**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

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

 

**For the quarterly period ended March 31,2006**

 

**OR**

 

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

 

**For the transition period from           to          **

 

**Commission file number:  000-31121**

 

**AVISTAR COMMUNICATIONS CORPORATION**

(Exact name of registrant asspecified in its charter)

 

| **DELAWARE**                       | ** ** | **88-0463156**                           |
|------------------------------------|------------|------------------------------------------|
| (State or other jurisdiction       |       | (I.R.S. Employer Identification  Number) |
| of incorporation or  organization) |       |                                     |

** **

**555 TWIN DOLPHIN DRIVE, SUITE 360, REDWOODSHORES, CA 94065**

(Address of Principal ExecutiveOffices) (Zip Code)

** **

Registrant’s telephone number,including area code: **(650) 610-2900**

 

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

 

**Yes ****ý      No ****o**

 

**Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act. (checkone):**

 

**Largeaccelerated filer ****o                                Acceleratedfiler  ****o                                Non-acceleratedfiler  ****ý**

 

**Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act). Yes ****o      No ****ý**

 

**AtMarch 31, 2006, 35,056,045 shares of common stock of the Registrant wereoutstanding.**

 

 

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**AVISTAR COMMUNICATIONS CORPORATION**

**INDEX**

 
| PART I.    | FINANCIAL INFORMATION                                                                       | 3      |
|------------|---------------------------------------------------------------------------------------------|--------|
|       |                                                                                        |   |
| Item 1.    | Financial Statements (unaudited)                                                            | 3      |
|       | Condensed Consolidated Balance Sheets                                                       | 3      |
|       | Condensed Consolidated Statements of  Operations                                            | 4      |
|       | Condensed Consolidated Statements of Cash  Flows                                            | 5      |
|       | Notes to Condensed Consolidated Financial  Statements                                       | 6      |
| Item 2.    | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 15     |
| Item 3.    | Quantitative and Qualitative Disclosures  About Market Risk                                 | 21     |
| Item 4.    | Controls and Procedures                                                                     | 21     |
|       |                                                                                        |   |
| PART II.   | OTHER INFORMATION                                                                           | 22     |
|       |                                                                                        |   |
| Item 1.    | Legal Proceedings                                                                           | 22     |
| Item 1a.   | Risk Factors                                                                                | 22     |
| Item 5.    | Other Information                                                                           | 30     |
| Item 6.    | Exhibits                                                                                    | 31     |
|       |                                                                                        |   |
| SIGNATURES | 32                                                                                          |

 

2

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**PART I - FINANCIAL INFORMATION**

 

**Item 1. *Financial Statements***

 

**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED BALANCE SHEETSas of March 31, 2006 and December 31, 2005(in thousands, except share and per share data)**

 
| ** **                                                                                                                                                                                                             | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                             | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                                                             | ** ** | **(unaudited)**    | ** ** |
| **Assets:**                                                                                                                                                                                                            | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                                        |       |               |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                              |       | $                  | 7,074      |                  | $          | 8,216 |   |
| Short-term investments                                                                                                                                                                                                 |       | 2,433              |       | 2,995                 |       |
| Total cash, cash equivalents and short-term  investments                                                                                                                                                               |       | 9,507              |       | 11,211                |       |
| Accounts receivable, net of allowance for  doubtful accounts of $102 and $121 at March 31, 2006 and  December 31, 2005, respectively                                                                         |       | 1,678              |       | 1,428                 |       |
| Inventories, including inventory shipped to  customers’ sites, not yet installed of $26 and $28 at March 31, 2006 and  December 31, 2005, respectively                                                  |       | 682                |       | 675                   |       |
| Deferred settlement and patent licensing  costs                                                                                                                                                                        |       | 1,256              |       | 1,256                 |       |
| Prepaid expenses and other current assets                                                                                                                                                                              |       | 301                |       | 463                   |       |
| Total current assets                                                                                                                                                                                                   |       | 13,424             |       | 15,033                |       |
| Long-term investments                                                                                                                                                                                                  |       | —             |       | 958                   |       |
| Property and equipment, net                                                                                                                                                                                            |       | 306                |       | 311                   |       |
| Long-term deferred settlement and patent  licensing costs                                                                                                                                                              |       | 3,345              |       | 3,685                 |       |
| Other assets                                                                                                                                                                                                           |       | 387                |       | 371                   |       |
| Total assets                                                                                                                                                                                                           |       | $                  | 17,462     |                  | $          | 20,358 |   |
|                                                                                                                                                                                                                   |       |               |       |                  |       |
| **Liabilities and Stockholders’ Equity  (Deficit):**                                                                                                                                                              |       |               |       |                  |       |
| Current liabilities:                                                                                                                                                                                                   |       |               |       |                  |       |
| Accounts payable                                                                                                                                                                                                       |       | $                  | 987        |                  | $          | 1,004 |   |
| Deferred income from settlement and patent  licensing                                                                                                                                                                  |       | 5,520              |       | 5,520                 |       |
| Deferred services revenue and customer  deposits                                                                                                                                                                       |       | 1,418              |       | 712                   |       |
| Accrued liabilities and other                                                                                                                                                                                          |       | 1,679              |       | 1,491                 |       |
| Total current liabilities                                                                                                                                                                                              |       | 9,604              |       | 8,727                 |       |
| Long-term liabilities:                                                                                                                                                                                                 |       |               |       |                  |       |
| Long-term deferred income from settlement  and patent licensing                                                                                                                                                        |       | 14,464             |       | 15,789                |       |
| Total liabilities                                                                                                                                                                                                      |       | 24,068             |       | 24,516                |       |
| Commitments and contingencies (Note 7)                                                                                                                                                                                 |       |               |       |                  |       |
| Stockholders’ equity (deficit):                                                                                                                                                                                   |       |               |       |                  |       |
| Common stock, $0.001 par value; 250,000,000  shares authorized at March 31, 2006 and December 31, 2005;  35,056,045 and 34,939,124 shares issued at March 31, 2006 and December  31, 2005, respectively |       | 35                 |       | 35                    |       |
| Less: treasury common stock, 1,181,625  shares at March 31, 2006 and December 31, 2005, at cost                                                                                                              |       | (53                | )          | (53                   | )          |
| Additional paid-in-capital                                                                                                                                                                                             |       | 91,122             |       | 90,519                |       |
| Other comprehensive loss                                                                                                                                                                                               |       | (7                 | )          | (12                   | )          |
| Accumulated deficit                                                                                                                                                                                                    |       | (97,703            | )          | (94,647               | )          |
| Total stockholders’ equity (deficit)                                                                                                                                                                              |       | (6,606             | )          | (4,158                | )          |
| Total liabilities and stockholders’ equity  (deficit)                                                                                                                                                             |       | $                  | 17,462     |                  | $          | 20,358 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

3

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**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONSfor the three months ended March 31, 2006 and 2005(in thousands, except per share data)**

 
| ** **                                                                         | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                         | ** ** | **March 31,  2006**         | ** ** | **March 31,  2005** | ** ** |
| ** **                                                                         | ** ** | **(unaudited)**                  | ** ** |
| ** **                                                                         | ** ** | ** **                       | ** ** | **Restated(1)** | ** ** |
| Revenue:                                                                           | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Product                                                                            |       | $                                | 877        |   | $ | 1,127 |   |
| Licensing                                                                          |       | 32                               |       | — |   |
| Services, maintenance and support                                                  |       | 949                              |       | 795 |   |
| Total revenue                                                                      |       | 1,858                            |       | 1,922 |   |
| Costs and Expenses:                                                                |       |                             |       |   |   |
| Cost of product revenue                                                            |       | 632                              |       | 450 |   |
| Cost of services, maintenance and support  revenue*                                |       | 607                              |       | 447 |   |
| Income from settlement and patent licensing                                        |       | (1,057                           | )          | (1,057 | ) |
| Research and development*                                                          |       | 1,272                            |       | 641 |   |
| Sales and marketing*                                                               |       | 1,300                            |       | 698 |   |
| General and administrative*                                                        |       | 2,256                            |       | 1,273 |   |
| Total costs and expenses                                                           |       | 5,010                            |       | 2,452 |   |
| Loss from operations                                                               |       | (3,152                           | )          | (530 | ) |
| Other income:                                                                      |       |                             |       |   |   |
| Interest income                                                                    |       | 103                              |       | 148 |   |
| Other expense, net                                                                 |       | (7                               | )          | (5 | ) |
| Total other income, net                                                            |       | 96                               |       | 143 |   |
| Net loss                                                                           |       | $                                | (3,056     | ) | $ | (387 | ) |
|                                                                               |       |                             |       |   |   |
| Net loss per share - basic and diluted                                             |       | $                                | (0.09      | ) | $ | (0.01 | ) |
| Weighted average shares used in calculating  basic and diluted net loss per share. |       | 35,015                           |       | 33,420 |   |

 
| *Including stock based compensation of:            |   |   |   |   |   |
|----------------------------------------------------|--------|--------|--------|--------|--------|
| Cost of services, maintenance and support  revenue |   | $      | 36     |   | $      | — |   |
| Research and development                           |   | 147    |   | — |   |
| Sales and marketing                                |   | 112    |   | — |   |
| General and administrative                         |   | 180    |   | 2      |   |
|                                               |   | $      | 475    |   | $      | 2 |   |

 

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(1) See Note 2 “Correction of an Error” ofthe Notes to Condensed Consolidated Financial Statements

 

Theaccompanying notes are an integral part of these financial statements.

 

4

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**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWSfor the three months ended March 31, 2006 and 2005(in thousands)**

 
| ** **                                                                   | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                   | ** ** | **March 31,**               | ** ** | **March 31,** | ** ** |
| ** **                                                                   | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | **(unaudited)**                  | ** ** |
| ** **                                                                   | ** ** | ** **                       | ** ** | **Restated(1)** | ** ** |
| Cash Flows from Operating Activities:                                        |       |                             |       |   |   |
| Net loss                                                                     |       | $                                | (3,056     | ) | $ | (387 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                             |       |   |   |
| Depreciation                                                                 |       | 114                              |       | 36 |   |
| Compensation on options issued to consultants  and employees                 |       | 475                              |       | 2 |   |
| Provision for doubtful accounts                                              |       | (19                              | )          | 33 |   |
| Changes in assets and liabilities:                                           |       |                             |       |   |   |
| Accounts receivable                                                          |       | (231                             | )          | 152 |   |
| Inventories                                                                  |       | (7                               | )          | 3 |   |
| Prepaid expenses and other current assets                                    |       | 162                              |       | 8 |   |
| Deferred settlement and patent licensing  costs                              |       | 340                              |       | 314 |   |
| Other assets                                                                 |       | (16                              | )          | (2 | ) |
| Accounts payable                                                             |       | (17                              | )          | (559 | ) |
| Deferred income from settlement and patent  licensing                        |       | (1,325                           | )          | (1,371 | ) |
| Deferred services revenue and customer  deposits                             |       | 706                              |       | 867 |   |
| Accrued liabilities and other                                                |       | 188                              |       | (291 | ) |
| Net cash used in operating activities                                        |       | (2,686                           | )          | (1,195 | ) |
|                                                                         |       |                             |       |   |   |
| Cash Flows from Investing Activities:                                        |       |                             |       |   |   |
| Maturities of short-term investments                                         |       | 1,525                            |       | — |   |
| Purchase of property and equipment                                           |       | (109                             | )          | (77 | ) |
| Net cash provided by (used in) investing  activities                         |       | 1,416                            |       | (77 | ) |
|                                                                         |       |                             |       |   |   |
| Cash Flows from Financing Activities:                                        |       |                             |       |   |   |
| Proceeds from issuance of common stock                                       |       | 128                              |       | 70 |   |
| Net cash provided by financing activities                                    |       | 128                              |       | 70 |   |
| Net decrease in cash and cash equivalents                                    |       | (1,142                           | )          | (1,202 | ) |
| Cash and cash equivalents, beginning of  period                              |       | 8,216                            |       | 21,656 |   |
| Cash and cash equivalents, end of period                                     |       | $                                | 7,074      |   | $ | 20,454 |   |
|                                                                         |       |                             |       |   |   |
| Supplemental Cash Flow Information:                                          |       |                             |       |   |   |
| Cash paid for income taxes                                                   |       | $                                | —     |   | $ | 315 |   |
| Cash paid for interest                                                       |       | $                                | 2          |   | $ | — |   |

 

----

(1) See Note 2 “Correction of an Error” ofthe Notes to Condensed Consolidated Financial Statements

 

Theaccompanying notes are an integral part of these financial statements.

