**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

**FORM 10-Q**

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

**For the quarterly period ended June 30, 2006**

**OR**

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

**For the transition period from          to          **

**Commission file number: 000-31121**

**AVISTARCOMMUNICATIONS CORPORATION**

(Exact name of registrant as specified in its charter)

 

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

 

**555TWIN DOLPHIN DRIVE, SUITE 360, REDWOOD SHORES, CA 94065**

(Address of Principal Executive Offices) (Zip Code)

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

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

**Yes ****x      No ****o**

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

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

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

**AtJuly 27, 2006, 35,066,607 shares of common stock of the Registrant wereoutstanding.**

 

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**AVISTARCOMMUNICATIONS CORPORATION**

** **

**INDEX**

 
| PART I.    | FINANCIAL INFORMATION                                                                       | 3      |
|------------|---------------------------------------------------------------------------------------------|--------|
|       |                                                                                        |   |
| Item 1.    | Financial  Statements (unaudited)                                                           | 3      |
|       | Condensed  Consolidated Balance Sheets                                                      | 3      |
|       | Condensed  Consolidated Statements of Operations                                            | 4      |
|       | Condensed  Consolidated Statements of Cash Flows                                            | 5      |
|       | Notes  to Condensed Consolidated Financial Statements                                       | 6      |
| Item 2.    | Management’s Discussion and Analysis of Financial  Condition and Results of Operations | 16     |
| Item 3.    | Quantitative and Qualitative Disclosures About Market  Risk                                 | 23     |
| Item 4.    | Controls and Procedures                                                                     | 23     |
|       |                                                                                        |   |
| PART  II.  | OTHER  INFORMATION                                                                          | 24     |
|       |                                                                                        |   |
| Item  1.   | Legal  Proceedings                                                                          | 24     |
| Item  1a.  | Risk  Factors                                                                               | 25     |
| Item 4.    | Submission Of Matters to a Vote of Security Holders                                         | 32     |
| Item  5.   | Other  Information                                                                          | 33     |
| Item 6.    | Exhibits                                                                                    | 34     |
|       |                                                                                        |   |
| SIGNATURES | 35                                                                                          |

 

2

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**PART I -FINANCIAL INFORMATION**

**Item 1. *FinancialStatements***

**AVISTAR COMMUNICATIONS CORPORATION ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETSas of June 30, 2006 and December 31, 2005(in thousands, except share and per share data)**

 
| ** **                                                                                                                                                                                                 |       | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                 | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                                                 | ** ** | **(unaudited)**   | ** ** |
| **Assets:**                                                                                                                                                                                                | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                            |       |              |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                 |       | $                 | 4,271      |                  | $          | 8,216 |   |
| Short-term  investments                                                                                                                                                                                    |       | 2,281             |       | 2,995                 |       |
| Total cash, cash  equivalents and short-term investments                                                                                                                                                   |       | 6,552             |       | 11,211                |       |
| Accounts  receivable, net of allowance for doubtful accounts of $57 and $121 at June  30, 2006 and December 31, 2005, respectively                                                                    |       | 857               |       | 1,428                 |       |
| Inventories,  including inventory shipped to customers’ sites, not yet installed of $60 and  $28 at June 30, 2006 and December 31, 2005, respectively                                            |       | 828               |       | 675                   |       |
| Deferred  settlement and patent licensing costs                                                                                                                                                            |       | 1,256             |       | 1,256                 |       |
| Prepaid expenses  and other current assets                                                                                                                                                                 |       | 375               |       | 463                   |       |
| Total current  assets                                                                                                                                                                                      |       | 9,868             |       | 15,033                |       |
| Long-term  investments                                                                                                                                                                                     |       | —            |       | 958                   |       |
| Property and  equipment, net                                                                                                                                                                               |       | 355               |       | 311                   |       |
| Long-term  deferred settlement and patent licensing costs                                                                                                                                                  |       | 3,027             |       | 3,685                 |       |
| Other assets                                                                                                                                                                                               |       | 175               |       | 371                   |       |
| Total assets                                                                                                                                                                                               |       | $                 | 13,425     |                  | $          | 20,358 |   |
|                                                                                                                                                                                                       |       |              |       |                  |       |
| **Liabilities and Stockholders’  Deficit:**                                                                                                                                                           | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current  liabilities:                                                                                                                                                                                      |       |              |       |                  |       |
| Accounts payable                                                                                                                                                                                           |       | $                 | 1,199      |                  | $          | 1,004 |   |
| Deferred income  from settlement and patent licensing                                                                                                                                                      |       | 5,520             |       | 5,520                 |       |
| Deferred  services revenue and customer deposits                                                                                                                                                           |       | 996               |       | 712                   |       |
| Accrued  liabilities and other                                                                                                                                                                             |       | 2,470             |       | 1,491                 |       |
| Total current  liabilities                                                                                                                                                                                 |       | 10,185            |       | 8,727                 |       |
| Long-term  liabilities:                                                                                                                                                                                    |       |              |       |                  |       |
| Long-term  deferred income from settlement and patent licensing                                                                                                                                            |       | 13,054            |       | 15,789                |       |
| Total  liabilities                                                                                                                                                                                         |       | 23,239            |       | 24,516                |       |
| Commitments and  contingencies (Note 7)                                                                                                                                                                    |       |              |       |                  |       |
| Stockholders’ deficit:                                                                                                                                                                                |       |              |       |                  |       |
| Common stock,  $0.001 par value; 250,000,000 shares authorized at June 30, 2006 and  December 31, 2005; 35,066,607 and 34,939,124 shares issued at June 30,  2006 and December 31, 2005, respectively |       | 35                |       | 35                    |       |
| Less: treasury  common stock, 1,181,625 shares at June 30, 2006 and December 31, 2005,  at cost                                                                                                       |       | (53               | )          | (53                   | )          |
| Additional  paid-in-capital                                                                                                                                                                                |       | 91,631            |       | 90,519                |       |
| Other  comprehensive loss                                                                                                                                                                                  |       | (4                | )          | (12                   | )          |
| Accumulated  deficit                                                                                                                                                                                       |       | (101,423          | )          | (94,647               | )          |
| Total stockholders’  deficit                                                                                                                                                                          |       | (9,814            | )          | (4,158                | )          |
| Total liabilities and  stockholders’ deficit                                                                                                                                                          |       | $                 | 13,425     |                  | $          | 20,358 |   |

 

The accompanying notes are anintegral part of these financial statements.

3

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**AVISTAR COMMUNICATIONSCORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**for the three and six monthsended June 30, 2006 and 2005(in thousands, except per share data)**

 
| ** **                                                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                        | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                                        | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                        | ** ** | **(unaudited)**                  | ** ** | **(unaudited)**                | ** ** |
| ** **                                                                        | ** ** | ** **                       | ** ** | **Restated (1)**          | ** ** | ** ** | ** ** | **Restated (1)** | ** ** |
| Revenue:                                                                          |       |                             |       |                           |       |   |   |   |   |
| Product                                                                           |       | $                                | 970        |                           | $          | 535 |   | $ | 1,847 |   | $ | 1,662 |   |
| Licensing                                                                         |       | 39                               |       | —                         |       | 71 |   | — |   |
| Services,  maintenance and support                                                |       | 745                              |       | 811                            |       | 1,694 |   | 1,606 |   |
| Total revenue                                                                     |       | 1,754                            |       | 1,346                          |       | 3,612 |   | 3,268 |   |
| Costs and Expenses:                                                               |       |                             |       |                           |       |   |   |   |   |
| Cost of product  revenue                                                          |       | 721                              |       | 318                            |       | 1,353 |   | 768 |   |
| Cost of  services, maintenance and support revenue*                               |       | 385                              |       | 525                            |       | 992 |   | 972 |   |
| Income from  settlement and patent licensing                                      |       | (1,057                           | )          | (1,057                         | )          | (2,114 | ) | (2,114 | ) |
| Research and  development*                                                        |       | 1,445                            |       | 706                            |       | 2,717 |   | 1,347 |   |
| Sales and  marketing*                                                             |       | 1,479                            |       | 819                            |       | 2,779 |   | 1,517 |   |
| General and  administrative*                                                      |       | 2,570                            |       | 1,362                          |       | 4,826 |   | 2,635 |   |
| Total costs and  expenses                                                         |       | 5,543                            |       | 2,673                          |       | 10,553 |   | 5,125 |   |
| Loss from  operations                                                             |       | (3,789                           | )          | (1,327                         | )          | (6,941 | ) | (1,857 | ) |
| Other income (expense):                                                           |       |                             |       |                           |       |   |   |   |   |
| Interest income                                                                   |       | 77                               |       | 73                             |       | 180 |   | 221 |   |
| Other income  (expense), net                                                      |       | (8                               | )          | (6                             | )          | (15 | ) | (11 | ) |
| Total other  income (expense), net                                                |       | 69                               |       | 67                             |       | 165 |   | 210 |   |
| Net loss                                                                          |       | $                                | (3,720     | )                              | $          | (1,260 | ) | $ | (6,776 | ) | $ | (1,647 | ) |
|                                                                              |       |                             |       |                           |       |   |   |   |   |
| Net loss per share -  basic and diluted                                           |       | $                                | (0.11      | )                              | $          | (0.04 | ) | $ | (0.19 | ) | $ | (0.05 | ) |
| Weighted average shares  used in calculating basic and diluted net loss per share |       | 35,061                           |       | 33,547                         |       | 35,038 |   | 33,486 |   |

 

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| *Including stock based  compensation of:           |   |   |   |   |   |   |   |   |   |
|----------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Cost of  services, maintenance and support revenue |   | $      | 37     |   | $      | — |   | $      | 73     |   | $ | — |   |
| Research and  development                          |   | 150    |   | — |   | 297    |   | — |   |
| Sales and  marketing                               |   | 120    |   | — |   | 232    |   | — |   |
| General and  administrative                        |   | 191    |   | 47     |   | 371    |   | 49     |   |
|                                               |   | $      | 498    |   | $      | 47     |   | $      | 973    |   | $ | 49 |   |

 

(1) See Note 2 “Correction of an Error” of the Notes toCondensed Consolidated Financial Statements

The accompanying notes are anintegral part of these financial statements.

4

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**AVISTAR COMMUNICATIONS CORPORATION ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**for the six months ended June 30, 2006 and 2005(in thousands)**

 
| ** **                                                                   | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                   | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** |
| ** **                                                                   | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | **(unaudited)**                | ** ** |
| ** **                                                                   | ** ** | ** **                     | ** ** | **Restated(1)** | ** ** |
| Cash Flows from  Operating Activities:                                       |       |                           |       |   |   |
| Net loss                                                                     |       | $                              | (6,776     | ) | $ | (1,647 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                           |       |   |   |
| Depreciation                                                                 |       | 190                            |       | 88 |   |
| Compensation on  options issued to consultants and employees                 |       | 973                            |       | 49 |   |
| Provision for  doubtful accounts                                             |       | (64                            | )          | 53 |   |
| Changes in  assets and liabilities:                                          |       |                           |       |   |   |
| Accounts  receivable                                                         |       | 635                            |       | (35 | ) |
| Inventories                                                                  |       | (153                           | )          | (15 | ) |
| Prepaid expenses  and other current assets                                   |       | 88                             |       | 22 |   |
| Deferred  settlement and patent licensing costs                              |       | 658                            |       | 628 |   |
| Other assets                                                                 |       | 196                            |       | 2 |   |
| Accounts payable                                                             |       | 195                            |       | (631 | ) |
| Deferred income  from settlement and patent licensing                        |       | (2,735                         | )          | (2,704 | ) |
| Deferred services  revenue and customer deposits                             |       | 284                            |       | 260 |   |
| Accrued  liabilities and other                                               |       | 979                            |       | (139 | ) |
| Net cash used in  operating activities                                       |       | (5,530                         | )          | (4,069 | ) |
|                                                                         |       |                           |       |   |   |
| Cash Flows from  Investing Activities:                                       |       |                           |       |   |   |
| Maturities of  short-term investments                                        |       | 1,680                          |       | — |   |
| Purchase of  property and equipment                                          |       | (234                           | )          | (243 | ) |
| Net cash  provided by (used in) investing activities                         |       | 1,446                          |       | (243 | ) |
|                                                                         |       |                           |       |   |   |
| Cash Flows from  Financing Activities:                                       |       |                           |       |   |   |
| Proceeds from  issuance of common stock                                      |       | 139                            |       | 280 |   |
| Net cash  provided by financing activities                                   |       | 139                            |       | 280 |   |
| Net decrease in  cash and cash equivalents                                   |       | (3,945                         | )          | (4,032 | ) |
| Cash and cash  equivalents, beginning of period                              |       | 8,216                          |       | 21,656 |   |
| Cash and cash  equivalents, end of period                                    |       | $                              | 4,271      |   | $ | 17,624 |   |
|                                                                         |       |                           |       |   |   |
| Supplemental Cash Flow  Information:                                         |       |                           |       |   |   |
| Cash paid for  income taxes                                                  |       | $                              | —     |   | $ | 315 |   |
| Cash paid for interest                                                       |       | $                              | 2          |   | $ | — |   |

 

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(1) See Note 2 “Correction of an Error” of the Notes toCondensed Consolidated Financial Statements

The accompanying notes are anintegral part of these financial statements.

5

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**AVISTAR COMMUNICATIONSCORPORATION AND SUBSIDIARIES**

**NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

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

# **Business**

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

# **Basis of Presentation**

Theunaudited condensed consolidated balance sheet as of June 30, 2006 presents theconsolidated financial position of Avistar and its two wholly-owned operatingsubsidiaries, Avistar Systems U.K. Limited (“ASUK”) and CPI, after theelimination of all intercompany accounts and transactions. The unauditedcondensed consolidated balance sheet of Avistar as of December 31, 2005 wasderived from audited financial statements, but does not contain all disclosuresrequired by accounting principles generally accepted in the United States ofAmerica. The consolidated results are referred to, collectively, as those ofAvistar or the Company in these notes.

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

TheCompany’s fiscal year end is December 31.

