UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549———————————FORM 10-Q

———————————(Mark One)x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended March 31, 2011oro
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934For the transition period from _________________ to _______________________Commission file number: 000-31121

————————————AVISTAR COMMUNICATIONS CORPORATION(Exact name of registrant as specified in its charter)DELAWARE
88-0463156(State or other jurisdiction of

incorporation or organization)
(I.R.S. Employer

Identification Number)1875 South Grant Street,

10THFloor, San Mateo, CA
94402(Address of principal executive offices)
(Zip Code))Registrant's telephone number, including area code: (650) 525-3300Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.Yesx   NooIndicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).YesoNooIndicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of "accelerated filer," "large accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.  (check one):Large accelerated filer o

Non-accelerated filer o

(Do not check if a small reporting company)
Accelerated filer o

Smaller reporting company xIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yeso    NoxAt April 20, 2011, 39,358,995 shares of common stock of the Registrant were outstanding.












AVISTAR COMMUNICATIONS CORPORATION




INDEX





PagePART I.
FINANCIAL INFORMATION
3Item 1.
Financial Statements (unaudited)
3Condensed Consolidated Balance Sheets
3Condensed Consolidated Statements of Operations
4Condensed Consolidated Statements of Cash Flows
5Notes to Condensed Consolidated Financial Statements
6Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
16Item 3.
Quantitative and Qualitative Disclosures about Market Risk
20Item 4T.
Controls and Procedures
20PART II.
OTHER INFORMATION
20Item 1.
Legal Proceedings
21Item 1A.
Risk Factors
21Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
29Item 3.
Defaults Upon Senior Securities
29Item 4.
Removed and Reserved
29Item 5.
Other Information
29Item 6.
Exhibits
29SIGNATURES

30





2


AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARY
  CONDENSED CONSOLIDATED BALANCE SHEETS
  as of March 31, 2011 and December 31, 2010
  (in thousands, except share and per share data)
 
 March 31,2011

December 31, 2010(unaudited)Assets:Current assets:Cash and cash equivalents
$

3,050
$

1,817Accounts receivable, net of allowance for doubtful accounts of $9 and $4 at March 31, 2011 and December 31, 2010, respectively

1,100

721Inventories

22

23Prepaid expenses and other current assets

316

413Total current assets

4,488

2,974Property and equipment, net

155

184Other assets

53

108Total assets
$

4,696
$

3,266Liabilities and Stockholders’ Equity (Deficit):Current liabilities:Line of credit
$

8,000
$

7,000Accounts payable

508

399Deferred services revenue and customer deposits

2,077

2,612Accrued liabilities and other

980

1,048Total current liabilities

11,565

11,059Long-term liabilities:Long-term convertible debt

3,000

—Other liabilities

45

59Total liabilities

14,610

11,118Commitments and contingencies (Note 9)Stockholders’ equity (deficit):Common stock, $0.001 par value; 250,000,000 shares authorized at March 31, 2011 and December 31, 2010; 40,541,870 and 40,304,235 shares issued at March 31, 2011 and December 31, 2010, respectively

40

40Less: treasury common stock, 1,182,875 shares at March 31, 2011 and December 31, 2010, at cost

(53)

(53)Additional paid-in-capital

104,176

103,817Accumulated deficit

(114,077)

(111,656)Total stockholders’ equity (deficit)

(9,914)

(7,852)Total liabilities and stockholders’ equity (deficit)
$

4,696
$

3,266
  The accompanying notes are an integral part of these condensed consolidated financial statements.


3




AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARY




CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS




for the three months ended March 31, 2011 and 2010




(in thousands, except per share data)







Three Months Ended March 31,2011


2010(unaudited)Revenue:Product

$
474


$
82Licensing and sale of patents


106



14,149Services, maintenance and support


810



545Total revenue


1,390



14,776Costs and expenses:Cost of product revenue*


95



153Cost of services, maintenance and support revenue*


273



383Research and development*


1,443



1,939Sales and marketing*


910



613General and administrative*


1,061



1,114Total costs and expenses


3,782



4,202Income (loss) from operations


(2,392)



10,574Other income (expense), net


(27)



(8)Income (loss) before provision for income taxes


(2,419)



10,566Provision for income taxes


2



337Net income (loss)

$
(2,421)


$
10,229Net income (loss) per share – basic and diluted

$
(0.06)


$
0.26Weighted average shares used in calculating basic net income (loss) per share


39,246



39,008Weighted average shares used in calculating diluted net income (loss) per share


39,246



39,297*Including stock based compensation of:Cost of product, services, maintenance and support revenue

$
9


$
23Research and development


72



101Sales and marketing


58



42General and administrative


166



153









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


4


AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARY




CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS




for the three months ended March 31, 2011 and 2010




(in thousands)







Three Months EndedMarch 31,2011


2010(unaudited)Cash Flows from Operating Activities:Net income (loss)

$
(2,421)


$
10,229Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:Depreciation


30



50Compensation on equity awards issued to consultants and employees


305



319Provision for doubtful accounts


5



3Changes in assets and liabilities:Accounts receivable


(384)



212Inventories


1



20Prepaid expenses and other current assets


97



107Other assets


55



(1)Accounts payable


109



(109)Other long term liabilities


(14)



—Deferred services revenue and customer deposits


(535)



(373)Income taxes payable


2



337Accrued liabilities and other


(70)



(155)Net cash provided by (used in) operating activities


(2,820)



10,639Cash Flows from Investing Activities:Purchase of property and equipment


(1)



(111)Net cash used in investing activities


(1)



(111)Cash Flows from Financing Activities:Line of credit payments


—



(11,250)Proceeds from line of credit


1,000



1,100Proceeds from convertible debt issuance


3,000



—Net proceeds from issuance of common stock


54



16Net cash provided by (used in) financing activities


4,054



(10,134)Net increase in cash and cash equivalents


1,233



394Cash and cash equivalents, beginning of period


1,817



294Cash and cash equivalents, end of period

$
3,050


$
688









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


5


AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(UNAUDITED)




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




Business




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




Basis of Presentation




The unaudited condensed consolidated balance sheet as of March 31, 2011, the unaudited condensed consolidated results of operations for the three months ended March 31, 2011 and 2010 and the unaudited condensed consolidated cash flows for the three months ended March 31, 2011 and 2010 present the consolidated financial position of Avistar and ASUK after the elimination of all intercompany accounts and transactions. The unaudited condensed consolidated balance sheet of Avistar as of December 31, 2010 was derived from audited consolidated financial statements, but does not contain all disclosures required by accounting principles generally accepted in the United States of America (“GAAP”), and certain information and footnote disclosures normally included have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  Because all of the disclosures required by GAAP are not included, as permitted by the rules of the SEC, these interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.  The consolidated results are referred to, collectively, as those of Avistar or the Company in these notes.




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




The Company’s fiscal year end is December 31.




Risks and Uncertainties




The markets for the Company’s products, services and patented technologies are in the early stages of development. Some of the Company’s products and patented technologies utilize changing and emerging technologies. As is typical in industries of this nature, demand and market acceptance are subject to a high level of uncertainty, particularly when there are adverse conditions in the economy. Acceptance of the Company’s products and patented technologies, over time, is critical to the Company’s success. The Company’s prospects must be evaluated in light of difficulties encountered by it and its competitors in further developing this evolving marketplace. The Company has generated losses since inception and had an accumulated deficit of $114.1 million as of March 31, 2011. The Company’s operating results may fluctuate significantly in the future as a result of a variety of factors, including, but not limited to, the economic environment, the adoption of different distribution channels, and the timing of new product announcements by the Company or its competitors.




