009 and 2008 using a Black-Scholes-Merton valuation model, consistent with the provisions of ASC 718 and SEC Staff Accounting Bulletin (SAB) No. 107 (SAB 107). The fair value of each option grant is estimated on the date
of grant using the Black-Scholes-Merton option valuation model and the straight-line attribution approach with the following weighted-average assumptions for both the three and nine month periods ended September 30, 2009 and 2008, respectively:




Three Months Ended September 30,


Nine Months Ended September 30,2009


2008


2009


2008(unaudited)


(unaudited)Employee Stock Option PlanExpected dividend


—
%


—
%


—
%


—
%Average risk-free interest rate


1.9
%


1.5
%


1.7
%


2.2
%Expected volatility


109
%


124
%


109
%


115
%Expected term (years)


4.0



6.1



4
.0


2.9Employee Stock Purchase PlanExpected dividend


—
%


—
%


—
%


—
%Average risk-free interest rate


0.3
%


1.9
%


0.3
%


2.0
%Expected volatility


115
%


111
%


132
%


144
%Expected term (months)


6.0



6.0



6.0



6.0
   The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. The risk-free interest rates are taken from the Daily Federal Yield Curve Rates as of the grant dates as published by the Federal Reserve, and represent the yields on actively traded treasury securities
for terms that approximate the expected term of the options. Expected volatility is based on the historical volatility of the Company’s common stock over a period consistent with the expected term of the stock-option. For the three and nine months ended September 30, 2009, the expected term of employee stock options represents the weighted average period the stock options are expected to remain outstanding and is based on the entire history of exercises and cancellations on all past option grants made by
the Company during which its equity shares have been publicly traded, the contractual term, the vesting period and the expected remaining term of the outstanding options.  For the three and nine months ended September 30, 2008, the expected term calculation is based on an average prescribed by SAB 107, based on the weighted average of the vesting periods, which is generally one quarter vesting after one year and one sixteenth vesting quarterly for twelve quarters, and adding the term of the option,
which is generally ten years, and dividing by two.


12




Comprehensive Income




ASC 220, Comprehensive Income (ASC 220), establishes standards for the reporting and the display of comprehensive income (loss) and its components. This standard defines comprehensive income (loss) as the changes in equity of an enterprise, except those resulting from stockholder transactions.
Accordingly, comprehensive income (loss) includes certain changes in equity that are excluded from the net income or loss.




The components of comprehensive loss were as follows (in thousands):




Three Months Ended September 30,


Nine Months Ended September 30,2009


2008


2009


2008(unaudited)


(unaudited)Net loss

$
(1,885
)

$
(774
)

$
(2,451
)

$
(6,153
)Other comprehensive income (loss)


—



—



—



—Total comprehensive loss

$
(1,885
)

$
(774
)

$
(2,451
)

$
(6,153
)







3. Fair Value Measurement




Effective January 1, 2008, the Company adopted ASC 820, Fair Value Measurements and Disclosures(ASC 820). ASC 820 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. Fair value is defined under ASC 820 as the
exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered
observable and the last unobservable, that may be used to measure fair value, which are the following:




Level 1 – Quoted prices in active markets for identical assets or liabilities.




Level 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable, or can be corroborated by observable market data for substantially the full term of the assets or liabilities.




Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.




In accordance with ASC 820, the following table represents the Company’s fair value hierarchy for its financial assets (cash equivalents) as of September 30, 2009 (in thousands):




Fair Value


Level 1


Level 2


Level 3Cash Equivalents (unaudited):Money market funds

$
5


$
5


$
—


$
—Total cash equivalents

$
5


$
5


$
—


$
—





4. Related Party Transactions




UBS Warburg LLC, which is an affiliate of UBS AG, is a stockholder of the Company and is also a customer of the Company. As of September 30, 2009 and December 31, 2008, UBS Warburg LLC held less than 5% of the Company’s stock. Revenue from UBS Warburg LLC and its affiliates represented 6% and 30% of the Company’s total revenue
for the three months ended September 30, 2009 and 2008, respectively, and 6% and 23% of the Company’s total revenue for the nine months ended September 30, 2009 and 2008, respectively.  Management believes the transactions with UBS Warburg LLC and its affiliates are at terms comparable to those provided to unrelated third parties. As of September 30, 2009 and December 31, 2008, the Company had accounts receivable outstanding from UBS Warburg LLC and its affiliates of approximately $10,000 and
$350,000, respectively.




On January 4, 2008, Avistar issued $7,000,000 of 4.5% Convertible Subordinated Secured Notes (the Notes), which are due in January 2010. The Notes were sold pursuant to a Convertible Note Purchase Agreement to Baldwin Enterprises, Inc., a subsidiary of Leucadia National Corporation, directors Gerald Burnett, R. Stephen Heinrichs, William
Campbell, and Craig Heimark, Simon Moss and Darren Innes, officers of the Company at the date of issuance, and WS Investment Company, a fund associated with Wilson Sonsini Goodrich & Rosati (WSGR), the Company’s legal counsel.  In May 2009, all Note holders, except Baldwin Enterprise, Inc. and Darren Innes, elected to have the principal amounts outstanding under their respective Notes converted into common stock of the Company.  All outstanding amounts under the Notes issued to Mr.
Innes (approximately $60,000) were repaid by the Company in full in October 2009.  See Note 8 for further details.




13




5. Net Loss Per Share




Basic and diluted net loss per share of common stock is presented in conformity with ASC 260, Earnings Per Share (ASC 260), for all periods presented.




In accordance with ASC 260, basic net loss per share has been computed using the weighted average number of shares of common stock outstanding during the period, less shares subject to repurchase. Diluted net loss per share is computed on the basis of the weighted average number of shares and potential common shares outstanding during the
period. Potential common shares result from the assumed exercise of outstanding stock options that have a dilutive effect when applying the treasury stock method. The Company excluded all outstanding stock options from the calculation of diluted net loss per share for the three months and nine months ended September 30, 2009 and 2008, because all such securities are anti-dilutive (owing to the fact that the Company was in a loss position during the time period). Accordingly, diluted net loss per share is equal
to basic net loss per share for those periods.




The total number of potential dilutive common shares excluded from the calculation of diluted net loss per share for the three months ended September 30, 2009 and 2008 was 50,686 and 484,229, respectively. The total number of potential dilutive common shares excluded from the calculation of diluted net loss per share for the nine months ended
September 30, 2009 and 2008 was 162,279 and 350,376, respectively.




The following table sets forth the computation of basic and diluted net loss per share (in thousands, except per share data):




Three Months Ended September 30,


Nine Months Ended September 30,2009


2008


2009


2008(unaudited)


(unaudited)Numerator – basic and diluted:Net loss

$
(1,885
)

$
(774
)

$
(2,451
)

$
(6,153
)Denominator – basic and diluted:Weighted average shares of common stock used in computing net loss per share


38,970



34,561



36,759



34,546Net loss per share – basic and diluted

$
(0.05
)

$
(0.02
)

$
(0.07
)

$
(0.18
)








6. Income Taxes




Income taxes are accounted for using an asset and liability approach in accordance with ASC 740, Income Taxes (ASC 740), which requires the recognition of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events
that have been recognized in the Company’s financial statements. The measurement of current and deferred tax liabilities and assets are based on the provisions of enacted tax law. The effects of future changes in tax laws or rates are not anticipated. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.




Deferred tax assets and liabilities are determined based on the difference between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are provided if based upon the weight of available evidence,
it is considered more likely than not that some or all of the deferred tax assets will not be realized.




The Company accounts for uncertain tax positions according to the provisions of ASC 740.  ASC 740 contains a two-step approach for recognizing and measuring uncertain tax positions. Tax positions are evaluated for recognition by determining if the weight of available evidence indicates that it is probable that the position will
be sustained on audit, including resolution of related appeals or litigation. Tax benefits are then measured as the largest amount which is more than 50% likely of being realized upon ultimate settlement. The Company considers many factors when evaluating and estimating tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes.  No material changes have occurred in the Company’s tax positions taken as of December 31, 2008 during
the three and nine months ended September 30, 2009.




As of December 31, 2008, the Company had a net deferred tax asset of $26.8 million and unrecognized tax benefit under ASC 740 of $915,000.  A valuation allowance has been provided for the entire net deferred tax assets.




14






7. Segment Reporting




Disclosure of segments is presented in accordance with ASC 280, Segment Reporting (ASC 280). ASC 280 establishes standards for disclosures regarding operating segments, products and services, geographic areas and major customers. The Company is organized and operates as two operating
segments: (1) the design, development, manufacturing, sale and marketing of networked video communications products (products division) and (2) the prosecution, maintenance, support and licensing of the Company’s intellectual property and technology, some of which is used in the Company’s products (intellectual property division). Service revenue relates mainly to the maintenance, support, training and software development, and is included in the products division for purposes of reporting and decision-making.
The products division also engages in corporate functions, and provides financing and services to its intellectual property division. The Company’s chief operating decision-maker, its Chief Executive Officer (CEO), monitors the Company’s operations based upon the information reflected in the following table (in thousands). The table includes a reconciliation of the revenue and expense classification used by the CEO with the revenue, other income and expenses reported in the Company’s condensed
consolidated financial statements included elsewhere herein. The reconciliation for the revenue category reflects the fact that the CEO views activity recorded in the account “income from settlement and patent licensing” as revenue within the intellectual property division.




