**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

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

 

**Forthe quarterly period ended March 31, 2004**

 

**OR**

 

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

 

**Forthe transition period from              to               **

 

**Commissionfile number:  000-31121**

 

**AVISTARCOMMUNICATIONS CORPORATION**

(Exact name ofregistrant 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 ofPrincipal Executive Offices) (Zip Code)

 

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

 

**Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities and Exchange Act of 1934 during the preceding 12 months (or forshorter period that the registrant was required to file such reports); and (2)has been subject to such filing requirements for the past 90 days.**

 

**Yes****ý     No****o**

 

**Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Act).**

 

**Yes****o     No****ý**

 

**At March 31, 2004, 33,277,038 shares ofcommon stock of the Registrant were outstanding.**

 

 

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**AVISTARCOMMUNICATIONS CORPORATION**

 

**INDEX**

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

 

2

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**PART I -FINANCIAL INFORMATION**

 

**Item 1. *FinancialStatements***

 

**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**as of March31, 2004 and December 31, 2003**

**(inthousands, except share and per share data)**

 
|                                                                                                                                                                                                    |   | **March 31,  2004** |   | **December  31,  2003** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|--------|-------------------------|--------|
|                                                                                                                                                                                                    |   | **(unaudited)**     |   |
| **Assets:**                                                                                                                                                                                             |   |                |   |                    |   |
| Current assets:                                                                                                                                                                                         |   |                |   |                    |   |
| Cash and cash equivalents                                                                                                                                                                               |   | $                   | 7,481  |                    | $      | 5,438 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $44 at March 31, 2004 and December 31, 2003                                                                                             |   | 733                 |   | 695                     |   |
| Inventories, including inventory shipped to  customers’ sites, not yet installed of $28 at March 31, 2004 and $41 at  December 31, 2003                                                            |   | 882                 |   | 937                     |   |
| Prepaid expenses and other current assets                                                                                                                                                               |   | 494                 |   | 515                     |   |
| Total current assets                                                                                                                                                                                    |   | 9,590               |   | 7,585                   |   |
| Property and equipment, net                                                                                                                                                                             |   | 376                 |   | 352                     |   |
| Other assets                                                                                                                                                                                            |   | 291                 |   | 291                     |   |
| Total assets                                                                                                                                                                                            |   | $                   | 10,257 |                    | $      | 8,228 |   |
|                                                                                                                                                                                                    |   |                |   |                    |   |
| **Liabilities and Stockholders’ Equity:**                                                                                                                                                          |   |                |   |                    |   |
| Current liabilities:                                                                                                                                                                                    |   |                |   |                    |   |
| Accounts payable                                                                                                                                                                                        |   | $                   | 1,136  |                    | $      | 941 |   |
| Deferred revenue and customer deposits                                                                                                                                                                  |   | 1,147               |   | 671                     |   |
| Accrued liabilities and other                                                                                                                                                                           |   | 903                 |   | 1,125                   |   |
| Total current liabilities                                                                                                                                                                               |   | 3,186               |   | 2,737                   |   |
| Stockholders’ equity:                                                                                                                                                                              |   |                |   |                    |   |
| Common stock, $0.001 par value; 250,000,000  shares authorized at March 31, 2004 and December 31, 2003; 34,456,663 and  31,390,383 shares issued at March 31, 2004 and December 31, 2003,  respectively |   | 34                  |   | 31                      |   |
| Less: treasury common stock, 1,179,625  shares at March 31, 2004 and December 31, 2003, at cost                                                                                                         |   | (51                 | )      | (51                     | )      |
| Additional paid-in-capital                                                                                                                                                                              |   | 89,943              |   | 86,278                  |   |
| Accumulated deficit                                                                                                                                                                                     |   | (82,855             | )      | (80,767                 | )      |
| Total stockholders’ equity                                                                                                                                                                         |   | 7,071               |   | 5,491                   |   |
| Total liabilities and stockholders’ equity                                                                                                                                                         |   | $                   | 10,257 |                    | $      | 8,228 |   |

 

The accompanying notes are an integral partof these financial statements.

 

3

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**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**for thethree months ended March 31, 2004 and 2003**

**(inthousands, except per share data)**

 
|                                                                                 |   | **Three  Months Ended** |   |
|--------------------------------------------------------------------------------------|--------|-------------------------|--------|
|                                                                                 |   | **March 31,  2004**     |   | **March 31,  2003** |   |
|                                                                                 |   | **(unaudited)**         |   |
| Revenue:                                                                             |   |                    |   |   |   |
| Product                                                                              |   | $                       | 562    |   | $ | 801 |   |
| Services, maintenance and support                                                    |   | 842                     |   | 862 |   |
| Total revenue                                                                        |   | 1,404                   |   | 1,663 |   |
| Cost of revenue:                                                                     |   |                    |   |   |   |
| Product                                                                              |   | 292                     |   | 386 |   |
| Services, maintenance and support                                                    |   | 482                     |   | 567 |   |
| Total cost of revenue                                                                |   | 774                     |   | 953 |   |
| Gross margin                                                                         |   | 630                     |   | 709 |   |
| Operating Expenses:                                                                  |   |                    |   |   |   |
| Research and development                                                             |   | 624                     |   | 696 |   |
| Sales and marketing                                                                  |   | 608                     |   | 971 |   |
| General and administrative                                                           |   | 1,505                   |   | 1,702 |   |
| Amortization of deferred stock compensation  *****                                   |   | —                  |   | 45 |   |
| Total operating expenses                                                             |   | 2,737                   |   | 3,414 |   |
| Loss from operations                                                                 |   | (2,107                  | )      | (2,705 | ) |
| Other income (expense):                                                              |   |                    |   |   |   |
| Interest income                                                                      |   | 13                      |   | 19 |   |
| Other income (expense), net                                                          |   | 6                       |   | (5 | ) |
| Total other income, net                                                              |   | 19                      |   | 14 |   |
| Net loss                                                                             |   | $                       | (2,088 | ) | $ | (2,690 | ) |
|                                                                                 |   |                    |   |   |   |
| Net loss per share - basic and diluted                                               |   | $                       | (0.07  | ) | $ | (0.11 | ) |
| Weighted average shares used in calculating  basic and diluted net loss per share    |   | 30,450                  |   | 25,321 |   |
|                                                                                 |   |                    |   |   |   |
|                                                                                      |
| * Amortization of deferred stock  compensation excluded from the following expenses: |   |                    |   |   |   |
| Cost of revenue                                                                      |   | $                       | — |   | $ | 5 |   |
| Research and development                                                             |   | —                  |   | 4 |   |
| Sales and marketing                                                                  |   | —                  |   | 35 |   |
| General and administrative                                                           |   | —                  |   | 1 |   |
|                                                                                 |   | $                       | — |   | $ | 45 |   |

 

The accompanying notes are an integral partof these financial statements.

 

4

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**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**for thethree months ended March 31, 2004 and 2003**

**(inthousands)**

 
|                                                                         |   | **Three  Months Ended** |   |
|------------------------------------------------------------------------------|--------|-------------------------|--------|
|                                                                         |   | **March 31,  2004**     |   | **March 31,  2003** |   |
|                                                                         |   | **(unaudited)**         |   |
|                                                                         |   |                    |   |   |   |
| Cash Flows from Operating Activities:                                        |   |                    |   |   |   |
| Net loss                                                                     |   | $                       | (2,088 | ) | $ | (2,690 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |   |                    |   |   |   |
| Depreciation                                                                 |   | 68                      |   | 51 |   |
| Stock-based compensation                                                     |   | —                  |   | 45 |   |
| Compensation on options issued to  consultants                               |   | 6                       |   | 9 |   |
| Provision for doubtful accounts                                              |   | —                  |   | 15 |   |
| Changes in current assets and liabilities:                                   |   |                    |   |   |   |
| Accounts receivable                                                          |   | (38                     | )      | (253 | ) |
| Inventories                                                                  |   | 55                      |   | 41 |   |
| Prepaid expenses and other current assets                                    |   | 21                      |   | 214 |   |
| Accounts payable                                                             |   | 195                     |   | 569 |   |
| Deferred revenue and customer deposits                                       |   | 476                     |   | 559 |   |
| Accrued liabilities and other                                                |   | (222                    | )      | (175 | ) |
| Net cash used in operating activities                                        |   | (1,527                  | )      | (1,615 | ) |
|                                                                         |   |                    |   |   |   |
| Cash Flows from Investing Activities:                                        |   |                    |   |   |   |
| Sale of short-term investments                                               |   | —                  |   | 1,900 |   |
| Purchase of property and equipment                                           |   | (92                     | )      | (17 | ) |
| Net cash provided by (used in) investing  activities                         |   | (92                     | )      | 1,883 |   |
|                                                                         |   |                    |   |   |   |
| Cash Flows from Financing Activities:                                        |   |                    |   |   |   |
| Proceeds from issuance of common stock                                       |   | 3,662                   |   | 35 |   |
| Net cash provided by financing activities                                    |   | 3,662                   |   | 35 |   |
| Net increase in cash and cash equivalents                                    |   | 2,043                   |   | 303 |   |
| Cash and cash equivalents, beginning of  period                              |   | 5,438                   |   | 4,783 |   |
| Cash and cash equivalents, end of period                                     |   | $                       | 7,481  |   | $ | 5,086 |   |
|                                                                         |   |                    |   |   |   |
| Supplemental Cash Flow Information:                                          |   |                    |   |   |   |
| Cash paid for income taxes                                                   |   | $                       | 14     |   | $ | — |   |