# **Risks and Uncertainties**

The markets for the Company’s products and servicesare in a formative stage of development. Some of the Company’s products utilizechanging and emerging technologies. As is typical in industries of this nature,demand and market acceptance are subject to a high level of uncertainty,particularly when there are adverse conditions in the economy. Acceptance ofthe Company’s products over time is critical to the Company’s success. TheCompany’s prospects must be evaluated in light of difficulties encountered byit and its competitors in further developing this evolving marketplace. TheCompany has generated losses since inception and had an accumulated deficit of$101.4 million as of June 30, 2006. The Company’s operating results mayfluctuate significantly in the future as a result of a variety of factors,including, but not limited to, the economic environment, the adoption ofdifferent distribution channels, the timing of new product announcements by theCompany or its competitors, and the timing of licensing and settlement agreements.

The Company’s futureliquidity and capital requirements will depend upon numerous factors,including, but not limited to, the costs and timing of its expansion of productdevelopment efforts and the success of these development efforts, the costs andtiming of its expansion of sales and marketing activities, the extent to whichits existing and new products gain market acceptance, competing technologicaland market developments, the costs involved in maintaining, enforcing anddefending patent claims and other intellectual property rights, the level andtiming of revenue, and other factors.

**2. Correction of an Error**

In September 2005, theCompany received a comment letter from the U. S. Securities and ExchangeCommission (“SEC”) relating to the Company’s 2004 Form 10-K, which included aquestion regarding the Company’s accounting for the November 2004 settlementand patent cross-license agreement with Polycom, Inc. (“Polycom”). Thesettlement and patent cross-license agreement resulted in a $27.5 million onetime payment by Polycom to Avistar and a payment by Avistar to its litigationcounsel of $6.4 million in contingent legal fees. The Company previouslyreported on Form 10-Q for the three and six months ended June 30, 2005 the onetime payment by Polycom as revenue, to be recognized ratably over a five-yearperiod, net of contingent legal fees. As a result of the SEC’s inquiry as towhether the Polycom transaction should be characterized as revenue, and afterdiscussions with the SEC, the Company concluded that a reclassification oflicense revenues from revenue to a component of operating expenses, andpresentation as “Income from settlement and patent licensing”, still nettedwith contingent legal fees and still recognized over a five year period, wasnecessary for previously filed financial reports. The restatement of the netproceeds and expenses from the Polycom settlement and patent cross-licenseagreement had no effect on reported net loss, loss per share, stockholders’equity (deficit) or net cash flow from operating, investing or financingactivities, but did have the effect of overstating revenues and operatingexpenses for previously issued interim condensed consolidated financialstatements, as of and for the three and six months ended June 30, 2005. Inaddition,

6

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the balance sheet as of June 30, 2005 has beenrestated to reflect the gross effect of the $27.5 million payment by Polycom toAvistar, and the payment of $6.4 million of contingent legal fees by Avistar,which was previously reported on a net basis as deferred revenue. See Notes 3and 6 regarding significant concentrations, revenue recognition, segmentreporting and the unaudited interim results which have been restated toreclassify the Polycom proceeds from license revenue to “Income from settlementand patent licensing,” to be consistent with the presentation of the netproceeds from the Polycom settlement and patent cross-license agreement in theStatement of Operations for the three and six months ended June 30, 2006. Thepresentation within operations is supported by a determination that the Polycomlicensing transaction is central to the activities that constitute the Company’songoing major or central operations, but that the proceeds may also contain again element related to the settlement, which is not considered revenue underthe Financial Accounting Standards Board (“FASB”) Concepts Statement No. 6, *Elements of Financial Statements.*TheCompany did not have sufficient historical evidence to support a reasonabledetermination of value for purposes of segregating the proceeds from Polycominto revenue related to the patent licensing, and an operating or non-operatinggain upon settlement of litigation, resulting in the determination that theentire transaction is more appropriately classified as “Income from settlementand patent licensing” within operations, as opposed to revenue.

Thefollowing table presents the impact of the adjustment to the condensedconsolidated statements of operations and cash flows for the three and sixmonths ended June 30, 2005 (in thousands):

 

|                                             | ** ** | **Three Month Ended June 30, 2005** | ** ** | **Six Months Ended June 30, 2005** | ** ** |
|---------------------------------------------|------------|--------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                  | ** ** | **(Unaudited)**                                              | ** ** | **(Unaudited)**                                             | ** ** |
| **Statement of Operations**       | ** ** | **As  Previously  Reported**                                 | ** ** | **Adjustment**                                              | ** ** | **As  Restated** | ** ** | **As  Previously  Reported** | ** ** | **Adjustment** | ** ** | **As  Restated** | ** ** |
| Revenues:                                   |       |                                                         |       |                                                        |       |   |   |   |   |   |   |   |   |
| Licensing revenue                           |       | $                                                            | 1,057      |                                                        | $          | (1,057 | ) | $ | — |   | $ | 2,114 |   | $ | (2,114 | ) | $ | — |   |
| Total revenue                               |       | 2,403                                                        |       | (1,057                                                      | )          | 1,346 |   | 5,382 |   | (2,114 | ) | 3,268 |   |
| Costs  and expenses:                        |       |                                                         |       |                                                        |       |   |   |   |   |   |   |   |   |
| Income from settlement and patent licensing |       | —                                                       |       | (1,057                                                      | )          | (1,057 | ) | — |   | (2,114 | ) | (2,114 | ) |
| Net  loss                                   |       | $                                                            | (1,260     | )                                                           | $          | — |   | $ | (1,260 | ) | $ | (1,647 | ) | $ | — |   | $ | (1,647 | ) |

 

|                                                      | ** ** | **Six Months Ended June 30, 2005** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                           | ** ** | **(Unaudited)**                                             | ** ** |
| **Statement of Cash Flows**           | ** ** | **As  Previously  Reported**                                | ** ** | **Adjustment** | ** ** | **As Restated** | ** ** |
| Cash  flows from operating activities:               |       |                                                        |       |   |   |   |   |
| Deferred settlement and patent licensing costs       |       | $                                                           | —     |   | $ | 628 |   | $ | 628 |   |
| Deferred license revenue                             |       | (2,076                                                      | )          | 2,076 |   | — |   |
| Deferred income from settlement and patent licensing |       | —                                                      |       | (2,704 | ) | (2,704 | ) |
| Net  cash used in operating activities               |       | $                                                           | (4,069     | ) | $ | — |   | $ | (4,069 | ) |

 

**3. Summary of Significant AccountingPolicies**

# **Unaudited Interim Financial Information**

The financial statementsfiled in this report have been prepared by the Company, without audit, pursuantto the rules and regulations of the SEC. Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith accounting principles generally accepted in the United States of Americahave been condensed or omitted pursuant to such rules and regulations. TheDecember 31, 2005 Condensed Consolidated Balance Sheet was derived fromaudited financial statements, but does not include all disclosures required byaccounting principles generally accepted in the United States of America.

Inthe opinion of management, the unaudited financial statements furnished in thisreport reflect all adjustments (consisting of normal recurring adjustments)necessary for a fair presentation of the results of operations for the interimperiods covered and of the Company’s financial position as of the interimbalance sheet date. The results of operations for the interim periods are notnecessarily indicative of the results for the entire year. These financialstatements should be read in conjunction with the Company’s auditedconsolidated financial statements and the accompanying notes for the year endedDecember 31, 2005, included in the Company’s annual report on Form 10-Kfiled with the Securities and Exchange Commission on April 28, 2006.

**Reclassifications**

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

7

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**Use of Estimates**

Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements, andthe reported amounts of revenues and expenses during the period. Actual resultscould differ from those estimates.

# **Cash and Cash Equivalents and Short and Long-termInvestments**

The Company considers allinvestment instruments purchased with an original maturity of three monthsor less to be cash equivalents. Investment securities with original orremaining maturities of more than three months but less than one year areconsidered short-term investments. Auction rate securities with original orremaining maturities of more than three months are considered short-terminvestments even if they are subject to re-pricing within three months.Investment securities held with intent to reinvest or hold for longer than ayear or with remaining maturities of one year or more are considered long-terminvestments. The Company’s cash equivalents at December 31, 2005 and June 30,2006 consisted of money market funds and short-term commercial paper withoriginal maturities of three months or less.

TheCompany accounts for its short-term and long-term investments in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 115, *Accounting**for Certain Investments inDebt and Equity Securities*. The Company’s short and long-terminvestments in securities are classified as available-for-sale and are reportedat fair value, with unrealized gains and losses, net of tax, recorded in othercomprehensive income (loss). Realized gains or losses and declines in valuejudged to be other than temporary, if any, on available-for-sale securities arereported in other income, net. The Company reviews the securities forimpairments considering current factors including the economic environment,market conditions and the operational performance, and other specific factorsrelating to the business underlying the securities. The Company recordsimpairment charges equal to the amount that the carrying value of itsavailable-for-sale securities exceeds the estimated fair market value of thesecurities as of the evaluation date. The fair value for publicly heldsecurities is determined based on quoted market prices as of the evaluationdate. In computing realized gains and losses on available-for-sale securities,the Company determines cost based on amounts paid, including direct costs suchas commissions, to acquire the security using the specific identificationmethod. The Company had net unrealized losses on its short and long-terminvestment securities of $4,000 and $12,000 at June 30, 2006 and December 31,2005, respectively.

Cash,cash equivalents, short and long-term investments consisted of the following atJune 30, 2006 and December 31, 2005 (in thousands):

|                                                                                                                                | ** **   | **June 30,** | ** **   | **December 31,** | ** **   |
|--------------------------------------------------------------------------------------------------------------------------------|--------------|-------------------|--------------|-----------------------|--------------|
| ** **                                                                                                                     | ** **   | **2006**          | ** **   | **2005**              | ** **   |
| ** **                                                                                                                     | ** **   | **(Unaudited)**   | ** **   |
| ***Description***                                                                                                              | *** *** | *** ***      | *** *** | *** ***          | *** *** |
| Cash  and cash equivalents:                                                                                                    |         |              |         |                  |         |
| Cash                                                                                                                           |         | $                 | 1,061        |                  | $            | 549 |   |
| Commercial paper cash equivalents                                                                                              |         | 3,210             |         | 7,667                 |         |
| Total cash and cash equivalents                                                                                                |         | 4,271             |         | 8,216                 |         |
| Short-term  investments:                                                                                                       |         |              |         |                  |         |
| Short-term investments (average 58 and 60 remaining days to maturity as  of June 30, 2006 and December 31, 2005, respectively) |         | 2,281             |         | 2,995                 |         |
| Total cash and cash equivalents and short term-investments                                                                     |         | 6,552             |         | 11,211                |         |
| Long-term-investments(average  390 days to maturity as of December 31, 2005)                                                   |         | —            |         | 958                   |         |
| Total  cash, cash equivalents and short- term and long-term investments                                                        |         | $                 | 6,552        |                  | $            | 12,169 |   |

 

# **ComprehensiveLoss**

 

The Company applies theprovisions of SFAS No. 130,*ReportingComprehensive Income*, which establishes standards for reporting anddisplaying comprehensive (loss) income and its components in the consolidatedfinancial statements. Comprehensive (loss) income is defined as the change inequity of a business enterprise during a period from transactions and otherevents and circumstances from non-owner sources. The only components ofcomprehensive loss reported by the Company are net unrealized gains and lossesfrom available-for-sale-investments and are as follows for the three and sixmonths ended June 30, 2006 and 2005 (in thousands): 

8

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|                                                               | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                    | ** ** | **(Unaudited)**                                     | ** ** | **(Unaudited)**                                   | ** ** |
| Net loss                                                      |       | $                                                   | 3,720      |                                              | $          | 1,260 |   | $ | 6,776 |   | $ | 1,647 |   |
| Unrealized gain  on available-for-sale-investments adjustment |       | (3                                                  | )          | —                                            |       | (8 | ) | — |   |
| Comprehensive loss                                            |       | $                                                   | 3,717      |                                              | $          | 1,260 |   | $ | 6,768 |   | $ | 1,647 |   |

 

# **Significant Concentrations**

A relatively small number ofcustomers have accounted for a significant percentage of the Company’srevenues. Revenues to these customers as a percentage of total revenues were asfollows for the three and six months ended June 30, 2006 and 2005:

 
|             | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **  | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **  | ** ** | **(Unaudited)**                                     | ** ** | **(Unaudited)**                                   | ** ** |
| Customer A  |       | 32                                                  | %          | 46                                                | %          | 36 | % | 39 | % |
| Customer B  |       | 41                                                  | %          | 36                                                | %          | 39 | % | 40 | % |
| Customer  C |       | 12                                                  | %          | *                                                 | %          | * | % | * | % |

 

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* Less than 10%

Anychange in the relationship with these customers could have a potentiallyadverse effect on the Company’s financial position.

Financial instruments that potentially subject theCompany to concentrations of credit risk consist primarily of temporary cashinvestments and trade receivables. The Company has cash and investment policiesthat limit the amount of credit exposure to any one financial institution orrestrict placement of these investments to financial institutions evaluated ashighly credit worthy. As of June 30, 2006, the Company had cash and cashequivalents on deposit with a major financial institution that were in excessof FDIC insured limits. Historically, the Company has not experienced any lossof its cash and cash equivalents due to such concentration of credit risk.Concentrations of credit risk with respect to trade receivables relate to thosetrade receivables from both United States and foreign entities, primarily inthe financial services industry. As of June 30, 2006, approximately 93% ofgross accounts receivable was concentrated with four customers, each of whomrepresented more than 10% of the Company’s total gross accounts receivablebalance. As of December 31, 2005, approximately 97% of accounts receivablewas concentrated with three customers. 

# **Inventories**

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

|                                                         | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                              | ** ** | **(Unaudited)**         | ** ** |
| Raw  materials and subassemblies                        |       | $                       | 43         |                        | $          | 43 |   |
| Finished goods                                          |       | 725                     |       | 604                         |       |
| Inventory shipped to  customer sites, not yet installed |       | 60                      |       | 28                          |       |
|                                                    |       | $                       | 828        |                        | $          | 675 |   |

 

Inventory shipped to customersites, not yet installed, represents product shipped to customer sites pendingcompletion of the installation process by the Company. As of June 30, 2006 and December 31, 2005, the Company hadbilled approximately $60,000 and $28,000, respectively, to customersrelated to these shipments, but did not record the revenue, as theinstallations had not been completed and confirmed by the customer. Althoughcustomers are billed in accordance with customer agreements, these deferredrevenue amounts are netted against accounts receivable until the customerconfirms installation.