The Company’s future liquidity and capital requirements will depend upon numerous factors, including, but not limited to, the ability to become profitable or generate positive cash flow from operations, the Company’s cost reduction efforts,  Dr. Burnett’s personal guarantee to Avistar to support an extension of the revolving line of credit through March 31, 2012, the Company’s ability to obtain a renewal of its existing line of credit or a new line of credit with another bank, the costs and timing of its expansion of product development efforts and the success of these development efforts, the costs and timing of its expansion of sales and marketing activities, the extent to which its existing and new products gain market acceptance, competing technological and market developments, the costs involved in maintaining, enforcing and defending patent claims and other intellectual property rights, the level and timing of revenue, and other factors.If adequate funds are not available on acceptable terms or at all, the Company’s ability to achieve or sustain positive cash flows, maintain current operations, fund any potential expansion, take advantage of unanticipated opportunities, develop or enhance products or services, or otherwise respond to competitive pressures would be significantly limited.




6




2. Summary of Significant Accounting Policies




Unaudited Interim Financial Information




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




In the opinion of management, the unaudited financial statements furnished in this report reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the results of operations for the interim periods covered and of the Company’s financial position as of the interim balance sheet date. The results of operations for the interim periods are not necessarily indicative of the results for the entire year. These financial statements should be read in conjunction with the Company’s audited consolidated financial statements and the accompanying notes for the year ended December 31, 2010, included in the Company’s Annual Report on Form 10-K filed with the SEC on March 31, 2011.




Use of Estimates




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




Cash and Cash Equivalents and Short and Long-term Investments




The Company considers all investment instruments purchased with an original maturity of three months or less to be cash equivalents. Investment securities with original or remaining maturities of more than three months but less than one year are considered short-term investments. Auction rate securities with original or remaining maturities of more than three months are considered short-term investments even if they are subject to re-pricing within three months.  The Company was not invested in any auction rate securities as of March 31, 2011 and December 31, 2010. Investment securities held with the intent to reinvest or hold for longer than a year, or with remaining maturities of one year or more, are considered long-term investments. The Company’s cash equivalents at March 31, 2011 and December 31, 2010 consisted of money market funds with original maturities of three months or less, and are therefore classified as cash and cash equivalents in the accompanying balance sheets.




See Note 3 for further information on fair value.




Significant Concentrations




A relatively small number of customers accounted for a significant percentage of the Company’s revenues for the three months ended March 31, 2011 and 2010. Revenue from these customers as a percentage of total revenue was as follows for the three months ended March 31, 2011 and 2010:




Three Months Ended March 31,2011

2010(Unaudited)Customer A


29
%


*
%Customer B


15
%


*
%Customer C


13
%


*
%Customer D


10
%


*
%Customer E


*
%


74
%Customer F


*
%


20
%


— — — — — — — — — — — — —




* Less than 10%




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




7




Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of temporary cash investments and trade receivables. The Company has cash and investment policies that limit the amount of credit exposure to any one financial institution, or restrict placement of these investments to financial institutions evaluated as highly credit worthy. As of March 31, 2011, the Company had cash and cash equivalents on deposit with a major financial institution that were above the Federal Deposit Insurance Corporation (“FDIC”) insured limits. Concentrations of credit risk with respect to trade receivables relate to those trade receivables from both United States and foreign entities. As of March 31, 2011, approximately 73% of the Company’s gross accounts receivable was concentrated with three customers, each of whom represented more than 10% of the total gross accounts receivable. As of December 31, 2010, approximately 74% of the Company’s gross accounts receivable was concentrated with two customers, each of whom represented more than 10% of the total gross accounts receivable. No other customer individually accounted for greater than 10% of total accounts receivable as of March 31, 2011 or December 31, 2010.




Allowance for Doubtful Accounts




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




Fair Value of Financial Instruments




The carrying amounts of the Company’s financial assets and liabilities, including cash and cash equivalents, accounts receivable, line of credit, and accounts payable at March 31, 2011and December 31, 2010, approximate fair value because of the short maturity of these instruments.




The convertible debt was stated at cost at March 31, 2011 since there were no unamortized discounts and the Company did not elect to measure the instrument at fair value in accordance with Accounting Standards Codification (“ASC”) 825-10, Financial Instruments.  As of March 31, 2011, the carrying amount of the convertible debt was $3.0 million and the estimated fair value was approximately $4.1 million.  The fair value is estimated as the sum of the present value of future interest and principal payments of the debt based on rates available to the Company for debt with similar terms and remaining maturities, and the fair value of the conversion feature calculated based on the Black-Scholes method. See Note 8 for further details on the terms of the convertible debt.





Revenue Recognition and Deferred Revenue





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





Arrangements that include multiple product and service elements may include software products, professional services, post-contract customer support and training. Pursuant to ASC 985-605, the Company recognizes revenue when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the fee is fixed or determinable, and (iv) collectibility is probable. The Company applies these criteria as discussed below:





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




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




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






8






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




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





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





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





The Company recognizes revenue from the licensing or sale of its intellectual property portfolio according to ASC 985-605, Revenue Recognition – Software, based on the terms of the royalty, partnership, cross-licensing and purchase agreements involved.





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





On September 8, 2008 and on September 9, 2008, the Company entered into a Licensed Works Agreement, Licensed Works Agreement Statement of Work and a Patent License Agreement with International Business Machines Corporation, or IBM, under which the Company agreed to integrate the Company’s bandwidth management technology and related intellectual property into future Lotus Unified Communications offerings by IBM, and to provide maintenance support services, for an initial non-refundable fee of $6.0 million of which $3.0 million, $1.5 million and $1.5 million were paid to the Company in 2008, 2009 and 2010. The Company determined the value of maintenance based on VSOE and allocated the residual portion of the initial $6.0 million to the integration project. The residual portion was recognized under the percentage of completion method, in accordance with the “Input Method”, and the maintenance revenue is being recognized over the maintenance service period. As the Company believes there are no future deliverables associated with the intellectual property patent licenses, no additional provision for this element has been made.  The integration project was fully completed and delivered as of September 2010, with maintenance support services being the only undelivered element that is being recognized as maintenance revenue over the service period through September 2011. The Company recognized approximately $179,000 in maintenance revenue for the three months ended March 31, 2011. The Company did not recognize any revenue related to the IBM agreement for the three months ended March 31, 2010 as no work was performed during that period. In addition, under the agreements, IBM has agreed to make future royalty payments to the Company equal to two percent of the world-wide net revenue derived by IBM from Lotus Unified Communications products sold that exceeds a contractual base amount, and maintenance payments received from existing customers, which incorporate the Company’s technology.  No royalty revenue was recognized by the Company for the three months ended March 31, 2011. The agreements have a six year term and are non-cancelable except upon material default by either party.  The agreements convey to IBM a non-exclusive world-wide license to the Company’s patent portfolio existing at the time of the agreements and for all subsequent patents issued with an effective filing date of up to five years from the date of the agreements.  The agreements also provide for a release of each party for any and all claims of past infringement.