Intellectual Property Division


Products Division


Reconciliation


TotalThree Months Ended September 30, 2009 (unaudited)Revenue

$
1,407


$
1,079


$
(1,057
)

$
1,429Depreciation expense


—



(62
)


—



(62
)Total costs and expenses


(532
)


(3,697
)


1,057



(3,172
)Interest income


—



—



—



—Interest expense


—



(125
)


—



(125
)Net income (loss)


875



(2,760
)


—



(1,885
)Assets


808



1,600



—



2,408Three Months Ended September 30, 2008 (unaudited)Revenue

$
1,424


$
2,338


$
(1,057
)

$
2,705Depreciation expense


—



(136
)


—



(136
)Total costs and expenses


(417
)


(4,012
)


1,057



(3,372
)Interest income


—



15



—



15Interest expense


—



(122
)


—



(122
)Net income (loss)


1,007



(1,781
)


—



(774
)Assets


2,038



9,208



—



11,246Nine Months Ended September 30, 2009 (unaudited)Revenue

$
3,743


$
6,365


$
(3,171
)

$
6,937Depreciation expense


—



(182
)


—



(182
)Total costs and expenses


(1,369
)


(10,869
)


3,171



(9,067
)Interest income


—



8



—



8Interest expense


—



(365
)


—



(365
)Net income (loss)


2,374



(4,825
)


—



(2,451
)Assets


808



1,600



—



2,408Nine Months Ended September 30, 2008 (unaudited)Revenue

$
3,845


$
4,972


$
(3,171
)

$
5,646Depreciation expense


—



(404
)


—



(404
)Total costs and expenses


(1,746
)


(12,971
)


3,171



(11,546
)Interest income


—



82



—



82Interest expense


—



(335
)


—



(335
)Net income (loss)


2,099



(8,252
)


—



(6,153
)Assets


2,038



9,208



—



11,246




International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 89% and 50% of total revenues for the three months ended September 30, 2009 and 2008, respectively, and 43% and 51% of total revenues for the nine months ended September 30, 2009 and 2008, respectively. For the three
months ended September 30, 2009 and 2008, international revenues from customers in the United Kingdom accounted for 64% and 12% of total product and services revenue, respectively, and 34% and 14% for the nine months ended September 30, 2009 and 2008, respectively.  The Company had no significant long-lived assets in any country other than in the United States for any period presented.







15




8.  Borrowings




Line of Credit




On December 22, 2008, the Company renewed its Revolving Credit and Promissory Note and a Security Agreement with a financial institution to borrow up to $10.0 million under a revolving line of credit. The agreement includes a first priority security interest in all of the Company’s assets. Gerald Burnett, Chairman of the Company, provided
a collateralized guarantee to the financial institution, assuring payment of the Company’s obligations under the agreement and as a consequence, there are no restrictive covenants, allowing the Company greater access to the full amount of the facility. In addition to the guarantee provided to the financial institution, on March 29, 2009, Dr. Burnett provided a personal guarantee to Avistar, assuring the Company a line of credit of $10.0 million with the same terms and mechanisms as the existing revolving
line of credit in the event the existing revolving line of credit from the financial institution was unavailable for any reason during the period from its termination on December 21, 2009 to March 31, 2010. The line of credit requires monthly interest-only payments based on Adjusted LIBOR plus 1.25% or Prime Rate plus 1.25%. The Company elected Prime Rate plus 1.25% or 4.5% at September 30, 2009 and December 31, 2008. The Company repaid $5.0 million and borrowed $4.7 million under the revolving line of credit
for the nine months ended September 30, 2009, and has a balance of $6.7 million outstanding as of September 30, 2009.  The Revolving Credit and Promissory Note matures on December 21, 2009, and is subject to annual renewal with the consent of the Company and the lender.




Convertible Debt




On January 4, 2008, Avistar issued $7,000,000 of 4.5% Convertible Subordinated Secured Notes (Notes). The Notes were sold pursuant to a Convertible Note Purchase Agreement to Baldwin Enterprises, Inc., a subsidiary of Leucadia National Corporation, directors Gerald Burnett,  R. Stephen Heinrichs, William Campbell, and Craig Heimark,
Simon Moss and Darren Innes, officers at the date of issuance, and WS Investment Company (collectively, the Purchasers). The Company’s obligations under the Notes are secured by the grant of a security interest in substantially all tangible and intangible assets of the Company pursuant to a Security Agreement among the Company and the Purchasers. The Notes have a two-year term, will be due on January 4, 2010 and are convertible prior to maturity.  Interest on the Notes accrues at the rate of 4.5%
per annum and is payable semi-annually in arrears on June 4 and December 4 of each year.  Commencing on the one-year anniversary of the issuance of the Notes until maturity, the Note holders became entitled to convert the Notes into the Company’s common stock at an initial conversion price per share of $0.70.




In May 2009, the Company issued a total of 4,199,997 shares of the Company’s common stock to Gerald Burnett, R. Stephen Heinrichs, William Campbell, Craig Heimark, Simon Moss and WS Investment Company upon their election to convert their respective notes into common stock.  The total principal amount of notes so converted
was $2.9 million.  $4.1 million in aggregate principal amount of notes remain outstanding as of September 30, 2009.




In October 2009, the Company repaid the Notes issued to Mr. Innes in full with a payment of approximately $60,000. The payment was made pursuant to a waiver and consent entered into by and between the Company, Baldwin Enterprises, Inc. and Mr. Innes effective as of August 28, 2009.




9. Commitments and Contingencies




Facilities Leases




The Company leases its facilities under operating leases that expire at various dates through March 2017.  During 2008 and 2009, the Company has subleased some of its operating facilities in San Mateo, California and New York, New York, and assigned its primary facility lease in London, United Kingdom to third parties. As a
result of these subleases and assignment, the future minimum lease commitments under all facility leases as of September 30, 2009, net of sublease proceeds, are as follows (in thousands):




Minimum lease payments


Sublease proceeds


Net(unaudited)


(unaudited)


(unaudited)Three Months Ending December 31,2009

$
314


$
(153
)

$
161Years Ending December 31,2010


1,280



(532
)


7482011


1,333



(343
)


9902012


567



(290
)


2772013


310



(284
)


26thereafter


1,008



(954
)


54Total future minimum lease payments

$
4,812


$
2,556


$
2,256






16




Software Indemnifications




Avistar enters into standard indemnification agreements in the ordinary course of business. Pursuant to these agreements, Avistar indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally Avistar’s business partners or customers, in connection with
any patent, copyright or other intellectual property infringement claim by any third party with respect to its products. The term of these indemnification agreements is generally perpetual. The maximum potential amount of future payments Avistar could be required to make under these indemnification agreements is generally limited to the cost of products purchased per customer, but may be material when customer purchases since inception are considered in aggregate. Avistar has never incurred costs to defend lawsuits
or settle claims related to these indemnification agreements. Accordingly, Avistar has no liabilities recorded for these agreements as of September 30, 2009.




Microsoft




In fiscal 2008, Microsoft Corporation (Microsoft) filed requests for reexamination of 29 U.S. patents held by Avistar. In June 2008, the U.S. Patent and Trademark Office (USPTO) completed its review of Microsoft’s requests for reexamination and rejected 19 of the requests in their entirety, and the majority of the arguments
for one additional patent under reexamination. The USPTO thus agreed to re-examine, either in part or fully, 10 of the Company’s existing U.S. patents.




During 2008, Microsoft submitted five petitions for reconsideration of the USPTO’s rejection of Microsoft’s request for reexamination.  As of October 31, 2009, two of the Microsoft petitions have been denied. These denials cannot be appealed. Three other petitions by Microsoft are still pending.




As of October 31, 2009, three of the 10 patents being reexamined have been issued with certificates of reexamination. Avistar has filed appeals with the USPTO Board of Patent Appeals and Interferences in six of the 10 patents under reexamination and a response to the latest rejection of the tenth patent under reexamination.




Avistar believes that its U.S. patents are valid and intends to defend its patents through the reexamination process.  However, the reexamination of patents by the USPTO, including appeals, is a lengthy, time consuming and expensive process in which the ultimate outcome is uncertain.  Once initiated, the USPTO may take
between one and three years to complete patent reexaminations.  The reexamination process by the USPTO may adversely impact the Company’s licensing negotiations in process, and may require the Company to spend substantial time and resources defending its patents, including the fees and expenses of legal advisors.  This may impact the Company’s results of operations negatively and require the Company to seek additional financing to fund its operations as well as the expense incurred
in the legal defense of the Company’s patents.




The Company has not recorded an expense related to damages in this matter because any potential loss is not currently probable or reasonably estimable under ASC 450,Contingencies.




10. Recent Accounting Pronouncements




In June 2008, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 07-5, Determining Whether an Instrument (or an Embedded Feature) is Indexed to an Entity’s Own Stock (EITF 07-5) or ASC 815-10-65-3. ASC 815-10-65-3 provides that an entity should use a two-step approach
to evaluate whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock, including evaluating the instrument’s contingent exercise and settlement provisions. ASC 815-10-65-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early application is not permitted. The Company adopted this statement on January 1, 2009.  The adoption of ASC 815-10-65-3 did not have a material
impact on the Company’s financial condition and results of operations.




In April 2009, the FASB issued FASB Staff Position No. FAS 141(R)-1 or ASC 805-10-65-1, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies (FSP FAS 141(R)-1), to amend SFAS 141 (revised 2007), Business
Combinations. ASC 805-10-65-1 addresses the initial recognition, measurement and subsequent accounting for assets and liabilities arising from contingencies in a business combination, and requires that such assets acquired or liabilities assumed be initially recognized at fair value at the acquisition date if fair value can be determined during the measurement period. If the acquisition-date fair value cannot be determined, the asset acquired or liability assumed arising from a contingency is recognized
only if certain criteria are met. This ASC also requires that a systematic and rational basis for subsequently measuring and accounting for the assets or liabilities be developed depending on their nature. ASC 805-10-65-1 is effective for assets or liabilities arising from contingencies in business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008.  The Company adopted this statement upon its issuance.  The
impact of ASC 805-10-65-1 on accounting for business combinations is dependent upon acquisition activity on or after its effective date.