**Revenue Recognition and Deferred Revenue**

TheCompany recognizes product and services revenue in accordance with Statement ofPosition (“SOP”) 97-2, *Software RevenueRecognition* (“SOP 97-2”), as amended by SOP 98-9, *Modification of SOP 97-2, Software Revenue Recognition, With Respect toCertain Transactions* (“SOP 98-9”). The Company derives productrevenue from the sale and licensing of a set of desktop (endpoint) products(hardware and software) and infrastructure products (hardware and software)that combine to form an Avistar video-enabled collaboration solution. Servicesrevenue includes revenue from installation services, post-contract customersupport, training and

9

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software development. Theinstallation services that the Company offers to customers relate to thephysical set-up and configuration of desktop and infrastructure components ofthe Company’s solution. The fair value of all product, installation services,post-contract customer support and training offered to customers is determinedbased on the price charged when such products or services are sold separately.

Arrangementsthat include multiple product and service elements may include software andhardware products, as well as installation services, post-contract customersupport and training. Pursuant to SOP 97-2, when an arrangement includesmultiple elements, the Company recognizes revenue when all of the followingcriteria are met: (i) persuasive evidence of an arrangement exists, (ii)delivery has occurred, (iii) the fee is fixed or determinable, and (iv)collectibility is probable. The Company applies these criteria as discussedbelow:

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

·      Deliveryhas occurred. The Company delivers software and hardware to customersphysically. The standard delivery terms are FOB shipping point.

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

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

Ifthere are any undelivered elements, the Company defers revenue for thoseelements, as long as Vendor Specific Objective Evidence (“VSOE”) exists for theundelivered elements. Additionally, per paragraph 14 of SOP 97-2, when theCompany provides installation services, the product and installation revenue isrecognized upon completion of the installation process and receipt of customerconfirmation, subject to the satisfaction of the revenue recognition criteriadescribed above. The Company believes that the fee associated with thedelivered product elements does not meet the collectibility criteria if the installationservices have not been completed. Customer confirmation is obtained anddocumented by means of a standard form indicating the installation serviceshave been provided and the hardware and software components installed. When thecustomer or a third party provides installation services, the product revenueis recognized upon shipment, subject to satisfaction of the revenue recognitioncriteria described above.

Paymentfor product is due upon shipment, subject to specific payment terms. Paymentfor installation and professional services is due upon providing the services,subject to specific payment terms. Reimbursements received for out-of-pocketexpenses and shipping costs incurred during installation and support services,which have not been significant to date, are recognized as revenue inaccordance with Emerging Issues Task Force (“EITF”) Issue No. 01-14 (“EITF01-14”), *Income Statement Characterization of ReimbursementsReceived for “Out of Pocket” Expenses Incurred*.

Theprice charged for maintenance and/or support is defined in the contract, and isbased on a fixed price for both hardware and software components as stipulatedin the customer agreement. Customers have the option to renew the maintenanceand/or support arrangement in subsequent periods at the same or similar rate aspaid in the initial year subject to contractual adjustments for inflation.Revenue from maintenance and support services is deferred and recognizedpro-rata over the maintenance and/or support term, which is typically one yearin length. Payments for services made in advance of the provision of servicesare recorded as deferred revenue and customer deposits in the accompanyingbalance sheets. Training services are offered independently of the purchase ofproduct. The value of these training services is determined based on the pricecharged when such services are sold separately. Training revenue is recognizedupon performance of the service.

TheCompany recognizes service revenue from software development contracts in accordancewith SOP 81-1, *Accounting for Performance ofConstruction-Type and Certain Production-Type Contracts.* Revenuerelated to contracts for software development is recognized using thepercentage of completion method, when all of the following conditions are met:a contract exists with the customer at a fixed price, the Company has fulfilledall of its material contractual obligations to the customer for eachdeliverable of the contract, verification of completion of the deliverable hasbeen received, and collection of the receivable is probable. The amounts billedto customers in excess of revenues recognized to date are deferred and recordedas deferred revenue and customer deposits in the accompanying balance sheets.Assumptions used for recording revenue and earnings are adjusted in the periodof change to reflect revisions in contract value and estimated costs to completethe contract. Any anticipated losses on contracts in progress are charged to

10

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earnings when identified.

TheCompany recognizes revenue from the licensing of its intellectual propertyportfolio according to SOP 97-2, based on the terms of the royalty, partnershipand cross-licensing agreements involved. In the event that a license to theCompany’s intellectual property is granted after the commencement of litigationproceedings between the Company and the licensee, the proceeds of suchtransaction  are recognized as licensingrevenue by us only if sufficient historical evidence exists for thedetermination of fair value of the licensed patents  to support the segregation of the proceedsbetween a gain on litigation settlement and patent license revenues. As of June30, 2006, these criteria for recognizing license revenue following thecommencement of litigation  had not beenmet.

**Income from Settlement and Patent Licensing**

TheCompany recognizes the proceeds from settlement and patent licensing agreementsbased on the terms involved. When litigation has been filed prior to asettlement and patent licensing agreement, and insufficient historical evidenceexists for the determination of fair value of the patents licensed to supportthe segregation of the proceeds between a gain on litigation settlement andpatent license revenues, the Company reports all proceeds in “income fromsettlement and patent licensing” within operating costs and expenses. Whenlitigation has been filed prior to a settlement and patent licensing agreement,and sufficient historical evidence exists for the determination of fair valueof the patents licensed to support the segregation of the proceeds between again on litigation settlement and patent license revenues, the Company reportsthe patent licensing proceeds, as license revenue, consistent with Financial AccountingStandards Board (“FASB”) Concepts Statement No. 6, *Elements ofFinancial Statements*. The gain portion of the proceeds, whensufficient historical evidence exists to segregate the proceeds, is reported inother income according to SFAS No. 5, Accounting for Contingencies.

**Stock-Based Compensation**

EffectiveJanuary 1, 2006, the Company adopted the provisions of SFAS No. 123(R), *Share-Based Payment* (“SFAS No. 123R”),whichestablishes the accounting for stock-based awards exchanged for employeeservices. Accordingly, stock-based compensation cost is measured at grant date,based on the fair value of the award, and is recognized as expense over theemployee’s service period.

The Company previously appliedAccounting Principles Board (“APB”) Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related interpretations, andprovided the required pro forma disclosures of SFAS No. 123, *Accounting for Stock-Based Compensation* (“SFAS No. 123”).Prior to the adoption of SFAS No. 123R, the Company provided thedisclosures required under SFAS No. 123 as amended by SFAS No. 148, *Accounting for Stock-Based Compensation – Transition and Disclosures.*   Thepro-forma information for the three and six months ended June 30, 2005 was asfollows (in thousands, except per share data):

 

|                                                                                                                  | ** ** | **Three Months Ended  June 30, 2005** | ** ** | **Six Months Ended  June 30, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **(unaudited)**                                           | ** ** | **(unaudited)**                                         | ** ** |
| Net loss, as reported                                                                                            |       | $                                                         | (1,260     | )                                                       | $          | (1,647 | ) |
| Add stock - based employee compensation expense included in reported  net loss, net of tax                       |       | 2                                                         |       | 2                                                       |       |
| Deduct total stock-based employee compensation expense under  fair-value-based method for all awards, net of tax |       | (627                                                      | )          | (1,112                                                  | )          |
| Pro forma net loss                                                                                               |       | $                                                         | (1,885     | )                                                       | $          | (2,757 | ) |
|                                                                                                             |       |                                                      |       |                                                    |       |
| Basic and diluted loss per share:                                                                                |       |                                                      |       |                                                    |       |
| As reported                                                                                                      |       | $                                                         | (0.04      | )                                                       | $          | (0.05 | ) |
| Pro forma                                                                                                        |       | $                                                         | (0.06      | )                                                       | $          | (0.08 | ) |
|                                                                                                             |       |                                                      |       |                                                    |       |

 

*Impactof the Adoption of SFAS No. 123R*

The Company elected to adopt the modified prospectiveapplication method as provided by SFAS No. 123R. The effect of recordingstock-based compensation for the three and six months ended June 30, 2006 wasas follows (in thousands, except per share data):

 
|                                                     | ** ** | **Three Months Ended  June 30, 2006** | ** ** | **Six Months Ended  June 30, 2006** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                          | ** ** | **(unaudited)**                                           | ** ** | **(unaudited)**                                         | ** ** |
| Stock-based compensation expense by type of award:  |       |                                                      |       |                                                    |       |
| Employee stock options                              |       | $                                                         | 450        |                                                    | $          | 863 |   |
| Non-employee stock options                          |       | 22                                                        |       | 40                                                      |       |
| Employee stock purchase plan                        |       | 26                                                        |       | 70                                                      |       |
| Total stock-based compensation                      |       | 498                                                       |       | 973                                                     |       |
| Tax effect on stock-based compensation              |       | —                                                    |       | —                                                  |       |
| Net  effect of stock-based compensation on net loss |       | $                                                         | 498        |                                                    | $          | 973 |   |

 

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As of June 30, 2006, theCompany had an unrecognized stock-based compensation balance related to stockoptions of approximately $5.6 million before estimated forfeitures. SFASNo. 123R requires forfeitures to be estimated at the time of grantand revised if necessary in subsequent periods if actual forfeitures differfrom those estimates. Based on the Company’s historical experience of optionpre-vesting cancellations, the Company has assumed an annualized forfeiturerate of 7% for its executive options and 29% for non-executive options.Accordingly, as of June 30, 2006, the Company estimated that the stock-basedcompensation for the awards not expected to vest was approximately $1.4 millionand therefore, the unrecognized deferred stock-based compensation balancerelated to stock options was adjusted to approximately $4.2 million afterestimated forfeitures. This amount will be recognized over an estimated weightedaverage amortization period of 2.4 years. During the three and six months endedJune 30, 2006, the Company granted 1,188,000 and 1,366,000 stock options toemployees, with an estimated total grant-date fair value of $1.25 and $1.26,respectively.

*ValuationAssumptions*

The Company estimated thefair value of stock options granted during the three and six months ended June30, 2006, using a Black-Scholes valuation model, consistent with the provisionsof SFAS No. 123R, SEC Staff Accounting Bulletin (“SAB”) No. 107, andthe Company’s prior period pro forma disclosures of stock-based compensationfor the three and six months ended June 30, 2005, (determined under a fairvalue method as prescribed by SFAS No. 123). The fair value of each optiongrant is estimated on the date of grant using the Black-Scholes optionvaluation model and the straight-line attribution approach with the followingweighted-average assumptions:

**Employee Stock Option Plan**

 

|                                 | ** ** | **Three and Six Months Ended  June 30,** | ** ** |
|---------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                                          | ** ** | **2005** | ** ** |
| Expected dividend               |       | —                                                            | %          | — | % |
| Average risk-free interest rate |       | 4.8                                                               | %          | 3.9 | % |
| Expected volatility             |       | 144                                                               | %          | 224 | % |
| Expected  term (years)          |       | 6.1                                                               |       | 4.0 |   |

 

**Employee Stock Purchase Plan**

 

|                                 | ** ** | **Three and Six Months Ended June 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                                              | ** ** | **2005** | ** ** |
| Expected dividend               |       | —                                                                | %          | — | % |
| Average risk-free interest rate |       | 2.8                                                                   | %          | 3.0 | % |
| Expected volatility             |       | 113                                                                   | %          | 96 | % |
| Expected  term (months)         |       | 6.0                                                                   |       | 6.0 |   |

The dividend yield of zero is based on the fact that the Company hasnever 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 Ratesas of the grant dates as published by the Federal Reserve, and represent theyields on actively traded Treasury securities for terms equal to the expectedterm of the options. Expected volatility is based on the historical volatilityof the Company’s common stock over a period consistent with the expected termof the stock-option. The expected term calculation is based on an averageprescribed by SAB No. 107, based on the vesting periods, which is generallyfour years, and the term of the option, which is generally 10 years, divided by2.

**4.Related Party Transactions**

RobertP. Latta, a member of the law firm Wilson Sonsini Goodrich & Rosati,Professional Corporation (“WSGR”), has served as a director of the Companysince February 2001. Mr. Latta and WSGR have represented the Company andits predecessors as corporate counsel since 1997. During the six months endedJune 30, 2006 and 2005, payments of approximately $86,000 and $65,000,respectively, were made to WSGR for legal services provided to the Company.

**5. Net Loss Per Share**

Basicand diluted net loss per share of common stock is presented in conformity withSFAS No. 128 (“SFAS No. 128”), *Earnings Per Share*,for all periods presented.

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Inaccordance with SFAS No. 128, basic net loss per share has been computed usingthe weighted average number of shares of common stock outstanding during theperiod, less shares subject to repurchase. Diluted net loss per share iscomputed on the basis of the weighted average number of shares and potentialcommon shares outstanding during the period. Potential common shares resultfrom the assumed exercise of outstanding stock options that have a dilutiveeffect when applying the treasury stock method. The Company has excluded alloutstanding stock options and shares subject to repurchase from the calculationof diluted net loss per share for the three and six months ended June 30, 2006and 2005, because all such securities are antidilutive (owing to the fact thatthe Company is in a loss position). Accordingly, diluted net loss per share isequal to basic net loss per share for all periods presented.

The total number of potential common shares excludedfrom the calculations of diluted net loss per share were 2,450,073 and5,272,936 for the three months ended June 30, 2006 and 2005, respectively, and2,794,151 and 4,417,208 for the six months ended June 30, 2006 and 2005,respectively.