 

5

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

 

**1. Business, Basis ofPresentation, and Risks and Uncertainties**

 

# **Business**

# ** **

AvistarCommunications Corporation (“Avistar” or the “Company”) provides theAvistar vBusiness integrated suite of video-enabled applications, including networked video communications software andhardware products and services. Avistar’s products include applications forinteractive video calling, content creation and publishing, broadcast video andvideo-on-demand, as well as data sharing, directory services and networkmanagement. Avistar designs, develops, markets, sells, manufactures and/orassembles and installs and supports its products. Avistar’s real-time and non-real-timeproducts are based upon its architecture and Video Operating System(AvistarVOSTM) platform, which facilitates distribution over local and wide areanetworks using telephony or Internet services as appropriate. Avistar’sservices include software development, consulting, implementation, training,maintenance and support. In addition, Avistar seeks to prosecute, maintain,support and license the intellectual property developed by the Company throughits wholly-owned subsidiary, Collaboration Properties, Inc., a Nevadacorporation (CPI).

 

# **Basis of Presentation**

# ** **

The unauditedbalance sheet as of March 31, 2006 presents the consolidated financialposition of Avistar and its two wholly-owned operating subsidiaries, AvistarSystems U.K. Limited (ASUK) and CPI, after the elimination of all intercompanyaccounts and transactions. 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 Statesdollar. Accordingly, all gains and losses resulting from those transactionsdenominated in currencies other than the United States dollar are included inthe statements of operations.

 

The Company’sfiscal year end is December 31.

 

# **Risks and Uncertainties**

# ** **

The markets for the Company’s products and servicesare in the early stages of development. Some of the Company’s products utilizechanging 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 ofthe Company’s products, over time, is critical to the Company’s success. TheCompany’s prospects must be evaluated in light of difficulties encountered byit and its competitors in further developing this evolving marketplace. TheCompany has generated losses since inception and had an accumulated deficit of$97.7 million as of March 31, 2006. The Company’s operating results mayfluctuate significantly in the future as a result of a variety of factors,including, but not limited to, the economic environment, the adoption ofdifferent distribution channels, and the timing of new product announcements bythe Company or its competitors.

 

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

 

**2. Correction ofan Error**

 

InSeptember 2005, the Company received a comment letter from the U. S. Securitiesand Exchange Commission (“SEC”) relating to the Company’s 2004 Form 10-K, whichincluded a question regarding the Company’s accounting for the November 2004settlement and patent cross-license agreement with Polycom, Inc. (“Polycom”).The settlement and patent cross-license agreement resulted in a $27.5 millionone time payment by Polycom to Avistar and a payment by Avistar to itslitigation counsel of $6.4 million in contingent legal fees. The Companypreviously reported on Form 10-Q for the three months ended March 31, 2005 theone time payment by Polycom as revenue, to be recognized ratably over afive-year period, net of contingent legal fees. As a result of the SEC’sinquiry as to whether the Polycom transaction should be characterized asrevenue, and after discussions with the SEC, the Company concluded that areclassification of license revenues from revenue to a component of operatingexpenses, and presentation as “Income from settlement and patent licensing” wasnecessary for previously filed financial reports. The restatement of the netproceeds and expenses from the Polycom settlement and patent cross-licenseagreement had no effect on reported net loss, loss per share, stockholders’equity (deficit) or net cash flows

 

6

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fromoperating, investing or financing activities, but did have the effect ofoverstating revenues and operating expenses for previously issued interimcondensed consolidated financial statements, as of and for the three-monthsended March 31, 2005. In addition, the balance sheet as of March 31, 2005 hasbeen restated to reflect the gross effect of the $27.5 million payment byPolycom to Avistar, and the payment of $6.4 million of contingent legal fees byAvistar, which was previously reported on a net basis as deferred revenue. SeeNotes 3 and 6 regarding significant concentrations, revenue recognition,segment reporting and the unaudited interim results which have been restated toreclassify the Polycom proceeds from license revenue to “Income from settlementand patent licensing,” to be consistent with the presentation of the netproceeds from the Polycom settlement and patent cross-license agreement in theStatement of Operations for the three months ended March 31, 2006. Thepresentation within operations is supported by a determination that the Polycomlicensing transaction is central to the activities that constitute the Company’songoing major or central operations, but that the settlement may also contain again element related to the settlement, which is not considered revenue underthe Financial Accounting Standards Board (“FASB”) Concepts Statement No. 6, *Elements of Financial Statements.*TheCompany did not have sufficient historical evidence to support a reasonabledetermination of value for purposes of segregating the proceeds from Polycominto revenue related to the patent licensing, and an operating or non-operatinggain upon settlement of litigation, resulting in the determination that theentire transaction is more appropriately classified as “Income from settlementand patent licensing” within operations, as opposed to revenue.

 

Thefollowing table presents the impact of the adjustment to the condensedconsolidated statement of operations and cash flows for the three-months endedMarch 31, 2005 (in thousands):

 
| ** **                                   | ** ** | **Three Months ended March 31, 2005** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                   | ** ** | **(Unaudited)**                                                | ** ** |
| **Statement of Operations**        | ** ** | **As  Previously  Reported**                                   | ** ** | **Adjustment** | ** ** | **As  Restated** | ** ** |
| Revenues:                                    |       |                                                           |       |   |   |   |   |
| Licensing revenue                            |       | $                                                              | 1,057      |   | $ | (1,057 | ) | $ | — |   |
| Total revenue                                |       | 2,979                                                          |       | (1,057 | ) | 1,922 |   |
| Costs and expenses:                          |       |                                                           |       |   |   |   |   |
| Income from settlement and  patent licensing |       | —                                                         |       | (1,057 | ) | (1,057 | ) |
| Net loss                                     |       | $                                                              | (387       | ) | $ | — |   | $ | (387 | ) |

 
| ** **                                            | ** ** | **Three Months ended March 31, 2005** | ** ** |
|-------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                            | ** ** | **(Unaudited)**                                                | ** ** |
| **Statement of Cash Flows**            | ** ** | **As  Previously  Reported**                                   | ** ** | **Adjustment** | ** ** | **As Restated** | ** ** |
| Cash flows from Operating  Activities:                |       |                                                           |       |   |   |   |   |
| Deferred settlement and patent  licensing costs       |       | $                                                              | —     |   | $ | 314 |   | $ | 314 |   |
| Deferred License revenue                              |       | (1,057                                                         | )          | 1,057 |   | — |   |
| Deferred income from settlement  and patent licensing |       | —                                                         |       | (1,371 | ) | (1,371 | ) |
| Net cash used in operating  activities                |       | $                                                              | (1,195     | ) | $ | — |   | $ | (1,195 | ) |

 

**3. Summary ofSignificant Accounting Policies**

 

# **Unaudited InterimFinancial Information**

# ** **

The financial statements filed in this reporthave been prepared by the Company, without audit, pursuant to the rules andregulations of the SEC. Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America have beencondensed or omitted pursuant to such rules and regulations. TheDecember 31, 2005 Condensed Consolidated Balance Sheet was derived fromaudited financial statements, but does not include all disclosures required byaccounting principles generally accepted in the United States of America.

 

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

 

7

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Commission on April 28, 2006.

 

**Reclassifications**

 

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

 

**Use of Estimates**

 

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

 

# **Cash and Cash Equivalentsand Short and Long-term Investments**

# ** **

The Company considers all investmentinstruments purchased with an original maturity of three months or less tobe cash equivalents. Investment securities with original or remainingmaturities of more than three months but less than one year are consideredshort-term investments. Auction rate securities with original or remainingmaturities of more than three months are considered short-term investments evenif they are subject to re-pricing within three months. Investment securitiesheld with intent to reinvest or hold for longer than a year or with remainingmaturities of one year or more are considered long-term investments. TheCompany’s cash equivalents at December 31, 2005 and March 31, 2006 consisted ofmoney market funds and short-term commercial paper with original maturities ofthree months or less and are therefore classified as cash and cash equivalentsin the accompanying balance sheets.

 

TheCompany accounts for its short-term and long-term investments in accordancewith Statement of Financial Accounting Standards (SFAS) No. 115, Accounting *for Certain Investments in Debt and Equity Securities*. TheCompany’s short and long-term investments in securities are classified asavailable-for-sale and are reported at fair value, with unrealized gains andlosses, net of tax, recorded in other comprehensive income (loss). Realizedgains 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. TheCompany reviews the securities for impairments considering current factorsincluding the economic environment, market conditions and the operationalperformance, and other specific factors relating to the business underlying thesecurities. The Company records impairment charges equal to the amount that thecarrying value of its available-for-sale securities exceeds the estimated fairmarket value of the securities as of the evaluation date. The fair value forpublicly held securities is determined based on quoted market prices as of theevaluation date. In computing realized gains and losses on available-for-salesecurities, the Company determines cost based on amounts paid, including directcosts such as commissions, to acquire the security using the specificidentification method. The Company had net unrealized losses on its short andlong-term investment securities of $7,000 and $12,000 at March 31, 2006 andDecember 31, 2005, respectively.

 

Cash, cash equivalents, short and long-terminvestments consisted of the following at March 31, 2006 and December 31, 2005(in thousands):

 

| ** **                                                                                                                        | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                        | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| ** **                                                                                                                        | ** ** | **(Unaudited)**    | ** ** |
| ***Description***                                                                                                                 | ** ** | ** **         | ** ** |
| Cash and cash equivalents:                                                                                                        |       |               |       |                  |       |
| Cash                                                                                                                              |       | $                  | 1,087      |                  | $          | 549 |   |
| Commercial paper cash  equivalents                                                                                                |       | 5,987              |       | 7,667                 |       |
| Total cash and cash equivalents                                                                                                   |       | 7,074              |       | 8,216                 |       |
| Short-term investments:                                                                                                           |       |               |       |                  |       |
| Short-term investments (average  183 and 60 remaining days to maturity as of March 31, 2006 and December 31,  2005, respectively) |       | 2,433              |       | 2,995                 |       |
| Total cash and cash equivalents  and short term-investments                                                                       |       | 9,507              |       | 11,211                |       |
| Long-term-investments(average  390 days to maturity as of December 31, 2005)                                                      |       | —             |       | 958                   |       |
| Total cash, cash equivalents  and short- term and long-term investments                                                           |       | $                  | 9,507      |                  | $          | 12,169 |   |

 

# **SignificantConcentrations**

 

A relativelysmall number of customers accounted for a significant percentage of the Company’srevenues. Revenues to these customers as a percentage of total revenues were asfollows for the three months ended March 31, 2006 and 2005:

 

8

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| ** ** | ** ** | **Three Months Ended March 31,** | ** ** |
|------------|------------|------------------------------------------------------|------------|
| ** ** | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| ** ** | ** ** | **(Unaudited)**                                      | ** ** |
| Customer A |       | 40                                                   | %          | 35 | % |
| Customer B |       | 37                                                   | %          | 42 | % |
| Customer C |       | *                                                    | %          | 12 | % |
| Customer D |       | 13                                                   | %          | * | % |

 

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* Less than 10%

 

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

 

Financial instruments that potentially subject theCompany to concentrations of credit risk consist primarily of temporary cashinvestments and trade receivables. The Company has cash and investment policiesthat limit the amount of credit exposure to any one financial institution orrestrict placement of these investments to financial institutions evaluated ashighly credit worthy. As of March 31, 2006, the Company had cash and cashequivalents on deposit with a major financial institution that were in excessof FDIC insured limits. Historically, the Company has not experienced any lossof its cash and cash equivalents due to such concentration of credit risk.Concentrations of credit risk with respect to trade receivables relate to thosetrade receivables from both United States and foreign entities, primarily inthe financial services industry. As of March 31, 2006, approximately 95%of gross accounts receivable was concentrated with two customers, each of whomrepresented more than 10% of the Company’s total gross accounts receivablebalance. As of December 31, 2005, approximately 97% of accounts receivablewas concentrated with three customers. No other customers individuallyaccounted for greater than 10% of total accounts receivable as ofDecember 31, 2005.

 

# **Inventories**

# ** **

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

 
| ** **                                              | ** ** | **MARCH 31,  2006** | ** ** | **DECEMBER 31,  2005** | ** ** |
|---------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                              | ** ** | **(Unaudited)**          | ** ** |
| Raw materials and subassemblies                         |       | $                        | 32         |                        | $          | 43 |   |
| Finished goods                                          |       | 624                      |       | 604                         |       |
| Inventory shipped to customer sites, not  yet installed |       | 26                       |       | 28                          |       |
|                                                    |       | $                        | 682        |                        | $          | 675 |   |

 

Inventory shipped to customersites, not yet installed, represents product shipped to customer sites pendingcompletion of the installation process by the Company. As of March 31, 2006 and December 31, 2005, the Company hadbilled approximately $26,000 and $28,000, respectively, to customersrelated to these shipments, but did not record the revenue, as the installationshad not been completed and confirmed by the customer. Although customers arebilled in accordance with customer agreements, these deferred revenue amountsare netted against accounts receivable until the customer confirmsinstallation.