In April 2009, the FASB issued three FASB Staff Position (FSP) statements intended to provide additional guidance and enhance disclosures regarding fair value measurements and impairments of securities.  FASB Staff Position No. FAS 157-4, Determining Fair Value When the Volume and
Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (FSP FAS 157-4) or ASC 820-10-65-4 provides guidelines for making fair value measurements more consistent with the principles presented in FASB Statement No. 157, Fair Value Measurements.  FASB Staff Position No. FAS 107-1 and APB 28-1, Interim Disclosures about Fair
Value of Financial Instruments (FSP FAS 107-1 and APB 28-1) or ASC 825-10-65-1, enhances consistency in financial reporting by increasing the frequency of fair value disclosures.  FASB Staff Position No. 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (FSP FAS 115-2 and FAS 124-2) or ASC 320-10-65-1, provides additional guidance designed to create greater clarity and consistency in accounting for and
presenting impairment losses on securities.  These ASCs are effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009 only if all three ASCs are early adopted at the same time. The Company adopted these ASCs on June 30, 2009.  The adoption of these statements did not have a material impact on the Company’s financial condition and results of operations.




17


In May 2009, the FASB issued Statement No. 165, Subsequent Events(SFAS No. 165) or ASC 855. ASC 855 is intended to establish general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are
available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for selecting that date, that is, whether that date represents the date the financial statements were issued or were available to be issued. ASC 855 is effective for interim or annual financial periods ending after June 15, 2009.  The Company adopted this statement on June 30, 2009.The adoption of ASC 855 did
not have a material impact on the Company’s financial condition and results of operations.




In June 2009, the FASB issued Statement No. 168, The FASB Accounting Codification and Hierarchy of Generally Accepted Accounting Principles- a replacement of FASB No. 162(SFAS No. 168) or ASC 105.  The FASB Accounting Standards CodificationTM  (“Codification”)
does not change U. S. GAAP, but combines all authoritative standards such as those issued by the FASB, AICPA, and EITF, into a comprehensive, topically organized online database.  The Codification was released on July 1, 2009 and will become the single source of authoritative U. S. GAAP applicable for all nongovernmental entities, except for rules and interpretive releases of the SEC.  The Codification is effective for all interim periods and year ends subsequent to September 15, 2009. The
Company adopted this statement on September 30, 2009.  The adoption of this statement affected the Company’s financial statement disclosure references since all future references to authoritative accounting literature will be references in accordance with SFAS 168, but did not have an impact on the Company’s financial condition and results of operations.




In August 2009, the FASB issued Accounting Standards Update No. 2009-05, Fair Value Measurements and Disclosures – Measuring Liabilities at Fair Value (ASU 2009-05).  The update provides clarification for circumstances in which a quoted price in an active market for
an identical liability is not available. ASU 2009-05 is effective for the first reporting period beginning after August 2009.  The Company adopted this statement upon its issuance. The adoption of this statement did not have a material impact on the Company’s financial condition and results of operations.




In October 2009, the FASB issued Accounting Standards Update No. 2009-13, Revenue Recognition (Topic 605) – Multiple-Deliverable Revenue Arrangements, a consensus of the FASB Emerging Issue Task Force (ASU 2009-13), and Accounting Standards Update No. 2009-14, Software
(Topic 985) – Certain Revenue Arrangements That Include Software Elements (ASU 2009-14). ASU 2009-13 requires companies to allocate revenue in multiple-element arrangements based on an element’s estimated selling price if vendor-specific or other third party evidence of value is not available.  ASU 2009-14 modifies the software revenue recognition guidance to exclude from its scope tangible products that contain both software and non-software components that function together to deliver
a product’s essential functionality.  Both statements are effective for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Early adoption is permitted. The Company is currently evaluating the timing and impact of adopting this statement.




11. Other Matters




On June 12, 2009, the Company received a letter from The Nasdaq Stock Market, or Nasdaq, indicating that the Nasdaq Hearings Panel, or the Panel, had determined to delist the shares of the Company from Nasdaq and would suspend the common stock of the Company from trading on Nasdaq effective at the open of
trading on June 24, 2009.  The Panel's decision to suspend the Company's common stock was the result of the Company not evidencing a market value of listed securities above $35 million for ten consecutive trading days, or otherwise demonstrating compliance with alternative continued listing standards, during the period from April 2, 2009 and June 22, 2009.  Trading of the Company’s common stock on Nasdaq was suspended on June 24, 2009. On June 17, 2009, the Company requested a review
by the Nasdaq Listing and Hearing Review Council, or the Council, of the Panel’s decision. The Council granted the Company’s request for a review and requested additional information from the Company be submitted by August 7, 2009.  On August 6, 2009, the Company withdrew its appeal to the Council. On August 20, 2009, Nasdaq notified the Securities and Exchange Commission that it has determined to remove the common stock of the Company from Nasdaq effective at the open of business on August
31, 2009.




The Company’s common stock is currently quoted and traded on the Pink Sheets, whichis an over-the-counter securities market, under the symbol AVSR.PK.





In July 2009, Simon Moss voluntarily resigned from all of the positions which he held with the Company, including his positions as Chief Executive Officer and board member.  On July 9, 2009, Robert Kirk was appointed to replace Simon Moss as the Company’s Chief Executive Officer.




In August 2009, Darren Innes resigned from the Company as its General Manager and Vice President, Global Sales.




18




12. Subsequent Events




The Company has evaluated subsequent events through November 3, 2009, the date the unaudited condensed consolidated financial statements are issued. As of this date, the Company had no other subsequent events.









Item 2.                      Management’s Discussion and Analysis of Financial
Condition and Results of Operations




The following discussion and analysis should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and the related Notes thereto included in this Quarterly Report on Form 10-Q and with Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report
on Form 10-K for the year ended December 31, 2008, as filed with the SEC on March 31, 2009.




This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains both historical information and forward-looking statements. These forward-looking statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors
that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may”, “will”, “should”, “expects”, “intends”, “plans”, “anticipates”, “believes”,
“estimates”, “predicts”, “potential”, “continue” or the negative of these terms, or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. In evaluating these statements, you should specifically consider the various risks and other factors that were discussed  under “Risk Factors” and elsewhere in the 2008 Annual Report on Form 10-K and this Quarterly Report on Form 10-Q. These factors
may cause our actual results to differ materially from any forward looking statement.   Although we believe that the expectations reflected in the forward looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, we are under no duty to update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform these statements to actual results.  These forward-looking statements are made in
reliance upon the safe harbor provision of The Private Securities Litigation Reform Act of 1995.  In addition, historical information should not be considered an indicator of future performance.




Overview




Avistar creates technology that provides the missing critical element in unified communications: bringing people in organizations face-to-face, through enhanced communications for true collaboration anytime, anyplace. Our latest product, Avistar C3, draws on over a decade of market experience to deliver a single-click desktop videoconferencing
and collaboration experience that moves business communications into a new era. Available as a stand-alone solution, or integrated with existing unified communications software from other vendors, Avistar C3 users gain an instant messaging-style ability to initiate video communications across and outside the enterprise. Patented bandwidth management enables thousands of users to access desktop videoconferencing, Voice over IP (VoIP) and streaming media without requiring substantial new network investment or impairing
network performance.  By integrating Avistar C3 tightly into the way they work, our customers can use our solutions to help reduce costs and improve productivity and communications within their enterprise and between enterprises, and to enhance their relationships with customers, suppliers and partners. Using Avistar C3 software and leveraging video, telephony and Internet networking standards, Avistar solutions are designed to be scalable, reliable, cost effective, easy to use, and capable of evolving
with communications networks as bandwidth increases and as new standards and protocols emerge. We currently sell our system directly and indirectly to the small and medium sized business, or SMB, and globally distributed organizations, or Enterprise, markets comprising the Global 5000. Our objective is to establish our technology as the standard for networked visual unified communications and collaboration through limited direct sales, indirect channel sales/partnerships, and the licensing of our technology to
others. We also seek to license our broad portfolio of patents covering, among other areas, video and rich media collaboration technologies, networked real-time text and non-text communications and desktop workstation echo cancellation.




We have three go-to-market strategies. Product and Technology Sales involves direct and channel sales of video and unified communications and collaboration solutions and associated support services to the Global 5000. Partner and Technology Licensing involves co-marketing, sales and development, embedding, integration and interoperability
to enterprises. IP Licensing involves the prosecution, maintenance, support and licensing of the intellectual property that we have developed, some of which is used in our products.




19


Since inception, we have recognized the innovative value of our research and development efforts, and have invested in securing protection for these innovations through domestic and foreign patent applications and issuance. As of September 30, 2009, we held 98 U.S. and foreign patents, which we look to license to others in the collaboration
technology marketplace.




In late 2007 and 2008, we implemented corporate initiatives aimed at increasing our product sales, expanding our customer deployments and support, improving our corporate efficiency and increasing our development capacity.  The components of these initiatives included:




·
Centering our sales, marketing and operations activities, and associated management functions in our New York City office;




·
Supplementing our position in the financial services vertical by expanding our market focus to additional verticals with complex business problems, where our collaboration products can help global organizations speed business processes, save costs and reduce their carbon footprints;




·
Engaging the market with a new, dynamic application integration and software-only product set with video as the primary, empowering technology;




·
Implementing aggressive cost control measures structured to effectively align operations and to address Microsoft's requests for reexamination of our U.S. Patents, while still allowing us to continue to invest in our product line and to license our intellectual property and technology,




·
A reduction in our employees from an average of 88 in 2007 to approximately 47 on September 30, 2009; and




·
Pursuing multiple distribution, services and technology partners.




These and other changes in our business were aimed at reducing our structural costs, increasing our organizational and partner-driven capacity, and leveraging our reputation for innovation and intellectual property leadership in order to grow and expand our business.  However, these organizational changes and initiatives involve
transitional costs and expenses and result in uncertainty in terms of their implementation and their impact on our business.