**6. Segment Reporting**

Disclosure of segments is presented in accordance withSFAS No. 131 (“SFAS No. 131”), *Disclosures About Segmentsof an Enterprise and Related Information*.  SFAS No. 131 establishes standards fordisclosures regarding operating segments, products and services, geographicareas and major customers. The Company isorganized and operates as two operating segments: (1) the design, development,manufacture, sale and marketing of networked video communications products(Avistar) and (2) the prosecution, maintenance, support and licensing ofthe intellectual property, some of which is used in the Company’s products(CPI). Service revenue relates mainly tothe maintenance, support, training, software development and installation ofproducts, and is included in Avistar for purposes of reporting anddecision-making. Avistar also engages in corporate functions andprovides financing and other services to its subsidiaries. The Company’s ChiefExecutive Officer, the Company’s chief operating decision maker, considers incomefrom settlement and patent licensing to be equivalent to revenue for purposesof monitoring the Company’s operations. A reconciliation of the revenue andexpense classification used by the Company’s CEO with the classification ofrevenue, other income and expenses as set forth in the Company’s unauditedfinancial statements included elsewhere herein is indicated in the followingtable(in thousands).

 
| ** **                           | ** ** | **CPI**    | ** ** | **Avistar** | ** ** | **Reconciliation** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|------------|------------|-------------|------------|--------------------|------------|-----------|------------|
| **Three Months Ended June 30, 2006** |       |       |       |        |       |               |       |      |       |
| Revenue                              |       | $          | 1,096      |        | $          | 1,715              |       | $         | (1,057     | ) | $ | 1,754 |   |
| Depreciation expense                 |       | —     |       | (76         | )          | —             |       | (76       | )          |
| Total costs and expenses             |       | (1,573     | )          | (5,027      | )          | 1,057              |       | (5,543    | )          |
| Interest income                      |       | —     |       | 77          |       | —             |       | 77        |       |
| Net loss                             |       | (477       | )          | (3,243      | )          | —             |       | (3,720    | )          |
| Assets                               |       | 4,318      |       | 9,107       |       | —             |       | 13,425    |       |
| **Three Months Ended June 30, 2005** | ** ** | ** ** |       |        |       |               |       |      |       |
| **(as restated)**                    | ** ** | ** ** |       |        |       |               |       |      |       |
| Revenue                              |       | $          | 1,057      |        | $          | 1,346              |       | $         | (1,057     | ) | $ | 1,346 |   |
| Depreciation expense                 |       | —     |       | (52         | )          | —             |       | (52       | )          |
| Total costs and expenses             |       | (401       | )          | (3,329      | )          | 1,057              |       | (2,673    | )          |
| Interest income                      |       | —     |       | 73          |       | —             |       | 73        |       |
| Net income (loss)                    |       | 655        |       | (1,915      | )          | —             |       | (1,260    | )          |
| Assets                               |       | 5,631      |       | 20,245      |       | —             |       | 25,876    |       |
| ** **                           |       |       |       |        |       |               |       |      |       |
| **Six Months Ended June 30, 2006**   |       |       |       |        |       |               |       |      |       |
| Revenue                              |       | $          | 2,185      |        | $          | 3,541              |       | $         | (2,114     | ) | $ | 3,612 |   |
| Depreciation expense                 |       | —     |       | (190        | )          | —             |       | (190      | )          |
| Total costs and expenses             |       | (2,786     | )          | (9,881      | )          | 2,114              |       | (10,553   | )          |
| Interest income                      |       | —     |       | 180         |       | —             |       | 180       |       |
| Net loss                             |       | (601       | )          | (6,175      | )          | —             |       | (6,776    | )          |
| Assets                               |       | 4,318      |       | 9,107       |       | —             |       | 13,425    |       |
| **Six Months Ended June 30, 2005**   | ** ** | ** ** |       |        |       |               |       |      |       |
| **(as restated)**                    | ** ** | ** ** |       |        |       |               |       |      |       |
| Revenue                              |       | $          | 2,114      |        | $          | 3,268              |       | $         | (2,114     | ) | $ | 3,268 |   |
| Depreciation expense                 |       | —     |       | (88         | )          | —             |       | (88       | )          |
| Total costs and expenses             |       | (899       | )          | (6,340      | )          | 2,114              |       | (5,125    | )          |
| Interest income                      |       | —     |       | 221         |       | —             |       | 221       |       |
| Net income (loss)                    |       | 1,214      |       | (2,861      | )          | —             |       | (1,647    | )          |
| Assets                               |       | 5,631      |       | 20,245      |       | —             |       | 25,876    |       |

 

International revenue,which consists of sales to customers with operations principally in WesternEurope and Asia, comprised 57% and 59% of total revenues for the three monthsended June 30, 2006 and 2005, respectively. International revenue comprised

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53% and 58% of total revenues for the six months endedJune 30, 2006 and 2005, respectively. For the three months ended June 30, 2006and 2005, international revenues from customers in the United Kingdom accountedfor 22% and 35%, respectively, of total product and services revenue.  For the six months ended June 30, 2006 and2005, international revenues from customers in the United Kingdom accounted for16% and 30%, respectively, of total revenues. The Company had no significantlong-lived assets in any country other than in the United States for any periodpresented.

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

**LegalProceedings**

On May 11, 2005, CPI,Avistar’s wholly-owned patent prosecution and licensing subsidiary, commenced apatent infringement lawsuit against Tandberg ASA and Tandberg, Inc., allegingthat numerous Tandberg videoconferencing products infringe three patents heldby CPI. The suit was filed in the United States District Court for the NorthernDistrict of California. The three patents involved are U.S. Patent Nos.5,867,654; 5,896,500; and 6,212,547. These patents cover technologies relatingto video and data conferencing over unshielded twisted pair (“UTP”) networks,distributed call-state management, and separate monitors for simultaneouscomputer-based data sharing and videoconferencing. These technologies are corecomponents of the AvistarVOS video operating system. In this action, CPI hasrequested injunctive relief, damages to compensate for past and presentinfringement, treble damages, costs associated with the litigation and suchfurther relief as the Court deems just and proper. Both of the Tandbergentities answered the complaint on July 15, 2005, at which time they assertedthat they did not infringe the patents and that the patents were invalid andunenforceable.

On January 30, 2006,Tandberg Telecom AS, a wholly-owned subsidiary of Tandberg ASA, filed a patentinfringement lawsuit against Avistar in the United States District Court forthe Eastern District of Texas. The suit alleges that Avistar videoconferencingproducts infringe one patent purchased by Tandberg Telecom AS. The patentinvolved is U.S. Patent No. 6,621,515, which claims a method and system forrouting video calls. In the Texas litigation, Tandberg Telecom AS has requestedinjunctive relief, monetary damages to compensate for its actual damages, costsassociated with the litigation and such further relief as the Court deems justand proper. Avistar responded to the complaint on March 23, 2006, at which timeAvistar asserted that Avistar did not infringe the patent, that the patent wasinvalid, and that the claim was without merit. Tandberg filed a motion todismiss one of Avistar’s defenses, which the Texas court summarily denied.

Tandberg ASA andTandberg, Inc. sought to add two defenses, and provisionally filed two motionsfor summary judgment in the California litigation on January 13, 2006 andFebruary 24, 2006, respectively. Each proposed defense asserts that Avistar issubject to a different contractual provision that either totally precludes orlimits CPI’s remedies in the California litigation. Specifically, Tandbergalleged that (1) it had a license to the subject patents and (2) that Avistarhad released its claims against Tandberg with respect to the subject patents.Both motions for summary judgment were determined to be procedurally defectivein that Tandberg had not previously pled the contractual provisions as defensesto CPI’s claims. In the first matter, on January 13, 2006, Tandberg voluntarilyfiled a motion to amend its complaint to add a license defense. On March 29,2006, the court conditionally granted Tandberg’s motion, subject to thetransfer and addition of the Texas suit to the California litigation.  Tandberg filed a motion for reconsiderationof the court’s ruling on May 17, 2006, which was denied by the court on June28, 2006.  As of August 2, 2006, Tandberghas not dismissed its Texas litigation, thereby precluding the furtherconsideration of its motion for summary judgment on the basis of a “license”defense.

During a hearing on March20, 2006 concerning Tandberg’s “release” defense, the court refused to permitTandberg to amend its complaint, holding that Tandberg could not prevail onthat defense, thereby prohibiting Tandberg from pursuing this defense in theCalifornia case. A third motion for summary judgment in the California litigationwas filed by Tandberg on April 17, 2006, claiming that CPI’s patents wereinvalid based on the ruling of *IPXL Holdings, LLC v.Amazon.com, Inc.*  The courtdenied Tandberg’s motion on June 23, 2006.

The Markman hearing forthe CPI claims, a pivotal stage of the litigation process at which timedefinitions are determined for the meaning of the patent claims language, washeld on May 24, 2006, and the judge issued her ruling on June 23, 2006.  A non-binding mediation related to theCalifornia case was held on May 12, 2006 without resolution.  A second non-binding mediation is currentlyscheduled for August 15, 2006. Discovery is on-going in the Californialitigation; the Texas case remains in its initial phases.  A jury trial date has not yet been scheduledfor either case.

The prosecution of thislawsuit and the defense of the Tandberg Telecom AS claim require Avistar andCPI to expend significant financial and managerial resources, and therefore mayhave a material negative impact on Avistar’s business, financial condition andresults of operations. The duration and ultimate outcome of these litigationproceedings are uncertain.

**8.      OtherMatter**

OnApril 13, 2006, Avistar notified The NASDAQ Capital Market that it did notexpect to file its Annual Report on Form 10-K with the SEC on or prior tothe extended filing deadline of April 17, 2006 and therefore expected tobe out of compliance with NASDAQ’s

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continuedlisting standard set forth in NASDAQ Marketplace Rule 4310(c)(14). As aresult of this noncompliance, Avistar received a notice from The NASDAQ CapitalMarket to the effect that, due to such noncompliance, Avistar’s common stockwould be subject to delisting. Upon receipt of the delisting notice, Avistarrequested a hearing before a NASDAQ Listing Qualifications Panel (the “Panel”)to appeal NASDAQ staff’s determination. The hearing request automaticallystayed the delisting of Avistar’s common stock pending the Panel’s decision.Avistar filed its Annual Report on Form 10-K on April 28, 2006. On May 5, 2006,Avistar received a written notice from NASDAQ indicating that, in light of thefiling of Avistar’s Annual Report, the delisting hearing was moot and thedelisting process had been cancelled.

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

On July 14, 2006, Avistarand CPI entered into a Patent License Agreement with Sony Corporation (“Sony”),a Japanese corporation, and Sony Computer Entertainment, Inc. (“SCEI”), aJapanese corporation.  Under the licenseagreement, CPI granted Sony and its subsidiaries a license to all of CPI’spatents with a filing date on or before January 1, 2006 for  a specific field of use relating to videoconferencing. The license covers Sony’s video conferencing apparatus as well asother products, including video-enabled personal computer products and certainSCEI PlayStation products.

As consideration for thelicenses granted under the agreement, Sony agreed to make an upfront license payment of $5.0 million and SCEI hasagreed to make future royalty payments relating to the sale in certain countries,including the United States, of certain SCEI products.

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

The following discussionshould be read in conjunction with the unaudited Condensed Consolidated FinancialStatements and the Notes to Condensed Consolidated Financial Statementselsewhere herein, and the Audited Consolidated Financial Statements containedin our Annual Report on Form 10-K for the year ended December 31, 2005, asfiled with the Securities and Exchange Commission on April 28, 2006.

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

Althoughwe believe that the expectations reflected in the forward-looking statementsare reasonable, we cannot guarantee future results, levels of activity,performance or achievements. We are under no duty to update any of theforward-looking statements after the date of this Quarterly Report on Form 10-Qto conform our prior statements to actual results.

**Overview**

We develop, market andsupport an integrated suite of vBusiness—video-enabled eBusiness—applications,all powered by the AvistarVOSTM software. From the desktop, we deliverbusiness-quality interactive video calling, content creation and publishing,broadcast origination and distribution, video- on-demand, and integrated datasharing. The Avistar video and data collaboration applications are all managedby the AvistarVOS video operating system. By integrating video tightly into theway they work, our customers can use our system to save costs and improveproductivity and communication within the enterprise and between enterprises,to enhance relationships with customers, suppliers and partners. UsingAvistarVOS software and leveraging video, telephony and Internet networkingstandards, Avistar applications are designed to be scalable, reliable, costeffective, easy to use, and capable of evolving with communications networks asbandwidth increases and as new standards and protocols emerge. We currentlysell our system directly to enterprises in selected strategic vertical markets,and have focused initially on the financial services industry. Additionally, wehave licensed our technology and patents to companies in the video conferencingmarket. Our objective is to establish our technology as the standard fornetworked video through direct sales, indirect channel sales/partnerships and thelicensing of our technology to others.

We operate in twosegments. Avistar Communications Corporation engages in the design,development, manufacture, sale and marketing of networked video communicationsproducts and associated support services. Collaboration Properties, Inc., orCPI, our wholly owned subsidiary, engages in the prosecution, maintenance,support and licensing of the intellectual property that we have developed, someof which is used in our products.

Since inception, we haverecognized the innovative value of our research and development efforts, andhave invested in securing protection for these innovations through domestic andforeign patent application and issuance. As of June 30, 2006, we hold 71 U.S.and foreign patents, which have been licensed to third parties. We continue topursue opportunities to license these patents to others in the collaborationtechnology marketplace.

**CriticalAccounting Policies**

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

We believe the followingcritical accounting policies, among others, affect our more significantjudgments and estimates used in the preparation of our Condensed ConsolidatedFinancial Statements:

·                  Revenuerecognition;

·                  Income fromsettlement and patent licensing;

·                  Valuation ofaccounts receivable; and

·                  Valuationof inventories.

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

**RevenueRecognition**

We derive product revenueprincipally from the sale and licensing of our video-enabled networkedcommunications system, consisting of a suite of Avistar-designed software andhardware products, including third party components. We also derive revenuefrom fees for installation, maintenance, support, training services andsoftware development. In addition, we derive revenue from the licensing of ourintellectual property portfolio. Product revenue as a percentage of totalrevenue was 55% and 40% for the three months ended June 30, 2006 and 2005,respectively.  Product revenue as apercentage of total revenue was 51% and 51% for the six months ended June 30,2006 and 2005, respectively.