9








On January 19, 2010, the Company entered into a patent license agreement with Springboard Group S.A.R.L. (“SKYPE”).  Under the agreement, the Company granted to SKYPE for the lives of the patents, a royalty-free, irrevocable, non-exclusive license under certain patents to make, have made (subject to certain limitations), use, import or export, offer to sell, sell, lease, license, or otherwise transfer or distribute certain licensed products.  These granted rights and license include rights for authorized entities and end users of SKYPE to form combinations with other products for certain authorized purposes.  As consideration for the license, the Company received a payment of $3.0 million from SKYPE on January 25, 2010 and recognized $3.0 million as revenue from licensing and sale of patents for the quarter ended March 31, 2010.





On January 21, 2010, the Company completed the sale of substantially all of its U.S. patents and patent applications, and related foreign patents and patent applications to Intellectual Ventures Fund 61 LLC (“Intellectual Ventures”) related to an agreement that was entered into on December 18, 2009.    The Company retained royalty rights under its existing patent license agreements, and also obtained a full grant-back royalty-free, irrevocable license to the patent portfolio from Intellectual Ventures to make, use and sell any current and future Avistar product or service covered by the patents sold.  The Company received the purchase price of $11.0 million from Intellectual Ventures on January 21, 2010 and recognized $11.0 million as revenue from licensing and sale of patents for the quarter ended March 31, 2010.




Warranty




The Company accrues the estimated costs of fulfilling the warranty provisions of its contracts over the warranty period, which is typically 90 days. There was no warranty accrual as of March 31, 2011 and December 31, 2010.




Research and Development




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




Stock-Based Compensation




The Company accounts for stock-based compensation in accordance with ASC 718,Compensation – Stock Compensation(“ASC 718”)which establishes accounting for stock-based awards exchanged for employee services. Accordingly, stock-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized as expense over the service period.




10






The effect of recording stock-based compensation for the three months ended March 31, 2011 and 2010 was as follows (in thousands):




Three Months Ended March 31,2011

2010(unaudited)Stock-based compensation expense by type of award:Employee stock options

$           160

$           234Employee restricted stock units

120

74Non-employee restricted stock units

10

3Employee stock purchase plan

15

8Total stock-based compensation

305

319Tax effect of stock-based compensation

—

—Net effect of stock-based compensation on net loss

$           305

$           319





Valuation Assumptions for Stock-Based Compensation




The Company estimated the fair value of stock options granted under the 2000 Stock Option Plan, the 2000 Director Stock Option Plan and the 2009 Equity Incentive Plan (the “Stock Plans”), and rights to acquire stock granted under the employee stock purchase plans (“ESPP”) using a Black-Scholes-Merton valuation model, consistent with the provisions of ASC 718 and SEC Staff Accounting Bulletin (“SAB”) No. 107. The following weighted-average assumptions and the straight-line attribution approach were used in estimating the fair value of employee stock option grants and ESPP shares for the three months ended March 31, 2011 and 2010, respectively:




Three Months Ended March 31,2011

2010(unaudited)Employee Stock Option PlanExpected dividend
—
%

—
%Average risk-free interest rate
1.5
%

2.1
%Expected volatility
161
%

136
%Expected term (years)
4.0


4.1Employee Stock Purchase PlanExpected dividend
—
%

—
%Average risk-free interest rate
0.2
%

0.2
%Expected volatility
232
%

241
%Expected term (months)
6.0


6.0





The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. The risk-free interest rates are taken from the Daily Federal Yield Curve Rates as of the grant dates as published by the Federal Reserve, and represent the yields on actively traded treasury securities for terms that approximate the expected term of the options. Expected volatility is based on the historical volatility of the Company’s common stock over a period consistent with the expected term of the stock-option. Expected term of employee stock options represents the weighted average period the stock options are expected to remain outstanding and is based on the entire history of exercises and cancellations on all past option grants made by the Company during which its equity shares have been publicly traded, the contractual term, the vesting period and the expected remaining term of the outstanding options.




The Company recognizes the estimated compensation expense of restricted stock units, net of estimated forfeitures, over the vesting term.  The estimated compensation expense is based on the fair value of the Company’s common stock on the date of grant.




11




Summary of Stock Options




Information regarding stock options outstanding at March 31, 2011 is summarized below (unaudited):




Number of Shares

Weighted Average Exercise price

Weighted Average Remaining Contractual Life (years)

Aggregate Intrinsic Value (thousands)As of March 31, 2011Options outstanding
8,226,123

$
0.69

7.99

$
—Options vested and expected to vest
7,478,148

$
0.70

7.90

$
—Options exercisable
2,222,058

$
0.96

5.32

$
—







The pretax intrinsic value of outstanding options is the difference between the closing price of Avistar stock as quoted on the OTC Market, an over-the-counter securities market, on March 31, 2011 and the exercise price, multiplied by the number of in-the-money options. The intrinsic value of options changes based on the fair market value of Avistar stock. As of March 31, 2011, all outstanding options had an exercise price equal to or above the closing price of Avistar stock.




For the three months ended March 31, 2011 and 2010, the Company granted 147,500 and 160,000 stock options to employees, with an estimated total grant date fair value of approximately $63,000 and $63,000, or $0.42 and $0.39 per share, respectively. As of March 31, 2011, the Company had an unrecognized stock-based compensation balance related to stock options of approximately $1.3 million before estimated forfeitures and after actual cancellations. ASC 718 requires forfeitures to be estimated at the time of grant and revised if necessary in subsequent periods if actual forfeitures differ from those estimates. Based on the Company’s historical experience of option pre-vesting cancellations,  the Company estimated that the stock-based compensation for the awards not expected to vest was approximately $418,000 as of March 31, 2011 and therefore, the unrecognized deferred stock-based compensation balance related to stock options was adjusted to approximately $906,000 after estimated forfeitures and after actual cancellations. This amount will be recognized over an estimated weighted average period of 1.63 years. In subsequent periods, if actual forfeitures differ from those estimates, an adjustment to stock-based compensation expense will be recognized at that time.






Summary of Restricted Stock Units




Information regarding the restricted stock units outstanding as of March 31, 2011 is summarized below (unaudited):




Number of Shares

Weighted Average Remaining Contractual Life (years)

Aggregate Intrinsic Value (thousands)As of March 31, 2011Restricted stock units outstanding
2,100,000

0.81

$
756Restricted stock units expected to vest
2,057,170

0.81

$
741







The intrinsic value of the restricted stock units is calculated as the market value at end of the fiscal period, based on the closing price of Avistar shares as quoted on the OTC Market as of March 31, 2011 of $0.36.




There were no restricted stock units granted during the three months ended March 31, 2011 and 2010. A total of 80,000 shares of restricted stock units were vested and released for the three months ended March 31, 2011. As of March 31, 2011, the Company had an unrecognized stock-based compensation balance related to restricted stock units to employees of approximately $377,000, adjusted for estimated forfeitures, which will be recognized over a weighted average period of approximately 10 months.







3. Fair Value Measurement




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




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




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






12






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




In accordance with ASC 820, the following table represents the Company’s fair value hierarchy for its financial assets (cash equivalents) as of March 31, 2011 and, December 31, 2010 (in thousands):






Fair Value

Level 1

Level 2

Level 3Cash Equivalents (unaudited):Money market funds

$5

$5

$—

$—Total cash equivalents

$5

$5

$—

$—








4. Related Party Transactions




Gerald Burnett, the Company’s Chairman, has provided a collateralized guarantee to the Company’s financial institution, assuring payment of the Company’s obligations under the revolving line of credit facility agreements (see Note 8) since December 2006 and at each annual renewal thereafter. Dr. Burnett also issued a personal guarantee to the Company in March 2010 and 2011, assuring the Company a line of credit of $7.0 million and $8.0 million, respectively, with the same terms and mechanisms as the existing revolving line of credit in the event the existing revolving line of credit from the financial institution terminated.