On February 25, 2008 we announced that Microsoft Corporation had filed requests for reexamination of 24 of our 29 U.S. patents. Subsequently, Microsoft also filed requests for reexamination of our remaining five U.S. patents. On June 10, 2008 we announced that the U.S. Patent and Trademark Office (USPTO) had completed its review of Microsoft’s
requests for reexamination and had rejected 19 of the requests in their entirety, and the majority of the arguments for one additional patent under reexamination. The USPTO thus agreed to reexamine, either in part or fully, 10 of our existing U.S. patents.




During 2008, Microsoft submitted five petitions for reconsideration of the USPTO’s rejection of Microsoft’s requests for reexamination. As of October 31, 2009 two of the Microsoft petitions have been denied. These denials cannot be appealed. Three other petitions by Microsoft are still pending.




As of October 31, 2009, three of the 10 patents being reexamined have been issued with certificates of reexamination.  We have filed appeals with the USPTO Board of Patent Appeals and Interferences in six of the 10 patents under reexamination and a response to the latest rejection of the tenth patent under reexamination.




We believe that our U.S. patents are valid and we intend to defend our patents through the reexamination process.  However, the reexamination of patents by the USPTO, including appeals, is a lengthy, time-consuming and expensive process in which the ultimate outcome is uncertain. Once initiated, the USPTO may take between one and
three years to complete patent reexaminations.   The reexamination process by the USPTO may adversely impact and delay our present and future licensing negotiations, and may require us to spend substantial time and resources defending our patents, including the fees and expenses of our legal advisors.  The potential impact to our results of operations may require us to reduce our other operating expenses and seek additional financing to fund our operations and the defense of our patents.




Critical Accounting Policies




The preparation of our Condensed Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base
our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.




Management believes that there have been no significant changes to our critical accounting policies during the three and nine months ended September 30, 2009 from those disclosed in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended December 31,
2008.






20




Results of Operations




The following table sets forth data expressed as a percentage of total revenue for the periods indicated.




Percentage of Total Revenue


Percentage of Total RevenueThree Months EndedSeptember 30,


Nine Months EndedSeptember 30,2009


2008


2009


2008Revenue:Product


20
%


48
%


47
%


37
%Licensing


25



14



8



12Services, maintenance and support


55



38



45



51Total revenue


100



100



100



100Costs and Expenses:Cost of product revenue


18



27



13



29Cost of services, maintenance and support revenue


52



22



35



30Income from settlement and patent licensing


(74
)


(39
)


(46
)


(56
)Research and development


62



41



40



70Sales and marketing


44



23



29



49General and administrative


120



51



60



83Total costs and expenses


222



125



131



205Loss from operations


(122
)


(25
)


(31
)


(105
)Other income (expense):Interest income


—



1



—



2Other expense, net


(10
)


(5
)


(4
)


(6
)Total other expense, net


(10
)


(4
)


(4
)


(4
)Net loss


(132
)%


(29
)%


(35
)%


(109
)%





COMPARISON OF THE THREE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008




Revenue




Total revenue decreased by $1.3 million or 47%, to $1.4 million for the three month period ended September 30, 2009, from $2.7 million for the three months ended September 30, 2008, primarily due to decrease in hardware sales revenue.




·
Product revenue decreased by $1.0 million or 78%, to $289,000 for the three month period ended September 30, 2009 from $1.3 million for the three months ended September 30, 2008. This was primarily due to decline in hardware sales revenue in the quarter ended September 30, 2009 as the Company shifted to more software-only based products and solutions.




·
Licensing revenue, relating to the licensing of our patent portfolio, remained relatively flat at $350,000 for the three months ended September 30, 2009 compared to $367,000 for the three months ended September 30, 2008.




·
Services, maintenance and support revenue, which includes funded software development and maintenance and support, decreased by $235,000, or 23%, to $790,000 for the three months ended September 30, 2009, from $1.0 million for the three months ended September 30, 2008, due primarily to a decrease in revenue from maintenance contracts with existing customers
in the quarter ended September 30, 2009.




For the three months ended September 30, 2009, revenue from three customers accounted for 86% of total revenue compared to four customers and 89% for the three months ended September 30, 2008. No other customer accounted for greater than 10% of total revenue in either period.  The level of sales to any customer may vary from quarter
to quarter. We expect that there will be significant customer concentration in future quarters. The loss of any one of those customers would have a materially adverse impact on our financial condition and operating results.




Costs and expenses




Cost of product revenue.Cost of product revenue decreased by $457,000 or 63%, to $263,000 for the three months ended September 30, 2009 from $720,000 for the three months ended September 30, 2008.  The decrease
was mainly attributable to lower hardware product sales in the quarter ended September 30, 2009 which carried a higher cost than software sales.




Cost of services, maintenance and support revenue.Cost of services, maintenance and support revenue increased by $153,000, or 26%, to $737,000 for the three months ended September 30, 2009, from $584,000 for the three months
ended September 30, 2008, primarily due to an increase in software implementation and enhancement services for customers in the quarter ended September 30, 2009 compared to the same period in 2008.






21




Income from settlement and patent licensing.Income from settlement and patent licensing was $1.1 million for the three months ended September 30, 2009 and 2008, reflecting the amortization of the net proceeds from the November
2004 Polycom settlement and cross-license agreement over a five year period, beginning in November 2004 and ending in November 2009.




Research and development.Research and development expenses decreased by $231,000, or 21%, to $891,000 for the three months ended September 30, 2009 from $1.1 million for the three months ended September 30, 2008.  This
decrease was primarily due to greater allocation of engineering employee and external labor expenses to cost of services, maintenance and support revenue associated with an increased number of software implementation and enhancement service deliveries and reduction in overhead expenses in the quarter ended September 30, 2009.




Sales and marketing. Sales and marketing expenses remained relatively flat at $629,000 for the three months ended September 30, 2009 compared to $634,000 for the same period in 2008.




General and administrative. General and administrative expenses increased by $340,000, or 25% to $1.7 million for the three months ended September 30, 2009, from $1.4 million for the three months ended September 30, 2008. The increase was due primarily to the severance pay of $473,000
for Simon Moss, former Chief Executive Officer, and other former executives,  and legal expense of $311,000 associated with patent and licensing related activities, offset by a decrease in personnel and personnel related expenses and cost optimization efforts.




Other income (expense)




Interest income. Interest income was nominal for the three months ended September 30, 2009, compared to $15,000 for the same period in 2008, primarily due to lower average outstanding balance of cash and cash equivalents that earned interest in the three months ended September 30, 2009
compared to the same period in 2008.




Other expense, net. Other expense, net, increased by $20,000, or 16%, to $142,000 for the three months ended September 30, 2009, from $122,000 for the three months ended September 30, 2008, primarily due to foreign corporate tax expense associated with our wholly-owned subsidiary, Avistar
Systems U.K. Limited, or ASUK.







COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008




Revenue




Total revenue increased by $1.3 million or 23%, to $6.9 million for the nine month period ended September 30, 2009, from $5.6 million for the nine months ended September 30, 2008, primarily due to increase in software product revenue.




·
Product revenue increased by $1.1 million or 53%, to $3.2 million for the nine month period ended September 30, 2009 from $2.1 million for the nine months ended September 30, 2008. The increase was due primarily to an increase in software product revenue from IBM and Deutsche Bank, partially offset by decrease in hardware sales revenue, in the nine months
ended September 30, 2009.




·
Licensing revenue, relating to the licensing of our patent portfolio, decreased by $102,000 or 15%, to $572,000 for the nine months ended September 30, 2009 from $674,000 for the nine months ended September 30, 2008, mainly due to a decline in the ongoing royalty revenue from Sony.




·
Services, maintenance and support revenue, which includes funded software development and maintenance and support, increased by $273,000, or 10%, to $3.1 million for the nine months ended September 30, 2009, from $2.9 million for the nine months ended September 30, 2008,  due primarily to increase in revenue from software implementation and enhancement
services and professional on-site services provided to existing customers, offset by a decrease in revenue from maintenance contracts with existing customers in the nine months ended September 30, 2009.




For the nine months ended September 30, 2009, revenue from three customers accounted for 71% of total revenue compared to three customers and 81% for the nine months ended September 30, 2008. No other customer accounted for greater than 10% of total revenue.  The level of sales to any customer may vary from quarter to quarter. We expect
that there will be significant customer concentration in future quarters. The loss of any one of those customers would have a materially adverse impact on our financial condition and operating results.




Costs and expenses




Cost of product revenue.Cost of product revenue decreased by $718,000 or 44%, to $926,000 for the nine months ended September 30, 2009 from $1.6 million for the nine months ended September 30, 2008.  The decrease
was mainly attributable to lower hardware product sales which carried a higher cost than software sales, offset by an increase of $95,000 in stock based compensation expense in the nine months ended September 30, 2009.




22




Cost of services, maintenance and support revenue.Cost of services, maintenance and support revenue increased by $694,000, or 41%, to $2.4 million for the nine months ended September 30, 2009, from $1.7 million for the nine
months ended September 30, 2008, primarily due to an increase in software implementation and enhancement services for customers in the nine months ended September 30, 2009 compared to the same period in 2008.




Income from settlement and patent licensing.Income from settlement and patent licensing was $3.2 million for the nine months ended September 30, 2009 and 2008, reflecting the amortization of the net proceeds from the November
2004 Polycom settlement and cross-license agreement over a five year period, beginning in November 2004 and ending in November 2009.




Research and development.Research and development expenses decreased by $1.2 million, or 29%, to $2.8 million for the nine months ended September 30, 2009 from $3.9 million for the nine months ended September 30, 2008. This
decrease was primarily due to a reduction in personnel and personnel related expenses, a greater allocation of engineering employee and external labor expenses to cost of services, maintenance and support revenue associated with an increase in software implementation and enhancement service deliveries in the nine months ended September 30, 2009, partially offset by an increase of $124,000 in stock based compensation expense.