 

**Revenue Recognition andDeferred Revenue**

 

The Companyrecognizes product and services revenue in accordance with Statement ofPosition (SOP) 97-2, Software Revenue Recognition (SOP 97-2), as amended by SOP98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect toCertain Transactions (SOP 98-9). The Company derives product revenue from thesale and licensing of a set of desktop (endpoint) products (hardware andsoftware) and infrastructure products (hardware and software) that combine toform an Avistar video-enabled collaboration solution. Services revenue includesrevenue from installation services, post-contract customer support, trainingand software development. The installation services that the Company offers tocustomers relate to the physical set-up and configuration of desktop andinfrastructure components of the Company’s solution. The fair value of allproduct, installation services, post-contract customer support and trainingoffered to customers is determined based on the price charged when suchproducts or services are sold separately.

 

Arrangementsthat include multiple product and service elements may include software andhardware products, as well as installation services, post-contract customersupport and training. Pursuant to SOP 97-2, when an arrangement includesmultiple elements, the Company recognizes revenue when all of the followingcriteria are met: (i) persuasive evidence of an

 

9

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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 awritten contract, signed by both the customer and the Company, or a purchaseorder from those customers that have previously negotiated a standard end-userlicense arrangement or volume purchase agreement, prior to recognizing revenueon an arrangement.

 

•      Delivery has occurred. The Company delivers software and hardware tocustomers physically. The standard delivery terms are FOB shipping point.

 

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

 

•      Collectibility is probable. To recognize revenue, the Company judgescollectibility of the arrangement fees on a customer-by-customer basis pursuantto a credit review policy. The Company typically sells to customers with whichit has had a history of successful collections. For new customers, the Companyevaluates the customer’s financial position and ability to pay. If the Companydetermines that collectibility is not probable based upon the credit reviewprocess or the customer’s payment history, revenue is recognized when cash iscollected.

 

If there are anyundelivered elements, the Company defers revenue for those elements, as long asVendor Specific Objective Evidence (VSOE) exists for the undelivered elements.Additionally, per paragraph 14 of SOP 97-2, when the Company providesinstallation services, the product and installation revenue is recognized uponcompletion of the installation process and receipt of customer confirmation,subject to the satisfaction of the revenue recognition criteria describedabove. The Company believes that the fee associated with the delivered productelements does not meet the collectibility criteria if the installation serviceshave not been completed. Customer confirmation is obtained and documented bymeans of a standard form indicating the installation services have beenprovided and the hardware and software components installed. When the customeror a third party provides installation services, the product revenue isrecognized upon shipment, subject to satisfaction of the revenue recognitioncriteria described above.

 

Payment forproduct is due upon shipment, subject to specific payment terms. Payment forinstallation and professional services is due upon providing the services,subject to specific payment terms. Reimbursements received for out-of-pocketexpenses and shipping costs incurred during installation and support services,which have not been significant to date, are recognized as revenue inaccordance with Emerging Issues Task Force (EITF) Issue No. 01-14 (EITF 01-14),“Income Statement Characterization of Reimbursements Received for “Out ofPocket” Expenses Incurred.”

 

The pricecharged for maintenance and/or support is defined in the contract, and is basedon a fixed price for both hardware and software components as stipulated in thecustomer agreement. Customers have the option to renew the maintenance and/orsupport arrangement in subsequent periods at the same or similar rate as paidin the initial year subject to contractual adjustments for inflation. Revenuefrom maintenance and support services is deferred and recognized pro-rata overthe maintenance and/or support term, which is typically one year in length.Payments for services made in advance of the provision of services are recordedas deferred revenue and customer deposits in the accompanying balance sheets.Training services are offered independently of the purchase of product. Thevalue of these training services is determined based on the price charged whensuch services are sold separately. Training revenue is recognized uponperformance of the service.

 

The Companyrecognizes service revenue from software development contracts in accordancewith SOP 81-1, “Accounting for Performance of Construction-Type and CertainProduction-Type Contracts.” Revenue related to contracts for softwaredevelopment is recognized using the percentage of completion method, when allof the following conditions are met: a contract exists with the customer at afixed price, the Company has fulfilled all of its material contractualobligations to the customer for each deliverable of the contract, verificationof completion of the deliverable has been received, and collection of thereceivable is probable. The amounts billed to customers in excess of revenuesrecognized to date are deferred and recorded as deferred revenue and customerdeposits in the accompanying balance sheets. Assumptions used for recordingrevenue and earnings are adjusted in the period of change to reflect revisionsin contract value and estimated costs to complete the contract. Any anticipatedlosses on contracts in progress are charged to earnings when identified.

 

10

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The Companyrecognizes revenue from the licensing of its intellectual property portfoliobased on the terms of the royalty, partnership and cross-licensing agreementsinvolved.

 

**Income from Settlement andPatent Licensing**

 

The Companyrecognizes the proceeds from settlement and patent licensing agreements basedon the terms involved. When litigation has been filed prior to a settlement andpatent licensing agreement, and insufficient historical evidence exists for thedetermination of fair value of the patents licensed to support the segregationof the proceeds between a gain on litigation settlement and patent licenserevenues, the Company reports all proceeds in “income from settlement andpatent licensing” within operating costs and expenses. When litigation has beenfiled prior to a settlement and patent licensing agreement, and sufficienthistorical evidence exists for the determination of fair value of the patentslicensed to support the segregation of the proceeds between a gain onlitigation settlement and patent license revenues, the Company reports thepatent licensing proceeds, as license revenue, consistent with FinancialAccounting Standards Board (“FASB”) Concepts Statement No. 6, Elements ofFinancial Statements. The gain portion of the proceeds, when sufficienthistorical evidence exists to segregate the proceeds, is reported in otherincome according to SFAS No. 5, Accounting for Contingencies.

 

**Stock-Based Compensation**

 

Effective January 1, 2006, the Companyadopted the provisions of SFAS No. 123 (R), “Share-Based Payment”. SFASNo. 123 (R) establishes accounting for stock-based awards exchangedfor employee services. Accordingly, stock-based compensation cost is measuredat grant date, based on the fair value of the award, and is recognized asexpense over the employee’s service period.

 

The Company previously applied AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations, and provided the required pro formadisclosures of SFAS No. 123, “Accounting for Stock-Based Compensation”. Priorto the adoption of SFAS No. 123 (R), the Company provided the disclosuresrequired under SFAS No. 123, “Accounting for Stock-Based Compensation,” asamended by SFAS No. 148, “Accounting for Stock-Based Compensation –Transition and Disclosures.”   The pro-forma information for thethree months ended March 31, 2005 was as follows (in thousands, except pershare data):

 
| ** **                                                                                                        | ** ** | **Three Months Ended  March 31, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                                                                                        | ** ** | ** **                                                 | ** ** |
| Net loss, as reported                                                                                             |       | $                                                          | (387       | ) |
| Add stock - based employee  compensation expense included in reported net loss, net of tax                        |       | 2                                                          |       |
| Deduct total stock-based  employee compensation expense under fair-value-based method for all awards,  net of tax |       | (487                                                       | )          |
| Pro forma net loss                                                                                                |       | $                                                          | (872       | ) |
|                                                                                                              |       |                                                       |       |
| Basic and diluted loss per  share:                                                                                |       |                                                       |       |
| As reported                                                                                                       |       | $                                                          | (0.01      | ) |
| Pro forma                                                                                                         |       | $                                                          | (0.03      | ) |

 

*Impact of the Adoption of SFAS No. 123 (R)*

 

TheCompany elected to adopt the modified prospective application method asprovided by SFAS No. 123 (R). The effect of recording stock-basedcompensation for the three months ended March 31, 2006 was as follows (inthousands, except per share data):

 
| ** **                                          | ** ** | **Three Months Ended  March 31, 2006** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------------|------------|
| Stock-based compensation  expense by type of award: |       |                                                       |       |
| Employee stock options                              |       | $                                                          | 413        |   |
| Non-employee stock options                          |       | 18                                                         |       |
| Employee stock purchase plan                        |       | 44                                                         |       |
| Total stock-based compensation                      |       | 475                                                        |       |
| Tax effect on stock-based  compensation             |       | —                                                     |       |
| Net effect of stock-based  compensation on net loss |       | $                                                          | 475        |   |

 

11

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Asof March 31, 2006, the Company had an unrecognized deferred stock-basedcompensation balance related to stock options of approximately$4.7 million before estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revisedif necessary in subsequent periods if actual forfeitures differ from thoseestimates. Based on the Company’s historical experience of option pre-vestingcancellations, the Company has assumed an annualized forfeiture rate of 7% forits executive options and 29% for non-executive options. Accordingly, as of March31, 2006, the Company estimated that the stock-based compensation for theawards not expected to vest was approximately $1.0 million, and therefore,the unrecognized deferred stock-based compensation balance related to stockoptions was adjusted to approximately $3.7 million after estimated forfeituresand will be recognized over an estimated weighted average amortization periodof 2.1 years. During the three months ended March 31, 2006, the Companygranted 178,000 stock options, with an estimated total grant-date fair value of$240,000.

 

*Valuation Assumptions*

 

TheCompany estimated the fair value of stock options granted during the threemonths ended March 31, 2006, using a Black-Scholes valuation model, consistentwith the provisions of SFAS No. 123 (R), SEC Staff Accounting Bulletin(SAB) No. 107 and the Company’s prior period pro forma disclosures of netloss for the three months ended March 31, 2005, including stock-basedcompensation (determined under a fair value method as prescribed by SFASNo. 123). The fair value of each option grant is estimated on the date ofgrant using the Black-Scholes option valuation model and the straight-lineattribution approach with the following weighted-average assumptions:

 

**Employee Stock Option Plan**

 
| ** **                      | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Expected dividend               |       | —%                                          |       | —% |   |
| Average risk-free interest rate |       | 4.3%                                             |       | 3.9% |   |
| Expected volatility             |       | 146%                                             |       | 225% |   |
| Expected term (years)           |       | 6.1                                              |       | 4.0 |   |

 

**Employee Stock Purchase Plan**

 
| ** **                      | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------|------------|------------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Expected dividend               |       | —%                                              |       | —% |   |
| Average risk-free interest rate |       | 2.8%                                                 |       | 2.7% |   |
| Expected volatility             |       | 113%                                                 |       | 96% |   |
| Expected term (months)          |       | 6.0                                                  |       | 6.0 |   |

 

Thedividend yield of zero is based on the fact that the Company has never paidcash dividends and has no present intention to pay cash dividends. Therisk-free interest rates are taken from the Daily Federal Yield Curve Rates asof the grant dates as published by the Federal Reserve, and represent theyields on actively traded Treasury securities for terms equal to the expectedterm of the options. Expected volatility is based on the historical volatilityof the Company’s common stock over a period consistent with the expected termof the stock-option. The expected term calculation is based on an averageprescribed by SAB No. 107, based on the vesting periods, which is generallyfour years, and the term of the option, which is generally 10 years, divided by2.

 

**4. Related Party Transactions**

 

Robert P. Latta,a member of the law firm Wilson Sonsini Goodrich & Rosati, ProfessionalCorporation (WSGR), has served as a director of the Company sinceFebruary 2001. Mr. Latta and WSGR have represented the Company and itspredecessors as corporate counsel since 1997. During the three months endedMarch 31, 2006 and 2005, payments of approximately $11,000 and $28,000,respectively, were made to WSGR for legal services provided to the Company.

 

**5.Net Loss Per Share**

 

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

 

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In accordancewith SFAS 128, basic net loss per share has been computed using the weightedaverage number of shares of common stock outstanding during the period, lessshares subject to repurchase. Diluted net loss per share is computed on thebasis of the weighted average number of shares and potential common sharesoutstanding during the period. Potential common shares result from the assumedexercise of outstanding stock options that have a dilutive effect when applyingthe treasury stock method. The Company has excluded all outstanding stockoptions and shares subject to repurchase from the calculation of diluted netloss per share for the three months ended March 31, 2006 and 2005, becauseall such securities are antidilutive (owing to the fact that the Company is ina loss position). Accordingly, diluted net loss per share is equal to basic netloss per share for all periods presented.

 

The total number of potential common shares excludedfrom the calculations of diluted net loss per share was 2,975,573 and 4,431,579for the three months ended March 31, 2006 and 2005, respectively.