On March 29, 2011, Avistar sold a 4.5% Convertible Subordinated Secured Note due 2013 in the principal amount of $3,000,000 pursuant to a Convertible Note Purchase Agreement, dated as of March 29, 2011 among the Company and director Gerald Burnett. See Note 8 for further details.







5. Net Income (Loss) Per Share





Basic and diluted net income (loss) per share of common stock is presented in conformity with ASC 260, Earnings Per Share (“ASC 260”), for all periods presented. In accordance with ASC 260, basic net income (loss) per share has been computed using the weighted average number of shares of common stock outstanding during the period, less shares subject to repurchase. Diluted net income (loss) per share is computed on the basis of the weighted average number of shares and potential common shares outstanding during the period. Potential common shares result from the assumed exercise of outstanding stock options and vesting of restricted stock units that have a dilutive effect when applying the treasury stock method. The following table sets forth the computation of basic and diluted net income (loss) per share (in thousands, except per share data):




Three Months Ended March 31,2011

2010(unaudited)Numerator:Net income (loss) – basic and diluted
$
(2,421)
$
10,229Denominator:Basic weighted average shares outstanding

39,246

39,008Effect of dilutive securities:Stock options

—

17Restricted stock units

—

272Diluted weighted average shares outstanding

39,246

39,297Net income (loss) per share – basic
$
(0.06)
$
0.26Net income (loss) per share - diluted
$
(0.06)
$
0.26







Due to a net loss for the three months ended March 31, 2011, basic and diluted net loss per share are equivalent for the period presented as the inclusion of potential common shares in the number of shares used for the diluted computation would be anti-dilutive to the net loss per share.  For the three months ended March 31, 2011, approximately 8.3 million weighted average shares of stock options and 2.2 million weighted average shares of restricted stock units were excluded from the computation of diluted net loss per share because their effect would have been anti-dilutive.




13




For the three months ended March 31, 2010, approximately 11.2 million weighted average shares of stock options and 25,000 weighted average shares of restricted stock units were excluded from the computation of diluted net income per share because their effect would have been anti-dilutive.







6. Income Taxes




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




Deferred tax assets and liabilities are determined based on the difference between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are provided if based upon the weight of available evidence, it is considered more likely than not that some or all of the deferred tax assets will not be realized. The Company accounts for uncertain tax positions according to the provisions of ASC 740.  ASC 740 contains a two-step approach for recognizing and measuring uncertain tax positions. Tax positions are evaluated for recognition by determining if the weight of available evidence indicates that it is probable that the position will be sustained on audit, including resolution of related appeals or litigation. Tax benefits are then measured as the largest amount which is more than 50% likely of being realized upon ultimate settlement. The Company considers many factors when evaluating and estimating tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes.  No material changes have occurred in the Company’s tax positions taken as of December 31, 2010 during the three months ended March 31, 2011. As of December 31, 2010, the Company had a net deferred tax asset of approximately $25.6 million and unrecognized tax benefit under ASC 740 of approximately $1.0 million.  A valuation allowance has been provided for the entire net deferred tax assets.




The provision for income taxes of $2,000 for the three months ended March 31, 2011 consisted primarily of foreign tax expense for ASUK.The provision for income taxes of $337,000 for the three months ended March 31, 2010 consisted primarily of federal and state alternative minimum taxes due to the Company’s profitability for the quarter as a result of the sale of substantially all of the Company’s patents and patent applications to Intellectual Ventures for $11.0 million.






7. Segment Reporting




Disclosure of segments is presented in accordance with ASC 280, Segment Reporting (“ASC 280”). ASC 280 establishes standards for disclosures regarding operating segments, products and services, geographic areas and major customers. The Company is organized and operates as two operating segments: (1) the design, development, manufacturing, sale and marketing of networked video communications products (products division) and (2) the prosecution, maintenance, support and generation of licensing revenue through license or sale of the Company’s intellectual property and technology, some of which is used in the Company’s products (intellectual property division). Service revenue relates mainly to the maintenance, support, training and software development, and is included in the products division for purposes of reporting and decision-making. The products division also engages in corporate functions, and provides financing and services to its intellectual property division. The Company’s chief operating decision-maker, its Chief Executive Officer (CEO), monitors the Company’s operations based upon the information reflected in the following table (in thousands).




14




Intellectual Property Division

Products Division

TotalThree Months Ended March 31, 2011 (unaudited)Revenue
$

106
$

1,284
$

1,390Depreciation expense

—

(30)

(30)Stock-based compensation

53

252

305Total costs and expenses

207

3,575

3,782Other income (expense), net

—

(27)

(27)Net income (loss)

(101)

(2,320)

(2,421)Assets

427

4,269

4,696Three Months Ended March 31, 2010 (unaudited)Revenue
$

14,149
$

627
$

14,776Depreciation expense

—

(50)

(50)Stock-based compensation

63

256

319Total costs and expenses

802

3,400

4,202Other income (expense), net

—

(8)

(8)Net income (loss)

13,347

(3,118)

10,229Assets

532

1,538

2,070






International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 53% and 25% of total revenue for the three months ended March 31, 2011 and 2010, respectively. For the three months ended March 31, 2011 and 2010, international revenue from customers in the United Kingdom accounted for 29% and 3% of total revenue, respectively.  The Company had no significant long-lived assets in any country other than in the United States for any period presented.




8. Reporting







Line of Credit




On December 20, 2010, the Company renewed and amended its revolving credit promissory note with a financial institution (the “Lender”) to extend the maturity date of the facility by one year to December 22, 2011 at a maximum revolving line of credit amount of $8.0 million. The security agreement between the Company with the Lender granted the Lender a security interest in and right of setoff against substantially all of the Company’s assets, tangible and intangible. The revolving credit facility is subject to annual renewal with the consent of the Company and the Lender.   Gerald Burnett, the Company’s Chairman, provided a collateralized guarantee to the financial institution, assuring payment of the Company’s obligations under the agreement and as a consequence, there are no restrictive covenants, allowing the Company greater access to the full amount of the facility. Dr. Burnett also provided a personal guarantee to the Company assuring the Company a line of credit of $8.0 million with the same terms and mechanism as the existing revolving line of credit in the event the existing revolving line of credit from the financial institution was unavailable for any reason during the period from its termination on December 22, 2011 to March 31, 2012. In connection with the issuance of the 4.5% Convertible Subordinated Secured Note due 2013, or the Note (as defined below), on March 29, 2011, the Company entered into amendments to the revolving credit promissory note and to the security agreement with the Lender to permit the grant of a security interest to the Purchaser of the Note and to allocate specific assets of the Company solely to secure the Company’s obligations under the Note.





The revolving line of credit requires monthly interest-only payments based on Adjusted LIBOR plus 0.90% or Prime Rate plus 1.00%. The Company elected Adjusted LIBOR plus 0.90% or 1.21% at March 31, 2011 and December 31, 2010. The Company borrowed an additional $1.0 million under the revolving line of credit during the three month period ended March 31, 2011, and had a balance of $8.0 million outstanding as of March 31, 2011.