 

The accompanying notes are an integral partof these financial statements.

 

5

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**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIES**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

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

 

# **Business**

 

Avistar Communications Corporation (“Avistar” or the “Company”)provides the Avistar vBusiness integrated suite of video-enabledapplications, including networked videocommunications software and hardware products and services. Avistar’s productsinclude applications for interactive video calling, content creation andpublishing, broadcast video and video-on-demand, as well as data sharing,directory services and network management. Avistar designs, develops, markets,sells, manufactures and/or assembles and installs and supports its products.Avistar’s real-time and non-real-time products are based upon its architectureand Video Operating System (AvistarVOSTM) platform, which facilitatesdistribution over local and wide area networks using telephony or Internetservices as appropriate.  Avistar’sservices include software development, consulting, implementation, training,maintenance and support.  In addition,Avistar seeks to prosecute, maintain, support and license the intellectualproperty developed by the Company through its wholly-owned subsidiary,Collaboration Properties, Inc., a Nevada corporation (CPI).  

 

# **Basis ofPresentation**

 

The unaudited balance sheet as ofMarch 31, 2004 presents the consolidated financial position of Avistar and itstwo wholly-owned operating subsidiaries, Avistar Systems U.K. Limited (ASUK)and CPI after elimination of all intercompany accounts and transactions.  The consolidated results are referred to,collectively, as those of Avistar or the Company in these notes.

 

The functionalcurrency of ASUK is the United States dollar. Accordingly, all gains and lossesresulting from those transactions denominated in currencies other than theUnited States dollar are included in the statements of operations.  

 

The Company’s fiscal year end is December 31. 

 

# **Risks andUncertainties**

 

The marketsfor the Company’s products and services are in the early stages ofdevelopment.  Some of the Company’sproducts utilize changing and emerging technologies. As is typical in industriesof this nature, demand and market acceptance are subject to a high level ofuncertainty, particularly when there are adverse conditions in theeconomy.  Acceptance of the Company’sproducts, over time, is critical to the Company’s success.  The Company’s prospects must be evaluated inlight of difficulties encountered by it and its competitors in furtherdeveloping this evolving marketplace. The Company has generated losses sinceinception and had an accumulated deficit of $82.9 million as of March 31,2004.  The Company’s operating resultsmay fluctuate significantly in the future as a result of a variety of factors,including, but not limited to, the economic environment, the adoption ofdifferent distribution channels, and the timing of new product announcements bythe Company or its competitors.

 

The Company’sfuture liquidity 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. The Company may need to raise additional funds in the future, andadditional financing may not be available on favorable terms, if at all.  If the Company cannot raise funds, ifneeded, on acceptable terms, the Company may not be able to develop or enhanceits products, take advantage of future opportunities or respond to competitivepressures or unanticipated requirements, which could seriously harm theCompany’s business, financial condition and results of operations. 

 

**2.****     Summary of Significant Accounting Policies**

 

# **Unaudited InterimFinancial Information**

 

The financialstatements filed in this report have been prepared by the Company, withoutaudit, pursuant to the rules and regulations of the Securities and ExchangeCommission. Certain information and footnote disclosures normally included infinancial

 

6

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statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to such rules andregulations. The December 31, 2003 Condensed Consolidated Balance Sheet wasderived from audited financial statements, but does not include all disclosuresrequired by accounting principles generally accepted in the United States ofAmerica.

 

In the opinion of management, the unaudited financial statementsfurnished in this report reflect all adjustments (consisting of normalrecurring adjustments) necessary for a fair presentation of the results ofoperations for the interim periods covered and of the Company’s financialposition as of the interim balance sheet date. The results of operations forthe interim periods are not necessarily indicative of the results for theentire year. These financial statements should be read in conjunction with theCompany’s audited consolidated financial statements and the accompanying notesfor the year ended December 31, 2003, included in the Company’s annual reporton Form 10-K filed with the Securities and Exchange Commission on March 16,2004. 

 

**Use of Estimates**

 

The preparation of financial statements in conformity with generallyaccepted accounting principles requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities, anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during theperiod.  Actual results could differfrom those estimates.

 

# **Cash and CashEquivalents and Short Term Investments**

 

The Company considers all investment instruments purchased with aremaining maturity of three months or less to be cash equivalents. The Company’scash equivalents at March 31, 2004 and December 31, 2003 consisted of moneymarket funds and short-term securities. The fair value of the Company’s investments was determined based onquoted market prices at the reporting date for those instruments.  As of March 31, 2004, there was nodifference between the cost and fair value of the Company’s investments. 

 

# **Supplemental CashFlow Information**

 

During thethree months ended March 31, 2004, the Company paid approximately $14,000 inincome taxes. During the three months ended March 31, 2004, no cash was paidfor interest. During the three months ended March 31, 2003, no cash was paidfor income taxes or interest.

 

# **SignificantConcentrations**

 

A relatively small number ofcustomers accounted for a significant percentage of the Company’s net sales.Sales to these customers as a percentage of sales were as follows for the threemonths ended March 31, 2004 and 2003:

 
|       |   | **THREE MONTHS ENDED  MARCH 31,** |   |
|------------|--------|-----------------------------------|--------|
|       |   | **2004**                          |   | **2003** |   |
|       |   | **(UNAUDITED)**                   |   |
| Customer A |   | 60                                | %      | 58 | % |
| Customer B |   | 16                                | %      | 10 | % |

 

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

 

Financialinstruments that potentially subject the Company to concentrations of creditrisk consist primarily of temporary cash investments and trade receivables. TheCompany has cash and investment policies that limit the amount of creditexposure to any one financial institution and restrict placement of theseinvestments to financial institutions evaluated as highly credit worthy.  Concentration of credit risk with respect totrade receivables relate to those trade receivables from both United States andforeign customers of Avistar.  As ofMarch 31, 2004, approximately 72% of accounts receivable were related to twocustomers, each of whom represented more than 10% of the Company’s totalaccounts receivable balance. As of December 31, 2003, approximately 89% ofaccounts receivable were concentrated with one customer. No other customersindividually accounted for greater than 10% of total accounts receivable as ofDecember 31, 2003.

 

7

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# **Inventories**

 

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

 
|                                                    |   | **MARCH 31,  2004** |   | **DECEMBER 31,  2003** |   |
|---------------------------------------------------------|--------|---------------------|--------|------------------------|--------|
|                                                    |   | **(UNAUDITED)**     |   |                   |   |
| Raw materials and subassemblies                         |   | $                   | 69     |                   | $      | 83 |   |
| Finished goods                                          |   | 785                 |   | 813                    |   |
| Inventory shipped to customer sites, not  yet installed |   | 28                  |   | 41                     |   |
|                                                    |   |                |   |                   |   |
|                                                    |   | $                   | 882    |                   | $      | 937 |   |

 

Inventoryshipped to customer sites, not yet installed, represents product shipped tocustomer sites pending completion of the installation process by the Company.As of March 31, 2004 and December 31, 2003, the Company had billedapproximately $69,000 and $57,000, respectively, to customers related to theseshipments, but did not record the revenue, as the installations had not beencompleted and confirmed by the customer. Although customers are billed in accordance with customer agreements,these deferred revenue amounts are netted against accounts receivable until thecustomer confirms installation.