Sales and marketing. Sales and marketing expenses decreased by $760,000, or 28%, to $2.0 million for the nine months ended September 30, 2009, from $2.8 million for the nine months ended September 30, 2008. The decrease was due primarily to a reduction in personnel and personnel related
expenses and cost optimization efforts, partially offset by an increase of $179,000 in stock based compensation expense.




General and administrative. General and administrative expenses decreased by $540,000, or 12% to $4.1 million for the nine months ended September 30, 2009, from $4.7 million for the nine months ended September 30, 2008. The decrease was due primarily to an overall decrease in personnel
and personnel related expenses and the ongoing cost optimization efforts, partially offset by severance expenses and an increase of $75,000 in stock based compensation expense, in the nine months ended September 30, 2009.




Other income (expense)




Interest income. Interest income decreased by $74,000, or 90%, to $8,000 for the nine months ended September 30, 2009, from $82,000 for the nine months ended September 30, 2008, primarily due to both a decrease in interest rates and a decrease in the average outstanding balance of cash
and cash equivalents that earned interest in the nine months ended September 30, 2009 compared to the same period in 2008.




Other expense, net. Other expense, net, decreased by $6,000, or 2%, to $329,000 for the nine months ended September 30, 2009, from $335,000 for the nine months ended September 30, 2008, primarily due to a decrease in the interest expense resulting from lower average convertible debt
and line of credit balances outstanding during the nine months ended September 30, 2009.




Liquidity and Capital Resources




We had cash and cash equivalents of $382,000 and $4.9 million as of September 30, 2009 and December 31, 2008, respectively. For the nine months ended September 30, 2009, we had a net decrease in cash and cash equivalents of $4.5 million. The net cash used by operations of $4.3 million for the nine months ended September 30, 2009 resulted
primarily from the net loss of $2.5 million,  a decrease in deferred income from settlement and patent licensing of $4.1 million, a decrease in deferred services revenue and customer deposits of $2.5 million, offset by a decrease in accounts receivable of $1.5 million, a decrease in inventory of $171,000,  a decrease in deferred settlement and patent licensing costs of $955,000 and non-cash expenses of $1.6 million.  The net cash used in investing activities of $47,000 for the nine months
ended September 30, 2009 was related to purchases of equipment.  The net cash used in financing activities of $176,000 for the nine months ended September 30, 2009 related primarily to payments made on our line of credit of $5.0 million, offset by $4.7 million of borrowings on our line of credit and $173,000 in proceeds from the issuance of common stock under employee stock option and stock purchase plans.




At September 30, 2009, we had approximately $2.3 million in minimum commitments under non-cancelable operating leases net of sublease proceeds.




On December 22, 2008, we renewed our Revolving Credit and Promissory Note and a Security Agreement with a financial institution to borrow up to $10.0 million under a revolving line of credit. The agreement includes a first priority security interest in all of our assets. Gerald Burnett, our Chairman, provided
a collateralized guarantee to the financial institution, assuring payment of our obligations under the agreement and as a consequence, there are no restrictive covenants, allowing us greater access to the full amount of the facility.  In addition to the guarantee provided to the financial institution, on March 29, 2009, Dr. Burnett provided a personal guarantee to us assuring us a line of credit of $10.0 million with the same terms and mechanisms as the existing revolving line of credit in the event
the existing revolving line of credit from the financial institution was unavailable for any reason during the period from its termination on December 21, 2009 to March 31, 2010.The line of credit requires monthly interest-only payments based on Adjusted LIBOR plus 1.25% or Prime Rate plus 1.25%. We elected Prime Rate plus 1.25% or 4.5% at September 30, 2009 and December 31, 2008. We repaid $5.0 million and borrowed $4.7 million under the revolving line of credit for the nine months ended September
30, 2009 and have a balance of $6.7 million outstanding as of September 30, 2009.  The Revolving Credit and Promissory Note matures on December 21, 2009, and is subject to annual renewal with the consent of the Company and the lender.




23


On January 4, 2008, we issued $7,000,000 of 4.5% Convertible Subordinated Secured Notes, which are due in 2010 (Notes). The Notes were sold pursuant to a Convertible Note Purchase Agreement to Baldwin Enterprises, Inc., a subsidiary of Leucadia National Corporation, directors Gerald Burnett, R. Stephen Heinrichs,
William Campbell, and Craig Heimark, former officers Simon Moss and Darren Innes, and WS Investment Company. Our obligations under the Notes are secured by the grant of a security interest in substantially all our tangible and intangible assets pursuant to a Security Agreement between us and the purchasers. The Notes have a two year term, will be due on January 4, 2010 and are convertible prior to maturity.  Interest on the Notes accrues at the rate of 4.5% per annum and is payable semi-annually in
arrears on June 4 and December 4 of each year.Commencing on the one-year anniversary of the issuance of the Notes, the Note holders became entitled to convert the Notes into common stock at an initial conversion price of $0.70 per share.  In May 2009, we issued a total of 4,199,997 shares of common stock to Gerald Burnett, R. Stephen Heinrichs, William Campbell, Craig Heimark, Simon Moss and WS Investment Company upon their election to convert
their notes with an aggregate principal amount of $2.9 million into common stock.  $4.1 million in notes remained outstanding as of September 30, 2009.




As of September 30, 2009, we had no material off-balance sheet arrangements, other than the operating leases described above.   We enter into indemnification provisions under agreements with other companies in our ordinary course of business, typically with our contractors, customers, landlords
and our investors. Under these provisions, we generally indemnify and hold harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of our activities or, in some cases, as a result of the indemnified party's activities under the agreement. These indemnification provisions generally survive termination of the underlying agreement. The maximum potential amount of future payments we could be required to make under these indemnification provisions is generally unlimited.
As of September 30, 2009, we have not incurred material costs to defend lawsuits or settle claims related to these indemnifications agreements and therefore, we have no liabilities recorded for these agreements as of September 30, 2009.




In October 2009, we paid approximately $60,000 to Darren Innes as payment in full for his note pursuant to a waiver and consent entered into by and between Avistar, Baldwin Enterprises, Inc. and Mr. Innes effective as of August 28, 2009. We are currently in discussions with the remaining holder of the Notes to
convert the Notes into shares of common stock in January 2010 or extend the term of the Notes.  Assuming the successful conversion or extension of the Notes in conjunction with the results of our cost reduction efforts, including Dr. Burnett's personal guarantee to Avistar to support an extension of the revolving line of credit, we believe that our existing cash and cash equivalents balance and line of credit will provide us with sufficient funds to finance our operations for the next 12 months. We
intend to continue to invest in the development of new products and enhancements to our existing products. Our future liquidity and capital requirements will depend upon numerous factors, including without limitation, whether or not the holders of the Notes elect to convert such Notes into our common stock, general economic conditions and conditions in the financial services industry in particular, the level and timing of product, services and patent licensing revenues and income, the maintenance of our cost
control measures structured to align operations with predictable revenues, the costs and timing of our product development efforts and the success of these development efforts, the costs and timing of our sales, partnering and marketing activities, the extent to which our existing and new products gain market acceptance, competing technological and market developments, and the costs involved in maintaining, defending and enforcing patent claims and other intellectual property rights, all of which may impact our
ability to achieve and maintain profitability or generate positive cash flows.




From time to time, we may be required to raise additional funds through public or private financing, strategic relationships or other arrangements. There can be no assurance that such funding, if needed, will be available on terms attractive to us, or at all. Furthermore, any additional debt or equity financing
arrangements may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants. Strategic arrangements, if necessary to raise additional funds, may require us to relinquish some or all of our rights to certain of our technologies or products. Our potential inability to raise capital when needed could have a material adverse effect on our business, operating results and financial condition.




Recent Accounting Pronouncements




See Note 10 to our unaudited condensed consolidated financial statements included in this report for recently issued accounting standards, including the expected dates of adoption and estimated effects on our condensed consolidated financial statements.




Item 3.                      Quantitative and Qualitative Disclosures about Market
Risk




As a “smaller reporting company” as defined by Regulation S-K, the Company is not required to provide information required by this item.






24




Item 4T.                      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 (the Evaluation Date). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded as of the Evaluation Date 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)) were effective such that information required to be disclosed by us in reports that we file or submit under the Exchange Act (i) is accumulated and communicated to our management, including our Chief Executive
Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure, and (ii) is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.  In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and executed, can provide only reasonable assurance of achieving the desired control objectives. 
In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.




(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.




PART II- OTHER INFORMATION




Item 1.                      Legal Proceedings




We are not currently party to any legal proceedings and are not aware of any threatened legal proceedings against us.




From time to time we may encounter other claims in the normal course of business that are not expected to have a material effect on our business.  However, dispute resolution is inherently unpredictable, and the costs and other effects of pending or future claims, litigation, legal and administrative cases and proceedings, and changes
in any such matters, and developments or assertions by or against us relating to intellectual property rights and intellectual property licenses, could have a material adverse effect on our business, financial condition and operating results.




Item 1A.                      Risk
Factors




This Quarterly Report on Form 10-Q, or Form 10-Q, including any information incorporated by reference herein, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, referred to as the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, referred to as
the Exchange Act.  In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “forecast,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” or the negative of these terms or other comparable terminology.  The forward-looking statements contained
in this Form 10-Q involve known and unknown risks, uncertainties and situations that may cause our or our industry’s actual results, level of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these statements.  These factors include those listed below in this Item 1A and those discussed elsewhere in this Form 10-Q.  We encourage investors to review these factors carefully.  We
may from time to time make additional written and oral forward-looking statements, including statements contained in our filings with the SEC.  However, we do not undertake to update any forward-looking statement that may be made from time to time by or on behalf of us.




Before you invest in our securities, you should be aware that our business faces numerous financial and market risks, including those described below, as well as general economic and business risks.  The following discussion provides information concerning the material risks and uncertainties that we have identified and believe
may adversely affect our business, our financial condition and our results of operations.  Before you decide whether to invest in our securities, you should carefully consider these risks and uncertainties, together with all of the other information included in this Quarterly Report on Form 10-Q, our Annual Report on Form 10-K for the year ended December 31, 2008 and in our other public filings.