Convertible Debt




On March 29, 2011, the Company sold a 4.5% Convertible Subordinated Secured Note due 2013 in the principal amount of $3,000,000 (the “Note”). The Note was sold pursuant to a Convertible Note Purchase Agreement, dated as of March 29, 2011 (the “Purchase Agreement”), among the Company and director Gerald Burnett (the “Purchaser”).  The Company’s obligations under the Note are secured by the grant of a security interest in substantially all tangible and intangible assets of the Company pursuant to a Security Agreement among the Company and the Purchaser dated as of March 29, 2011.   The Note has a two year term and will be due on March 29, 2013.  The Note may not be prepaid or redeemed prior to maturity.  In the event certain circumstances as described in the Purchase Agreement occur prior to March 29, 2012, the Company has the option, at its sole discretion, to prepay the Note without the consent of the Purchaser.  The pre-payment fee would be $50,000 for every one million dollars that is pre-paid.  Interest on the Note will accrue at the rate of 4.5% per annum and will be payable semi-annually in arrears on March 29 and September 29 of each year, commencing on September 29, 2011.  From the one year anniversary of the issuance of the Note until maturity, the holder of the Note will be entitled to convert the Note into shares of common stock of the Company at an initial conversion price per share of $0.70.






15






9. Commitments and Contigencies






Software Indemnifications




The Company enters into standard indemnification agreements in the ordinary course of business. Pursuant to these agreements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally the Company’s business partners or customers, in connection with any patent, copyright or other intellectual property infringement claim by any third party with respect to its products. The term of these indemnification agreements is generally perpetual. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is generally limited to the cost of products purchased per customer, but may be material when customer purchases since inception are considered in aggregate. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. Accordingly, the Company has no liabilities recorded for these agreements as of March 31, 2011.






10. Recent Accounting Pronouncements


In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2009-13, Revenue Recognition (Topic 605) – Multiple-Deliverable Revenue Arrangements, a consensus of the FASB Emerging Issue Task Force (“ASU 2009-13”), and ASU No. 2009-14, Software (Topic 985) – Certain Revenue Arrangements That Include Software Elements (“ASU 2009-14”). ASU 2009-13 requires companies to allocate revenue in multiple-element arrangements based on an element’s estimated selling price if vendor-specific or other third party evidence of value is not available.  ASU 2009-14 modifies the software revenue recognition guidance to exclude from its scope tangible products that contain both software and non-software components that function together to deliver a product’s essential functionality.  Both statements are effective for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Early adoption is permitted. The Company adopted these statements on January 1, 2011. The adoption of these statements did not have a material impact on the Company’s financial condition and results of operations.




In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820) – Improving Disclosures about Fair Value Measurements. This ASU requires new disclosures and clarifies certain existing disclosure requirements about fair value measurements. ASU 2010-06 requires a reporting entity to disclose significant transfers in and out of Level 1 and Level 2 fair value measurements, to describe the reasons for the transfers and to present separately information about purchases, sales, issuances and settlements for fair value measurements using significant unobservable inputs. ASU 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll forward of activity in Level 3 fair value measurements, which is effective for interim and annual reporting periods beginning after December 15, 2010; early adoption is permitted. The Company adopted this statement on January 1, 2010. The adoption of this statement did not have a material impact on the Company’s financial condition and results of operation.  The adoption of this statement, on January 1, 2011, relating to disclosures about purchases, sales, issuances and settlements in the roll forward of activity in Level 3 fair value measurements did not have a material impact on the Company’s financial condition and results of operations.






11. Subsequent Events




The Company has evaluated subsequent events and has concluded that no subsequent events have occurred since the quarter ended March 31, 2011 that required additional disclosure in the financial statements.









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




The following discussion and analysis should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and the related Notes thereto included in this Quarterly Report on Form 10-Q and with Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2010, as filed with the SEC on March 31, 2011.






16




This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains both historical information and forward-looking statements. These forward-looking statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may”, “will”, “should”, “expects”, “intends”, “plans”, “anticipates”, “believes”, “estimates”, “predicts”, “potential”, “continue” or the negative of these terms, or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. In evaluating these statements, you should specifically consider the various risks and other factors that were discussed under “Risk Factors” and elsewhere in the 2010 Annual Report on Form 10-K and this Quarterly Report on Form 10-Q. These factors may cause our actual results to differ materially from any forward looking statement.   Although we believe that the expectations reflected in the forward looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, we are under no duty to update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform these statements to actual results.  These forward-looking statements are made in reliance upon the safe harbor provision of The Private Securities Litigation Reform Act of 1995.  In addition, historical information should not be considered an indicator of future performance.







Overview




We create technology that provides the missing critical element in unified communications: bringing people in organizations face-to-face, through enhanced communications for true collaboration anytime, anyplace. Our latest product, Avistar C3TM, draws on over a decade of market experience to deliver a single-click desktop videoconferencing and collaboration experience that moves business communications into a new era. Available as a stand-alone solution, or integrated with existing unified communications software from other vendors, Avistar C3TM users gain an instant messaging-style ability to initiate video communications across and outside the enterprise. Patented bandwidth management enables thousands of users to access desktop videoconferencing, Voice over IP (VoIP) and streaming media without requiring substantial new network investment or impairing network performance.  By integrating Avistar C3TM tightly into the way they work, our customers can use our solutions to help reduce costs and improve productivity and communications within their enterprise and between enterprises, and to enhance their relationships with customers, suppliers and partners. Using Avistar C3TM software and leveraging video, telephony and Internet networking standards, Avistar solutions are designed to be scalable, reliable, cost effective, easy to use, and capable of evolving with communications networks as bandwidth increases and as new standards and protocols emerge. We currently sell our system directly and indirectly to the small and medium sized business, or SMB, and globally distributed organizations, or Enterprise, markets comprising the Global 5000. Our objective is to establish our technology as the standard for networked visual unified communications and collaboration through limited direct sales, indirect channel sales/partnerships, and the licensing or sale of our technology and patents to others.




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




Financial Highlights




·
For the quarter ended March 31, 2011, total revenue was $1.4 million as compared to $14.8 million in the same quarter of 2010.  The difference primarily reflects the recognition of the license and sale of patents for $14 million in the first quarter of 2010.  Product division (product and services, maintenance and support) revenue was $1.3 million in the first quarter of 2011 and compare favorably with product division revenue of $0.6 million in 2010.  This results from the Company’s continued investment in product development and key go-to-market growth strategies.




·
Operating expenses (research and development, sales and marketing, and general and administrative) were $3.4 million for the first quarter of 2011, as compared to $3.7 million for the same quarter in 2010. The 2010 operating expenses were higher due primarily to the expenses associated with our Intellectual Property Division related to patent license and sales activities in the quarter ended March 31, 2010.




·
Net loss in the first quarter of 2011 was $2.4 million, or $0.06 per basic and diluted share, as compared to a net income of $10.2 million, or $0.26 per basic and diluted share, in the first quarter of 2010.




·
Cash and cash equivalents balance as of March 31, 2011 was $3.1 million. Cash used in operations during the three months ended March 31, 2011 was $2.8 million, compared to cash generated from operations of $10.6 million for the three months ended March 31, 2010.




·
Total debt balance was $11.0 million as of March 31, 2011, compared to $7.0 million as of December 31, 2010, due primarily to the issuance of a 4.5% Convertible Subordinated Note due 2013 in the principal amount of $3.0 million in March 2011.