We recognize product andservices revenue in accordance with Statement of Position (“SOP”) *97-2, Software Revenue Recognition*(“SOP 97-2”), as amendedby SOP 98-9, Modification of SOP 97-2, *Software RevenueRecognition, With Respect to Certain Transactions* (“SOP 98-9”). Wederive product revenue from the sale and licensing of a set of desktop(endpoint) products (hardware and software) and infrastructure products (hardwareand software) that combine to form an Avistar video-enabled collaborationsolution. Services revenue includes revenue from installation services,post-contract customer support, training, and software development. Theinstallation services that we offer to customers relate to the physical set-upand configuration of desktop and infrastructure components of our solution. Thefair value of all product, installation services, post-contract customersupport and training offered to customers is determined based on the pricecharged when such products or services are sold separately.

Arrangements that includemultiple product and service elements may include software and hardwareproducts, as well as installation services, post-contract customer support andtraining. Pursuant to SOP 97-2, when an arrangement includes multiple elements,we recognize revenue when all of the following criteria are met: (i) persuasiveevidence of an arrangement exists, (ii) delivery has occurred, (iii) the fee isfixed or determinable, and (iv) collectibility is probable. We apply thesecriteria as discussed below:

·        Persuasive evidence of an arrangementexists. We require a written contract, signed by both the customer and us, or apurchase order from those customers that have previously negotiated a standardend-user license arrangement or volume purchase agreement with us prior torecognizing revenue on an arrangement.

·        Delivery has occurred. We deliversoftware and hardware to our customers physically. Our standard delivery termsare FOB shipping point.

·        The fee is fixed or determinable. Ourdetermination that an arrangement fee is fixed or determinable dependsprincipally on the arrangement’s payment terms. Our standard terms generally require payment within 30 to 90 days of thedate of invoice. Where these terms apply, we regard the fee as fixed ordeterminable, and we recognize revenue upon delivery (assuming other revenuerecognition criteria are met). If the payment terms do not meet this standard,but rather involve “extended payment terms,” we may not consider the fee to befixed or determinable and would then recognize revenue when customerinstallments are due and payable.

·        Collectibility is probable. To recognizerevenue, we must judge collectibility of the arrangement fees, which we do on acustomer-by-customer basis pursuant to our credit review policy. We typicallysell to customers with which we have had a history of successful collections.For new customers, we evaluate the customer’s financial position and ability topay. If we determine that collectibility is not probable based upon our creditreview process or the customer’s payment history, we recognize revenue whencash is collected.

If there are anyundelivered elements, we defer revenue for those elements, as long as VendorSpecific Objective Evidence (“VSOE”) exists for the undelivered elements.Additionally, when we provide installation services, the product andinstallation revenue is recognized upon completion of the installation processand receipt of customer confirmation, subject to the satisfaction of therevenue recognition criteria described above. We believe that the feeassociated with the delivered product elements does not meet the collectibilitycriteria if the installation services have not been completed. Customerconfirmation is obtained and documented by means of a standard form indicatingthe installation services were provided and the hardware and softwarecomponents  were installed. When the customeror a third party provides installation services, the product revenue isrecognized upon shipment, subject to satisfaction of the revenue recognitioncriteria described above.

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

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The price charged formaintenance and/or support is defined in the product sale contract, and isbased on a fixed price for both hardware and software components as stipulatedin the customer agreement. Customers have the option to renew the maintenanceand/or support services in subsequent periods at the same or similar rate as paid in the initial yearsubject to contractual adjustments for inflation. Revenue frommaintenance and support is recognized pro-rata over the maintenance and/orsupport term, which is typically one year in length. Payments for services madein advance of the provision of services are recorded as deferred revenue andcustomer deposits in the accompanying balance sheets. Training services areoffered independently of the purchase of product. The value of these training servicesis determined based on the price charged when such services are soldseparately. Training revenue is recognized upon performance of the service.

We recognize servicerevenue from software development contracts in accordance with SOP 81-1, *Accounting for Performance of Construction-Type and CertainProduction-Type Contracts.* Revenue related to contracts for softwaredevelopment is recognized using the percentage of completion method, when allof the following conditions are met: a contract exists with the customer at afixed price, we have fulfilled all of our material contractual obligations tothe customer for each deliverable of the contract, verification of completionof the deliverable has been received, and collection of the receivable isprobable.  Amounts billed to customers inexcess of revenues recognized to date are deferred and recorded as deferredrevenue and customer deposits in the accompanying balance sheets. Assumptionsused for recording revenue and earnings are adjusted in the period of change toreflect revisions in contract value and estimated costs to complete thecontract. Any anticipated losses on contracts in progress are charged toearnings when identified.

We recognize revenue fromthe licensing of our intellectual property portfolio according to SOP 97-2, based on the terms of the royalty,partnership and cross-licensing agreements involved. In the event that alicense to our intellectual property is granted after the commencement oflitigation proceedings between us and the licensee, the proceeds of suchtransaction  are recognized as licensingrevenue by us only if sufficient historical evidence exists for thedetermination of fair value of the licensed patents  to support the segregation of the proceedsbetween a gain on litigation settlement and patent license revenues. As of June30, 2006, these criteria for recognizing license revenue following thecommencement of litigation  had not beenmet.

To date, a significantportion of our revenue has resulted from sales to a limited number ofcustomers, particularly Deutsche Bank AG and UBS Warburg LLC and theiraffiliates. Collectively, Deutsche Bank AG and UBS Warburg LLC and theiraffiliates accounted for approximately 75% and 79% of total revenue for the sixmonth periods ended June 30, 2006 and June 30, 2005, respectively. DeutscheBank AG and UBS Warburg LLC and their affiliates accounted for approximately73% and 82% of total revenue for the three month periods ended June 30, 2006and June 30, 2005, respectively. As of June 30, 2006, approximately 50% of ourgross accounts receivable was concentrated with these two customers, each ofwhom represented more than 10% of our gross accounts receivable. As of June 30,2006, approximately 93% of our gross accounts receivable was concentrated with fourcustomers, each of whom represented more than 10% of our gross accountsreceivable.

International revenue,which consists of sales to customers with operations principally in WesternEurope and Asia, comprised 57% and 59% of total revenues for the three monthsended June 30, 2006 and 2005, respectively. International revenue comprised 53% and 58% of total revenues for thesix months ended June 30, 2006 and 2005, respectively.

**Incomefrom Settlement and Patent Licensing**

We recognize the proceedsfrom settlement and patent licensing agreements based on the terms involved.When litigation has been filed prior to a settlement and patent licensingagreement, and insufficient historical evidence exists for the determination offair value of the patents licensed to support the segregation of the proceedsbetween a gain on litigation settlement and patent license revenues, we reportall proceeds in “income from settlement and patent licensing” within operatingcosts and expenses. When litigation has been filed prior to a settlement andpatent licensing agreement, and sufficient historical evidence exists for thedetermination of fair value of the patents licensed to support the segregationof the proceeds between a gain on litigation settlement and patent licenserevenues, we report the patent licensing proceeds as license revenue,consistent with FASB Concepts Statement No. 6, *Elements ofFinancial Statements*. The gain portion of the proceeds, whensufficient historical evidence exists to segregate the proceeds, is reported inother income according to SFAS No. 5, Accounting for Contingencies.

In September 2005, wereceived a comment letter from the U. S. Securities and Exchange Commission (“SEC”)relating to our 2004 Form 10-K, which included a question regarding ouraccounting for the November 2004 settlement and patent cross-license agreementwith Polycom, Inc.. The settlement and patent cross-license agreement resultedin a $27.5 million one time payment by Polycom to us and a payment by us to ourlitigation counsel of $6.4 million in contingent legal fees. We previouslyreported on Form 10-Q for the three and six months ended June 30, 2005 the onetime payment by Polycom as revenue, to be recognized ratably over a five-year period,net of contingent legal fees. As a result of the SEC’s inquiry as to whetherthe Polycom transaction should be characterized as revenue, and afterdiscussions with the SEC, we concluded that a reclassification of Polycomlicense revenues from revenue to a component of operating expenses presented as“Income from settlement and patent licensing” was necessary for previouslyfiled financial reports. The restatement of the net proceeds and expenses fromthe Polycom settlement and patent cross-license agreement had no effect onreported net loss, loss per share, stockholders’ equity (deficit) or net cashflows from operating, investing or financing activities, but did have theeffect of overstating revenues and operating expenses for previously issued interimcondensed consolidated financial statements, as of and for the three and sixmonths ended June 30, 2005. In addition, the balance sheet as of June 30, 2005has been restated to reflect the gross effect of the $27.5 million payment byPolycom to Avistar, and the payment

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of $6.4 million of contingent legal fees by us, whichwas previously reported on a net basis as deferred revenue. See Note 2 “Correction of an Error” of the Notesto Condensed Consolidated Financial Statements in Part I, Item 1.

**Valuationof Accounts Receivable**

Estimates are used indetermining our allowance for doubtful accounts and are based on our historicalcollection experience, historical write-offs, current trends, and the creditquality of our customer base and the characteristics of our accounts receivableby aging category. If the allowance for doubtful accounts were to beunderstated, our operating results would be negatively affected. The impact ofany such change or deviation may be increased by our reliance on a relativelysmall number of customers for a large portion of our total revenue. As ofDecember 31, 2005, three customers represented 48%, 32% and 17% of our grossaccounts receivable balance. As of June 30, 2006,  four customers represented 40%, 26%,17% and10% of our gross accounts receivable.

**Valuationof Inventories**

We record a provision forobsolete or excess inventory for systems and components that are no longermanufactured or are at risk of being replaced with new versions of our product.In determining the allowance for obsolete or excess inventory, we look at ourforecasted demand versus quantities on hand and commitments. Any significantunanticipated changes in demand or technological developments could have asignificant impact on the value of our inventory, commitments, and our reportedresults. If actual market conditions are less favorable than those projected,additional inventory write-downs, provision for purchase commitments andcharges against earnings may be required, which would negatively affect ouroperating results for that period.

**Stock Compensation**

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

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**Results of Operations**

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

 
| ** **                                         | ** ** | **Percentage of Total Revenue**  | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                         | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
| ** **                                         | ** ** | **2006**                                        | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | ** **                                      | ** ** | **Restated(1)** | ** ** | ** ** | ** ** | **Restated(1)** | ** ** |
| Revenue:                                           |       |                                            |       |   |   |   |   |   |   |
| Product                                            |       | 55                                              | %          | 40 | % | 51 | % | 51 | % |
| Licensing                                          |       | 2                                               |       | — |   | 2 |   | — |   |
| Services, maintenance and  support                 |       | 43                                              |       | 60 |   | 47 |   | 49 |   |
| Total revenue                                      |       | 100                                             |       | 100 |   | 100 |   | 100 |   |
| Costs and Expenses:                                |       |                                            |       |   |   |   |   |   |   |
| Cost of product revenue                            |       | 41                                              |       | 24 |   | 37 |   | 24 |   |
| Cost of services, maintenance  and support revenue |       | 22                                              |       | 39 |   | 28 |   | 30 |   |
| Income from settlement and  patent licensing       |       | (60                                             | )          | (79 | ) | (59 | ) | (65 | ) |
| Research and development                           |       | 82                                              |       | 53 |   | 75 |   | 41 |   |
| Sales and marketing                                |       | 84                                              |       | 61 |   | 77 |   | 46 |   |
| General and administrative                         |       | 147                                             |       | 101 |   | 134 |   | 81 |   |
| Total costs and expenses                           |       | 316                                             |       | 199 |   | 292 |   | 157 |   |
| Loss from operations                               |       | (216                                            | )          | (99 | ) | (192 | ) | (57 | ) |
| Other income (expense):                            |       |                                            |       |   |   |   |   |   |   |
| Interest income                                    |       | 4                                               |       | 5 |   | 5 |   | 7 |   |
| Other expense, net                                 |       | —                                          |       | — |   | (1 | ) | — |   |
| Total other income, net                            |       | 4                                               |       | 5 |   | 4 |   | 7 |   |
| Net  loss                                          |       | (212                                            | )%         | (94 | )% | (188 | )% | (50 | )% |

 

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(1) See Note 2 “Correction of an Error” of the Notes toCondensed Consolidated Financial Statements

**COMPARISON OF THE THREE MONTHSENDED JUNE 30, 2006 AND 2005**

** **

## ***Revenue***

Total revenues increased by $408,000, or 30%, to $1.8million for the three months ended June 30, 2006, compared to $1.3 millionfor the three months ended June 30, 2005. The increase was attributable toincreased revenues from product sales and licensing, partially offset by aslight decrease in services, maintenance and support revenues. For the three months ended June 30, 2006, revenuefrom three customers accounted for 85% of total revenue, each of whom accountedfor greater than 10% of total revenue. For the three months ended June 30,2005, revenue from two customers accounted for 82% of total revenue, each ofwhom accounted for greater than 10% of total revenue. We expect that there willbe significant customer concentration in future quarters.  The loss of any one of those customers wouldhave a material adverse impact on our financial condition and operatingresults.

 
|   | · |   | Product revenue  increased by $435,000, or 81%, to $970,000 for the three months ended  June 30, 2006, from $535,000 for the three months ended June 30, 2005.  The increase was due to increased purchasing of products for upgrading  existing infrastructure among our existing customer base, and increased sales  of products to new customers in the current quarter.  |
|--------|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 
|   | · |   | Licensing revenue,  which reflects the licensing of our patent portfolio, increased to $39,000  for the three months ended June 30, 2006, compared to no licensing revenues  for the three months ended June 30, 2005. The increase was primarily attributable  to new licensing agreements signed in 2006.   Licensing revenue during the three months ended September 30, 2006 is  expected to increase by $5.0 million due the licensing of our patent  portfolio to Sony and SCEI.  Licensing  revenue in future quarters may   dramatically increase or decrease dependent on the magnitude and  timing of third party licences to our patent portfolio. |
|--------|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 
|   | · |   | Services, maintenance  and support revenues, which include our installation services, funded  software development and maintenance and support, decreased by $66,000, or  8%, to $745,000 for the three months ended June 30, 2006, from $811,000  for the three months ended June 30, 2005. The decrease was primarily due to a  decrease in the dollar value of renewals for our annual maintenance and  support contracts and installation services. |
|--------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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## ***Costs and Expenses***

*Cost of product revenue*. Our costsof products include inventory and personneland related expenses for the assembly, testing and shipping of productssold. Cost of product revenues increased by $403,000, or 127%, to $721,000 forthe three months ended June 30, 2006, from $318,000 for the three monthsended June 30, 2005.  The increase was primarily attributable toincreased sales of our products and  anincrease in personnel and related expenses for the assembly, testing of theincreased products sold.