 

**6. Segment Reporting**

 

Disclosure of segments is presented inaccordance with SFAS No. 131 (“SFAS 131”), “Disclosures About Segments of anEnterprise and Related Information.” SFAS 131 establishes standards for disclosures regarding operatingsegments, products and services, geographic areas and major customers. The Company is organized and operates as twooperating segments: (1) the design, development, manufacture, sale andmarketing of networked video communications products (Avistar) and (2) theprosecution, maintenance, support and licensing of the intellectual property, someof which is used in the Company’s products (CPI). Service revenue relates mainly to the maintenance, support, training,software development and installation of products, and is included in Avistarfor purposes of reporting and decision-making. Avistar also engages incorporate functions and provides financing and other services to itssubsidiaries. The Company’s Chief Executive Officer, the Company’s chiefoperating decision maker, considers income from settlement and patent licensingto be equivalent to revenue for purposes of monitoring the Company’s operations.A reconciliation of the revenue and expense classification used by the Company’sCEO with the classification of revenue, other income and expenses as set forthin the Company’s unaudited financial statements included elsewhere herein isindicated in the following table(in thousands).

 
| ** **                                                      | ** ** | **CPI**    | ** ** | **Avistar** | ** ** | **Reconciliation** | ** ** | **Total** | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|-------------|------------|--------------------|------------|-----------|------------|
| **Three Months Ended  March 31, 2006**                     |       |       |       |        |       |               |       |      |       |
| Revenue                                                         |       | $          | 1,089      |        | $          | 1,826              |       | $         | (1,057     | ) | $ | 1,858 |   |
| Depreciation expense                                            |       | —     |       | (114        | )          | —             |       | (114      | )          |
| Total costs and expenses                                        |       | (1,213     | )          | (4,854      | )          | 1,057              |       | (5,010    | )          |
| Interest income                                                 |       | —     |       | 103         |       | —             |       | 103       |       |
| Net loss                                                        |       | (124       | )          | (2,932      | )          | —             |       | (3,056    | )          |
| Assets                                                          |       | 4,658      |       | 12,804      |       | —             |       | 17,462    |       |
| **Three Months Ended March 31, 2005   (as restated)** | ** ** | ** ** |       |        |       |               |       |      |       |
| Revenue                                                         |       | $          | 1,057      |        | $          | 1,922              |       | $         | (1,057     | ) | $ | 1,922 |   |
| Depreciation expense                                            |       | —     |       | (36         | )          | —             |       | (36       | )          |
| Total costs and expenses                                        |       | (498       | )          | (3,011      | )          | 1,057              |       | (2,452    | )          |
| Interest income                                                 |       | —     |       | 148         |       | —             |       | 148       |       |
| Net income (loss)                                               |       | 559        |       | (946        | )          | —             |       | (387      | )          |
| Assets                                                          |       | 5,980      |       | 22,759      |       | —             |       | 28,739    |       |

 

International revenue, which consists ofsales to customers with operations principally in Western Europe and Asia,comprised 49% and 57% of total product and services revenue for the threemonths ended March 31, 2006 and 2005, respectively. For the three monthsended March 31, 2006 and 2005, international revenues from customers inthe United Kingdom accounted for 10% and 26%, of total product and servicesrevenue, respectively. The Company had no significant long-lived assets in anycountry other than in the United States for any period presented.

 

**7.****              Legal Proceedings**

 

On May 11, 2005, CPI, Avistar’s wholly-ownedpatent prosecution and licensing subsidiary, commenced a patent infringementlawsuit against Tandberg ASA and Tandberg, Inc, alleging that several Tandbergvideoconferencing products infringe three patents held by CPI. The suit wasfiled in the United States District Court for the Northern District ofCalifornia. The three patents involved are U.S. Patent Nos. 5,867,654;5,896,500; and 6,212,547. These patents cover technologies relating to videoand data conferencing over unshielded twisted pair (UTP) networks, distributedcall-state management, and separate monitors for simultaneous computer-baseddata sharing and videoconferencing. These technologies are core components ofthe AvistarVOS video operating system. In this action, CPI has requestedinjunctive

 

13

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relief, damages to compensate for past and present infringement, trebledamages, costs associated with the litigation and such further relief as theCourt deems just and proper. Both of the Tandberg entities answered thecomplaint on July 15, 2005, at which time they asserted that they did notinfringe the patents and that the patents were invalid and unenforceable. OnJanuary 30, 2006, Tandberg Telecom AS, a wholly-owned manufacturing and patentholding subsidiary of Tandberg ASA, filed a patent infringement lawsuit againstAvistar in the United States District Court for the Eastern District of Texas.The suit alleges that Avistar videoconferencing products infringe one patentpurchased by Tandberg Telecom AS. The patent involved is U.S. Patent No.6,621,515, which claims a method and system for routing video calls. In theTexas litigation, Tandberg Telecom AS has requested injunctive relief, monetarydamages to compensate for its actual damages, costs associated with thelitigation and such further relief as the Court deems just and proper. Avistarresponded to the complaint on March 23, 2006, at which time Avistar assertedthat Avistar did not infringe the patent, that the patent was invalid, and thatthe claim was without merit. Tandberg ASA and Tandberg, Inc. sought to add twodefenses, and provisionally filed two motions for summary judgment in theCalifornia litigation on January 13, 2006 and February 24, 2006, respectively.Each proposed defense asserts that Avistar is subject to a differentcontractual provision that either totally precludes or limits CPI’s remedies inthe California litigation. Specifically, Tandberg alleged that (1) it had alicense to the subject patents and (2) that Avistar had released its claimsagainst Tandberg with respect to the subject patents. Both motions for summaryjudgment were determined to be procedurally defective in that Tandberg had notpreviously pled the contractual provisions as defenses to CPI’s claims. In thefirst case, on January 13, 2006, Tandberg voluntarily filed a motion to amendits complaint to add a license defense. That motion to amend has been fullybriefed and argued and is pending. If the court permits Tandberg to amend itscomplaint, the briefing on Tandberg’s motion for summary judgment will becompleted and the issue will be submitted to the court for resolution. During ahearing on March 20, 2006 concerning the “release” defense, the court refusedto permit Tandberg to amend its complaint, holding that Tandberg could notprevail on that defense, and thereby prohibiting Tandberg from pursuing thisdefense in the California case. The Markman hearing for the CPI claims, apivotal stage of the litigation process at which time definitions aredetermined for the following proceeding, is currently scheduled for May 24,2006. The prosecution of this lawsuit and the defense of the Tandberg TelecomAS claim may require Avistar and CPI to expend significant financial andmanagerial resources, and therefore may have a material negative impact onAvistar’s business, financial condition and results of operations. The durationand ultimate outcome of this litigation are uncertain.

 

**8.****              Recent AccountingPronouncements**

 

InJune 2005, the Financial Accounting Standards Board issued SFAS No. 154, “AccountingChanges and Error Corrections” (“SFAS No. 154”), which will require entitiesthat make a voluntary change in accounting principle to apply that changeretrospectively to prior periods’ financial statements, unless this would beimpracticable. SFAS No. 154 supersedes Accounting Principles Board Opinion No.20, “Accounting Changes” (“APB 20”), which previously required that mostvoluntary changes in accounting principle be recognized by including in thecurrent period’s net income the cumulative effect of changing to the newaccounting principle. SFAS No. 154 also makes a distinction between “retrospectiveapplication” of an accounting principle and the “restatement” of financialstatements to reflect the correction of an error.

 

Under SFAS No. 154, if an entity changes its methodof depreciation, amortization, or depletion for long-lived, non-financialassets, the change must be accounted for as a change in accounting estimate.Under APB 20, such a change would have been reported as a change in accountingprinciple. SFAS No. 154 applies to accounting changes and error corrections thatare made in fiscal years beginning after December 15, 2005. The Company adoptedof SFAS No. 154 as of January 1, 2006 and the adoption did not have a materialimpact on its financial position, results of operations or cash flows.

 

**9.****              Subsequent Event**

 

OnApril 13, 2006, Avistar notified The NASDAQ Capital Market that it did notexpect to file its Annual Report on Form 10-K with the SEC on or prior tothe extended filing deadline of April 17, 2006. The Company notified TheNASDAQ Stock Market that beginning on April 17, 2006, it expected to beout of compliance with NASDAQ’s continued listing standard set forth in NASDAQMarketplace Rule 4310(c)(14). As a result of this noncompliance, Avistarreceived a notice from The NASDAQ Capital Market to the effect that, due tosuch noncompliance, Avistar’s common stock would be subject to delisting. Uponreceipt of the delisting notice, Avistar requested a hearing before a NASDAQListing Qualifications Panel (the “Panel”) to appeal NASDAQ staff’sdetermination. The hearing request automatically stayed the delisting ofAvistar’s common stock pending the Panel’s decision. Avistar filed its AnnualReport on Form 10-K on April 28, 2006. On May 5, 2006, Avistar received awritten notice from NASDAQ indicating that, in light of the filing of Avistar’sAnnual Report, the delisting hearing was moot and the delisting process hadbeen cancelled.

 

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**Item 2. *Management’sDiscussion and Analysis of Financial Condition and Results of Operations***

 

The following discussion should be read inconjunction with the unaudited Condensed Consolidated Financial Statements andthe Notes to Condensed Consolidated Financial Statements elsewhere herein, andthe Audited Consolidated Financial Statements contained in our Annual Report onForm 10-K for the year ended December 31, 2005, as filed with theSecurities and Exchange Commission on April 28, 2006.

 

Certainstatements in this “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” are forward looking statements. These statementsrelate to future events or our future financial performance and involve knownand unknown risks, uncertainties and other factors that may cause our or ourindustry’s actual results, levels of activity, performance or achievements tobe materially different from any future results, levels of activity,performance or achievements expressed or implied by the forward lookingstatements. These risks and other factors include those listed under “RiskFactors” elsewhere in this Quarterly Report on Form 10-Q. In some cases, youcan 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 comparableterminology. These statements are only predictions. Actual events or resultsmay differ materially. In evaluating these statements, you should specificallyconsider various factors, including the risks outlined under “Risk Factors.”These factors may cause our actual results to differ materially from anyforward-looking statement.

 

Although webelieve that the expectations reflected in the forward-looking statements arereasonable, we cannot guarantee future results, levels of activity, performanceor achievements. We are under no duty to update any of the forward-lookingstatements after the date of this Quarterly Report on Form 10-Q to conform ourprior statements to actual results.

 

**Overview**

 

We develop, market and support an integratedsuite of vBusiness—video-enabled eBusiness—applications, all powered by theAvistarVOSTM software. From the desktop, we deliver business-quality interactivevideo calling, content creation and publishing, broadcast origination anddistribution, video- on-demand, and integrated data sharing. The Avistar videoand data collaboration applications are all managed by the AvistarVOS videooperating system. By integrating video tightly into the way they work, ourcustomers can use our system to save costs and improve productivity andcommunication within the enterprise and between enterprises, to enhancerelationships with customers, suppliers and partners. Using AvistarVOS softwareand leveraging video, telephony and Internet networking standards, Avistarapplications are designed to be scalable, reliable, cost effective, easy touse, and capable of evolving with communications networks as bandwidthincreases and as new standards and protocols emerge. We currently sell oursystem directly to enterprises in selected strategic vertical markets, and havefocused initially on the financial services industry. Additionally, we havelicensed our technology and patents to companies in the video conferencingmarket. Our objective is to establish our technology as the standard fornetworked video through direct sales, indirect channel sales/partnerships andthe licensing of our technology to others.

 

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

 

Since inception, we have recognized theinnovative value of our research and development efforts, and have invested insecuring protection for these innovations through domestic and foreign patentapplication and issuance. As of March 31, 2006, we hold 70 U.S. and foreignpatents, which have been licensed to third parties. We continue to pursueopportunities to license these patents to others in the collaborationtechnology marketplace.

 

**Critical Accounting Policies**

 

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

 

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

 

•                  Revenuerecognition;

•                  Income from settlement and patent licensing;

 

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•                  Valuationof accounts receivable; and

•                  Valuationof inventories.

 

Inlight of the recent adoption of Statement of Financial Accounting Standards No.123 (revised 2004), “Share-Based Payment,” (“SFAS No. 123 (R)”), we have alsoincluded our stock-based compensation policy as a critical accounting policy,as set forth below.

 

**Revenue Recognition**

 

We derive product revenue principally from the saleand licensing of our video-enabled networked communications system, consistingof a suite of Avistar-designed software and hardware products, including thirdparty components. We also derive revenue from fees for installation,maintenance, support, training services and software development. In addition,we derive revenue from the licensing of our intellectual property portfolio.Product revenue as a percentage of total revenue was 47% and 59% for the threemonths ended March 31, 2006 and 2005, respectively.