Intellectual Property




Since inception, we have recognized the innovative value of our research and development efforts, and have invested in securing protection for these innovations through domestic and foreign patent applications and issuance. As of March 31, 2011, we held 1 issued U.S. patent and 1 issued Canadian patent, as well as 18 U.S. patent applications and 1 European patent application. We continue an active program to strategically grow and protect our intellectual property portfolio, primarily through the filing of patent applications, and to generate licensing revenue through our royalty rights under existing patent license agreements as well as new license or sale of our existing and future patent portfolio and patent applications.






17




Critical Accounting Policies




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




Management believes that there have been no significant changes to our critical accounting policies during the three months ended March 31, 2011 from those disclosed in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010.




Results of Operations




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




Percentage of Total RevenueThree Months Ended March 31,2011

2010Revenue:Product

34
%
1
%Licensing and sale of patents

8

96Services, maintenance and support

58

3Total revenue

100

100Costs and Expenses:Cost of product revenues

7

1Cost of services, maintenance and support revenues

20

3Research and development

104

13Sales and marketing

65

4General and administrative

76

8Total costs and expenses

272

29Income (loss) from operations

(172)

71Other income (expense), net

(2)

—Income (loss) before provision for income taxes

(174)

71Provision for income taxes

—

2Net income (loss)

(174)
%
69
%








COMPARISON OF THE THREE MONTHS ENDED MARCH 31, 2011 AND 2010




Revenue




Total revenue decreased by $13.4 million or 91%, to $1.4 million for the three month period ended March 31, 2011, from $14.8 million for the three months ended March 31, 2010, primarily due to the decrease in revenue from licensing and sale of patents, partially offset by an increase in product, services, maintenance and support revenues.




·
Product revenue increased by $392,000 or 478%, to $474,000 for the three month period ended March 31, 2011 from $82,000 for the three months ended March 31, 2010. This was primarily due to an increase in software product revenue from technology licensing to an original equipment manufacturer, and higher software product sales during the quarter ended March 31, 2011, compared to the same period in 2010.




·
Licensing and patent sale revenue, relating to the licensing and sale of our patent portfolio, decreased by $14.0 million, to $106,000 for the three month period ended March 31, 2011 from $14.1 million for the three months ended March 31, 2010.  This was due primarily to the sale of substantially all of our patents to Intellectual Ventures for $11.0 million and licensing revenue from SKYPE for $3.0 million during the three month period ended March 31, 2010 with no comparable patent licensing and sale activities during the quarter ended March 31, 2011.




·
Services, maintenance and support revenue, which includes software implementation and enhancement, maintenance and support, increased by $265,000, or 49%, to $810,000 for the three months ended March 31, 2011, from $545,000 for the three months ended March 31, 2010. This was primarily due to an increase in revenue from maintenance contracts with existing customers in the quarter ended March 31, 2011.




For the three months ended March 31, 2011, revenue from four customers accounted for 68% of total revenue compared to two customers and 94% for the three months ended March 31, 2010. No other customer accounted for greater than 10% of total revenue in either period.  The level of sales to any customer may vary from quarter to quarter. We expect that there will be significant customer concentration in future quarters. The loss of any one of those customers would have a materially adverse impact on our financial condition and operating results.






18




Costs and expenses




Cost of product revenue.Cost of product revenue decreased by $58,000 or 38%, to $95,000 for the three months ended March 31, 2011 from $153,000 for the three months ended March 31, 2010.  The decrease was mainly attributable to a decrease in obsolete inventory write-off and a reduction in stock-based compensation.




Cost of services, maintenance and support revenue.Cost of services, maintenance and support revenue decreased by $110,000, or 29%, to $273,000 for the three months ended March 31, 2011, from $383,000 for the three months ended March 31, 2010, primarily due to a decrease in software implementation and enhancement services for customers, and a decrease in personnel expenses.




Research and development.Research and development expenses decreased by $496,000, or 26%, to $1.4 million for the three months ended March 31, 2011 from $1.9 million for the three months ended March 31, 2010.  The decrease was primarily due to the bonus payout to employees of our Intellectual Property division totaling $470,000 as a result of the completion of the sale of substantially all of our patents to Intellectual Ventures during the three months ended March 31, 2010, with no comparable expense during the three months ended March 31, 2011.




Sales and marketing. Sales and marketing expenses increased $297,000 or 48%, to $910,000 for the three months ended March 31, 2011, from $613,000 for the three months ended March 31, 2010, primarily due to an increase in marketing activities and an increase in personnel related expenses.




General and administrative. General and administrative expenses remained relatively flat at approximately $1.1 million for the three months ended March 31, 2011 and 2010.




Other income (expense), net


Other income (expense), net increased by $19,000, or 238%, to a net expense of $27,000 for the three months ended March 31, 2011, from a net expense of $8,000 for the three months ended March 31, 2010, primarily due to an increase in interest expense as a result of a higher average debt balance.




Provision for income taxes




The provision for income taxes of $2,000 for the three months ended March 31, 2011 consisted of foreign tax expense.  The provision for income taxes of $337,000 for the three months ended March 31, 2010 consisted primarily of federal and state alternative minimum taxes due to the Company’s profitability for the quarter as a result of the sale of substantially all of the Company’s patents and patent applications to Intellectual Ventures for $11.0 million.






Liquidity and Capital Resources




We historically funded our operations with revenues generated from our products, services and patents, line of credit, proceeds from patent litigation settlements, public and private equity and debt financing.




We had cash and cash equivalents of $3.1 million and $1.8 million as of March 31, 2011 and December 31, 2010, respectively. For the three months ended March 31, 2011, we had a net increase in cash and cash equivalents of $1.2 million. The net cash used in operations of $2.8 million for the three months ended March 31, 2011 resulted primarily from the net loss of $2.4 million, an increase in accounts receivable of $384,000 and a decrease in deferred services revenue and customer deposits of $535,000, partially offset by an adjustment for non-cash stock-based compensation expense of $305,000 and an increase in accounts payable of $109,000.  The net cash provided by financing activities of $4.1 million for the three months ended March 31, 2011 related primarily to $1 million of borrowings on our line of credit, and $3 million in proceeds from the issuance of a convertible note.




At March 31, 2011, we had approximately $874,000 in minimum commitments under non-cancelable operating leases net of sublease proceeds related to our office space facilities in California and New York.




As of March 31, 2011, we had no material off-balance sheet arrangements, other than the operating lease described above.   We enter into indemnification provisions under agreements with other companies in our ordinary course of business, typically with our contractors, customers, landlords and our investors. Under these provisions, we generally indemnify and hold harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of our activities or, in some cases, as a result of the indemnified party's activities under the agreement. These indemnification provisions generally survive termination of the underlying agreement. The maximum potential amount of future payments we could be required to make under these indemnification provisions is generally unlimited. As of March 31, 2011, we have not incurred material costs to defend lawsuits or settle claims related to these indemnifications agreements and therefore, we have no liabilities recorded for these agreements as of March 31, 2011.