 

**Revenue Recognitionand Deferred Revenue**

** **

The Company recognizes revenue in accordance with Statement of Position(“SOP”) 97-2, “Software Revenue Recognition”, and SOP 98-9, “Modification ofSOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions.”  The Company recognizes revenue from productsales when all of the following conditions are met: the product has beenshipped, an arrangement exists with the customer at a fixed price and theCompany has the right to invoice the customer, collection of the receivable isprobable, and the Company has fulfilled all of its material contractualobligations to the customer.

 

When the Company provides 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. When the customer or a third party provides installation services, theproduct revenue is recognized upon shipment, subject to satisfaction of therevenue recognition criteria described above. Payment for product is due upon shipment, subject to specific paymentterms.  Payment for installation andprofessional services are due upon providing the services, subject to specificpayment terms.  If payments for systemsare made in advance of the completion of installation, such amounts aredeferred and recorded as deferred revenue and customer deposits in theaccompanying balance sheets until installation has occurred and the customerhas provided confirmation.  Reimbursementsreceived for out-of-pocket expensesincurred during installation and support services have not been significant todate. These expenses are recognized as revenue in accordance with EmergingIssues Task Force (EITF) Issue No. 01-14 (EITF 01-14), “Income StatementCharacterization of Reimbursements Received for “Out of Pocket” ExpensesIncurred.”    

 

The price charged for maintenance and/or support is defined in thecontract, and is based on a fixed price for both hardware and softwarecomponents as stipulated in the customer agreement.  Customers have the option to renew the maintenance and/or supportarrangement in subsequent periods at the same rate as paid in the initial year.  Revenue from maintenance and supportservices is deferred and recognized pro-rata over the maintenance and/orsupport term, which is typically one year in length.  Payments for services made in advance of the provision ofservices are recorded as deferred revenue and customer deposits in theaccompanying balance sheets.  Trainingservices are offered together with and independently of the purchase ofproduct.  The value of training servicesprovided with the purchase of product is determined based on the price chargedwhen such services are sold separately. Training revenue is recognized uponperformance of the service.

 

The Company recognizes service revenue from software developmentcontracts in accordance with SOP 81-1, “Accounting for Performance ofConstruction-Type and Certain Production-Type Contracts.” Revenue related tocontracts for software development is recognized using the percentage ofcompletion method, when all of the following conditions are met: a contractexists with the customer at a fixed price, the Company has fulfilled all of itsmaterial contractual obligations to the customer for each deliverable of thecontract, verification of completion of the deliverable has been received, andcollection of the receivable is probable. The amounts billed to customers in excess of revenues recognized to dateare deferred and recorded as deferred revenue and customer deposits in theaccompanying balance sheets. Assumptions used for recording revenue and earnings are adjusted in theperiod of change to reflect revisions in contract value and estimated costs tocomplete the contract.  Any anticipatedlosses on contracts in progress are charged to earnings when identified.

 

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**Stock-BasedCompensation**

 

The Companyapplies the intrinsic-value-based method of accounting for stock-basedcompensation prescribed by Accounting Principles Board (APB) OpinionNo. 25, “Accounting for Stock Issued to Employees”, and relatedinterpretations including FASB Interpretation No. 44, “Accounting forCertain Transactions involving Stock Compensation, an interpretation of APBOpinion No. 25”, to account for its fixed-plan stock options. Under thismethod, compensation expense is recorded on the date of grant only if thecurrent market price of the underlying stock exceeded the exercise price.Statement of Financial Accounting Standards (SFAS) No. 123,“Accounting for Stock-Based Compensation”, established accounting anddisclosure requirements using a fair-value-based method of accounting forstock-based employee compensation plans. As allowed by SFAS No. 123, theCompany has elected to continue to apply the intrinsic-value-based method ofaccounting described above, and has adopted only the disclosure requirements ofSFAS No. 123. The following table illustrates the effect on net income if thefair-value-based method had been applied to all outstanding and unvested awardsin each period (in thousands, except per share data).

 
|                                                                                                                         |   | **Three Months  Ended March 31,** |   |
|------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                                                                         |   | **2004**                          |   | **2003** |   |
| Net loss, as reported                                                                                                        |   | $                                 | (2,088 | ) | $ | (2,690 | ) |
| Add stock – based employee  compensation expense included in reported net loss, net of tax                              |   | —                            |   | 45 |   |
| Deduct total stock-based  employee compensation expense determined under fair-value-based method for  all awards, net of tax |   | (451                              | )      | (1,000 | ) |
| Pro forma net loss                                                                                                           |   | $                                 | (2,539 | ) | $ | (3,645 | ) |
|                                                                                                                         |   |                              |   |   |   |
| Basic and diluted loss per  share                                                                                            |   |                              |   |   |   |
| As reported                                                                                                                  |   | $                                 | (0.07  | ) | $ | (0.11 | ) |
| Pro forma                                                                                                                    |   | $                                 | (0.08  | ) | $ | (0.14 | ) |

 

The fair valueof options granted for the three months ended March 31, 2004 and 2003 isestimated on the date of grant using the following assumptions: 

 
|                            |   | **2004** |   | **2003** |   |
|---------------------------------|--------|----------|--------|----------|--------|
| Expected dividend               |   | 0        | %      | 0        | %      |
| Average risk-free interest rate |   | 3.1      | %      | 2.8      | %      |
| Expected volatility             |   | 120      | %      | 187      | %      |
| Expected term (in years)        |   | 4        |   | 4        |   |

 

**RecentAccounting Pronouncements**

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity,”which establishes standards for how an issuer classifies and measures certainfinancial instruments with characteristics of both liabilities and equity. Financialinstruments that are within the scope of the statement, which previously wereoften classified as equity, must now be classified as liabilities. Thisstatement is effective for financial instruments entered into or modified afterMay 31, 2003, and otherwise shall be effective at the beginning of the firstinterim period beginning after June 15, 2003. The adoption of SFAS No. 150 didnot have an impact on the Company’s condensed consolidated financialstatements.

 

9

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**3. Line of Credit**

 

On February27, 2002, the Company entered into a Loan and Security Agreement with afinancial institution for a revolving line of credit.  As collateral under this Loan and Security Agreement, the Companygranted a first priority interest in all of the Company’s assets, excludingintellectual property.  On December 16,2002, Gerald Burnett, Chairman and Chief Executive Officer of the Company,provided a collateralized guarantee, assuring payment of the Company’sobligations under the agreement and as a consequence, restrictive covenantsfrom the original Loan and Security agreement were deleted in the amendment,except for a quick ratio and loan to value covenant, allowing the Companygreater access to the full amount of the facility.  On February 27, 2004, the Loan and Security Agreement was amendedto change the maximum borrowings under the line to $3.5 million, subject tocertain quick ratio and loan to value covenants, and to extend the term of theLoan and Security Agreement to February 27, 2005.  In connection with this amendment, Dr. Burnett’s collateralizedguarantee was amended to reduce the amount of such guarantee to $3.5million.  As of March 31, 2004, theCompany had no outstanding borrowings under the line of credit and was eligibleto borrow up to $3.5 million.  

 

**4. Related Party Transactions**

 

Robert P.Latta, a member of the law firm Wilson Sonsini Goodrich & Rosati,Professional Corporation (WSGR), has served as a director of the Company sinceFebruary 2001.  Mr. Latta and WSGR haverepresented the Company and its predecessors as corporate counsel since1997.  During the three months endedMarch 31, 2004 and 2003, payments of approximately $7,000 and $89,000,respectively, were made to WSGR for legal services provided to the Company.

 

During thethree months ended March 31, 2003, paymentsfor consulting fees of approximately $74,000 were made to R. Stephen Heinrichs,a former officer of the Company, who is also a member of the Board ofDirectors, pursuant to a Separation Agreement between Mr. Heinrichs andthe Company dated April 26, 2001. During the three months ended March 31, 2004,no payments for consulting fees were made to R. Stephen Heinrichs.