*Cost of services, maintenance andsupport revenues*. Our cost of services, maintenance and support revenuesincludes personnel and related expenses for our maintenance and supportservices,  an overhead allocation consisting primarily of that portion ofour facilities, communications and depreciation expenses that is attributableto providing these services, and  personnel and related expenses fromperforming installation services for our customers. Cost of services, maintenance and support revenuesdecreased by $140,000, or 27%, to $385,000 for the three months endedJune 30, 2006.  The decrease wasprimarily attributable to reduced installation and professional servicesactivities.

*Income from settlement and patent licensing.*****Income from settlement and patent licensing was$1.1 million for the three month periods ended June 30, 2006 and June 30, 2005,reflecting the amortization of the net proceeds from the November 2004 Polycomsettlement and cross-license agreement over a five year period beginning inNovember 2004 and ending in November 2009.

*Research and development.*****Research and development expenses increased by$739,000, or 105%, to $1.4 million for the three months ended June 30, 2006from $706,000 for the three months ended June 30, 2005. The increase wasprimarily attributable to an increase in personnel and related expenses,and to a lesser extent, an increase in stock based compensation of $150,000.

*Sales and marketing.* Sales and marketing expenses increased by$660,000, or 81%, to $1.5 million for the three months ended June 30, 2006 from$819,000 for the three months ended June 30, 2005. The increase was primarilyattributable to an increase in personnel and related expenses, and to alesser extent, an increase in stock based compensation of $120,000.

*General and administrative.* General and administrative expenses increased by$1.2 million, or 89% to $2.6 million for the three months ended June 30, 2006from $1.4 million for the three months ended June 30, 2005. The increasewas due primarily to the legal fees associated with our litigation againstTandberg for patent infringement, and to a lesser extent, an increase in stockbased compensation of $144,000.

*Otherincome, net.* Other income, net increased by $2,000, or 3% to$69,000 for the three months ended June 30, 2006 from $67,000 for the threemonths ended June 30, 2005.  The increasewas due to increased interest rates earned on our balances of cash equivalentsand short-term investments, offset by a decrease in the balances of cashequivalents and short-term investments on which we earned interest.

**COMPARISON OF THE SIX MONTHS ENDED JUNE 30, 2006AND 2005**

## ***Revenue***

Total revenue increased by $344,000, or 11%, to $3.6million for the six months ended June 30, 2006, from $3.3 million for thesix months ended June 30, 2005. The increase was primarily the result ofincreased product sales, and partially attributable to increased services,maintenance and support and licensing revenue. For the six months ended June 30, 2006, revenue from two customersaccounted for 75% of total revenue, each of whom accounted for greater than 10%of total revenue. For the six months ended June 30, 2005, revenue from twocustomers accounted for 79% of total revenue, each of whom accounted forgreater than 10% of total revenue. We expect that there will be significantcustomer concentration in future quarters. The loss of any one of those customers would have a material adverseimpact on our financial condition and operating results.

 
|   | · |   | Product revenue increased  by $185,000, or 11%, to $1.8 million for the six months ended June 30,  2006, from $1.7 million for the six months ended June 30, 2005. The increase  was due to increased purchasing of products to  upgrade existing infrastructure among our  existing customer base and increased sales of products to new customers in  the six month period ended June 30, 2006   as compared to the same period in 2005.  |
|--------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 
|   | · |   | Licensing revenue,  relating to the licensing of our patent portfolio, increased to $71,000 for  the six months ended June 30, 2006, compared to no licensing revenue for the  six months ended June 30, 2005. The increase was primarily attributable to  new licensing agreements signed in 2006. |
|--------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 
|   | · |   | Services, maintenance  and support revenue, which includes our installation services, funded  software development and maintenance and support, increased by $88,000, or  5%, to $1.7 million for the six months ended June 30, 2006, from $1.6  million for the three months ended June 30, 2005. The increase was primarily  due to increased funded software development revenue  offset by a decrease in the dollar value of  renewals of annual maintenance and support contracts and installation  revenues. |
|--------|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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*Cost of product revenue*. Cost ofproduct revenues increased by $585,000, or 76%, to $1.4 million for the sixmonths ended June 30, 2006, from $768,000 for the six months ended June30, 2005.  The increase was primarily attributable to increased sales of ourproducts and an increase in personnel and related expenses for the assembly andtesting of  our products.

*Cost of services, maintenance andsupport revenues*. Cost of services, maintenance and support revenues remained flat at $1.0million for the six months ended June 30, 2006 and June 30, 2005.  The six months ended June 30, 2006 includedan increase in software development costs associated with increased fundedsoftware revenue, offset by a reduction in installation and professionalservices activities.

*Income from settlement and patent licensing.*****Income from settlement and patent licensing was$2.1 million for the six month periods ended June 30, 2006 and June 30, 2005,reflecting the amortization of the net proceeds from the November 2004 Polycomsettlement and cross-license agreement over a five year period beginning in November2004 and ending in November 2009.

*Research and development.*****Research and development expenses increased by$1.4 million, or 102%, to $2.7 million for the six months ended June 30, 2006from $1.3 million for the six months ended June 30, 2005. The increase wasprimarily attributable to an increase in personnel and related expenses,and to a lesser extent, an increase in stock based compensation of $297,000.

*Sales and marketing.* Sales and marketing expenses increased by $1.3million, or 83%, to $2.8 million for the six months ended June 30, 2006 from$1.5 million for the six months ended June 30, 2005. The increase was primarilyattributable to an increase in personnel and related expenses, and to alesser extent, an increase in stock based compensation of $232,000.

*General and administrative.* General and administrative expenses increased by$2.2 million, or 83% to $4.8 million for the six months ended June 30, 2006from $2.6 million for the six months ended June 30, 2005. The increasewas due primarily to the legal fees associated with our litigation againstTandberg for patent infringement, and to a lesser extent, an increase in stockbased compensation of $322,000.

*Other income, net.* Other income,net decreased by $45,000, or 21% to $165,000 for the three months ended June30, 2006 from $210,000 for the three months ended June 30, 2005.  The decrease was due to a decrease in the balances of cash equivalents andshort-term investments on which we earned interest, offset in part by increasedinterest rates earned on our balances of cash equivalents and short-terminvestments.

**Liquidity and Capital Resources**

We had cash, cash equivalents and short and long-terminvestments of $6.6 million as of June 30, 2006, and $12.2 million as ofDecember 31, 2005. For the six months ended June 30, 2006, we had a netdecrease in cash, cash equivalents and short and long-term investments of $5.6million resulting primarily from a net loss of $6.8 million and a decrease indeferred income from settlement and patent licensing of $2.7 million, offset byan increase in accrued liabilities of $979,000 and deferred services revenue of$284,000, a decrease in deferred settlement and patent licensing costs of$658,000 and accounts receivable of $635,000, and non-cash expenses of $1.1 million, which included $973,000 innon-cash stock based compensation.

We had cash and cash equivalents of $4.3 million as ofJune 30, 2006 compared to cash and cash equivalents of $8.2 million as ofDecember 31, 2005. For the six months ended June 30, 2006, we had anoverall net cash outflow of $3.9 million, resulting primarily from net cashused in operations of $5.5 million offset by cash inflows from investingactivities of $1.4 million due to maturities of short-term marketablesecurities. The net cash used in operations of $5.5 million resulted from a netloss of $6.8 million and a decrease in deferred income from settlement andpatent licensing of $2.7 million, offset by an increase in accrued liabilitiesof $979,000 and deferred services revenue of $284,000, a decrease in deferredsettlement and patent licensing costs of $658,000 and accounts receivable of$635,000,  and non-cash expenses of $1.1million. The net cash inflow from investing activities of $1.4 million was dueto maturities of short-term marketable securities offset by the purchase ofequipment and leasehold improvements. The net cash inflow from financingactivities was $139,000, due to proceeds from issuance of common stock throughour employee stock option and purchase plans.

At June 30, 2006, we had open purchase orders andother contractual obligations of approximately $815,000 primarily related toinventory purchases. We also have commitments that consist of obligations underour operating leases. These purchase order commitments and contractualobligations are reflected in our financial statements once goods or serviceshave been received or payments related to the obligations become due.

On March 15, 2006, wesigned a new lease for 2,500 square feet of office space in London, UnitedKingdom to house our sales and operational personnel. The new office spacereplaces similar facilities vacated in March 2006. The new lease requiresminimum payments of approximately $112,000, $144,000, $144,000 and $80,000 forfiscal years 2006, 2007, 2008 and 2009, respectively.

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On May 11, 2005, CPI, ourwholly-owned subsidiary, commenced a patent infringement lawsuit againstTandberg ASA and Tandberg, Inc. alleging that several Tandbergvideoconferencing products infringe three patents held by CPI. The suit wasfiled in the United States District Court for the Northern District ofCalifornia.  Tandberg subsequently filed suit in Texas against Avistar andCPI.  The prosecution of this lawsuit andthe defense of  the  Tandberg claims requires us to expendsignificant financial and managerial resources and therefore may have amaterial negative impact on our business and financial condition.

We currently believe thatexisting cash and cash equivalents balances will provide us with sufficientfunds to finance our operations for the next 12 months. We intend to continueto invest in the development of new products and enhancements to our existingproducts. Our future liquidity and capital requirements will depend uponnumerous factors, including without limitation, general economic conditions andconditions in the financial services industry in particular, the level andtiming of product, services and patent licensing revenues and income, the costsand timing of our product development efforts and the success of thesedevelopment efforts, the costs and timing of our sales and marketingactivities, the extent to which our existing and new products gain marketacceptance, competing technological and market developments, and the costsinvolved in maintaining and enforcing patent claims and other intellectualproperty rights, all of which may impact our ability to achieve and maintainprofitability.

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

We develop products primarily in the United States and sell those products primarily in North America, Europe and Asia. International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 57% and 59% of total revenues for the three months ended June 30, 2006 and 2005, respectively.  International revenue comprised 53% and 58% of total revenues for the six months ended June 30, 2006 and 2005, respectively. As a result, our financial condition could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. As all of our sales are currently made in United States dollars, a strengthening of the United States dollar could make our products less competitive in foreign markets. We do not use derivative financial instruments for speculative or trading purposes, nor do we currently engage in any foreign currency hedging transactions.

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

**Cash, Cash Equivalents and Short-term investments**

Cashequivalents consist primarily of commercial paper and money market andmunicipal bond funds acquired with remaining maturity periods of three monthsor less, and are stated at cost, plus accrued interest that approximates marketvalue. We would not expect our operating results or cash flow to besignificantly impacted by the effect of sudden changes in market interest ratesgiven the nature of our short-term investments.

The following table providesinformation about our investment portfolio. For investment securities, thetable presents cash, cash equivalents and short-term investments, and relatedweighted average interest rates by category at June 30, 2006.

 

|                                                    | ** ** | **Amounts**             | ** ** | **Weighted Average  Interest Rate** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|-----------------------------------------------|------------|
| ** **                                         | ** ** | **(in thousands)** | ** ** | **(%)**                                       | ** ** |
| **Description**                                    |       |                    |       |                                          |       |
| Cash, cash equivalents and short-term investments: |       |                    |       |                                          |       |
| Cash                                               |       | $                       | 1,061      |                                          | —     |   |
| Commercial Paper and US  Government Agency Notes   |       | 5,491                   |       | 4.9                                           | %          |
| Fair  Value at June 30, 2006                       |       | $                       | 6,552      |                                          |       |   |

 

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

(a) Evaluation of disclosure controls and procedures: Our management , with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated 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

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Financial Officer have concluded that, as of the Evaluation Date, our disclosure controls and procedures (as defined in Rules13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act))  were effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act (i) is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure, and (ii) is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

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

**PART II- OTHER INFORMATION**

**Item 1. *Legal Proceedings***

On May 11, 2005, CPI, ourwholly-owned patent prosecution and licensing subsidiary, commenced a patentinfringement lawsuit against Tandberg ASA and Tandberg, Inc., alleging thatnumerous Tandberg videoconferencing products infringe three patents held byCPI. The suit was filed in the United States District Court for the NorthernDistrict of California. The three patents involved are U.S. Patent Nos.5,867,654; 5,896,500; and 6,212,547. These patents cover technologies relatingto video and data conferencing over unshielded twisted pair (UTP) networks,distributed call-state management, and separate monitors for simultaneouscomputer-based data sharing and videoconferencing. These technologies are corecomponents of the AvistarVOS video operating system. In this action, CPI hasrequested injunctive relief, damages to compensate for past and presentinfringement, treble damages, costs associated with the litigation and suchfurther relief as the Court deems just and proper. Both of the Tandberg entitiesanswered the complaint on July 15, 2005, at which time they asserted that theydid not infringe the patents and that the patents were invalid andunenforceable.

On January 30, 2006,Tandberg Telecom AS, a wholly-owned subsidiary of Tandberg ASA, filed a patentinfringement lawsuit against us and CPI in the United States District Court forthe Eastern District of Texas. The suit alleges that our videoconferencingproducts infringe one patent purchased by Tandberg Telecom AS. The patentinvolved is U.S. Patent No. 6,621,515, which claims a method and system forrouting video calls. In the Texas litigation, Tandberg Telecom AS has requestedinjunctive relief, monetary damages to compensate for its actual damages, costsassociated with the litigation and such further relief as the Court deems justand proper. We responded to the complaint on March 23, 2006, at which time weasserted that we did not infringe the patent, that the patent was invalid, andthat the claim was without merit. Tandberg filed a motion to dismiss one of ourdefenses, which the Texas court summarily denied.