This risks set forth below supersede the description of the risk factors associated with our business previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2008.




25




Risks Relating to the Stock Markets and Our Stock Price




Our Stock is quoted on the Pink Sheets, which may decrease the liquidity of our common stock.




On June 24, 2009, the Nasdaq Stock Market, Inc. suspended our common stock from trading on Nasdaq because we did not evidence a market value of listed securities above $35 million for ten consecutive trading days, or otherwise demonstrate compliance with alternative continued listing standards, during the period from April 2, 2009 and June
22, 2009.  Since that time our common stock has been quoted on the Pink Sheets under the symbol AVSR.PK.  On August 6, 2009, we withdrew our appeal to the Nasdaq Listing and Hearing Review Council. On August 31, 2009, the Nasdaq Stock Market, Inc. officially delisted our common stock.




Broker-dealers often decline to trade in Pink Sheet stocks given that the market for such securities is often limited, the stocks are more volatile, and the risk to investors is greater than with stocks listed on other national securities exchanges. Consequently, selling our common stock can be difficult because smaller quantities of shares
can be bought and sold, transactions can be delayed and news media coverage of our Company may be reduced. These factors could result in lower prices and larger spreads in the bid and ask prices for shares of our common stock as well as lower trading volume. Investors should realize that they may be unable to sell shares of our common stock that they purchase. Accordingly, investors must be able to bear the financial risks associated with losing their entire investment in our common stock.




Our common stock may be subject to penny stock rules, which may make it more difficult for our stockholders to sell their common stock.




Our common stock may be considered a “penny stock” pursuant to Rule 3a51-1 of the Exchange Act. Broker-dealer practices in connection with transactions in penny stocks are regulated by certain penny stock rules adopted by the SEC. Penny stocks generally are defined as equity securities with a price of less than $5.00 per share.
The penny stock rules require a broker-dealer, prior to purchase or sale of a penny stock not otherwise exempt from the rules, to deliver to the customer a standardized risk disclosure document that provides information about penny stocks and the risks associated with the penny stock market. The broker-dealer also must provide the customer with current bid and offer quotations for the penny stock, the compensation of the broker-dealer and its salesperson in the transaction, and monthly account statements showing
the market value of each penny stock held in the customer account. In addition, the penny stock rules generally require that, prior to a transaction in a penny stock, the broker-dealer make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser’s written agreement to the transaction. These disclosure requirements may have the effect of reducing the level of trading activity in the secondary market of a stock that becomes subject to the penny
stock rules.




We have incurred substantial losses in the past and may not be profitable in the future.




We recorded a net loss of $2.5 million for the nine months ended September 30, 2009, a net loss of $6.4 million for fiscal year 2008 and a net loss of $2.9 million for fiscal year 2007. As of September 30, 2009, our accumulated deficit was $115 million. Our revenue and income from settlement and patent licensing may not increase, or even
remain at its current level. In addition, our operating expenses, which have been reduced recently, may increase as we continue to develop our business and pursue licensing opportunities. As a result, to become profitable, we will need to increase our revenue and income from settlement and patent licensing by increasing sales to existing customers and by attracting additional new customers, distribution partners and licensees. If our revenue does not increase adequately, we may not become profitable. Due to the
volatility of our product and licensing revenue and our income from settlement and patent licensing activities, we may not be able to achieve, sustain or increase profitability on a quarterly or annual basis. If we fail to achieve or to maintain profitability or to sustain or grow our profits within the time frame expected by investors, the market price of our common stock may be adversely impacted.




Our common stock has been and will likely continue to be subject to substantial price and volume fluctuations due to a number of factors, many of which will be beyond our control, which may prevent our stockholders from reselling our common stock at a profit.




The trading price of our common stock has in the past been and could in the future be subject to significant fluctuations in response to:




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




•      quarterly variations in our results of operations;




•      announcements regarding our product developments;




•      the size and timing of agreements to license our patent portfolio or enter into technology or distribution partnerships;




•
developments in the examination of our patent applications and the reexamination of some of our issued patents by the U.S. Patent and Trademark Office;




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




•      announcements of competitive product introductions by our competitors;




•      limited trading volume of shares; and,




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




If our revenue and results of operations are below the expectations of public market securities analysts or investors, then significant fluctuations in the market price of our common stock could occur. In addition, the securities markets have recently experienced significant price and volume fluctuations, which have particularly affected
the market prices for high technology and micro-cap companies, and which often are unrelated and disproportionate to the operating performance of specific companies. These broad market fluctuations, as well as general economic, political and market conditions, may negatively affect the market price of our common stock.




26


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




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




These provisions may have the effect of delaying, deferring or preventing a change in the control of Avistar despite possible benefits to our stockholders, may discourage bids at a premium over the market price of our common stock, and may adversely affect the market price of our common stock and the voting and other rights of our stockholders.




Our principal stockholders can exercise a controlling influence over our business affairs and they may make business decisions with which you disagree and which may affect the value of your investment.




Our executive officers, directors and entities affiliated with them, in the aggregate, beneficially owned approximately 63% of our common stock as of September 30, 2009. If they were to act together, these stockholders would be able to exercise control over most matters requiring approval by our stockholders, including the election of directors
and approval of significant corporate transactions. These actions may be taken even if they are opposed by other investors. This concentration of ownership may also have the effect of delaying or preventing a change in control of Avistar, which could cause the market price of our common stock to decline.




If our share price is volatile, we may be the target 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 technology companies have been subject to this type of litigation. Our share price has, in the past, experienced price volatility, and may continue to do so in the future. If
the market value of our common stock experiences adverse fluctuations and we become involved in this type of litigation, regardless of the merits or outcome, we could incur substantial legal costs and our management’s attention could be diverted, causing our business, financial condition and operating results to suffer.




Risks Related to Our Business




Our expected future working capital needs may require that we seek additional debt or equity funding which, if not available on acceptable terms, could cause our business to suffer.




We may need to arrange for the availability of additional funding in order to meet our future business requirements. We have a revolving credit facility under which $6.7 million was outstanding on September 30, 2009, which matures on December 21, 2009, and $4.1 million in outstanding convertible promissory notes that become due and payable
on January 4, 2010 if not earlier converted. If we are unable to obtain additional funding when needed on acceptable terms, we may not be able to develop or enhance our products, take advantage of opportunities, respond to competitive pressures or unanticipated requirements, or finance our efforts to protect and enforce our intellectual property rights, which could seriously harm our business, financial condition, results of operations and ability to continue operations.  We have in the past, and may
in the future, reduce our expenditures by reducing our employee headcount in order to better align our expenditures with our available resources.  Any such reductions may adversely affect our ability to maintain or grow our business.




27




We have implemented significant changes in our organizational structure, sales, marketing and distribution strategies, licensing efforts and strategic direction, which, if unsuccessful, could adversely affect our business and results of operations.




We have experienced significant changes in our management structure and composition.  In September 2007, William Campbell resigned from the position of Chief Operating Officer.  Simon Moss was appointed as President of our products division in July 2007 and was appointed as our Chief Executive Officer in January 2008 when
Gerald Burnett resigned from his position as our Chief Executive Officer.  In January 2009, Bob Habig resigned from the position of Chief Financial Officer and he was replaced in that position by Elias MurrayMetzger, the Company’s Corporate Controller.  In July 2009, Simon Moss resigned from his positions as Chief Executive Officer and board member.  Shortly thereafter, Robert Kirk was appointed to replace Simon Moss as the Company’s Chief Executive Officer.  In
August 2009, Darren Innes resigned from the position of General Manager and Vice President, Global Sales. In addition, during the second half of 2007 and in 2008, we implemented a number of other management changes.  In 2007 and 2008, we implemented an intensive set of corporate initiatives aimed at increasing our product sales, expanding our customer deployments and support, improving our corporate efficiency and increasing our development capacity.  The components of this initiative included:




•
Supplementing our position in the financial services vertical by expanding our market focus to additional verticals through indirect distribution partners, where our collaboration products can help global organizations speed business processes, save costs and reduce their carbon footprints;




•
Implementing aggressive cost control measures structured to effectively align operations  with predictable revenues and to address Microsoft's requests for reexamination of our U.S. Patents, while still allowing us to continue to invest in our product line and to license our intellectual property and technology;




•      A reduction in our employees from an average of 88 in 2007 to approximately 47 at September 30, 2009; and




•      Pursuing multiple distribution, services and technology licensing partners.




These and other changes in our business are aimed at reducing our structural costs, increasing our organizational and partner-driven capacity, leveraging our reputation for innovation and intellectual property leadership, and growing and expanding our business.  However, these organizational changes and initiatives involve transitional
costs and expenses and result in uncertainty in terms of their implementation and their impact on our business. For example, our efforts to expand our market focus to additional verticals through the use of distribution partners has proven challenging as such distribution partners work to better understand our product and service offerings and integrate them into their own marketing and sales strategies.   As with any significant organizational change, our initiatives will take time to implement,
and the results of these initiatives may not be fully apparent in the near term.  If our initiatives are unsuccessful in achieving our stated objectives, our business could be harmed and our results of operations and financial condition could be adversely affected.




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




Our ability to achieve profitability depends in part on the widespread adoption of networked video communications systems and the sale and adoption of our video system in particular, either as a separate solution or as a technology integrated into a unified communications platform. If the market for our system and technology fails to grow
or grows more slowly than we anticipate, we may not be able to increase revenue or achieve profitability. The market for our system is relatively new and evolving. We have to devote substantial resources to educating prospective customers, distributors and technology partners about the uses and benefits of our system and the value added through the adoption of our technology. Our efforts to educate potential customers and partners may not result in our system achieving broad market acceptance. In addition, businesses
that have invested or may invest substantial resources in other video products may be reluctant or slow to adopt our system or technology. Consequently, the conversion from traditional methods of communication to the extensive use of networked video and unified communications may not occur as rapidly as we wish.