** **

**5.  Legal Proceedings**

** **

On September23, 2002, CPI, the Company’s wholly-owned subsidiary, commenced a patentinfringement lawsuit against Polycom, Inc. alleging that several Polycomvideoconferencing products infringe four patents held by CPI. The suit wasfiled in the United States District Court for the Northern District ofCalifornia.  The four patents involvedare U.S. Patent Nos. 5,867,654, 5,896,500, 6,212,547 and 6,343,314.  These patents cover technologies relating tovideo and data conferencing over unshielded twisted pair (UTP) networks,distributed call-state management, separate monitors for simultaneouscomputer-based data sharing and videoconferencing and remote participant holdand disconnect functions in multi-party conferencing. Polycom responded toCPI’s claims on November 14, 2002, at which time it both answered the complaintand asserted counterclaims against CPI for non-infringement, invalidity andunenforceability.  On January 31, 2003,Polycom filed a motion with the court, which was subsequently granted by thecourt on March 7, 2003, requesting permission to amend its counterclaims toincorporate claims of alleged infringements by Avistar Communications of fourPictureTel patents that Polycom has told us it has had assigned to it. Three ofthe four counterclaims involved a third party, and these three counterclaimswere dropped by Polycom on June 23, 2003, subsequent to an agreement betweenPolycom and the third party.  On August9, 2003, CPI and Polycom filed motions for summary judgment with the court,seeking judgment as a matter of law concerning CPI’s ability to qualify for“small entity status” in the filing of its four patents being asserted againstPolycom.  On October 17, 2003, the courtdenied Polycom’s motion for summary judgment and granted CPI’s motion forsummary judgment, thereby negating Polycom’s defense of unenforceablityconcerning CPI’s having filed these patents as a “small entity.”

 

Briefings on claims constructionissues and a hearing before the presiding judge (Markman hearing) took place onMarch 8, 2004, and the presiding judge issued her ruling on March 23, 2004. Atrial date for CPI’s claims against Polycom and Polycom’s counterclaim has beenset for January 10, 2005.  Theprosecution of this lawsuit and the defense of the Polycom counterclaim hasrequired and may continue to require the Company and CPI to expend significantfinancial and managerial resources and therefore may have a material negativeimpact on the Company and CPI.  Theduration and ultimate outcome of this litigation are uncertain.  

 

**6.****     Net Loss Per Share**

 

Basic and diluted net loss per share of common stock is presented inconformity with SFAS No. 128, “Earnings Per Share,” for all periods presented. 

 

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In accordance with SFAS 128, basic net loss per share has been computedusing the weighted average number of shares of common stock outstanding duringthe period.  Diluted net loss per shareis computed on the basis of the weighted average number of shares and commonequivalent shares outstanding during the period. Common equivalent sharesresult from the assumed exercise of outstanding stock options that have adilutive effect when applying the treasury stock method.  The Company has excluded all outstanding stockoptions from the calculation of diluted net loss per share for the three monthsended March 31, 2004 and 2003, because all such securities are antidilutive(because the Company is in loss position). Accordingly, diluted net loss per share approximates basic net loss pershare for all periods presented.

 

The totalnumber of shares excluded from the calculations of diluted net loss per sharewas 2,513,825 and 254,426 for the three months ended March 31, 2004 and 2003,respectively.

 

**7.  Segment Reporting**

 

Disclosure ofsegments is presented in accordance with SFAS No. 131, “Disclosures AboutSegments of an Enterprise and Related Information.”  SFAS 131 establishes standards for disclosures regardingoperating segments, products and services, geographic areas and majorcustomers. The Company is organized andoperates as two operating segments: (1) the design, development, manufacturing,sale and marketing of networked video communications products (Avistar,including ASUK) and (2) the prosecution, maintenance, support andlicensing of the intellectual property used in the Company’s products(CPI).  Service revenue relates mainly to the maintenance, support, training,software development and installation of products, and is included in theAvistar entity for purposes of reporting and decision-making.  Avistar also performs corporatefunctions and provides financing and services to its subsidiaries. TheCompany’s chief operating decision maker, its Chief Executive Officer, monitorsthe Company’s operations based upon the information reflected in the followingtable (in thousands):

 
|                              |   | **Avistar** |   | **CPI** |   | **Total** |   |
|-----------------------------------|--------|-------------|--------|---------|--------|-----------|--------|
|                              |   |        |   |    |   |      |   |
| Three Months Ended March 31, 2004 |   |        |   |    |   |      |   |
| Revenue                           |   | $           | 1,404  |    | $      | —    |   | $ | 1,404 |   |
| Gross margin                      |   | 630         |   | —  |   | 630       |   |
| Depreciation expense              |   | (68         | )      | —  |   | (68       | )      |
| Total operating expenses          |   | (1,992      | )      | (745    | )      | (2,737    | )      |
| Interest income                   |   | 13          |   | —  |   | 13        |   |
| Net loss                          |   | (1,343      | )      | (745    | )      | (2,088    | )      |
| Assets                            |   | 10,190      |   | 67      |   | 10,257    |   |
| Three Months Ended March 31, 2003 |   |        |   |    |   |      |   |
| Revenue                           |   | $           | 1,663  |    | $      | —    |   | $ | 1,663 |   |
| Gross margin                      |   | 709         |   | —  |   | 709       |   |
| Depreciation expense              |   | (50         | )      | (1      | )      | (51       | )      |
| Total operating expenses          |   | (2,757      | )      | (657    | )      | (3,414    | )      |
| Interest income                   |   | 19          |   | —  |   | 19        |   |
| Net loss                          |   | (2,033      | )      | (657    | )      | (2,690    | )      |
| Assets                            |   | 8,691       |   | 59      |   | 8,750     |   |

 

Internationalrevenue, which consists of sales to customers with operations principally in WesternEurope and Asia, comprised 55% and 50% of total revenue for the three monthsended March 31, 2004 and 2003, respectively. For the three months ended March 31, 2004 and 2003, internationalrevenues from customers in the United Kingdom accounted for 42% and 34%,respectively, of total revenue. All of the Company’s sales are currently billedin United States dollars. The Company had no significant long-lived assets inany country other than in the United States for any period presented.

 

**8.****              Sale of UnregisteredSecurities**

 

On March 26,2004, the Company completed the private sale of a total of 3,000,000 shares ofcommon stock to Fuller & Thaler Avalanche Fund, L.P. and Fuller &Thaler Behavioral Finance Fund, Ltd. at a price per share of $1.20.  The net proceeds of this private financingafter deducting expenses of the financing were approximately $3.6 million. Suchproceeds are expected to be used for working capital and other generalcorporate purposes. Pursuant to the foregoing sale, the Company agreed to useits

 

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commercially reasonable effortsto register the shares under the Securities Act of 1933, as amended, as whenrequested to do so by Fuller & Thaler during the two years following theclose date of the transaction, unless Fuller & Thaler is able to sell theirholdings under rule 144 during any 90 day period.

 

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

 

The followingdiscussion should be read in conjunction with the Unaudited CondensedConsolidated Interim Financial Statements and the Notes thereto includedelsewhere herein, and the audited consolidated financial statements containedin our Annual Report on Form 10-K for the year ended December 31, 2003, asfiled with the Securities and Exchange Commission on March 16, 2004. 

 

Certain statements in this “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” are forward looking statements.These statements relate to future events or our future financial performanceand involve known and unknown risks, uncertainties and other factors that maycause our or our industry’s actual results, levels of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by the forwardlooking statements. These risks and other factors include those listed under“Factors Affecting Future Operating Results” elsewhere in this report on Form10-Q. In some cases, you can identify forward looking statements by terminologysuch as “may”, “will”, “should”, “expects”, “intends”, “plans”, “anticipates”,“believes”, “estimates”, “predicts”, “potential”, “continue” or the negative ofthese terms, or other comparable terminology. These statements are onlypredictions. Actual events or results may differ materially. In evaluatingthese statements, you should specifically consider various factors, includingthe risks outlined under “Factors Affecting Future Operating Results.”  These factors may cause our actual resultsto differ materially from any forward looking statement.

 

Although webelieve that the expectations reflected in the forward looking statements arereasonable, we cannot guarantee future results, levels of activity, performanceor achievements.  We are under no dutyto update any of the forward-looking statements after the date of this reporton Form 10-Q in order to conform our prior statements to actual results.