Tandberg ASA andTandberg, Inc. sought to add two defenses, and provisionally filed two motionsfor summary judgment in the California litigation on January 13, 2006 andFebruary 24, 2006, respectively. Each proposed defense asserts that we aresubject to a different contractual provision that either totally precludes orlimits CPI’s remedies in the California litigation. Specifically, Tandbergalleged that (1) it had a license to the subject patents and (2) that Avistarhad released its claims against Tandberg with respect to the subject patents.Both motions for summary judgment were determined to be procedurally defectivein that Tandberg had not previously pled the contractual provisions as defensesto CPI’s claims. In the first matter, on January 13, 2006, Tandberg voluntarilyfiled a motion to amend its complaint to add a license defense. On March 29,2006, the court conditionally granted Tandberg’s motion, subject to thetransfer and addition of the Texas suit to the California litigation.  Tandberg filed a motion for reconsiderationof the court’s ruling on May 17, 2006, which was denied by the court on June28, 2006.  As of August 2, 2006, Tandberghas not dismissed its Texas litigation, thereby precluding the furtherconsideration of its motion for summary judgment on the basis of a “license”defense.

During a hearing on March20, 2006 concerning  Tandberg’s “release”defense, the court refused to permit Tandberg to amend its complaint, holdingthat Tandberg could not prevail on that defense, and thereby prohibitingTandberg from pursuing this defense in the California case.  A third motion for summary judgment was filedby Tandberg on April 17, 2006, claiming that CPI’s patents were invalid basedon the ruling of *IPXL Holdings, LLC v. Amazon.com, Inc.*  The court denied Tandberg’s motion on June23, 2006.

The Markman hearing forthe CPI claims, a pivotal stage of the litigation process at which timedefinitions are determined for the meaning of the patent claims language, washeld on May 24, 2006, and the judge issued her ruling on June 23, 2006.  A non-binding mediation related to theCalifornia case was held on May 12, 2006 without resolution.  A second non-binding mediation is currentlyscheduled for August 15, 2006. Discovery is on-going in the Californialitigation; the Texas case remains in its initial phases.  A jury trial date has not yet been scheduledfor either case.

The prosecution of thislawsuit and the defense of the Tandberg Telecom AS claim requires us to expendsignificant financial and managerial resources, and therefore may have amaterial negative impact on our business, financial condition and results ofoperations. The duration and ultimate outcome of these litigation proceedingsare uncertain.

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** **

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

**Factors Affecting Future Operating Results**

**Our marketis in the early stages of development, and our system may not be widelyaccepted.**

Ourability to achieve profitability depends in part on the widespread adoption ofnetworked video communications systems and the adoption of our video operatingsystem in particular. If the market for our system fails to grow or grows moreslowly 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 devotesubstantial resources to educating prospective customers about the uses andbenefits of our system. Our efforts to educate potential customers may notresult in our system achieving broad market acceptance. In addition, businessesthat have invested or may invest substantial resources in other video productsmay be reluctant or slow to adopt our system. Similarly, customers usingexisting systems in which they have made significant investments may refuse toadopt our system if they perceive that our offerings will not complement theirexisting systems. Consequently, the conversion from traditional methods ofcommunication to the extensive use of networked video may not occur as rapidlyas we wish.

**We haveincurred substantial losses in the past and may not be profitable in thefuture.**

We incurred net losses of$6.8 million for the six months ended June 30, 2006, $5.2 million for fiscalyear 2005 and $8.7 million for fiscal year 2004. As of June 30, 2006, ouraccumulated deficit was $101.4 million. Our revenue and income from settlementand patent licensing may not increase, or even remain at its current level. Inaddition, our operating expenses may increase as we continue to develop ourbusiness in the future. As a result, to become profitable, we will need toincrease our revenue by increasing sales to existing customers and byattracting additional customers. If our expenses increase more rapidly than ourrevenue, or if revenue and expense levels remain the same, we may never becomeprofitable. If we do become profitable, we may not be able to sustain orincrease profitability on a quarterly or annual basis. In addition, if we failto reach profitability or to sustain or grow our profits within the time frameexpected by investors, the market price of our common stock may be adverselyimpacted.

**General economic conditions have and may impactour revenues and harm our business in the future.**

Theinternational economic slowdown and the downturn in the investment bankingindustry that began in the year 2000 timeframe negatively affected ourbusiness, and a reoccurrence of a difficult economic environment may do so inthe future. During this most recent economic downturn, the investment bankingindustry suffered a sharp decline, which caused many of our existing andpotential customers to cancel or delay orders for our products. Although theU.S. economy has improved, our customers and potential customers may continueto delay ordering our products, and we could fall short of our revenueexpectations for 2006 and beyond. Slower growth among our customers, tighteningof customers’ operating budgets, retrenchment in the capital markets and othergeneral economic factors all have had and could in the future have a materiallyadverse effect on our revenue, capital resources, financial condition andresults of operations.

**Our lengthysales cycle to acquire new customers or large follow-on orders may cause ouroperating results to vary significantly and make it more difficult to forecastour revenue.**

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

Ourlengthy sales cycle is one of the factors that has caused, and may in thefuture continue to cause, our operating results to vary significantly fromquarter to quarter and year to year. This makes it difficult for us to forecastrevenue, and could cause volatility in the market price of our common stock. Alost or delayed order could result in lower revenue than expected in aparticular quarter or year.

**Futurerevenues and income are difficult to predict for several reasons, including ourlengthy and costly licensing cycle, and our failure to predict revenues andincome accurately may cause us to miss analysts’ estimates  and result in our stock price declining.**

Because our licensingcycle is a lengthy process, the accurate prediction of future revenues andincome from settlement and patent licensing from new licensees is difficult. Byway of example, the process of persuading companies to adopt our technologiesor convincing them that their products infringe our intellectual propertyrights can be lengthy. There is also a tendency in the technology industry toclose business deals at the end of a quarter, thereby increasing the likelihoodthat a possible material deal would not be concluded in the current quarter,but slip into a subsequent reporting perid. This kind of delay may result in a given quarter’s

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performance being below analyst or shareholderexpectation.  The proceeds of ourlicensing and enforcement efforts tend to be sporadic and difficult topredict.  Recognition of such proceeds asrevenue or income from settlement and licensing activities depends on the termsof the license agreement involved and the circumstances surrounding theagreement.  As a result, our licensingand enforcement efforts are expected to result in significant volatility in ourquarterly financial condition and results of operations, which may result in usmissing investor expectations, which would likely cause our stock price todecline.

**Since amajority of our revenue has come from follow-on orders, our financialperformance could be harmed if we fail to obtain follow-on orders in thefuture.**

Ourcustomers typically place limited initial orders for our networked videocommunications system, as they seek to evaluate its usefulness and value. Ourstrategy is to pursue additional and larger follow-on orders after theseinitial orders. Revenue generated from follow-on orders accounted forapproximately 92% and 99% of our revenue for the six months ended June 30, 2006and 2005, respectively. Our future financial performance depends on successfulinitial installations of our system and successful generation of follow-on ordersas the Avistar network expands within a customer organization. If our systemdoes not meet the needs and expectations of customers, we may not be able togenerate follow-on orders.

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

To date, a significantportion of our revenue and income from settlement and patent licensing hasresulted from sales and licensing to a limited number of customers,particularly Deutsche Bank AG, UBS Warburg LLC, Polycom, Inc. and theiraffiliates. Since November 12, 2004, income from settlement and patentlicensing has come solely from our settlement and patent licensing agreementwith Polycom. Collectively, Polycom, Deutsche Bank AG and UBS Warburg LLC andtheir affiliates accounted for approximately 85% and 87% of total revenues andincome from settlement and patent licensing for the six month periods ended June30, 2006 and June 30, 2005, respectively. As of June 30, 2006, approximately 93% of our gross accounts receivablewas concentrated with four customers, each of whom represented more than 10% ofour gross accounts receivable. As of December 31, 2005, approximately 97%of our gross accounts receivable was concentrated with three customers, each ofwhom represented more than 10% of our gross accounts receivable.

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

**We may notbe able to modify and improve our products in a timely and cost effectivemanner to respond to technological change and customer demands.**

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

·                  rapidtechnological change;

·                  the emergence ofnew competitors;

·                  significant development costs;

·                  changes in the requirements of our customers andtheir communities of users;

·                  evolving industry standards; and

·                  transition to Internet protocol connectivity forvideo at the desktop, with increasing availability of bandwidth and quality ofservice.

Oursystem is designed to work with a variety of hardware and softwareconfigurations and data networking infrastructures used by our customers. Themajority of these customer networks rely on Microsoft Windows servers. However,our software may not operate correctly on other hardware and software platformsor with other programming languages, database environments and systems that ourcustomers use. Also, we must constantly modify and improve our system to keeppace with changes made to our customers’ platforms, data networkinginfrastructures, and their evolving ability to transport video and otherapplications. This may result in uncertainty relating to the timing and natureof our new release announcements, introductions or modifications, which in turnmay cause confusion in the market, with a potentially harmful effect on ourbusiness. If we fail to promptly modify or improve our system in response toevolving industry standards or customers’ demands, our system could become lesscompetitive, which would harm our financial condition and reputation.

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**Difficultiesor delays in installing our products could harm our revenue and margins.**

Werecognize revenue upon the installation of our system in those cases where weare responsible for installation, which often entails working withsophisticated software and computing and communications systems. If weexperience difficulties with installation or do not meet deadlines due todelays caused by our customers or ourselves, we could be required to devotemore customer support, technical and other resources to a particularinstallation. If we encounter delays in installing our products for new orexisting customers or installation requires significant amounts of ourprofessional services support, our revenue recognition could be delayed, ourcosts could increase and our margins could suffer.

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

Currently, our competitioncomes from many other kinds of companies, including communication equipment,integrated solution, broadcast video and stand-alone point solution providers.Within the video-enabled network communications market, we compete primarilyagainst Polycom, Tandberg Inc. and Emblaze-VCON Ltd. We believe we face increasingcompetition from alternative video communications solutions that employ newtechnologies or new combinations of technologies from companies such as CiscoSystems, Inc., Avaya, Inc., Microsoft Corporation, Nortel Networks Corporationand WebEx Communications, Inc., that enable web-based or network-based videocommunications with low-cost digital camera systems. The market in which weoperate is highly competitive. In addition, because our industry is relativelynew and one which is characterized by rapid technological change, evolving userneeds, developing industry standards and protocols and the introduction of newproducts and services, it is difficult for us to predict whether or when newcompeting technologies or new competitors will enter our market.

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

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

**Infringementof our proprietary rights could affect our competitive position, harm ourreputation or cost us money.**

Weregard our system as open but proprietary. In an effort to protect ourproprietary rights, we rely primarily on a combination of patent, copyright,trademark and trade secret laws, as well as licensing, non-disclosure and otheragreements with our consultants, suppliers, customers and employees. However,these laws and agreements provide only limited protection of our proprietaryrights. In addition, we may not have signed agreements in every case and thecontractual provisions that are in place and the protection they produce maynot provide us with adequate protection in all circumstances. Although CPIholds patents and has filed patent applications covering some of the inventionsembodied in our systems, our means of protecting our proprietary rights may notbe adequate. It may be possible for a third party to copy or otherwise obtainand use our technology without authorization and without our detection. Inthe event that we believe a third party is infringing our intellectual propertyrights, an infringement claim brought by us could, regardless of the outcome,result in substantial cost to us, divert our management’s attention andresources, be time consuming to prosecute and result in unpredictable damageawards. A third party may also developsimilar technology independently, without infringing upon our patents andcopyrights. In addition, the laws of some countries in which we sell our systemmay not protect our software and intellectual property rights to the sameextent as the laws of the United States or other countries where we holdpatents. Unauthorized copying, use or reverse engineering of our system couldharm our business, financial condition or results of operations.

**We have filed a complaintalleging patent infringement against Tandberg ASA and Tandberg, Inc.  The prosecution of  this lawsuit and our defense of Tandberg’s claims require us to expend significantfinancial and managerial resources and may have a material negative impact onour business.   If we do not prevail, wemay be required to pay monetary damages.**

On May 11, 2005, CPI, ourwholly-owned patent prosecution and licensing subsidiary, commenced a patentinfringement lawsuit against Tandberg ASA and Tandberg, Inc. alleging thatseveral Tandberg videoconferencing products infringe three patents held by CPI.The suit was filed in the United States District Court for the NorthernDistrict of California.  The three patentsinvolved are U.S. Patent Nos. 5,867,654; 5,896,500; and 6,212,547.  These patents cover technologies relating tovideo and data conferencing over unshielded twisted pair (UTP) networks,distributed call-state management and separate monitors for simultaneouscomputer-based data sharing and videoconferencing. These technologies are corecomponents of the AvistarVOS video operating system.  In this action, CPI has requested injunctiverelief, damages to compensate for past and present infringement, trebledamages, costs associated with the litigation and such further relief as theCourt deems just and proper. Both of the Tandberg entities answered thecomplaint on July 15, 2005, at which time they asserted that they did notinfringe the patents and that the patents were invalid and unenforceable.

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The prosecution of this lawsuit  and our defense ofTandberg’s claims require us and CPI to expend significant financial andmanagerial resources, and therefore may have a material negative impact on ourbusiness, financial condition and results of operations.  The duration and ultimate outcome of theselitigation proceedings are uncertain.