 

We recognize product and services revenue inaccordance with Statement of Position (SOP) 97-2, Software Revenue Recognition(SOP 97-2), as amended by SOP 98-9, Modification of SOP 97-2, Software RevenueRecognition, With Respect to Certain Transactions (SOP 98-9). We derive productrevenue 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. Servicesrevenue includes revenue from installation services, post-contract customersupport, training, and software development. The installation services that weoffer to customers relate to the physical set-up and configuration of desktopand infrastructure components of our solution. The fair value of all product,installation services, post-contract customer support and training offered tocustomers is determined based on the price charged when such products orservices are sold separately.

 

Arrangements that include multiple product andservice elements may include software and hardware products, as well asinstallation services, post-contract customer support and training. Pursuant toSOP 97-2, when an arrangement includes multiple elements, we recognize revenuewhen all of the following criteria are met: (i) persuasive evidence of an arrangementexists, (ii) delivery has occurred, (iii) the fee is fixed or determinable, and(iv) collectibility is probable. We apply these criteria as discussed below:

 

•      Persuasive evidence of an arrangement exists. We require a writtencontract, signed by both the customer and us, or a purchase order from thosecustomers that have previously negotiated a standard end-user licensearrangement or volume purchase agreement with us prior to recognizing revenueon an arrangement.

 

•      Delivery has occurred. We deliver software and hardware to ourcustomers physically. Our standard delivery terms are FOB shipping point.

 

•      The fee is fixed or determinable. Our determination that an arrangementfee is fixed or determinable depends principally on the arrangement’s paymentterms. Our standard terms generallyrequire payment within 30 to 90 days of the date of invoice. Where these terms apply, we regard the feeas fixed or determinable, and we recognize revenue upon delivery (assumingother revenue recognition criteria are met). If the payment terms do not meetthis standard, but rather involve “extended payment terms,” we may not considerthe fee to be fixed or determinable and would then recognize revenue whencustomer installments are due and payable.

 

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

 

If there are any undelivered elements, we deferrevenue for those elements, as long as Vendor Specific Objective Evidence(VSOE) exists for the undelivered elements. Additionally, when we provideinstallation services, the product and installation revenue is recognized uponcompletion of the installation process and receipt of customer confirmation,subject to the satisfaction of the revenue recognition criteria describedabove. We believe that the fee associated with the delivered product elementsdoes not meet the collectibility criteria if the installation services have notbeen completed. Customer confirmation is obtained and documented by means of astandard form indicating the installation services provided and the

 

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hardwareand software components are installed. When the customer or a third partyprovides installation services, the product revenue is recognized uponshipment, subject to satisfaction of the revenue recognition criteria describedabove.

 

Payment for product is due upon shipment, subject tospecific payment terms. Payment for installation and professional services isdue upon providing the services, subject to specific payment terms.Reimbursements received for out-of-pocket expenses and shipping costs incurredduring installation and support services have not been significant to date.These expenses are recognized as revenue in accordance with Emerging IssuesTask Force (EITF) Issue No. 01-14 (EITF 01-14), “Income StatementCharacterization of Reimbursements Received for “Out of Pocket” ExpensesIncurred.”

 

The price charged for maintenance and/or support isdefined in the product contract, and is based on a fixed price for bothhardware and software components as stipulated in the customer agreement. Customershave the option to renew the maintenance and/or support services in subsequentperiods at the same or similar rateas paid in the initial year subject to contractual adjustments for inflation. Revenue from maintenance and support isrecognized pro-rata over the maintenance and/or support term, which istypically one year in length. Payments for services made in advance of theprovision of services are recorded as deferred revenue and customer deposits inthe accompanying balance sheets. Training services are offered independently ofthe purchase of product. The value of these training services is determinedbased on the price charged when such services are sold separately. Trainingrevenue is recognized upon performance of the service.

 

We recognize service revenue from softwaredevelopment contracts in accordance with SOP 81-1, “Accounting for Performanceof Construction-Type and Certain Production-Type Contracts.” Revenue related tocontracts for software development is recognized using the percentage ofcompletion method, when all of the following conditions are met: a contractexists with the customer at a fixed price, we have fulfilled all of ourmaterial contractual obligations to the customer for each deliverable of thecontract, verification of completion of the deliverable has been received, andcollection of the receivable is probable. The amounts billed to customers inexcess of revenues recognized to date are deferred and recorded as deferredrevenue and customer deposits in the accompanying balance sheets. Assumptionsused for recording revenue and earnings are adjusted in the period of change toreflect revisions in contract value and estimated costs to complete thecontract. Any anticipated losses on contracts in progress are charged to earningswhen identified.

 

We recognize revenue from the licensing of ourintellectual property portfolio based on the terms of the royalty, partnershipand cross-licensing agreements involved. In the event that a license to ourintellectual property is granted after the commencement of litigationproceedings between us and the licensee, the proceeds of such transaction mayonly be recognized as licensing revenue by us if sufficient historical evidenceexists for the determination of fair value of the patents licensed to supportthe segregation of the proceeds between a gain on litigation settlement andpatent license revenues. As of March 31, 2006, these criteria for recognizinglicense revenue following the commencement of litigation have not been met.

 

To date, a significant portion of our revenuehas resulted from sales to a limited number of customers, particularly DeutscheBank AG and UBS Warburg LLC and their affiliates. Collectively, Deutsche BankAG and UBS Warburg LLC and their affiliates accounted for approximately 77% oftotal revenue for the three month periods ended March 31, 2006 and March31 2005. As of March 31, 2006, approximately 95% of our gross accountsreceivable was concentrated with two customers, each of whom represented morethan 10% of our gross accounts receivable. As of December 31, 2005,approximately 97% of our gross accounts receivable was concentrated with threecustomers, each of whom represented more than 10% of our gross accountsreceivable.

 

International revenue, which consists of sales tocustomers with operations principally in Western Europe and Asia, comprised 49%and 57% of total revenue for the three months ended March 31, 2006 and 2005,respectively.

 

**Income from Settlement and Patent Licensing**

 

We recognize the proceeds from settlement and patentlicensing agreements based on the terms involved. When litigation has beenfiled prior to a settlement and patent licensing agreement, and insufficienthistorical evidence exists for the determination of fair value of the patentslicensed to support the segregation of the proceeds between a gain onlitigation settlement and patent license revenues, we report all proceeds in “incomefrom settlement and patent licensing” within operating costs and expenses. Whenlitigation has been filed prior to a settlement and patent licensing agreement,and sufficient historical evidence exists for the determination of fair valueof the patents licensed to support the segregation of the proceeds between again on litigation settlement and patent license revenues, we report the patentlicensing proceeds, as license revenue, consistent with FASB Concepts StatementNo. 6, Elements of Financial Statements. The gain portion of the proceeds, whensufficient historical evidence exists to segregate the proceeds, is reported inother income according to SFAS No. 5, Accounting for Contingencies.

 

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InSeptember 2005, we received a comment letter from the U. S. Securities andExchange Commission (“SEC”) relating to our 2004 Form 10-K, which included aquestion regarding our accounting for the November 2004 settlement and patentcross-license agreement with Polycom, Inc. (“Polycom”). The settlement andpatent cross-license agreement resulted in a $27.5 million one time payment byPolycom to us and a payment by us to our litigation counsel of $6.4 million incontingent legal fees. We previously reported on Form 10-Q for the three monthsended March 31, 2005 the one time payment by Polycom as revenue, to be recognizedratably over a five-year period, net of contingent legal fees. As a result ofthe SEC’s inquiry as to whether the Polycom transaction should be characterizedas revenue, and after discussions with the SEC, we concluded that areclassification of license revenues from revenue to a component of operatingexpenses, and presented as “Income from settlement and patent licensing” wasnecessary for previously filed financial reports. The restatement of the netproceeds and expenses from the Polycom settlement and patent cross-licenseagreement had no effect on reported net loss, loss per share, stockholders’equity (deficit) or net cash flows from operating, investing or financingactivities, but did have the effect of overstating revenues and operating expensesfor previously issued interim condensed consolidated financial statements, asof and for the three-months ended March 31, 2005. In addition, the balancesheet as of March 31, 2005 has been restated to reflect the gross effect of the$27.5 million payment by Polycom to Avistar, and the payment of $6.4 million ofcontingent legal fees by us, which was previously reported on a net basis asdeferred revenue. See Note 2 “Correctionof an Error” of the Notes to Condensed Consolidated Financial Statements.

 

**Valuation of Accounts Receivable**

 

Estimates are used in determining our allowance fordoubtful accounts and are based on our historical collection experience,historical write-offs, current trends, and the credit quality of our customerbase and the characteristics of our accounts receivable by aging category. Ifthe allowance for doubtful accounts were to be understated, our operatingresults would be negatively affected. The impact of any such change ordeviation may be increased by our reliance on a relatively small number ofcustomers for a large portion of our total revenue. As of December 31, 2005,three customers represented 48%, 32% and 17% of our accounts receivable balance.As of March 31, 2006, approximately 95% of our gross accountsreceivable was concentrated with two customers, each of whom represented morethan 10% of our gross accounts receivable.

 

**Valuation of Inventories**

 

We record a provision for obsolete or excessinventory for systems and components that are no longer manufactured or are atrisk of being replaced with new versions of our product. In determining theallowance for obsolete or excess inventory, we look at our forecasted demandversus quantities on hand and commitments. Any significant unanticipatedchanges in demand or technological developments could have a significant impacton the value of our inventory, commitments, and our reported results. If actualmarket conditions are less favorable than those projected, additional inventorywrite-downs, provision for purchase commitments and charges against earningsmay be required, which would negatively affect our operating results for thatperiod.

 

**Stock Compensation**

 

We adopted SFAS No. 123 (R) effective January 1,2006. SFAS No. 123 (R) is a new and very complex accounting standard, theapplication of which requires significant judgment and the use of estimates,particularly surrounding Black-Scholes assumptions such as stock pricevolatility and expected option terms, as well as expected option forfeiturerates to value equity-based compensation. There is little experience orguidance with respect to developing these assumptions and models. SFAS No. 123(R) requires the recognition of the fair value of stock compensation in netincome (loss). Refer to Note 3 – Stock-Based Compensation in the Notes to ourUnaudited Condensed Consolidated Financial Statements included elsewhere inthis Quarterly Report of Form 10-Q for more information.

 

**Results of Operations**

 

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

 

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| ** **                                         | ** ** | **Percentage of Total Revenue**           | ** ** |
|----------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                         | ** ** | **Three Months Ended**** March 31,** | ** ** |
| ** **                                         | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | ** **                                               | ** ** | **Restated(1)** | ** ** |
| Revenue:                                           |       |                                                     |       |   |   |
| Product                                            |       | 47                                                       | %          | 59 | % |
| Licensing                                          |       | 2                                                        |       | — |   |
| Services, maintenance and  support                 |       | 51                                                       |       | 41 |   |
| Total revenue                                      |       | 100                                                      |       | 100 |   |
| Costs and Expenses:                                |       |                                                     |       |   |   |
| Cost of product revenue                            |       | 34                                                       |       | 24 |   |
| Cost of services, maintenance  and support revenue |       | 33                                                       |       | 23 |   |
| Income from settlement and  patent licensing       |       | (57                                                      | )          | (55 | ) |
| Research and development                           |       | 69                                                       |       | 34 |   |
| Sales and marketing                                |       | 70                                                       |       | 36 |   |
| General and administrative                         |       | 121                                                      |       | 66 |   |
| Total costs and expenses                           |       | 270                                                      |       | 128 |   |
| Loss from operations                               |       | (170                                                     | )          | (28 | ) |
| Other income (expense):                            |       |                                                     |       |   |   |
| Interest income                                    |       | 5                                                        |       | 8 |   |
| Other income (expense), net                        |       | —                                                   |       | — |   |
| Total other income, net                            |       | 5                                                        |       | 8 |   |
| Net loss                                           |       | (165                                                     | )%         | (20 | )% |

 

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(1) See Note 2 “Correction of an Error” ofthe Notes to Condensed Consolidated Financial Statements

 

**COMPARISON OF THE THREE MONTHS ENDED MARCH 31, 2006 AND2005**

 

## ***Revenue***

## *** ***

Total revenue decreased by $64,000 and was $1.9million for the three month periods ended March 31, 2006 and March 31, 2005.This decrease was due primarily to a $250,000 decrease in product revenue,partially offset by a $154,000 increase in services, maintenance and supportrevenue and a $32,000 increase from licensing.