On March 29, 2011, we sold a 4.5% Convertible Subordinated Secured Note due 2013 in the principal amount of $3,000,000 (the “Note”). The Note was sold pursuant to a Convertible Note Purchase Agreement, dated as of March 29, 2011 (the “Purchase Agreement”), among us and our director Gerald Burnett (the “Purchaser”).  Our obligations under the Note are secured by the grant of a security interest in substantially all of our tangible and intangible assets pursuant to a Security Agreement among us and the Purchaser dated as of March 29, 2011.   The Note has a two year term and will be due on March 29, 2013.  The Note may not be prepaid or redeemed prior to maturity.  In the event certain circumstances as described in the Purchase Agreement occur prior to March 29, 2012, we have the option, at our sole discretion, to prepay the Note without the consent of the Purchaser.  The pre-payment fee would be $50,000 for every one million dollars that is pre-paid.  Interest on the Note will accrue at the rate of 4.5% per annum and will be payable semi-annually in arrears on March 29 and September 29 of each year, commencing on September 29, 2011.  From the one year anniversary of the issuance of the Note until maturity, the holder of the Note will be entitled to convert the Note into shares of our common stock at an initial conversion price per share of $0.70.






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On December 20, 2010, we renewed and amended our revolving credit promissory note with a financial institution (the “Lender”) to extend the maturity date of the facility by one year to December 22, 2011 at a maximum revolving line of credit amount of $8.0 million. Our Security Agreement with the Lender granted the Lender a security interest in and right of setoff against substantially all of our assets, tangible and intangible. The revolving credit facility is subject to annual renewal with the consent of Avistar and the Lender.  Gerald Burnett, our Chairman, provided a collateralized guarantee to the Lender, assuring payment of our obligations under the agreement and as a consequence, there are no restrictive covenants, allowing us greater access to the full amount of the facility. Dr. Burnett also provided us with a personal guarantee assuring us a line of credit of $8.0 million with the same terms and mechanisms as the existing revolving line of credit in the event the existing revolving line of credit from the financial institution was unavailable for any reason during the period from its termination on December 22, 2011 to March 31, 2012. In connection with the issuance of the Note (see above), on March 29, 2011, we entered into amendments to the revolving credit promissory note and to the security agreement with the Lender to permit the grant of a security interest to the Purchaser of the Note and to allocate specific assets of Avistar solely to secure our obligations under the Note. The revolving line of credit requires monthly interest-only payments based on Adjusted LIBOR plus 0.90% or Prime Rate plus 1.00%. We elected Adjusted LIBOR plus 0.90% or 1.21% at March 31, 2011 and December 31, 2010. We borrowed an additional $1.0 million under the revolving line of credit during the three month ended March 31, 2011, and had a balance of $8.0 million outstanding as of March 31, 2011.





Based on the proceeds we received from issuance of the Note, the results of our ongoing revenue generation and cost reduction efforts, the availability of the revolving credit facility with a financial institution, and Dr. Burnett’s personal guarantee of a line of credit, we believe that there will be sufficient funds to finance our operations for the next 12 months. We intend to continue to invest in the development of new products and enhancements to our existing products. Our future liquidity and capital requirements will depend upon numerous factors, including without limitation, general economic conditions and conditions in the financial services industry in particular, the level and timing of product, licensing and service revenue, the maintenance of our cost control measures structured to align operations with predictable revenues, the costs and timing of our product development efforts and the success of these development efforts, the costs and timing of our sales, partnering and marketing activities, the extent to which our existing and new products gain market acceptance and competing technological and market developments, all of which may impact our ability to achieve and maintain profitability or generate positive cash flows.





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






Recent Accounting Pronouncements


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






Item 3.              Quantitative and Qualitative Disclosures about Market Risk




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






Item 4T.                      Controls and Procedures




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






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(b)         Changes in internal control over financial reporting: There have been no changes 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




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






Item 1A.                      Risk Factors




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




Before you invest in our securities, you should be aware that our business faces numerous financial and market risks, including those described below, as well as general economic and business risks.  The following discussion provides information concerning the material risks and uncertainties that we have identified and believe may adversely affect our business, our financial condition and our results of operations.  Before you decide whether to invest in our securities, you should carefully consider these risks and uncertainties, together with all of the other information included in this Quarterly Report on Form 10-Q, our Annual Report on Form 10-K for the year ended December 31, 2010 and in our other public filings.




This risks set forth below supersede the description of the risk factors associated with our business previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2010.







Risks Relating to Our Common Stock






Our stock is quoted on the OTC Market, which may decrease the liquidity of our common stock.




On June 24, 2009, the NASDAQ Stock Market, Inc. suspended our common stock from trading on NASDAQ because we did not evidence a market value of listed securities above $35.0 million for ten consecutive trading days, or otherwise demonstrate compliance with alternative continued listing standards, during the period from April 2, 2009 to June 22, 2009.  Since that time our common stock has been quoted on the OTC Market under the symbol AVSR.  On August 6, 2009, we withdrew our appeal to the NASDAQ Listing and Hearing Review Council. On August 31, 2009, the NASDAQ Stock Market, Inc. officially delisted our common stock.




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






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




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






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




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




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




•
Quarterly variations in our results of operations;




•
Announcements regarding our product developments;




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




•
Developments in the examination of our patent applications by the U.S. Patent and Trademark Office;




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




•
Announcements of competitive product introductions by our competitors;




•
Limited trading volume of shares; and,




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




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






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




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




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






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




Our executive officers, directors and entities affiliated with them, in the aggregate, beneficially owned approximately 65% of our common stock as of March 31, 2011. If they were to act together, these stockholders would be able to exercise control over most matters requiring approval by our stockholders, including the election of directors and approval of significant corporate transactions. These actions may be taken even if they are opposed by other investors. This concentration of ownership may also have the effect of delaying or preventing a change in control of Avistar, which could cause the market price of our common stock to decline.






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




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






Risks Related to Our Business






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





We recorded a net loss of $2.4 million for the three months ended March 31, 2011, a net income of $4.4 million for fiscal year 2010, and a net loss of $4.0 million for fiscal year 2009.  As of March 31, 2011, our accumulated deficit was $114.1 million.  Our revenue may not increase, or even remain at its current level.  In addition, our operating expenses, which have been reduced recently, may increase as we continue to develop our business and pursue licensing opportunities.  As a result, to become profitable, we will need to increase our revenue by increasing sales to existing customers and by attracting additional new customers, distribution partners and licensees.  If our revenue does not increase adequately, we may not become profitable.  Due to the volatility of our product and licensing revenue, we may not be able to achieve, sustain or increase profitability on a quarterly or annual basis.  If we fail to achieve or to maintain profitability or to sustain or grow our profits within the time frame expected by investors, the market price of our common stock may be adversely impacted.







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




We may need to arrange for the availability of additional funding in order to meet our future business requirements. We have a revolving credit facility that matures on December 22, 2011, which provides us with a maximum line of credit amount of $8.0 million that was fully drawn as of March 31, 2011. On March 29, 2011, we issued $3.0 million of 4.5% Convertible Subordinated Secured Notes, with a two year term due in 2013, to Gerald Burnett, our Chairman.  If we are unable to obtain additional funding when needed on acceptable terms, we may not be able to develop or enhance our products, take advantage of opportunities, respond to competitive pressures or unanticipated requirements, or finance our efforts to protect and enforce our intellectual property rights, which could seriously harm our business, financial condition, results of operations and ability to continue operations.  We have in the past, and may in the future, reduce our expenditures by reducing our employee headcount in order to better align our expenditures with our available resources.  Any such reductions may adversely affect our ability to maintain or grow our business.