**Others maybring infringement claims against us, which could be time-consuming andexpensive to defend.**

In recent years, therehas been significant litigation in the United States involving patents andother intellectual property rights and we have been a party to such litigation.On January 30, 2006, Tandberg Telecom AS, a wholly-owned manufacturing andpatent holding subsidiary of Tandberg ASA, filed a patent infringement lawsuitagainst Avistar in the United States District Court for the Eastern District ofTexas. The suit alleges that Avistar videoconferencing products infringe onepatent purchased by Tandberg Telecom AS. The patent involved is U.S. Patent No.6,621,515, which covers a method and system for routing video calls. In thisaction, Tandberg Telecom AS has requested injunctive relief, money damages tocompensate for its actual damages, costs associated with the litigation andsuch further relief as the Court deems just and proper. We responded to thecomplaint on March 23, 2006, at which time we asserted that we did not infringethe patent and that the patent was invalid. The prosecution of this lawsuit anddefense of the Tandberg claims require us and CPI to expend significantfinancial and managerial resources, and therefore may have a material negativeimpact on our financial position and results of operations. The duration andultimate outcome of these proceedings are uncertain. We may be a party toadditional litigation in the future, to protect our intellectual property or asa result of an alleged infringement of the intellectual property of others.These claims and any resulting lawsuit, could subject us to significantliability for damages and invalidation of proprietary rights. These lawsuits,regardless of their success, would likely be time-consuming and expensive toresolve and would divert management’s time and attention. Any potentialintellectual property litigation also could force us to do one or more of thefollowing:

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

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

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

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

**Ourinability to protect the intellectual property created by us would cause ourbusiness to suffer.**

We rely on a combinationof license, development and nondisclosure agreements, trademark, trade secretand copyright law, and contractual provisions to protect our other,non-patentable intellectual property rights. If we fail to protect theseintellectual property rights, our licensees, potential licensees and others mayseek to use our technology without the payment of license fees and royalties,which could weaken our competitive position, reduce our operating results andincrease the likelihood of costly litigation. The growth of our businessdepends in part on the applicability of our intellectual property to theproducts of third parties, and our ability to enforce intellectual propertyrights against them. In addition, effective trade secret protection may be unavailableor limited in certain foreign countries. Although we intend to protect ourrights vigorously, if we fail to do so, our business will suffer.

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

Oursystem may contain errors or defects, especially when new products areintroduced or when new versions are released. Despite internal system testing,we have in the past discovered software errors in some of the versions of oursystem after their introduction. Errors in new systems or versions could befound after commencement of commercial shipments, and this could result inadditional development costs, diversion of technical and other resources fromour other development efforts or the loss of credibility with current or futurecustomers. Any of these events could result in a loss of revenue or a delay inmarket acceptance of our system and could harm our reputation.

Inaddition, we have warranted to some of our customers that our software is freeof viruses. If a virus infects a customer’s computer software, the customercould assert claims against us, which, regardless of their merits, could becostly to defend and could require us to pay damages and potentially harm ourreputation.

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

The third party software we license with our systemmay also contain errors or defects for which we do not maintain insurance.

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Typically, our license agreements transfer anywarranty from the third party to our customers to the extent permitted. Productliability, warranty or other claims brought against us with respect to suchwarranties could, regardless of their merits, harm our business, financialcondition or results of operations.

**The loss ofany of our outside contract manufacturers or third party equipment suppliersthat produce key components of our system could significantly disrupt our manufacturingand new product development process.**

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

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

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

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

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

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

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

Ifthese manufacturers or suppliers cease to provide us with the assistance or thecomponents necessary for the operation of our business, we may not be able toidentify alternate sources in a timely fashion. Any transition to alternatemanufacturers or suppliers would likely result in operational problems andincreased expenses, and could cause delays in the shipment of or otherwiselimit our ability to provide our products. We cannot assure you that we wouldbe able to enter into agreements with new manufacturers or suppliers oncommercially reasonable terms, or at all. Any disruption in product flow maylimit our revenue, delay our product development, seriously harm ourcompetitive position and/or result in additional costs or cancellation oforders by our customers.

**If we areunable to expand our direct sales force and/or add distribution channels, ourbusiness will suffer.**

Toincrease our revenue, we must increase the size of our direct sales force andadd indirect distribution channels, such as systems integrators, productpartners and/or value-added resellers, and/or effect sales through ourcustomers. If we are unable to maintain or increase our direct sales force oradd indirect distribution channels due to our own cost constraints, limitedavailability of qualified personnel or other reasons, our future revenue growthmay be limited and our future operating results may suffer. We cannot assureyou that we will be successful in attracting, integrating, motivating andretaining sales personnel. Furthermore, it can take several months before a newhire becomes a productive member of our sales force. The loss of existingsalespeople, or the failure of new salespeople and/or indirect sales partnersto develop the necessary skills in a timely manner, could reduce our revenuegrowth.

**We may notbe able to retain our existing key personnel, or hire and retain the additionalpersonnel that we need to sustain and grow our business.**

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

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

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**Our planscall for growth in our business, and our inability to achieve or manage growthcould harm our business.**

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

**Ourinternational operations expose us to potential tariffs and other tradebarriers, unexpected changes in foreign regulatory requirements and laws andeconomic and political instability, as well as other risks that could adverselyaffect our results of operations.**

International revenue,which consists of sales to customers with operations principally in WesternEurope and Asia, comprised 57% and 59% of total revenues for the three months endedJune 30, 2006 and 2005, respectively. International revenue comprised 53% and 58% of total revenues for thesix months ended June 30, 2006 and 2005, respectively. Some of the risks we mayencounter in conducting international business activities include thefollowing:

·                  tariffs and other trade barriers;

·                  unexpected changes in foreign regulatoryrequirements and laws;

·                  economic and political instability;

·                  increased risk of infringement claims;

·                  protection of our intellectual property;

·                  restrictions on the repatriation of funds;

·                  potentially adverse tax consequences;

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

·                  fluctuations in foreign currencies; and

·                  limitations in communications infrastructures insome foreign countries.

Some of our products aresubject to various federal, state and international laws governing substancesand materials in products, including those restricting the presence of certainsubstances in electronics products. We could incur substantial costs, includingfines and sanctions, or our products could be enjoined from entering certainjurisdictions, if we were to violate environmental laws or if our products becomenon-compliant with environmental laws. We also face increasing complexity inour product design and procurement operations as we adjust to new and futurerequirements relating to the materials composition of our products, includingthe restrictions on lead and certain other substances that will apply tospecified electronics products sold in the European Union as of July 1,2006 (Restriction of Hazardous Substances Directive). The ultimate costs underenvironmental laws and the timing of these costs are difficult to predict.Similar legislation has been or may be enacted in other regions, including inthe United States, the cumulative impact of which could be significant.

**Internationalpolitical instability may increase our cost of doing business and disrupt ourbusiness.**

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

**If ourcustomers do not perceive our system or services to be effective or of highquality, our brand and name recognition would suffer.**

We believe thatestablishing and maintaining brand and name recognition is critical forattracting and expanding our targeted customer base. We also believe that theimportance of reputation and name recognition will increase as competition inour market increases. Promotion and enhancement of our name will depend on thesuccess of our marketing efforts, and on our ability to continue to providehigh quality systems and services, neither of which can be assured. If ourcustomers do not perceive our system or services to be effective or of highquality, our brand and name recognition will suffer, which would harm ourbusiness.

**We may notmeet the continued listing criteria for the NASDAQ Capital Market, which couldmaterially adversely affect the price and liquidity of our stock, our businessand our financial condition.**

For continued listing of our common stock on TheNASDAQ Capital Market, we are required to, among other things (i) maintainstockholders’ equity of at least $2.5 million, or a market value of listedsecurities of at least $35 million or annual net income from continuingoperations of at least $500,000, and (ii) maintain a minimum closing bid priceof our common stock of at least $1.00. If we do not meet the continued listing requirements, our common stockcould be subject to delisting from trading on The NASDAQ Capital

 

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Market.  There can be no assurance that we willcontinue to meet all requirements for continued listing on The NASDAQ CapitalMarket.

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

**Our commonstock has been and will likely continue to be subject to substantial price andvolume fluctuations due to a number of factors, many of which will be beyondour control, which may prevent our stockholders from reselling our common stockat a profit.**

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

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

·                  quarterly variations in our results ofoperations;

·                  announcements regarding our product developments;

·                  the size and timing of agreements to license ourpatent portfolio;

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

·                  announcements of competitive productintroductions by our competitors;

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

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

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

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

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

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

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

**Provisionsof our certificate of incorporation, our bylaws and Delaware law may make itdifficult for a third party to acquire us, despite the possible benefits to ourstockholders.**

Ourcertificate of incorporation, our bylaws and Delaware law contain provisionsthat may inhibit changes in our control that are not approved by our Board ofDirectors. For example, the Board of Directors has the authority to issue up to10,000,000 shares of preferred stock and to determine the terms of thispreferred stock, without any further vote or action on the part of thestockholders.

Theseprovisions may have the effect of delaying, deferring or preventing a change inour control despite possible benefits to our stockholders, may discourage bidsat a premium over the market price of our common stock, and may adverselyaffect the market price of our common stock and the voting and other rights ofour stockholders.

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

Our executive officers,directors and entities affiliated with them, in the aggregate, beneficiallyowned approximately  63% of our commonstock as of June 30, 2006. If they were to act together, these stockholderswould be able to exercise control over most matters requiring approval by ourstockholders, including the election of directors and approval of significantcorporate transactions. These actions may be taken even if they are opposed byother investors. This concentration of ownership may also have the effect ofdelaying or preventing a change in control of our company, which could causethe market price of our common stock to decline.

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

In December 2004, theFASB issued SFAS No. 123R, *Share-Based Payment*.SFAS No. 123R requires employee stock options and rights to purchase sharesunder stock participation plans to be accounted for under the fair valuemethod, and eliminates the ability to account for these instruments under theintrinsic value method prescribed by APB Opinion No. 25, and allowed under theoriginal provisions of SFAS No. 123. SFAS No. 123R requires the use of anoption pricing model for estimating fair value, which is amortized to expense overthe service periods. The requirements of SFAS No. 123R were effective beginningin the first quarter of an issuer’s first fiscal year commencing after June 15,2005, which for us was our fiscal quarter beginning January 1, 2006. We haveadopted the provisions of SFAS No. 123R using the modified prospectiveapplication. Under a modified prospective application, SFAS No. 123R applies tonew awards, unvested awards, and to awards that are outstanding on theeffective date and are subsequently modified or cancelled. Compensation expensefor outstanding awards for which the requisite service had not been rendered asof December 31, 2005 are expected to be recognized over the remaining serviceperiod using the compensation cost calculated for pro forma disclosure purposesunder SFAS No. 123. The new method of valuing stock-based compensation, asprescribed in SFAS 123R, will be applied to the valuation of stock-based awardsgranted after our adoption of SFAS 123R on January 1, 2006. The impact of therecognition of compensation expense related to such awards was $498,000 and$973,000 for the three and six months ended June 30, 2006. The impact of stockbased compensation in future periods will vary depending on new optionsgranted, and the assumptions used in the Black-Scholes-Merton model used todetermine fair value of options granted, in conjunction with our employee’shistorical option exercise and forfeiture behavior. The assumptions includedividend rate, risk-free interest rate, expected term of the option,volatility, exercise price and the price of our stock on the date of valuation.

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

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

At our Annual Meeting of Stockholders held June 1,2006 at our offices in Redwood Shores, California, our stockholders approvedthe following matters:

1. A proposal to elect seven (7) directors of theCompany to serve for the ensuing year and until their successors are elected oruntil such director’s earlier resignation or removal.

 

| Nominee              | ** ** | **For**    | ** ** | **Against** | ** ** | **Abstentions  and Broker  Non-Votes** | ** ** |
|----------------------|------------|------------|------------|-------------|------------|---------------------------------------------|------------|
| Gerald J.  Burnett   |       | 22,405,731 |       |        |       | 285,167                                     |       |
| William L.  Campbell |       | 22,405,731 |       |        |       | 285,167                                     |       |
| R. Stephen Heinrichs |       | 56,949,708 |       |        |       | 967,654                                     |       |
| Robert P. Latta      |       | 22,359,266 |       |        |       | 331,632                                     |       |
| Robert M.  Metcalfe  |       | 22,359,266 |       |        |       | 331,632                                     |       |
| Craig F. Heimark     |       | 22,410,373 |       |        |       | 280,525                                     |       |
| James W. Zeigon      |       | 22,410,373 |       |        |       | 280,525                                     |       |

 

2. A proposal to ratify the appointment of Burr, Pilger & Mayer,LLP as our independent auditors for the fiscal year ending December 31, 2006.

 

| For        | ** ** | **Against** | ** ** | **Withheld** | ** ** |
|------------|------------|-------------|------------|--------------|------------|
| 27,712,750 |       | 10,400      |       | 100          |       |

 

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**Item 5. *Other Information***

On April 13, 2006,Avistar notified The NASDAQ Capital Market that it did not expect to file itsAnnual Report on Form 10-K with the SEC on or prior to the extended filingdeadline of April 17, 2006. The Company notified The NASDAQ Stock Marketthat beginning on April 17, 2006, it expected to be out of compliance withNASDAQ’s continued listing standard set forth in NASDAQ MarketplaceRule 4310(c)(14). As a result of this noncompliance, Avistar received anotice from The NASDAQ Capital Market to the effect that, due to suchnoncompliance, Avistar’s common stock would be subject to delisting. Uponreceipt of the delisting notice, Avistar requested a hearing before a NASDAQListing Qualifications Panel (the “Panel”) to appeal NASDAQ staff’sdetermination. The hearing request automatically stayed the delisting of Avistar’scommon stock pending the Panel’s decision. Avistar filed its Annual Report onForm 10-K on April 28, 2006. On May 5, 2006, Avistar received a written noticefrom NASDAQ indicating that, in light of the filing of Avistar’s Annual Report,the delisting hearing was moot and the delisting process had been cancelled.

On July 14, 2006, Avistar CommunicationsCorp. and its wholly-owned subsidiary, Collaboration Properties, Inc., enteredinto a Patent License Agreement with Sony Corporation (Sony), a Japanesecorporation, and Sony Computer Entertainment, Inc. (SCEI), a Japanesecorporation.  Under the license agreement, CPI granted Sony and itssubsidiaries a license to all of CPI’s patents with a filing date on or beforeJanuary 1, 2006 for the specific field of use relating to video conferencing.The license covers Sony’s video conferencing apparatus as well as otherproducts, including video-enabled personal computer products and certain SCEIPlayStation products.  As partialconsideration for the licenses granted under the agreement, Sony agreed to makean upfront license payment of $5,000,000 to Avistar and SCEI agreed to makefuture royalty payments to Avistar relating to the sale in certain countries,including the United States, of certain SCEI products.

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**Item 6. *Exhibits***

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

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**SIGNATURES**

Pursuant to the requirements ofthe Securities and Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized,on this 4th day ofAugust 2006.

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

 

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**EXHIBITINDEX**

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

 

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