 

For the threemonths ended March 31, 2006, revenue from three customers accounted for91% of total revenue, each of whom accounted for greater than 10% of totalrevenue. For the three months ended March 31, 2005, revenue from threecustomers accounted for 89% of total revenue, each of whom accounted forgreater than 10% of total revenue. The level of sales to any customer may varyfrom quarter to quarter. We expect that there will be significant customerconcentration in future quarters. The loss of any one of those customers wouldhave a material adverse impact on our financial condition and operatingresults.

 

## ***Costs and Expenses***

## *** ***

*Costof product revenue.*****Cost of product revenue increased by $182,000, or40%, to $632,000 for the three months ended March 31, 2006, from $450,000 forthe three months ended March 31, 2005. This increase was due primarily toincreased headcount within our warehouse and operations.

 

*Costof services, maintenance and support revenue.*****Cost of services,maintenance and support revenue increased by $160,000, or 36%, to $607,000 forthe three months ended March 31, 2006, from $447,000 for the three months endedMarch 31, 2005. This increase was due primarily to increased headcount withinour support services group, and the allocation of labor costs associated with afunded software project that was completed during the quarter ended March 31,2006, and to a lesser extent, an increase in stock based compensation of$36,000.

 

*Incomefrom settlement and patent licensing.*****Income from settlement and patent licensing was$1.1 million for the three month periods ended March 31, 2006 and March 31,2005, reflecting the amortization of the $21.1 in net proceeds from theNovember 2004 Polycom settlement and cross-license agreement over a five yearperiod beginning in November 2004 and ending in November 2009.

 

*Researchand development.*****Research anddevelopment expenses increased by$631,000, or 98%, to $1.3 million for the three months ended March 31, 2006from $641,000 for the three months ended March 31, 2005. This increase was dueprimarily to increased personnel and to a lesser extent, an increase in stockbased compensation of $147,000, partially offset by the allocation ofengineering employee expenses associated with the funded software project thatwas completed during the quarter ended March 31, 2006.

 

*Salesand marketing.*Sales and marketing expenses increased by $602,000, or 86%, to $1.3 million forthe three months ended March 31, 2006, from $698,000 for the three monthsended March 31, 2005. The increase was due primarily to increasedpersonnel and personnel related expenses and, to a lesser extent, an increase in stock based compensation of $112,000.

 

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*Generaland administrative.*General and administrative expenses increased by $1.0 million, or 77%, to $2.3million for the three months ended March 31, 2006, from $1.3 million forthe three months ended March 31, 2005. The increase was due primarily tothe legal fees associated with our litigation against Tandberg for patentinfringement, and to a lesser extent, anincrease in stock based compensation of $178,000.

 

## ***Other Income***

## *** ***

Other income, net decreased by $47,000, or 33%, to$96,000 for the three months ended March 31, 2006, from $143,000 for thethree months ended March 31, 2005. The decrease was due to decreasedinterest income from our marketable securities classified as cash equivalentsand short and long-term investments, partially offset by increasing short terminterest rates.

 

**Liquidity and Capital Resources**

 

We had cash, cash equivalents and short and long-terminvestments of $9.5 million as of March 31, 2006, and $12.2 million as ofDecember 31, 2005. For the three months ended March 31, 2006, we had a netdecrease in cash, cash equivalents and short and long-term investments of $2.7million resulting primarily from a net loss of $3.1 million and a decrease indeferred income from settlement and patent licensing of $1.3 million, offset byan increase in deferred services revenue of $706,000, a decrease in deferredsettlement and patent licensing costs of $340,000 and non-cash expenses of$570,000, which included $475,000 in non-cash stock based compensation.

 

We had cash and cash equivalents of $7.1 million as ofMarch 31, 2006 compared to cash and cash equivalents of $8.2 million as ofDecember 31, 2005. For the three months ended March 31, 2006, we hadan overall net cash outflow of $1.1 million, resulting primarily from net cashused in operations of $2.7 million offset by cash inflows from investingactivities of $1.4 million due to maturities of short-term marketablesecurities. The net cash used in operations of $2.7 million resulted from a netloss of $3.1 million and a decrease in deferred income from settlement andpatent licensing of $1.3 million, offset by an increase in deferred servicesrevenue of $706,000, a decrease in deferred settlement and patent licensingcosts of $340,000 and non-cash expenses of $570,000, including stock basedcompensation of $475,000. The net cash inflow from investing activities of $1.4million was due to maturities of short-term marketable securities. The net cashinflow from financing activities was $128,000 due to proceeds from issuance ofcommon stock through our employee stock option and purchase plans.

 

At March 31, 2006, we had open purchase ordersand other contractual obligations of approximately $188,000, primarily relatedto inventory purchases. We also have commitments that consist of obligationsunder our operating leases. These purchase order commitments and contractualobligations are reflected in our financial statements once goods or serviceshave been received or payments related to the obligations become due.

 

On March 15, 2006, we signed a new lease for2,500 square feet of office space in London, United Kingdom to house our salesand operational personnel. The new office space replaces similar facilitiesvacated in March 2006. The new lease requires minimum payments of approximately$112,000, $144,000, $144,000 and $80,000 for fiscal years 2006, 2007, 2008 and2009, respectively.

 

On May 11, 2005, CPI, our wholly-ownedsubsidiary, commenced a patent infringement lawsuit against Tandberg ASA andTandberg, Inc. alleging that several Tandberg videoconferencing productsinfringe three patents held by CPI. The suit was filed in the United StatesDistrict Court for the Northern District of California.  The prosecutionof this lawsuit and the defense of any counterclaims may require us to expendsignificant financial and managerial resources and therefore may have amaterial negative impact on our business and financial condition.

 

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

 

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**Recent Accounting Pronouncements**

 

InJune 2005, the Financial Accounting Standards Board issued SFAS No. 154, “AccountingChanges and Error Corrections” (“SFAS No. 154”), which will require entitiesthat make a voluntary change in accounting principle to apply that changeretrospectively to prior periods’ financial statements, unless this would beimpracticable. SFAS No. 154 supersedes Accounting Principles Board Opinion No.20, “Accounting Changes” (“APB 20”), which previously required that mostvoluntary changes in accounting principle be recognized by including in thecurrent period’s net income the cumulative effect of changing to the newaccounting principle. SFAS No. 154 also makes a distinction between “retrospectiveapplication” of an accounting principle and the “restatement” of financialstatements to reflect the correction of an error.

 

Under SFAS No. 154, if an entity changes its methodof depreciation, amortization, or depletion for long-lived, non-financialassets, the change must be accounted for as a change in accounting estimate.Under APB 20, such a change would have been reported as a change in accountingprinciple. SFAS No. 154 applies to accounting changes and error correctionsthat are made in fiscal years beginning after December 15, 2005. We adopted ofSFAS No. 154 as of January 1, 2006 and the adoption did not have a materialimpact on our financial position, results of operations or cash flows.

 

**Item 3. *Quantitativeand Qualitative Disclosures About Market Risk***

 

We develop products primarily in the United States and sell those products primarily in North America, Europe and Asia. International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 49% of total product and services revenue for the three months ended March 31, 2006 and 57% for the three months ended March 31, 2005. As a result, our financial condition could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. As all of our sales are currently made in United States dollars, a strengthening of the United States dollar could make our products less competitive in foreign markets. We do not use derivative financial instruments for speculative or trading purposes, nor do we engage in any foreign currency hedging transactions.

 

Our interest income is sensitive to changes in the general level of United States interest rates, particularly since the majority of our investments are in short-term instruments. There has not been a material change in our exposure to interest rate and foreign currency risk since the date of our annual report on Form 10-K for the year ended December 31, 2005 filed with the Securities and Exchange Commission on April 28, 2006.

 

**Cash, Cash Equivalents andShort-term investments**

 

Cash equivalentsconsist primarily of commercial paper and money market and municipal bond fundsacquired with remaining maturity periods of three months or less, and arestated at cost, plus accrued interest that approximates market value. We wouldnot expect our operating results or cash flow to be significantly impacted bythe effect of sudden changes in market interest rates given the nature of ourshort-term investments.

 

The followingtable provides information about our investment portfolio. For investmentsecurities, the table presents cash, cash equivalents and short-terminvestment, and related weighted average interest rates by category atMarch 31, 2006.

 
| ** **                                          | ** ** | **Amounts**             | ** ** | **Weighted Average  Interest Rate** | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|-----------------------------------------------|------------|
| ** **                                          | ** ** | **(in thousands)** | ** ** | ** **                                    | ** ** |
| **Description**                                     |       |                    |       |                                          |       |
| Cash, cash equivalents and  short-term investments: |       |                    |       |                                          |       |
| Cash                                                |       | $                       | 1,105      |                                          | —     |   |
| Commercial Paper and US  Government Agency Notes    |       | 8,402                   |       | 4.5                                           | %          |
| Fair Value at March 31,  2006                  |       | $                       | 9,507      |                                          |       |   |

 

# **Item 4. *Controlsand Procedures***

 

(a) Evaluation of disclosure controls and procedures: Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act (i) is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions

 

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regarding required disclosure, and (ii) is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

 

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

 

**PART II - OTHER INFORMATION**

 

**Item 1. *Legal Proceedings***

 

On May 11, 2005, CPI, Avistar’s wholly-ownedpatent prosecution and licensing subsidiary, commenced a patent infringementlawsuit against Tandberg ASA and Tandberg, Inc, alleging that several Tandbergvideoconferencing products infringe three patents held by CPI. The suit wasfiled in the United States District Court for the Northern District ofCalifornia. The three patents involved are U.S. Patent Nos. 5,867,654;5,896,500; and 6,212,547. These patents cover technologies relating to videoand data conferencing over unshielded twisted pair (UTP) networks, distributedcall-state management and separate monitors for simultaneous computer-baseddata sharing and videoconferencing. These technologies are core components ofthe AvistarVOS video operating system. In this action, CPI has requestedinjunctive relief, damages to compensate for past and present infringement,treble damages, costs associated with the litigation and such further relief asthe Court deems just and proper. Both of the Tandberg entities answered thecomplaint on July 15, 2005, at which time they asserted that they did notinfringe the patents and that the patents were invalid and unenforceable. OnJanuary 30, 2006, Tandberg Telecom AS, a wholly-owned manufacturing andpatent holding subsidiary of Tandberg ASA, filed a patent infringement lawsuitagainst Avistar in the United States District Court for the Eastern District ofTexas. The suit alleges that Avistar videoconferencing products infringe onepatent purchased by Tandberg Telecom AS. The patent involved is U.S. PatentNo. 6,621,515, which claims a method and system for routing video calls.In the Texas litigation, Tandberg Telecom AS has requested injunctive relief,monetary damages to compensate for its actual damages, costs associated withthe litigation and such further relief as the Court deems just and proper. Weresponded to the complaint on March 23, 2006, at which time we assertedthat Avistar did not infringe the patent, that the patent was invalid, and thatthe claim was without merit. Tandberg ASA and Tandberg, Inc. sought to addtwo defenses, and provisionally filed two motions for summary judgment in theCalifornia litigation on January 13, 2006 and February 24, 2006,respectively. Each proposed defense asserts that we are subject to a differentcontractual provision that either totally precludes or limits CPI’s remedies inthe California litigation. Specifically, Tandberg alleged that (1) it hada license to the subject patents and (2) that Avistar had released itsclaims against Tandberg with respect to the subject patents. Both motions forsummary judgment were determined to be procedurally defective in that Tandberghad not previously pled the contractual provisions as defenses to CPI’s claims.In the first case, on January 13, 2006, Tandberg voluntarily filed amotion to amend its complaint to add a license defense. That motion to amendhas been fully briefed and argued and is pending. If the court permits Tandbergto amend its complaint, the briefing on Tandberg’s motion for summary judgmentwill be completed and the issue will be submitted to the court for resolution.During a hearing on March 20, 2006 concerning the “release” defense, thecourt refused to permit Tandberg to amend its complaint, holding that Tandbergcould not prevail on that defense, and thereby prohibiting Tandberg frompursuing this defense in the California case. The Markman hearing for the CPIclaims, a pivotal stage of the litigation process at which time definitions aredetermined for the following proceeding, is currently scheduled forMay 24, 2006. The prosecution of this lawsuit and the defense of theTandberg Telecom AS claim may require Avistar and CPI to expend significantfinancial and managerial resources, and therefore may have a material negativeimpact on our business, financial condition and results of operations. Theduration and ultimate outcome of this litigation are uncertain.