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




We have experienced significant changes in our management structure and composition in the past.  Simon Moss was appointed as President of our products division in July 2007 and was appointed as our Chief Executive Officer in January 2008 when Gerald Burnett resigned from his position as our Chief Executive Officer.  In January 2009, Bob Habig resigned from the position of Chief Financial Officer and he was replaced in that position by Elias MurrayMetzger, our Corporate Controller.  In July 2009, Simon Moss resigned from his positions as Chief Executive Officer and board member.  Shortly thereafter, Robert Kirk was appointed to replace Simon Moss as our Chief Executive Officer.  In August 2009, Darren Innes resigned from the position of General Manager and Vice President, Global Sales.




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






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




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







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




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




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






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




We currently depend on a limited number of customers with lengthy budgeting cycles and unpredictable buying patterns, and as a result, our revenue from quarter-to-quarter or year-to-year may be volatile. The loss of a major customer or the reduction, delay or cancellation of orders from one or more of our significant customers could cause our revenue to decline and our losses to increase.  Adverse changes in our revenue or operating results as a result of these budgeting cycles or any other reduction in capital expenditures by our large customers could also substantially reduce the trading price of our common stock.






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




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




•      Rapid technological change;




•      The emergence of new competitors;




•      Significant development costs;




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




•      Integration of joint solutions in collaboration platforms;




•      Evolving industry standards;




•      Transition from hardware appliances and infrastructure to software; and




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




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







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




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






Competition could reduce our market share and decrease our revenue.




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




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




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






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




The U.S. and global economy has entered a recession and our customers and potential customers, partners and distributors may delay or forego ordering our products, and we could fall short of our revenue expectations for 2011 and beyond. Slower growth among our customers, tightening of customers’ operating budgets, retrenchment in the capital markets and other general economic factors all have had, and could in the future have, a materially adverse effect on our revenue, capital resources, financial condition and results of operations.






The sale of substantially all of our patents and patent applications in January 2010 is expected to affect our cash, expenses, revenue and income in future periods.




In prior periods, we have relied on patent licensing revenue and income from settlement and licensing activities to provide significant funding for our operations.  We recognized a total of $15.1 million, $4.5 million, and $5.2 million in patent licensing and sale revenue and income from settlement and licensing activities for the years ended December 31, 2010, 2009, and 2008, respectively.  In January 2010, we sold substantially all of our patent portfolio and associated patent applications to Intellectual Ventures for a one time cash payment of $11.0 million.  We retained royalty rights under our existing patent license agreements as well as a grant back license to the patents and patent applications for our current and future products.  As a result of this sale, we expect our efforts and expenditures on patent prosecution, licensing and settlement activities in future periods to be substantially reduced and our prospects for revenues from the licensing or sale of patents and patent applications and our prospects for generating new income from settlement and licensing activities to also be substantially reduced.  Accordingly, our ongoing operations will have to be funded directly from operations and from debt and equity financing activities.  Failure to generate cash from operations or from debt or equity financing activities could have a substantial and adverse affect on our business, operations and prospects.







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




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






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




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






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




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




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




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




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




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






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If we fail to maintain proper and effective internal controls, our ability to produce accurate financial statements on a timely basis could be impaired, which would adversely affect our consolidated operating results, our ability to operate our business and our stock price.




As a smaller reporting company, we are required to comply with certain portions of Section 404 of the Sarbanes Oxley Act of 2002.  We have expended significant resources in developing the necessary documentation and testing procedures required by Section 404 of the Sarbanes Oxley Act.  We cannot be certain that the actions we have taken and are taking to improve our internal control over financial reporting will be sufficient to maintain effective internal control over financial reporting in subsequent reporting periods or that we will be able to implement our planned processes and procedures in a timely manner.  In addition, we may be unable to produce accurate financial statements on a timely basis.  Any of the foregoing could cause investors to lose confidence in the reliability of our consolidated financial statements, which could cause the market price of our common stock to decline and make it more difficult for us to finance our operations and growth.






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




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






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




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




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




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




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






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




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






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




We depend on the continued services of our executive officers and other key personnel. We do not have long-term employment agreements with our executive officers or other key personnel and we do not carry any “key man” life insurance.






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The loss of the services of any of our executive officers or key personnel could harm our business, financial condition and results of operations.




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






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




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






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




International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 53% and 25% of total revenue for the three months ended March 31, 2011 and 2010, respectively. Some of the risks we may encounter in conducting international business activities include the following:




•      Tariffs and other trade barriers;




•      Unexpected changes in foreign regulatory requirements and laws;




•      Economic and political instability;




•      Increased risk of infringement claims;




•      Protection of our intellectual property;




•      Restrictions on the repatriation of funds;




•      Potentially adverse tax consequences;




•
Timing, cost and potential difficulty of adapting our system to the local language standards in those foreign countries that do not use the English language;




•      Fluctuations in foreign currencies; and




•      Limitations in communications infrastructures in some foreign countries.




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






International political instability may increase our cost of doing business and disrupt our business.




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




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







Not applicable.






Item 3.              Defaults Upon Senior Securities






Not applicable.






Item 4.              Removed and Reserved






Item 5.              Other Information






Not applicable.






Item 6.Exhibits








The following exhibits are filed herewith or incorporated by reference as indicated below.





Exhibit Number

Description10.1

Convertible Note Purchase Agreement among Avistar Communications Corporation and the Purchaser named therein dated March 29, 2011 (incorporated by reference to an exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 4, 2011)10.2

Security Agreement among Avistar Communications Corporation and the Purchaser named there in dated March 29, 2011 (incorporated by reference to an exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 4, 2011)10.3

4.5% Convertible Subordinated Secured Note Due 2013 (incorporated by reference to an exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 4, 2011)10.4

Fourth Amendment to Second Amended and Restated Revolving Credit Promissory Note issued by Avistar Communications Corporation to JPMorgan Chase Bank, N.A. dated March 29, 2011.10.5

Amendment to Fourth Amended and Restated Security Agreement between Avistar Communications Corporation and JPMorgan Chase Bank, N.A. dated March 29, 201110.6

Reaffirmation of Guaranty issued by Gerald J. Burnett and Marjorie J. Burnett Revocable Trust in favor of JPMorgan Chase Bank, N.A. dated March 29, 201131.1

Rule 13a-14(a)/15d-14(a) Certification by the Chief Executive Officer.31.2

Rule 13a-14(a)/15d-14(a) Certification by the Chief Financial Officer.32.1

Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.







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SIGNATURES




Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized, on the 12th day of May 2011.





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





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EXHIBIT INDEX





Exhibit Number

Description10.1

Convertible Note Purchase Agreement among Avistar Communications Corporation and the Purchaser named therein dated March 29, 2011 (incorporated by reference to an exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 4, 2011)10.2

Security Agreement among Avistar Communications Corporation and the Purchaser named there in dated March 29, 2011 (incorporated by reference to an exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 4, 2011)10.3

4.5% Convertible Subordinated Secured Note Due 2013 (incorporated by reference to an exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 4, 2011)10.4

Fourth Amendment to Second Amended and Restated Revolving Credit Promissory Note issued by Avistar Communications Corporation to JPMorgan Chase Bank, N.A. dated March 29, 2011.10.5

Amendment to Fourth Amended and Restated Security Agreement between Avistar Communications Corporation and JPMorgan Chase Bank, N.A. dated March 29, 201110.6

Reaffirmation of Guaranty issued by Gerald J. Burnett and Marjorie J. Burnett Revocable Trust in favor of JPMorgan Chase Bank, N.A. dated March 29, 201131.1

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.







31