 

**Overview**

 

We develop, market and support an integrated suite of video-enabledvBusiness applications, all powered by our AvistarVOS (video operating system)software.  From the desktop, we deliverTV-quality interactive video calling, content creation and publishing,broadcast origination and distribution, video-on-demand and integrated datasharing.  Our customers use our systemto improve productivity and communication within their enterprise, and betweenenterprises to enhance relationships with colleagues, customers, suppliers andpartners.  Using AvistarVOS software and leveraging video, telephony and Internetnetworking standards, our applications are designed to be scalable, reliable,cost effective, easy to use and capable of evolving with communications networks as bandwidth increasesand as new standards and protocols emerge. We sell our system directly toenterprises in selected strategic vertical markets and have focused primarilyon the financial services, and to a lesser degree, manufacturingindustries.  Our objective is toestablish our technology as the standard for networked video.

 

We operate in twosegments.  We engage in the design,development, manufacturing, sale and marketing of networked videocommunications products, and associated support services, and CollaborationProperties, Inc. (CPI), our wholly-owned subsidiary, engages in theprosecution, maintenance, support and licensing of the intellectual propertythat we have developed, some of which is used in our products. As of March 31,2004, CPI had not entered into any such third party licensing agreements.

 

**CriticalAccounting Policies**

 

The preparation of ourCondensed Consolidated Financial Statements in accordance with accountingprinciples generally accepted in the United States requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities. We base our estimates on historical experience and assumptionsthat we believe to be reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates.

 

We believe the following critical accounting policies, among others,affect our more significant judgments and estimates used in the preparation ofour Consolidated Financial Statements:

 

•                  Revenuerecognition;

•                  Valuation of accountsreceivable; and

•                  Valuation ofinventories.

 

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Revenue Recognition

 

We deriveproduct revenue principally from the sale and licensing of our video-enablednetworked communications system, consisting of a suite of Avistar-designedsoftware and hardware products, including third party components.  In addition, we derive revenue from fees forinstallation, maintenance, support, training services and software development.Product revenue as a percentage of total revenue was 40% for the three-monthperiod ended March 31, 2004 and 48% for the three-month period ended March 31,2003.

 

We recognize revenue from productsales when all of the following conditions are met:  the product has been shipped, an arrangement exists with thecustomer at a fixed price and we have the right to invoice the customer,collection of the receivable is probable, and we have fulfilled all of ourmaterial contractual obligations to the customer.  When we provide installation services, the product andinstallation revenue is recognized upon completion of installation and receiptof customer confirmation, subject to the satisfaction of the revenuerecognition criteria described above. When the customer or a third party provides installation services, theproduct revenue is recognized upon shipment, subject to satisfaction of therevenue recognition criteria described above. Payment for product is due upon shipment, subject to specific paymentterms.  The price charged for maintenanceand/or support is defined in the contract, and is based on a fixed price forboth hardware and software components as stipulated in the customeragreement.   Customers have the optionto renew the maintenance and/or support services in subsequent periods at thesame rate as paid in the initial year. Revenue from maintenance and support isrecognized pro-rata over the maintenance and/or support term, which istypically one year in length.  Trainingservices are offered together with and independently of the purchase ofproduct.  The value of training servicesis determined based on the price charged when such services are soldseparately. Training revenue is recognized upon performance of the service. Werecognize service revenue from software development contracts using thepercentage of completion method, when all of the following conditions are met:a contract exists with the customer at a fixed price, we have fulfilled all ofour material contractual obligations to the customer for a deliverable of thecontract, verification of completion of the deliverable has been received, andcollection of the receivable is probable. Reimbursements received for out-of-pocket expenses incurred during installation and supportservices have not been significant to date. These expenses are recognized asrevenue in accordance with Emerging Issues Task Force (EITF) Issue No. 01-14(EITF 01-14), “Income Statement Characterization of Reimbursements Received for“Out of Pocket” Expenses Incurred.”    

 

To date, a significantportion of our revenue has resulted from sales to a limited number ofcustomers.  For the three months endedMarch 31, 2004, we recorded revenue of approximately $1.1 million, or 76% oftotal revenue, from Deutsche Bank AG and UBS Warburg LLC and their affiliates,with each of Deutsche Bank and UBS representing greater than 10% of our totalrevenue.  For the three months endedMarch 31, 2003, we recorded revenue of approximately $1.1 million, or 68% oftotal revenue, from Deutsche Bank AG and UBS Warburg LLC and their affiliates,with each of Deutsche Bank and UBS representing greater than 10% of our totalrevenue. We anticipate that our revenue, and therefore, our operating resultsfor any given period, will continue to depend to a significant extent on a limitednumber of customers.  As a result, theloss of or a reduction in sales to any one of these customers would have asignificant adverse impact on our operations and financial performance.

 

International revenue, which consists of sales to customers withoperations principally in Western Europe and Asia,  comprised 55% of total revenue for the threemonths ended March 31, 2004 and 50%for the three months ended March 31, 2003.  

 

Valuation of AccountsReceivable

 

Estimates areused in determining our allowance for doubtful accounts and are based on ourhistorical collection experience, historical write-offs, current trends and thecredit quality of our customer base and the characteristics of our accountsreceivable by aging category.  If theallowance for doubtful accounts was understated, our operating income could besignificantly reduced. The impact of any such change or deviation may beincreased by our reliance on a relatively small number of customers for a largeportion of our total revenue. As of March 31, 2004, approximately 72% of ouraccounts receivable balance was concentrated with two customers, each of whomrepresented more than 10% of our total accounts receivable.  As of December 31, 2003, approximately 89%of our accounts receivable were concentrated with one customer.

 

Valuation of Inventories

 

We record aprovision for obsolete or excess inventory for models 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 significant unanticipated changes indemand or technological developments could have a significant impact on thevalue of our inventory and commitments and our reported results.  If actual market conditions are lessfavorable than those projected, additional inventory write-downs, provision forpurchase commitments and charges against earnings may be required, which wouldnegatively affect our operating income for such period.

 

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Emerging AccountingDevelopments

 

On March 31,2004, the Financial Accounting Standards Board, or FASB, issued its exposuredraft, “Share-Based Payment,” which is a proposed amendment to the FASB’sStatement No. 123, “Accounting for Stock-Based Compensation,” or SFAS 123.  Generally, the approach in the exposuredraft is similar to the approach described in SFAS 123.  However, the exposure draft would requireall share-based payments to employees, including grants of employee stockoptions and the right to purchase shares under our employee stock purchaseplan, to be recognized in our income statement based on their fair values.  There are a number of issues that are notresolved in the exposure draft, including the final methodology for calculatingfair value.  The FASB expects to issue afinal standard late in 2004 that would be effective in 2005.  The pro forma impact of the adoption of SFAS123 on our historical financial statements is included in the condensed notesto the condensed consolidated financial statements presented elsewhere in thisForm 10-Q.  We expect to continue togrant stock-based compensation to employees and that the impact of the newstandard, when and if issued, may have a material impact on our future resultsof operations.

 

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**Results of Operations**

 

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

 
|                                         |   | **PERCENTAGE OF TOTAL REVENUE**   |   |
|----------------------------------------------|--------|-----------------------------------|--------|
|                                         |   | **THREE MONTHS ENDED  MARCH 31,** |   |
|                                         |   | **2004**                          |   | **2003** |   |
| Revenue:                                     |   |                              |   |   |   |
| Product                                      |   | 40                                | %      | 48 | % |
| Services, maintenance and  support           |   | 60                                |   | 52 |   |
| Total revenue                                |   | 100                               |   | 100 |   |
| Cost of revenue:                             |   |                              |   |   |   |
| Product                                      |   | 21                                |   | 23 |   |
| Services, maintenance and  support           |   | 34                                |   | 34 |   |
| Total cost of revenue                        |   | 55                                |   | 57 |   |
| Gross margin                                 |   | 45                                |   | 43 |   |
| Operating expenses:                          |   |                              |   |   |   |
| Research and development                     |   | 44                                |   | 42 |   |
| Sales and marketing                          |   | 43                                |   | 59 |   |
| General and administrative                   |   | 107                               |   | 102 |   |
| Amortization of deferred stock  compensation |   | —                            |   | 3 |   |
| Total operating expenses                     |   | 195                               |   | 206 |   |
| Loss from operations                         |   | (150                              | )      | (163 | ) |
| Other income (expense):                      |   |                              |   |   |   |
| Interest income                              |   | 1                                 |   | 1 |   |
| Other income (expense), net                  |   | —                            |   | — |   |
| Total other income                           |   | 1                                 |   | 1 |   |
| Net loss                                     |   | (149                              | )%     | (162 | )% |

 

**COMPARISON OF THE THREE MONTHS ENDED MARCH31, 2004 AND 2003**

 

## ***Revenue***

 

Total revenuedecreased by 16% to $1.4 million for the three months ended March 31, 2004 from$1.7 million for the three months ended March 31, 2003. The decline was dueprimarily to lower product sales, reflecting lower demand for enterpriseinformation technology in the financial services industry, resulting in delayedprocurement decisions by existing and potential customers.  