Our lengthy sales cycle to acquire new customers, large follow-on orders, distributors and technology partners may cause our operating results to vary significantly and make it more difficult to forecast our revenue.




We have generally experienced a product sales cycle of four to nine months for new customers or large follow-on orders from existing customers through direct sales.   This sales cycle is due to the time needed to educate customers about the uses and benefits of our system, and the time needed to process the investment decisions
that our prospective customers must make when they decide to buy our system. Many of our prospective customers have neither budgeted expenses for networked video communications systems, nor for personnel specifically dedicated to the procurement, installation or support of these systems. As a result, our customers spend a substantial amount of time before purchasing our system in performing internal reviews and obtaining capital expenditure approvals. Economic conditions over the last several years have contributed
to additional deliberation and an associated delay in the sales cycle.




Our lengthy sales cycle is one of the factors that has caused, and may continue to cause our operating results to vary significantly from quarter-to-quarter and year-to-year in the future. This makes it difficult for us to forecast revenue, and could cause volatility in the market price of our common stock.  Our shift to indirect
distribution partners further limits the visibility we have on the progress and timing of large initial or follow-on orders. A lost or delayed order could result in lower than expected revenue in a particular quarter or year. There is also a tendency in the technology industry to close business deals at the end of a quarter, thereby increasing the likelihood that a possible material deal would not be concluded in a current quarter, but slip into a subsequent reporting period. This kind of delay may result in
a given quarter’s performance being below shareholder expectations.




28


Because we still depend on a few customers for a majority of our product revenue, services revenue, and income from settlement and patent licensing, the loss of one or more of them could cause a significant decrease in our operating results.




To date, a significant portion of our revenue and income from settlement and patent licensing has resulted from sales or licenses to a limited number of customers. For the nine months ended September 30, 2009, revenue from three customers accounted for 71% of total revenue. For the nine months ended September 30, 2008, revenue from three
customers accounted for 81% of total revenue. No other customer accounted for greater than 10% of total revenue. As of September 30, 2009, approximately 82% of our gross accounts receivable was concentrated with two customers, each of whom represented more than 10% of the total gross accounts receivable. As of December 31, 2008, approximately 98% of our gross accounts receivable was concentrated with four customers, each of whom represented more than 10% of our gross accounts receivable.




The loss of a major customer or the reduction, delay or cancellation of orders from one or more of our significant customers could cause our revenue to decline and our losses to increase.  Additionally, we expect to complete the amortization of the Polycom, Inc. proceeds in 2009. If we are unable to license our patent portfolio
to additional parties on terms equal to or better than our agreements with Polycom, Inc. and Tandberg, our licensing revenue and our income from settlement and licensing will decline, which could cause our losses to increase. We currently depend on a limited number of customers with lengthy budgeting cycles and unpredictable buying patterns, and as a result, our revenue from quarter-to-quarter or year-to-year may be volatile. Adverse changes in our revenue or operating results as a result of these budgeting cycles
or any other reduction in capital expenditures by our large customers could substantially reduce the trading price of our common stock.




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




Future hardware and software platforms embodying new technologies and the emergence of new industry standards and customer requirements could render our system non-competitive or even obsolete.  Additionally, communication and collaboration products and technologies are moving towards integrated platforms characterized as unified
communications. The market for our system reflects:




•      rapid technological change;




•      the emergence of new competitors;




•      significant development costs;




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




•      integration of joint solutions in collaboration platforms;




•      evolving industry standards;




•      transition from hardware appliances and infrastructure to software; and




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




Our system is designed to work with a variety of hardware and software configurations, and be integrated with commoditized components (example: “web cams”) of data networking infrastructures used by our customers. The majority of these customer networks rely on Microsoft Windows servers. However, our software may not operate correctly
on other hardware and software platforms or with other programming languages, database environments and systems that our customers use. Also, we must constantly modify and improve our system to keep pace with changes made to our customers’ platforms, data networking infrastructures, and their evolving ability to integrate video with other applications. This may result in uncertainty relating to the timing and nature of our new release announcements, introductions or modifications, which in turn may cause
confusion in the market, with a potentially harmful effect on our business. If we fail to promptly modify, integrate, or improve our system in response to evolving industry standards or customers’ demands, our system could become less competitive, which would harm our financial condition and reputation.




Difficulties or delays in integrating our products with technology partner’s products could harm our revenue and margins.




We generally recognize initial product and installation revenue upon the installation of our system in those cases where we are responsible for installation, which often entails working with sophisticated software and computing and communications systems. Under certain circumstances initial product and installation revenue is recognized under
the percentage of completion method. The estimate of current period percentage of completion requires significant management judgment and is subject to updates in future periods until the project is complete. If we experience difficulties with installations or do not meet deadlines due to delays caused by our customers or ourselves, we could be required to devote more customer support, technical, engineering and other resources to a particular installation, modification or enhancement project, and revenue may
be delayed.




29


Competition could reduce our market share and decrease our revenue.




The market in which we operate is highly competitive. In addition, because our industry is relatively new and is characterized by rapid technological change, evolving user needs, developing industry standards and protocols and the introduction of new products and services, it is difficult for us to predict whether or when new competing technologies
or new competitors will enter our market. Currently, our competition comes from many other kinds of companies, including communication equipment, integrated solution, broadcast video and stand-alone “point solution” providers. Within the video-enabled network communications market, we compete primarily against Polycom, Inc., Tandberg ASA, Sony Corporation, Apple Inc., Radvision Ltd. and Emblaze-VCON Ltd.  Many of these companies, including Polycom, Inc., Tandberg, Sony, Radvision and Emblaze-VCON
have acquired rights to use our patented technology through licensing agreements with us, which, in some cases, include rights to use future patents filed by us.  With increasing interest in the power of video collaboration and the establishment of communities of users, we believe we face increasing competition from alternative video communications solutions that employ new technologies or new combinations of technologies from companies such as Cisco Systems, Inc., Avaya, Inc., Microsoft Corporation
and Nortel Networks Corporation that enable web-based or network-based video communications with low-cost digital camera systems.




We expect competition to increase in the future from existing competitors, partnerships of competitors, and from new market entrants with products that may be less expensive than ours, or that may provide better performance or additional features not currently provided by our products. Many of our current and potential competitors have
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 bases than we do. As a result, they may be able to adapt more quickly to new or emerging technologies and changes in customer requirements.




We may be required to reduce prices or increase spending in response to competition in order to retain or attract customers, pursue new market opportunities or invest in additional research and development efforts. As a result, our revenue, margins and market share may be harmed. We cannot assure you that we will be able to compete successfully
against current and future competitors and partnerships of our competitors, or that competitive pressures faced by us will not harm our business, financial condition and results of operations.




General economic conditions may impact our revenues and harm our business in the future, as they have in the past.




The U.S. and global economy has entered a recession and our customers and potential customers, partners and distributors may delay or forego ordering our products, and we could fall short of our revenue expectations for 2009 and beyond. Slower growth among our customers, tightening of customers’ operating budgets, retrenchment in the
capital markets and other general economic factors all have had, and could in the future have, a materially adverse effect on our revenue, capital resources, financial condition and results of operations.




Future revenues and income from settlement and licensing activities are difficult to predict for several reasons, including our lengthy and costly licensing cycle. Our failure to predict revenues and income accurately may cause us to miss analysts’ estimates and result in our stock price declining.




Because our licensing cycle is a lengthy process, the accurate prediction of future revenues and income from settlement and patent licensing from new licensees is difficult. The process of persuading companies to adopt our technologies, or convincing them that their products infringe upon our intellectual property rights, can be lengthy.
The reexamination of our patents by the USPTO as described below or other challenges to our patent portfolio further complicate and delay our patent licensing efforts.  There is also a tendency in the technology industry to close business deals at the end of a quarter, thereby increasing the likelihood that a possible material deal would not be concluded in a current quarter, but slip into a subsequent reporting period. This kind of delay may result in a given quarter’s performance being below
analyst or shareholder expectations. The proceeds of our intellectual property licensing and enforcement efforts tend to be sporadic and difficult to predict. Recognition of those proceeds as revenue or income from settlement and licensing activities depends on the terms of the license agreement involved, and the circumstances surrounding the agreement. To finance litigation to defend or enforce our intellectual property rights, we may enter into contingency arrangements and other strategic transactions with
investors, legal counsel or other advisors that would give such parties a significant portion of any future licensing and settlement amounts derived from our patent portfolio. As a result, our licensing and enforcement efforts are expected to result in significant volatility in our quarterly and annual financial condition and results of operations, which may result in us missing investor expectations, which may cause our stock price to decline.




Our U.S. Patents are the subject of a reexamination request filed with the U.S. Patent and Trademark Office by Microsoft Corporation, which could adversely affect our business and results of operations.




On February 25, 2008 we announced that Microsoft Corporation had filed requests for reexamination of 24 of our 29 U.S. patents. Subsequently, Microsoft also filed requests for reexamination of our remaining five U.S. patents. On June 10, 2008 we announced that the U.S. Patent and Trademark Office (USPTO) had completed its review of Microsoft’s
requests for reexamination and had rejected 19 of the requests in their entirety, and the majority of the arguments for one additional patent under reexamination. The USPTO thus agreed to reexamine, either in part or fully, 10 of our existing U.S. patents.




During 2008, Microsoft submitted five petitions for reconsideration of the USPTO’s rejection of Microsoft’s requests for reexamination. As of October 31, 2009 two of the Microsoft petitions have been denied. These denials cannot be appealed. Three other petitions by Microsoft are still pending.




As of October 31, 2009, three of the 10 patents being reexamined have been issued with certificates of reexamination.  We have filed appeals with the USPTO Board of Patent Appeals and Interferences in six of the 10 patents under reexamination and a response to the latest rejection of the tenth patent under reexamination.