 

**Item 1a*.Risk Factors***

 

**Factors Affecting FutureOperating Results**

 

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

 

Our ability toachieve profitability depends in part on the widespread adoption of networkedvideo communications systems and the adoption of our video operating system inparticular. If the market for our system fails to grow or grows more slowlythan we anticipate, we may not be able to increase revenue or achieveprofitability. The market for our system is relatively new and evolving. Wehave to devote substantial resources to educating prospective customers aboutthe uses and benefits of our system. Our efforts to educate potential customersmay not result in our system achieving broad market acceptance. In addition,businesses that have invested or may invest substantial resources in othervideo products may be reluctant or slow to adopt our system. Similarly,customers using existing information systems in which they have made significantinvestments may refuse to adopt our system if they perceive that our offeringswill not complement their existing systems. Consequently, the conversion fromtraditional methods of communication to the extensive use of networked videomay not occur as rapidly as we wish.

 

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

 

We incurred netlosses of $3.1 million for the three months ended March 31, 2006, $5.2 millionfor fiscal year 2005 and $8.7 million for fiscal year 2004. As of March 31, 2006, our accumulated deficit was $97.7 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 mayincrease as we continue to develop our business in the future. As a result, tobecome profitable, we will need to increase our revenue by increasing sales toexisting customers and by attracting additional customers. If our expensesincrease more rapidly than our revenue, or if revenue and expense levels remainthe same, we may never become profitable.  If we do become profitable, we may not be able to sustain or increaseprofitability on a quarterly or annual basis. In addition, if we fail to reachprofitability or to sustain or grow our profits within the time frame expectedby investors, the market price of our common stock may be adversely impacted.

 

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

 

Theinternational economic slowdown and the downturn in the investment bankingindustry that began in the year 2000 negatively affected our business, and areoccurrence of a difficult economic environment may do so in the future. Duringthis most recent economic downturn, the investment banking industry suffered asharp decline, which caused many of our existing and potential customers tocancel or delay orders for our products. Although the U.S. economy hasimproved, our customers and potential customers may continue to delay orderingour products, and we could fall short of our revenue expectations for 2006 andbeyond. Slower growth among our customers, tightening of customers’ operatingbudgets, retrenchment in the capital markets and other general economic factorsall have had and could in the future have a materially adverse effect on ourrevenue, capital resources, financial condition and results of operations.

 

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

 

We have generally experienced a product sales cycle offour to nine months for new customers or large follow-on orders from existingcustomers due to the time needed to educate customers about the uses andbenefits of our system, and the significant investment decisions that ourprospective customers must make when they decide to buy our system. Many of ourprospective customers have neither budgeted expenses for networked videocommunications systems, or for personnel specifically dedicated to theprocurement, installation or support of these systems. As a result, ourcustomers spend a substantial amount of time before purchasing our system inperforming internal reviews and obtaining capital expenditure approvals.Economic conditions over the last several years have contributed to additionaldeliberation and an associated delay in the sales cycle.

 

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

 

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

 

Our customerstypically place limited initial orders for our networked video communicationssystem, as they seek to evaluate its usefulness and value. Our strategy is topursue additional and larger follow-on orders after these initial orders. Revenuegenerated from follow-on orders accounted for approximately 86% and 100% of ourrevenue for the three months ended March 31, 2006 and 2005, respectively. Ourfuture financial performance depends on successful initial installations of oursystem and successful generation of follow-on orders as the Avistar networkexpands within a customer organization. If our system does not meet the needsand expectations of customers, we may not be able to generate follow-on orders.

 

**Because we depend on a few customers for amajority of our product revenue and income from settlement and patent licensing,the loss of one or more of them could cause a significant decrease in our operatingresults.**

** **

To date, a significant portion of our revenueand income from settlement and patent licensing has resulted from sales to alimited number of customers, particularly Deutsche Bank AG, UBS Warburg LLC,Polycom, Inc. and their affiliates. Since November 12, 2004, income fromsettlement and patent licensing has come solely from our settlement and patentlicensing agreements with Polycom. Collectively, Polycom, Deutsche Bank AG andUBS Warburg LLC and their affiliates accounted for approximately 85% of totalrevenues and income from settlement and patent licensing for the three monthperiods ended March 31, 2006 and March 31, 2005.  As of March 31, 2006, approximately 95%of our gross accounts receivable was concentrated with two customers, each ofwhom

 

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represented more than 10% of our gross accounts receivable. As ofDecember 31, 2005, approximately 97% of our gross accounts receivable wasconcentrated with three customers, each of whom represented more than 10% ofour gross accounts receivable.

 

The loss of amajor customer or the reduction, delay or cancellation of orders from one ormore of our significant customers could cause our revenue to decline and ourlosses to increase. If we are unable to license our patent portfolio toadditional parties on terms equal to or better than our agreements with Polycomprior to the completion of our amortization of the Polycom proceeds, our incomefrom settlement and licensing will decline, which could cause our losses toincrease. We currently depend on a limited number of customers with lengthybudgeting cycles and unpredictable buying patterns, and as a result, ourrevenue from quarter to quarter or year to year may be volatile. Adversechanges in our revenue or operating results as a result of these budgetingcycles or any other reduction in capital expenditures by our large customerscould substantially reduce the trading price of our common stock.

 

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

 

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

 

•                  rapidtechnological change;

 

•                  theemergence of new competitors;

 

•      significantdevelopment costs;

 

•      changesin the requirements of our customers and their communities of users;

 

•      evolvingindustry standards; and

 

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

 

Our system isdesigned to work with a variety of hardware and software configurations anddata networking infrastructures used by our customers. The majority of thesecustomer networks rely on Microsoft Windows servers. However, our software maynot operate correctly on other hardware and software platforms or with otherprogramming languages, database environments and systems that our customers use.Also, we must constantly modify and improve our system to keep pace withchanges made to our customers’ platforms, data networking infrastructures, andtheir evolving ability to transport video and other applications. This mayresult in uncertainty relating to the timing and nature of our new releaseannouncements, introductions or modifications, which in turn may causeconfusion in the market, with a potentially harmful effect on our business. Ifwe fail to promptly modify or improve our system in response to evolvingindustry standards or customers’ demands, our system could become lesscompetitive, which would harm our financial condition and reputation.

 

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

 

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

 

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

** **

Currently, our competitioncomes 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 primarilyagainst Polycom, Tandberg Inc. and Emblaze-VCON Ltd. We believe we faceincreasing competition from alternative video communications solutions thatemploy new technologies or new combinations of technologies from companies suchas Cisco Systems, Inc., Avaya, Inc., Microsoft Corporation, Nortel NetworksCorporation and WebEx Communications, Inc., that enable web-based ornetwork-based video communications with low-cost digital camera systems. Themarket in which we operate is highly competitive. In addition, because ourindustry is relatively new

 

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and one which ischaracterized by rapid technological change, evolving user needs, developingindustry standards and protocols and the introduction of new products andservices, it is difficult for us to predict whether or when new competingtechnologies or new competitors will enter our market.

 

We expect competition toincrease in the future from existing competitors, partnerships of competitors,and from new market entrants with products that may be less expensive than oursor that may provide better performance or additional features not currentlyprovided by our products. Many of our current and potential competitors havesubstantially greater financial, technical, manufacturing, marketing,distribution and other resources, greater name recognition and market presence,longer operating histories, lower cost structures and larger customer basesthan we do. As a result, they may be able to adapt more quickly to new oremerging technologies and changes in customer requirements.

 

We may be required to reduceprices or increase spending in response to competition in order to retain orattract customers, pursue new market opportunities or invest in additionalresearch and development efforts. As a result, our revenue, margins and marketshare may be harmed. We cannot assure you that we will be able to competesuccessfully against current and future competitors, and partnerships of ourcompetitors, or that competitive pressures faced by us will not harm ourbusiness, financial condition and results of operations.

 

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

 

We regard oursystem as open but proprietary. In an effort to protect our proprietary rights,we rely primarily on a combination of patent, copyright, trademark and tradesecret laws, as well as licensing, non-disclosure and other agreements with ourconsultants, suppliers, customers and employees. However, these laws and agreementsprovide only limited protection of our proprietary rights. In addition, we maynot have signed agreements in every case and the contractual provisions thatare in place and the protection they produce may not provide us with adequateprotection in all circumstances. Although CPI holds patents and has filedpatent applications covering some of the inventions embodied in our systems,our means of protecting our proprietary rights may not be adequate. It may bepossible for a third party to copy or otherwise obtain and use our technologywithout authorization and without our detection. In the eventthat we believe a third party is infringing our intellectual property rights,an infringement claim brought by us could, regardless of the outcome, result insubstantial cost to us, divert our management’s attention and resources, betime consuming to prosecute and result in unpredictable damage awards. A third party may also develop similar technologyindependently, without infringing upon our patents and copyrights. In addition,the laws of some countries in which we sell our system may not protect oursoftware and intellectual property rights to the same extent as the laws of theUnited States or other countries where we hold patents. Unauthorized copying,use or reverse engineering of our system could harm our business, financialcondition or results of operations.

 

**We have filed a complaint alleging patent infringement against TandbergASA and Tandberg, Inc.  The prosecutionof this lawsuit could require us to expend significant financial and managerialresources and may have a material negative impact on our business.   If we do not prevail, we may be required topay monetary damages.**

 

On May 11,2005, CPI, our wholly-owned patent prosecution and licensing subsidiary,commenced a patent infringement lawsuit against Tandberg ASA and Tandberg, Inc.alleging that several Tandberg videoconferencing products infringe threepatents held by CPI. The suit was filed in the United States District Court forthe Northern District of California.  Thethree patents involved are U.S. Patent Nos. 5,867,654; 5,896,500; and6,212,547.  These patents covertechnologies relating to video and data conferencing over unshielded twistedpair (UTP) networks, distributed call-state management and separate monitorsfor simultaneous computer-based data sharing and videoconferencing. Thesetechnologies are core components of the AvistarVOS video operating system.  In this action, CPI has requested injunctiverelief, damages to compensate for past and present infringement, trebledamages, costs associated with the litigation and such further relief as theCourt deems just and proper. Both of the Tandberg entities answered thecomplaint on July 15, 2005, at which time they asserted that they did notinfringe the patents and that the patents were invalid and unenforceable.  The prosecution of this lawsuit may requireus and CPI to expend significant financial and managerial resources, andtherefore may have a material negative impact on our business, financialcondition and results of operations.  Theduration and ultimate outcome of this litigation are uncertain.

 

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

 

In recent years, there has been significant litigation in the UnitedStates involving patents and other intellectual property rights and we havebeen a party to such litigation. On January 30, 2006, Tandberg Telecom AS, awholly-owned manufacturing and patent holding subsidiary of Tandberg ASA, fileda patent infringement lawsuit against Avistar in the United States DistrictCourt for the Eastern District of Texas. The suit alleges that Avistarvideoconferencing products infringe one patent purchased by Tandberg TelecomAS. The patent involved is U.S. Patent No. 6,621,515, which covers a method andsystem for routing video calls. In this action, Tandberg Telecom AS hasrequested injunctive relief, money damages to compensate for its actualdamages, costs associated with the litigation and such further relief as theCourt deems just and proper. We responded to the complaint on March 23, 2006,at which time we asserted that we did not infringe the patent and that thepatent was invalid. The prosecution of this lawsuit and defense of the Tandbergclaims may require us and CPI to expend significant financial and managerialresources, and therefore may have a material negative impact on our financialposition and results of operations. The duration and ultimate outcome of theseproceedings are uncertain. We may be a party to additional litigation in thefuture, to protect our intellectual property or as a result of an allegedinfringement of the intellectual property of others. These claims and anyresulting lawsuit, could subject us to significant liability for damages andinvalidation of proprietary rights. These lawsuits, regardless of theirsuccess, would likely be time-consuming and expensive to resolve and woulddivert management’s time and attention. Any potential intellectual property litigationalso could force us to do one or more of the following:

 

• stopselling, incorporating or using products or services that use the challengedintellectual property;

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

• redesignthose products or services that use technology that is the subject of aninfringement claim.

 

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

 

**Our inability to protect the intellectual property created byus would cause our business to suffer.**

 

Werely on a combination of license, development and nondisclosure agreements,trademark, trade secret and copyright law, and contractual provisions toprotect our other, non-patentable intellectual property rights. If we fail toprotect these intellectual property rights, our licensees, potential licenseesand others may seek to use our technology without the payment of license feesand royalties, which could weaken our competitive position, reduce ouroperating results and increase the likelihood of costly litigation. The growthof our business depends in part on the applicability of our intellectualproperty to the products of third parties, and our ability to enforceintellectual property rights against them. In addition, effective trade secretprotection may be unavailable or limited in certain foreign countries. Althoughwe intend to protect our rights vigorously, if we fail to do so, our businesswill suffer.