 

For the three months ended March 31, 2004, revenue from two customersaccounted for 76% of total revenue, each of whom accounted for greater than 10%of total revenue. For the three months ended March 31, 2003, revenue from twocustomers accounted for 68% of total revenue, each of whomaccounted for greater than 10% of our total revenue. The level of sales to any customer may vary from quarter toquarter.  We expect that there will besignificant customer concentration in future quarters.  The loss of any one of those customers wouldhave a material adverse impact on our financial condition and operatingresults.

 

## ***Cost of Revenue***

 

The cost ofrevenue declined by 19% to $0.8 million for the three months ended March 31,2004 from $1.0 million for the three months ended March 31, 2003.  Cost of product revenue declined by 24% to$0.3 million for the three months ended March 31, 2004 from  $0.4 million for the three months endedMarch 31, 2003.  This decline in cost ofproduct revenue was primarily due to the lower level of product sales and theassociated direct product costs and, to a lesser extent, due to a reduction inthe fixed component of product costs, due in turn to our reduced building leaserate. Cost of service revenue decreased by 15% to $0.5 million for the threemonths ended March 31, 2004 from $0.6 million for the three months ended March31, 2003.  This decline in cost ofservice revenue was due primarily to the reduction in maintenance and supportcosts caused by the consolidation of our support center operations into ourcorporate headquarters and the associated closure of two outlyingfacilities.  

 

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## ***Gross Margin***

 

Gross marginas a percentage of revenue increased to 45% for the three months ended March31, 2004 from 43% for the three months ended March 31, 2003. The increase wasdue primarily to the increase in services gross margin. Product gross margin asa percentage of total product revenue decreased to 48% for the three-monthperiod ended March 31, 2004 compared to 52% for the three-month period endedMarch 31, 2003.  The decrease is dueprimarily to the reduced product revenue, which resulted in less coverage ofthe fixed component of the cost of product sales. Services gross margin as apercentage of total service revenue increased to 43% for the three months March31, 2004 compared to 34% for the three months ended March 31, 2003, dueprimarily to the decline in maintenance and support costs caused by theconsolidation of our support center into our corporate headquarters and theassociated closure of two outlying facilities.

 

## ***Operating expenses***

 

*Research anddevelopment.*****Research anddevelopment expenses decreased by 10% to $0.6 million for the three monthsended March 31, 2004 from $0.7 million for the three months ended March 31,2003. The decrease was primarily due to reductions in property leasecosts.  

 

*Sales and marketing.* Sales and marketing expenses decreased by 37% to$0.6 million for the three months ended March 31, 2004 from $1.0 million forthe three months ended March 31, 2003. The decrease was due to the reduction inpersonnel and personnel related expenses, as a result of a 23% reduction instaffing levels relative to March 31, 2003, and a reduction in outside servicesand property lease costs.

 

*General andadministrative.*General and administrative expenses decreased by 12% to $1.5 million for thethree months ended March 31, 2004 from $1.7 million for the three months endedMarch 31, 2003. The decrease was due primarily to the reduction in personneland personnel related expenses, due to a 12% decrease in staffing levelsrelative to March 31, 2003, and a reduction in outside services/externalconsulting expenses and property lease costs. 

 

*Amortization ofdeferred stock compensation.* Amortization of deferred stock compensation decreased by 100% to $0 forthe three months ended March 31, 2004 from $45,000 for the three months endedMarch 31, 2003. The decrease was due to the completion of pre-IPO option awardamortization, and the forfeitures of stock options by employees no longer withour company.

 

## ***Other Income(Expense)***

 

Other income,net increased by 36% to $19,000 for the three months ended March 31, 2004 from$14,000 for the three months ended March 31, 2003.  

 

**Liquidity and CapitalResources**

 

We have fundedour operations since inception primarily from product and services revenue, thenet proceeds of $31.3 million from our August 2000 initial public offering ofcommon stock, lines of credit with related parties and financial institutions,the proceeds of approximately $6.4 million from the sale of Series B preferredstock in December 1999 and the proceeds of approximately $5.7 million and $3.6million from the private sale of our common stock in October 2003 and March2004, respectively.

 

We had cashand cash equivalents of $7.5 million as of March 31, 2004 compared to cash andcash equivalents of $5.4 million as of December 31, 2003.  For the three months ended March 31, 2004 wehad an overall net cash inflow of $2.0 million, resulting primarily from netcash proceeds from issuance of common stock of $3.7 million, offset by net cashused in operations of $1.5 million.  Thenet cash proceeds from issuance of common stock are primarily due to theprivate sale of 3,000,000 shares of our common stock to Fuller & ThalerAsset Management, Inc., at a price per share of $1.20 in March 2004. The netcash used in operating activities of $1.5 million resulted from a net loss of$2.1 million, a decrease in accrued liabilities and other of $0.2 million,offset by an increase in deferred revenue and customer deposits of $0.5 millionand an increase in accounts payable of $0.2 million.  

 

At March 31,2004, we had open purchase orders and other contractual obligations ofapproximately $0.7 million, primarily related to inventory purchases. We alsohave commitments that consist of obligations under our operating leases. Thesepurchase order commitments and contractual obligations are reflected in ourfinancial statements once goods or services have been received or paymentsrelated to the obligations become due. 

 

The followingtable represents our future commitments under minimum annual operating leasepayments as of March 31, 2004 (in thousands):

 

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| **Year Ending December 31,**              |   | **Amount** |   |
|-------------------------------------------|--------|------------|--------|
| Second, third and fourth  Quarter of 2004 |   | $          | 504    |   |
| 2005                                      |   | 768        |   |
| 2006                                      |   | 682        |   |
| 2007                                      |   | 300        |   |
| 2008                                      |   | 230        |   |
| Thereafter                                |   | 566        |   |
| Total minimum lease payments              |   | $          | 3,050  |   |

 

In July 2003we entered into a non-cancelable operating lease to remain at our currentoffice facility in Redwood Shores, California. The new operating leasecommenced on October 1, 2003 and expires on September 30, 2007. The commitmentsfor this new lease are reflected in the table above. The previous operatinglease expired on September 30, 2003. 

 

On February27, 2002, we entered into a Loan and Security Agreement with a financialinstitution for a revolving line of credit. As collateral under this Loan and Security Agreement, we granted a firstpriority security interest in all of our assets, excluding intellectualproperty.  On December 16, 2002, GeraldBurnett, our Chairman and Chief Executive Officer provided a collateralizedguarantee, assuring payment of our obligations under the agreement and as aconsequence, restrictive covenants from the original Loan and Securityagreement were deleted in the amendment, except for a quick ratio and loan tovalue covenant, allowing us greater access to the full amount of thefacility.  On February 27, 2004, theLoan and Security Agreement was amended to change the maximum borrowings underthe line to $3.5 million, subject to certain quick ratio and loan to valuecovenants, and to extend the term of the Loan and Security Agreement toFebruary 27, 2005.  In connection with thisamendment, Dr. Burnett’s collateralized guarantee was amended to reduce theamount of such guarantee to $3.5 million. As of March 31, 2004, we had no outstanding borrowings under the line ofcredit and we were eligible to borrow up to $3.5 million. On February 27, 2004,Dr. Burnett provided us with a further commitment to provide us with a loan ofup to $2.0 million in the event that at least $2.0 million was not available tous under the line of credit or an alternate financing arrangement.  This additional commitment was subject todollar for dollar reduction in the event that a financing event occursproviding us with comparable funding, or other net addition to our workingcapital.      

 

On October 15,2003, we completed the private sale of 4,615,385 shares of our common stock toGerald J. Burnett and members of his family at a price per share of $1.30.  The net proceeds of this private financing,after deducting expenses of the financing, were approximately $5.7 million.Under the terms of the private placement, Dr. Burnett agreed to certainrestrictions on 1,602,847 of the 3,661,539 shares purchased by him.  These restrictions require Dr. Burnett tovote such shares in the same proportion as our outstanding common stock notbeneficially owned by Dr. Burnett.  