We believe that our U.S. patents are valid and we intend to defend our patents through the reexamination process.  However, the reexamination of patents by the USPTO, including appeals, is a lengthy, time-consuming and expensive process in which the ultimate outcome is uncertain.  Once initiated, the USPTO may take between
one and three years to complete patent reexaminations. The reexamination process by the USPTO may adversely impact our licensing negotiations in process, and may require us to spend substantial time and resources defending our patents, including the fees and expenses of our legal advisors.  The potential impact to our results of operations may require us to seek additional financing to fund our operations and the defense of our patents.




30


Infringement of our proprietary rights could affect our competitive position, harm our reputation or cost us money.




We regard our system as open but proprietary. In an effort to protect our proprietary rights, we rely primarily on a combination of patent, copyright, trademark and trade secret laws, as well as licensing, non-disclosure and other agreements with our consultants, suppliers, customers, partners and employees. However, these laws and agreements
provide only limited protection of our proprietary rights. In addition, we may not have signed agreements in every case, and the contractual provisions that are in place and the protection they produce may not provide us with adequate protection in all circumstances. Although we hold patents and have filed patent applications covering some of the inventions embodied in our systems, our means of protecting our proprietary rights may not be adequate. It is possible that a third party could copy or otherwise obtain
and use our technology without authorization and without our detection. In the event that we believe a third party is infringing our intellectual property rights, an infringement claim brought by us could, regardless of the outcome, result in substantial cost to us, divert our management’s attention and resources, be time consuming to prosecute and result in unpredictable damage awards. A third party may also develop similar technology independently, without infringing upon our patents and copyrights. In
addition, the laws of some countries in which we sell our system may not protect our software and intellectual property rights to the same extent as the laws of the United States or other countries where we hold patents. As we move to more of a software based system, inadequate licensing controls, unauthorized copying, and use, or reverse engineering of our system could harm our business, financial condition or results of operations.




Others may bring infringement claims against us or challenge the legitimacy of our patents, which could be time-consuming and expensive to defend.




In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. We have been party to such litigation in the past and may be again in the future. The prosecution and defense of such lawsuits would require us to expend significant financial and managerial resources, and
therefore may have a material negative impact on our financial position and results of operations. The duration and ultimate outcome of these proceedings are uncertain. We may be a party to additional litigation in the future to protect our intellectual property, or as a result of an alleged infringement of the intellectual property of others. These claims and any resulting lawsuit could subject us to significant liability for damages and invalidation of our proprietary rights. In addition, the validity of our
patents has been challenged in the past and may be challenged in the future through reexamination requests or other means. These lawsuits or challenges of our patents legitimacy in the US or foreign patent offices, regardless of their success, would likely be time-consuming and expensive to resolve and would divert management’s time and attention. Any potential intellectual property litigation also could force us to do one or more of the following:




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




•
obtain from the owner of the infringed intellectual property a license to the relevant intellectual property, which may require us to license our intellectual property to such owner, or may not be available on reasonable terms or at all; and




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




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




31


Our Compliance with the Sarbanes-Oxley Act and SEC rules concerning internal controls may be time-consuming, difficult and costly for us.




It may be time consuming, difficult and costly for us to fully implement internal controls and reporting procedures required by the Sarbanes-Oxley Act which relate to auditor attestation.  We may need to hire additional financial reporting, internal control and other finance staff in order to support the auditor attestation of appropriate
internal controls and reporting procedures.  If we are unable to comply with these additional requirements of the Sarbanes-Oxley Act, we may not be able to obtain the independent accountant certifications/attestations that the Sarbanes-Oxley Act requires of smaller reporting companies effective for issuers with fiscal years ending on or after June 15, 2010.




If our customers do not perceive our system or services to be effective or of high quality, our brand and name recognition would suffer.




We believe that establishing and maintaining brand and name recognition is critical for attracting and expanding our targeted customer base. We also believe that the importance of reputation and name recognition will increase as competition in our market increases. Promotion and enhancement of our name will depend on the success of our marketing
efforts, and on our ability to continue to provide high quality systems and services, neither of which can be assured. If our customers do not perceive our system or services to be effective or of high quality, our brand and name recognition will suffer, which would harm our business.




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




Our system may contain errors or defects, especially when new products are introduced or when new versions are released. Despite internal system testing, we have in the past discovered software errors in some of the versions of our system after their introduction. Errors in new systems or versions could be found after commencement of commercial
shipments, and this could result in additional development costs, diversion of technical and other resources from our other development efforts or the loss of credibility with current or future customers. Any of these events could result in a loss of revenue or a delay in market acceptance of our system, and could harm our reputation.




In addition, we have warranted to some of our customers that our software is free of viruses. If a virus infects a customer’s computer software, the customer could assert claims against us, which, regardless of their merits, could be costly to defend and could require us to pay damages and potentially harm our reputation.




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




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




If we are unable to expand our indirect distribution channel, our business will suffer.




To increase our revenue, we must increase our indirect distribution channels, such as systems integrators, product partners and/or value-added resellers, which is a focus of our go-to market strategy, and/or effect sales through our customers. If we are unable to increase our indirect distribution channel due to our own cost constraints,
limited availability of qualified partners or other reasons, our future revenue growth may be limited and our future operating results may suffer. We cannot assure you that we will be successful in attracting, integrating, motivating and retaining sales personnel and channel partners. Furthermore, it can take several months before a new hire or channel partner becomes a productive member of our sales force effort. The loss of existing salespeople, or the failure of new salespeople and/or indirect sales partners
to develop the necessary skills in a timely manner, could impact our revenue growth.




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




We depend on the continued services of our executive officers and other key personnel. We do not have long-term employment agreements with our executive officers or other key personnel and we do not carry any “key man” life insurance. The loss of the services of any of our executive officers or key personnel could harm our business,
financial condition and results of operations.




Our products and technologies are complex, and to successfully implement our business strategy and manage our business, an in-depth understanding of video communication and collaboration technologies and their potential uses is required. We need to attract and retain highly skilled technical and managerial personnel for whom there is intense
competition. If we are unable to attract and retain qualified technical and managerial personnel due to our own cost constraints, limited availability of qualified personnel or other reasons, our results of operations could suffer and we may never achieve profitability. The failure of new personnel to develop the necessary skills in a timely manner could harm our business.




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




Failure to achieve or effectively manage growth will harm our business, financial condition and operating results. Furthermore, in order to remain competitive or to expand our business, we may find it desirable in the future to acquire other businesses, products or technologies. If we identify an appropriate acquisition candidate, we may
not be able to negotiate the terms of the acquisition successfully, to finance the acquisition or to integrate the acquired businesses, products or technologies into our existing business and operations. In addition, completing a potential acquisition and integrating an acquired business may strain our resources and require significant management time.




Our international operations expose us to potential tariffs and other trade barriers, unexpected changes in foreign regulatory requirements and laws and economic and political instability, as well as other risks that could adversely affect our results of operations.




International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 43 % and 51% of total revenues for the nine months ended September 30, 2009, and 2008, respectively. International revenue comprised 51% and 72% of total revenue for the years ended December 31, 2008 and 2007, respectively.  Some
of the risks we may encounter in conducting international business activities include the following:




•      tariffs and other trade barriers;




•      unexpected changes in foreign regulatory requirements 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 adapting our system to the local language standards in those foreign countries that do not use the English language;




•      fluctuations in foreign currencies; and




•      limitations in communications infrastructures in some foreign countries.




Some of our products are subject to various federal, state and international laws governing substances and materials in products, including those restricting the presence of certain substances in electronics products. We could incur substantial costs, including fines and sanctions, or our products could be enjoined from entering
certain jurisdictions, if we were to violate environmental laws or if our products become non-compliant with environmental laws. We also face increasing complexity in our product design and procurement operations as we adjust to new and future requirements relating to the materials composition of our products, including the restrictions on lead and certain other substances that apply to specified electronics products sold in the European Union (Restriction of Hazardous Substances Directive). The ultimate costs
under environmental laws and the timing of these costs are difficult to predict. Similar legislation has been or may be enacted in other regions, including in the United States, the cumulative impact of which could be significant.




International political instability 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 national security measures and/or sustained military action may halt or hinder our ability to do business, may increase our costs and may adversely affect our stock price. This increased instability has had and may continue
to have negative effects on financial markets, including significant price and volume fluctuations in securities markets. If this international political instability continues or escalates, our business and results of operations could be harmed and the market price of our common stock could decline.






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Item 2.                      Unregistered Sales of Equity Securities and Use of Proceeds




Not applicable.




Item 3.                      Defaults Upon Senior Securities




Not applicable.




Item 4.                      Submission of Matters to a Vote of Security Holders




Not applicable.




Item 5.                      Other Information




Not applicable.




Item 6.Exhibits





Exhibit Number

Description10.1

Separation Agreement and Release between the Registrant and Simon Moss dated July 8, 200910.2

Employment Agreement between the Registrant and Robert Kirk dated July 14, 200910.3

Compromise Agreement between Avistar Systems (UK) Limited and Darren Innes dated August 19, 200931.1

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 the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized, on the 3rd  day of November 2009.





AVISTAR COMMUNICATIONS CORPORATIONBy:
/s/ Robert F. KirkRobert F. KirkChief Executive Officer(Principal Executive Officer)By:
/s/ Elias A. MurrayMetzgerElias A. MurrayMetzgerChief Financial Officer(Principal Financial and Accounting Officer)





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EXHIBIT INDEX





Exhibit Number

Description10.1

Separation Agreement and Release between the Registrant and Simon Moss dated July 8, 200910.2

Employment Agreement between the Registrant and Robert Kirk dated July 14, 200910.3

Compromise Agreement between Avistar Systems (UK) Limited and Darren Innes dated August 19, 200931.1

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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