 

**Future revenues and income are difficult to predict forseveral reasons, including our lengthy and costly licensing cycle, and ourfailure to predict revenues and income accurately may cause us to miss analysts’estimates and result in our stock price declining.**

 

Becauseour licensing cycle is a lengthy process, the accurate prediction of futurerevenues and income from settlement and patent licensing from new licensees isdifficult. By way of example, the process of persuading companies to adopt ourtechnologies or convincing them that their products infringe our intellectualproperty rights can be lengthy. These factors make it difficult to predictfuture licensing revenue and income from settlement and patent licensing, andmay result in us missing analysts’ estimates which would likely cause our stockprice to decline.

 

**Our system could have defectsfor 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 acceptanceof our system in the market.**

 

Our system maycontain errors or defects, especially when new products are introduced or whennew versions are released. Despite internal system testing, we have in the pastdiscovered software errors in some of the versions of our system after theirintroduction. Errors in new systems or versions could be found aftercommencement of commercial shipments, and this could result in additionaldevelopment costs, diversion of technical and other resources from our otherdevelopment 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 marketacceptance of our system and could harm our reputation.

 

In addition, wehave warranted to some of our customers that our software is free of viruses. Ifa virus infects a customer’s computer software, the customer could assertclaims against us, which, regardless of their merits, could be costly to defendand could require us to pay damages and potentially harm our reputation.

 

Our licenseagreements with our customers typically contain provisions designed to limitour exposure to potential product liability and certain contract claims. Ourlicense agreements also typically limit a customer’s entire remedy to either arefund 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 underthe laws of some jurisdictions. Although we maintain product liability (“errorsand omissions”) insurance coverage, we cannot assure you that such coveragewill be adequate. A product liability, warranty or other claim could harm ourbusiness, financial condition and/or results of operations. Performanceinterruptions at a customer’s site could negatively affect the demand for oursystem or give rise to claims against us.

 

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

 

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

 

We depend onoutside contract manufacturers to produce components of our systems, such ascameras, microphones, gateway, speakers and monitors that we install atdesktops and in conference rooms. One supplier, Pacific Corporation, is asingle source supplier for a key component of our product. Another supplier,Equator Technologies Inc., is our only current source of a component used inour IP gateway product. In addition, during the first quarter of 2006, we beganusing an offshore contract resource for product development work. Our relianceon these third parties involves a number of risks, including:

 

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

 

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

 

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

 

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

 

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

 

•                  the possibility that an offshore contractdeveloper could misappropriate our source code through reverse engineering orother means, and thereby compromise our intellectual property rights.

 

If thesemanufacturers or suppliers cease to provide us with the assistance or thecomponents necessary for the operation of our business, we may not be able toidentify alternate sources in a timely fashion. Any transition to alternatemanufacturers or suppliers would likely result in operational problems andincreased expenses and could cause delays in the shipment of or otherwise limitour ability to provide our products. We cannot assure you that we would be ableto enter into agreements with new manufacturers or suppliers on commerciallyreasonable terms, or at all. Any disruption in product flow may limit ourrevenue, delay our product development, seriously harm our competitive positionand/or result in additional costs or cancellation of orders by our customers.

 

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

 

To increase ourrevenue, we must increase the size of our direct sales force and add indirectdistribution channels, such as systems integrators, product partners and/orvalue-added resellers, and/or effect sales through our customers. If we areunable to maintain or increase our direct sales force or add indirectdistribution channels due to our own cost constraints, limited availability ofqualified personnel or other reasons, our future revenue growth may be limitedand our future operating results may suffer. We cannot assure you that we willbe successful in attracting, integrating, motivating and retaining salespersonnel. Furthermore, it can take several months before a new hire becomes aproductive member of our sales force. The loss of existing salespeople, or thefailure of new salespeople and/or indirect sales partners to develop thenecessary skills in a timely manner, could reduce our revenue growth.

 

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

 

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

 

We need to attract and retain highly skilled technicaland managerial personnel for whom there is intense competition. If we areunable to attract and retain qualified technical and managerial personnel dueto our own cost constraints, limited availability of qualified personnel orother reasons, our results of operations could suffer and we may never achieveprofitability. The failure of new personnel to develop the necessary skills ina timely manner could harm our business.

 

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

 

Failure toachieve or manage growth effectively will harm our business, financialcondition and operating results. Furthermore, in order to remain competitive orto expand our business, we may find it necessary or desirable in the future toacquire other businesses, products or technologies. If we identify anappropriate acquisition candidate, we may not be able to negotiate the terms ofthe acquisition successfully, to finance the acquisition or to integrate theacquired businesses, products or technologies into our existing business andoperations. In addition, completing a potential acquisition and integrating anacquired business may strain our resources and require significant managementtime.

 

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

 

Internationalrevenue, which consists of sales to customers with operations principally inWestern Europe and Asia,  comprised49% of total product and services revenue for the three months endedMarch 31, 2006 and 57% of our total product and services revenue for thethree months ended March 31, 2005. Some of the risks we may encounter inconducting international business activities include the following:

 

•                  tariffs and other trade barriers;

•                  unexpected changes in foreign regulatoryrequirements and laws;

•                  economic and political instability;

•                  increased risk of infringement claims;

•                  protection of our intellectual property;

•                  restrictions on the repatriation of funds;

•                  potentially adverse tax consequences;

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

•                  fluctuations in foreign currencies; and

•                  limitations in communications infrastructures insome foreign countries.

 

Some of our products are subject to variousfederal, state and international laws governing substances and materials inproducts, including those restricting the presence of certain substances inelectronics products. We could incur substantial costs, including fines andsanctions, or our products could be enjoined from entering certainjurisdictions, if we were to violate environmental laws or if our productsbecome non-compliant with environmental laws. We also face increasingcomplexity in our product design and procurement operations as we adjust to newand future requirements relating to the materials composition of our products,including the restrictions on lead and certain other substances that will applyto specified electronics products sold in the European Union as of July 1,2006 (Restriction of Hazardous Substances Directive). The ultimate costs underenvironmental laws and the timing of these costs are difficult to predict. Similarlegislation has been or may be enacted in other regions, including in theUnited States, the cumulative impact of which could be significant.

 

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

 

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

 

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

 

We believe that establishing and maintaining brand and name recognitionis critical for attracting and expanding our targeted customer base. We alsobelieve that the importance of reputation and name recognition will increase ascompetition in our market increases. Promotion and enhancement of our name willdepend on the success of our marketing efforts, and on our ability to continueto provide high quality systems and services, neither of which can be assured. Ifour customers do not perceive our system or services to be effective or of highquality, our brand and name recognition will suffer, which would harm ourbusiness.

 

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

 

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

 

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If we are unable to continue to list our common stockfor trading on The NASDAQ Capital Market, there may be adverse impact on themarket price and liquidity of our common stock, and our stock may be subject tothe “penny stock rules” contained in Section 15(g) of the SecuritiesExchange Act of 1934, as amended, and the rules promulgated there under. Delistingof our common stock from The NASDAQ Capital Market could also materiallyadversely affect our business, including, among other things: our ability toraise additional financing to fund our operations; our ability to attract andretain customers; and our ability to attract and retain personnel, includingmanagement personnel. In addition, if we were unable to list our common stockfor trading on NASDAQ, many institutional investors would no longer be able toretain their interests in and/or make further investments in our common stockbecause of their internal rules and protocols.

 

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

 

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

 

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

•                  quarterly variations in our results ofoperations;

•                  announcements regarding our product developments;

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

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

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

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

 

If our revenue and results of operations are below theexpectations of public market securities analysts or investors, thensignificant fluctuations in the market price of our common stock could occur. Inaddition, the securities markets have, from time to time, experiencedsignificant price and volume fluctuations, which have particularly affected themarket prices for high technology companies, and which often are unrelated anddisproportionate to the operating performance of particular companies. Thesebroad market fluctuations, as well as general economic, political and marketconditions, may negatively affect the market price of our common stock.

 

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

** **

In the past,following periods of market volatility in the price of a company’s securities,security holders have often instituted class action litigation. Many technologycompanies have been subject to this type of litigation. Our share price has, inthe past, experienced price volatility, and may continue to do so in thefuture. If the market value of our common stock experiences adversefluctuations and we become involved in this type of litigation, regardless ofthe merits or outcome, we could incur substantial legal costs and our management’sattention could be diverted, causing our business, financial condition andoperating results to suffer.

 

**Our expected future working capital needs may require that weseek additional debt or equity funding which, if not available, could cause ourbusiness to suffer.**

 

Wemay need to arrange for the availability of additional funding in order to meetour future business requirements. If we are unable to obtain additional fundingwhen needed on acceptable terms, we may not be able to develop or enhance ourproducts, take advantage of future opportunities, respond to competitivepressures or unanticipated requirements, or finance our efforts to protect andenforce our intellectual property rights, which could seriously harm ourbusiness, financial condition, results of operations and ability to continueoperations.

 

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

 

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

 

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

 

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

** **

Our executive officers, directors and entities affiliated with them, inthe aggregate, beneficially owned approximately 63% of our common stock as of March 31, 2006. If they were toact together, these stockholders would be able to exercise control over mostmatters requiring approval by our stockholders, including the election ofdirectors and approval of significant corporate transactions. These actions maybe taken even if they are opposed by other investors. This concentration ofownership may also have the effect of delaying or preventing a change incontrol of our company, which could cause the market price of our common stockto decline.

 

**Changes in stockoption accounting rules adopted January 1, 2006 will adversely impact ourreported operating results prepared in accordance with generally acceptedaccounting principles, which may in turn adversely impact our stock price andour ability to attract and retain employees.**

 

In December 2004, the FASB issued SFAS No. 123R, “Share-BasedPayment.” SFAS No. 123R requires employee stock options and rights to purchaseshares under stock participation plans to be accounted for under the fair valuemethod, and eliminates the ability to account for these instruments under theintrinsic value method prescribed by APB Opinion No. 25, and allowed under theoriginal provisions of SFAS No. 123. SFAS No. 123R requires the use of anoption pricing model for estimating fair value, which is amortized to expenseover the service periods. The requirements of SFAS No. 123R are effectivebeginning in the first quarter of an issuer’s first fiscal year commencingafter June 15, 2005, which for us was our fiscal quarter beginningJanuary 1, 2006. We have adopted the provisions of SFAS123(R) using the modified prospective application. Under a modified prospectiveapplication, SFAS 123(R) applies to new awards, unvested awards, and to awardsthat are outstanding on the effective date and are subsequently modified orcancelled. Compensation expense for outstanding awards for which the requisiteservice had not been rendered as of the effective date are expected to berecognized over the remaining service period using the compensation costcalculated for pro forma disclosure purposes under SFAS 123. We have determinedthe new method of valuing stock-based compensation as prescribed in SFAS123(R), which will be applied to the valuation of stock-based awards grantedafter our adoption of SFAS 123(R) on January 1, 2006. The impact of therecognition of compensation expense related to such awards was $475,000 for thethree months ended March 31, 2006. The impact of stock based compensation infuture periods will vary depending on the inputs to the Black-Scholes-Mertonmodel used to determine fair value of options granted, in conjunction with ouremployee’s historical option exercise and forfeiture behavior. The inputsinclude dividend rate, risk-free interest rate, expected term of the option,volatility, exercise price and the price of our stock on the date of valuation.

 

The pro forma impact of the adoption of SFAS 123 onour historical financial statements is included in the notes to the condensedconsolidated financial statements presented in Item 1 of this Form 10-Q. Weexpect to continue to grant stock-based compensation to employees. This newstandard will have a material adverse impact on our future results ofoperations.

 

**Item 5. *OtherInformation***

 

OnApril 13, 2006, Avistar notified The NASDAQ Capital Market that it did notexpect to file its Annual Report on Form 10-K with the SEC on or prior tothe extended filing deadline of April 17, 2006. The Company notified TheNASDAQ Stock Market that beginning on April 17, 2006, it expected to beout of compliance with NASDAQ’s continued listing standard set forth in NASDAQMarketplace Rule 4310(c)(14). As a result of this noncompliance, Avistarreceived a notice from The NASDAQ Capital Market to the effect that, due tosuch noncompliance, Avistar’s common stock would be subject to delisting. Uponreceipt of the delisting notice, Avistar requested a hearing before a NASDAQListing Qualifications Panel (the “Panel”) to appeal NASDAQ staff’sdetermination. The hearing request automatically stayed the delisting ofAvistar’s common stock pending the Panel’s decision. Avistar filed its AnnualReport on Form 10-K on April 28, 2006. On May 5, 2006, Avistar received awritten notice from NASDAQ indicating that, in light of the filing of Avistar’sAnnual Report, the delisting hearing was moot and the delisting process hadbeen cancelled.

 

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**Item 6. *Exhibits***

(a)

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

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities and Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized, on this 12th day of May 2006.

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

 

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**EXHIBIT INDEX**

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

 

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