 

On March 26,2004, we completed the private sale of 3,000,000 shares of our common stock tofunds affiliated with Fuller & Thaler Asset Management, Inc., at a priceper share of $1.20.  The net proceeds ofthis private financing after deducting expenses of the financing were approximately$3.6 million. As a consequence of this private financing, Dr. Burnett’scommitment to provide us with a loan of up to $2.0 million in the event that atleast $2.0 million was not available to us under the line of credit wasautomatically terminated by its terms. 

 

We intend tocontinue to invest in the development of new products and enhancements to ourexisting products.  We may need toarrange for the availability of additional funding upon the expiration of theLoan and Security Agreement on February 27, 2005, either through the executionof an extension of the Loan and Security Agreement or through other means, inorder to meet our operating and capital requirements for the next twelvemonths.  Additional funds and additionalfinancing may not be available on favorable terms, or at all. If we are unableto obtain additional funding on acceptable terms, we may not be able to developor enhance our products, take advantage of future opportunities, or respond tocompetitive pressures or unanticipated requirements, which could seriously harmour business, financial condition and results of operations.  Furthermore, any additional equity financingmay be dilutive to our stockholders and such equity securities may have rights,preferences or privileges senior to those of the holders of our common stock,and debt financing, if available, may involve significant fees, interestpayment obligations and restrictive covenants. Strategic arrangements, ifnecessary to raise additional funds, may require us to relinquish our rights tocertain of our technologies or products. 

 

Our futureliquidity and capital requirements will depend upon numerous factors, includingwithout limitation, general economic conditions and conditions in the financialservices industry in particular, the level and timing of revenue, the costs andtiming of our product development efforts and the success of these developmentefforts, the costs and timing of our sales and marketing activities, the extentto which our existing and new products gain market acceptance, competingtechnological and market developments, the

 

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costs involved in maintainingand enforcing patent claims and other intellectual property rights including,without limitation, the costs and result of CPI’s litigation with Polycom andother factors, all of which may impact our ability to achieve and maintainprofitability.  

 

**RecentAccounting Pronouncements**

 

In May 2003,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (SFAS) No. 150, “Accounting for Certain FinancialInstruments with Characteristics of Both Liabilities and Equity,” whichestablishes standards for how an issuer classifies and measures certainfinancial instruments with characteristics of both liabilities and equity.Financial instruments that are within the scope of the statement, whichpreviously were often classified as equity, must now be classified asliabilities. This statement is effective for financial instruments entered intoor modified after May 31, 2003, and otherwise shall be effective at thebeginning of the first interim period beginning after June 15, 2003. Theadoption of SFAS No. 150 did not have an impact on our condensed consolidatedfinancial statements.

 

**Factors Affecting Future Operating Results**

 

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

 

Our ability to achieve profitability depends in part on the widespreadadoption of networked video communications systems and the adoption of ourvideo operating system in particular. If the market for our system fails to grow or grows more slowly than weanticipate, we may not be able to increase revenue or achieve profitability.The market for our system is relatively new and evolving.  We have to devote substantial resources toeducating prospective customers about the uses and benefits of our system.  Our efforts to educate potential customersmay not result in our system achieving broad market acceptance.  In addition, businesses that have investedor may invest substantial resources in other video products may be reluctant orslow to adopt our system.  Similarly,customers using existing information systems in which they have madesignificant investments may refuse to adopt our system if they perceive thatour offerings will not complement their existing systems.  Consequently, the conversion fromtraditional methods of communication to the extensive use of networked videomay not occur as rapidly as we wish.

 

**Wehave incurred substantial losses in the past and may not be profitable in thefuture.**

 

We incurred net losses of $2.1 million for the three months ended March31, 2004, $8.6 million for the year 2003, and $7.6 million for the year2002.  As of March 31, 2004, ouraccumulated deficit was $82.9 million. Our revenue may not increase, or even remain at its current level.  In addition, our operating expenses mayincrease as we continue to develop our business in the future.  As a result, to become profitable, we willneed to increase our revenue by increasing sales to existing customers and byattracting additional customers.  If ourexpenses increase more rapidly than our revenue, or if revenue and expense levelsremain the same, we may never become profitable.  We cannot predict whether or when we will becomeprofitable.  If we do become profitable,we may not be able to sustain or increase profitability on a quarterly orannual 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 andmay continue to impact our revenues and harm our business.**

 

The international economic slowdown and the downturn in the investmentbanking industry that began in the year 2000 has negatively affected ourbusiness in 2001, 2002 and 2003, and may continue to do so in the future.  During this period, the investment bankingindustry suffered a sharp decline, which caused many of our existing andpotential customers to cancel or delay orders for our products.  If our customers and potential customerscontinue to delay ordering our products, we will fall short of our revenueexpectations for 2004 and beyond.  Theoutlook for the video communications industry is uncertain.  Slower growth among our customers,tightening of customers’ operating budgets, retrenchment in the capital marketsand other general economic factors all have had and could in the future have amaterially adverse effect on our revenue, capital resources, financialcondition and results of operations.

 

**We have filed a complaint allegingpatent infringement against Polycom, Inc. The prosecution of this lawsuit could 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 September23, 2002, CPI, our wholly-owned subsidiary, commenced a patent infringementlawsuit against Polycom, Inc. alleging that several Polycom videoconferencingproducts infringe four patents held by CPI. The suit was filed in the UnitedStates District Court for the Northern District of California.  The four patents involved are U.S. PatentNos. 5,867,654, 5,896,500, 6,212,547

 

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and 6,343,314.  These patents cover technologies relating tovideo and data conferencing over unshielded twisted pair (UTP) networks,distributed call-state management, separate monitors for simultaneouscomputer-based data sharing and videoconferencing and remote participant holdand disconnect functions in multi-party conferencing. Polycom responded toCPI’s claims on November 14, 2002, at which time it both answered the complaintand asserted counterclaims against CPI for non-infringement, invalidity andunenforceability On January 31, 2003, Polycom filed a motion with the court,which was subsequently granted by the court on March 7, 2003, requesting permissionto amend its counterclaims to incorporate claims of alleged infringements byAvistar Communications of four PictureTel patents that Polycom has told us ithas had assigned to it. Three of the four counterclaims involved a third party,and Polycom dropped these three counterclaims on June 23, 2003, subsequent toan agreement between Polycom and the third party.  On August 9, 2003, CPI and Polycom filed motions for summaryjudgment with the court, seeking judgment as a matter of law concerning CPI’s abilityto qualify for “small entity status” in the filing of its four patents beingasserted against Polycom.  On October17, 2003 the court denied Polycom’s motion for summary judgment and grantedCPI’s motion for summary judgment, thereby negating Polycom’s defense ofunenforceability concerning CPI’s having filed these patents as a “smallentity.”

 

Briefings onclaims construction issues and a hearing before the presiding judge (Markmanhearing) took place on March 8, 2004, and the presiding judge issued her rulingon March 23, 2004.  A trial date forCPI’s claims against Polycom and Polycom’s counterclaim has been set forJanuary 10, 2005.  The prosecution ofthis lawsuit and the defense of the Polycom counterclaim have required and maycontinue to require us to expend significant financial and managerial resourcesand therefore may have a material negative impact on our business.  The duration and ultimate outcome of thislitigation are uncertain.  In addition,an adverse judgment, if entered against CPI or Avistar, could require CPI orAvistar to pay substantial damages to Polycom, which could harm our business,financial position and results of operations, and cause our stock price todecline substantially. Litigation such as this suit can take years to resolveand can be expensive to prosecute and defend. Regardless of the outcome, the prosecution of CPI’s claims and defenseof the counterclaim in this lawsuit may require us to obtain additionalfinancing in the future.  

 

**Our expected future working capital needs mayrequire that we seek additional debt or equity funding which, if not available,could cause our business to suffer.**

 

Our futureliquidity and working capital requirements will depend upon numerous factors,including:

 

•                  general economicconditions and conditions in the financial services industry in particular;

•                  the level andtiming of our revenue;

•                  the costs andtiming of product development efforts and the success of these developmentefforts;

•                  the costs andtiming of sales and marketing activities;

•                  the extent towhich our existing and new products gain market acceptance;

•                  competingtechnological and market developments;

•                  the costsinvolved in maintaining and enforcing patent claims and other IP rights,including the costs associated with CPI’s litigation with Polycom; and

•                  availableborrowings under line of credit arrangements and other factors.

 

We may need toarrange for the availability of additional funding in order to meet our futurebusiness requirements.  If we are unableto obtain additional funding when needed on acceptable terms, we may not beable to develop or enhance our products, take advantage of futureopportunities, respond to competitive pressures or unanticipated requirements,or finance our litigation with Polycom, which could seriously harm ourbusiness, financial condition and results of operations.  There can be no assurance that such fundingwill be available on terms attractive to us, or at all.  Furthermore, any additional equity financingmay be dilutive to stockholders and such equity securities may have rights,preferences or privileges senior to those of the holders of our common stock,and debt financing, if available, may involve restrictive covenants. Strategicarrangements, if necessary to raise additional funds, may require us torelinquish our rights to certain of our technologies or products.

 

**Ourlengthy sales cycle to acquire new customers or large follow-on orders maycause our quarterly operating results to vary significantly and make it more difficultto forecast our revenue.**

 

We havegenerally experienced a product sales cycle of four to nine months for newcustomers or large follow-on orders due to the time needed to educate customersabout the uses and benefits of our system, and the significant investmentdecisions that our prospective customers must make when they decide to buy oursystem.  Many of our prospectivecustomers have neither budgeted expenses for networked video communicationssystems, or for personnel specifically dedicated to the procurement,installation or support of these systems. As a result, our customers spend a substantial amount of time inperforming internal reviews and obtaining

 

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capital expenditure approvalsbefore purchasing our system. Recent economic conditions have contributed toadditional deliberation, and an associated delay in the sales cycle.

 

Our lengthy sales cycle is one of the factors that has caused, and mayin the future continue to cause, our operating results to vary significantlyfrom quarter to quarter and year to year. This makes it difficult for us to forecast revenue, and could causevolatility in the market price of our common stock.  A lost or delayed order could result in lower revenue than expectedin a particular quarter or year.

 

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

 

Our customers typically place limited initial orders for our networkedvideo communications system, as they seek to evaluate its usefulness andvalue.  Our strategy is to pursueadditional and larger follow-on orders after these initial orders.  Revenue generated from follow-on ordersaccounted for approximately 93% and 99% of our revenue for the three monthsended March 31, 2004 and 2003, respectively. Economic conditions have contributed to decreases in our clients’capital spending in the past, and we have experienced a decrease in the sizeand number of follow-on orders.  Ourfuture financial performance depends on successful initial installations of oursystem and successful generation of follow-on orders as the Avistar networkexpands within a customer organization. If our system does not meet the needs and expectations of customers, wemay not be able to generate follow-on orders.

 

**Becausewe depend on a few customers for a majority of our revenue, the loss of one ormore of them could cause a significant decrease in our revenue.**

 

We havehistorically derived the majority of our revenue from a limited number ofcustomers, particularly Deutsche Bank AG and UBS Warburg LLC and theiraffiliates.  Collectively, thesecustomers accounted for 76% of our revenue for the three months ended March 31,2004. No other customers individually contributed great than 10% of our totalrevenue for the three months ended March 31, 2004.  For the three months ended March 31, 2003, Deutsche Bank AG andUBS Warburg LLC and their affiliates accounted for 68% of our revenue, witheach Deutsche Bank and UBS accounting for greater than 10% of our totalrevenue.  This contribution reflects theacquisition by Deutsche Bank and UBS Warburg LLC of other financial servicesfirms that were previously Avistar customers, as well as the purchase ofAvistar technology by Deutsche Bank for new accounts as part of Deutsche Bank’sclient connectivity program and/or joint ventures. We expect to continue todepend upon a limited number of customers for a substantial portion of ourrevenue.  As of March 31, 2004,approximately 72% of our accounts receivable were concentrated with twocustomers, each of whom represented more than 10% of our total accountsreceivable.  As of December 31, 2003,approximately 89% of our accounts receivable were concentrated with onecustomer. 

 

The loss of a major customer or the reduction, delay or cancellation oforders from one or more of our significant customers could cause our revenue todecline and our losses to increase. Because we currently depend on a limited number of customers withlengthy budgeting cycles and unpredictable buying patterns, our revenue fromquarter to quarter or year to year may be volatile.  Adverse changes in our revenue or operating results as a resultof these budgeting cycles or any other reduction in capital expenditures by ourlarge customers could substantially reduce the trading price of our commonstock.

 

**Wemay not be able to modify and improve our products in a timely and costeffective manner to respond to technological change and customer demands.**

 

Future hardware and software platforms embodying new technologies andthe emergence of new industry standards and customer requirements could renderour system non-competitive or even obsolete. The market for our system is characterized by:

 

•                  rapid technological change; 

•                  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.

 

Our system is designed to work with a variety of hardware and softwareconfigurations and data networking infrastructures used by our customers.  The majority of these customer networks relyon Microsoft Windows servers.  However,our software may not operate correctly on other hardware and software platformsor with other programming languages, database environments and systems that ourcustomers use.  Also, we must constantlymodify and improve our system to keep pace with changes made to our customers’

 

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platforms,data networking infrastructures, and their evolving ability to transport videoand other applications.  This may resultin uncertainty relating to the timing and nature of our new releaseannouncements, introductions or modifications, which in turn may causeconfusion in the market, with a potentially harmful effect on ourbusiness.  If we fail to promptly modifyor improve our system in response to evolving industry standards or customers’demands, our system could become less competitive, which would harm ourfinancial condition and reputation.

 

**Difficultiesor delays in installing our products, fulfilling software development, ordelivering other professional service contracts could harm our revenue andmargins.  **

 

We recognize revenue upon the installation of our system in those caseswhere we are 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 ininstalling our products for new or existing customers or installation requiressignificant amounts of our professional services support, our revenuerecognition could be delayed, our costs could increase and our margins couldsuffer.

 

**Competition could reduce ourmarket share and decrease our revenue.**

 

Currently, our competition comes from many other kinds of companies,including communication equipment, integrated solution, broadcast video andstand-alone point solution providers. Within the video-enabled networkcommunications market, we compete primarily against Polycom, Tandberg Inc. andVCON Telecommunications Ltd. We believe we may face increasing competition inthe future from alternative video communications solutions that employ newtechnologies or new combinations of technologies from companies such as CiscoSystems, Inc., Hewlett-Packard Company, Microsoft Corporation, RealNetworks,Inc. and WebEx Communications, Inc., that enable web-based or network-basedvideo communications with low-cost digital camera systems. The market in whichwe operate is highly competitive.  Inaddition, because our industry is relatively new and one which is characterizedby rapid technological change, evolving user needs, developing industrystandards and protocols and the frequent introduction of new products andservices, it is difficult for us to predict whether or when new competingtechnologies or new competitors will enter our market.

 

We expectcompetition to increase in the future from existing competitors and from newmarket entrants with products that may be less expensive than ours or that mayprovide better performance or additional features not currently provided by ourproducts.  Many of our current andpotential competitors have substantially greater financial, technical,manufacturing, marketing, distribution and other resources, greater namerecognition and market presence, longer operating histories, lower coststructures and larger customer bases than we do.  As a result, they may be able to adapt more quickly to new oremerging technologies and changes in customer requirements.

 

We may berequired to reduce prices or increase spending in response to competition inorder to retain or attract customers, pursue new market opportunities or investin additional research and development efforts.  As a result, our revenue, margins and market share may beharmed.  We cannot assure you that we willbe able to compete successfully against current and future competitors, or thatcompetitive pressures faced by us will not harm our business, financialcondition and results of operations.

 

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

 

We regard our system as open but proprietary. In an effort to protectour proprietary rights, we rely primarily on a combination of patent,copyright, trademark and trade secret laws, as well as licensing,non-disclosure and other agreements with our consultants, suppliers, customersand employees.  However, these laws andagreements provide only limited protection of our proprietary rights. Inaddition, we may not have signed agreements in every case and the contractualprovisions that are in place and the protection they produce may not provide uswith adequate protection in all circumstances. Although CPI holds patents and has filed patent applications coveringsome of the inventions embodied in our systems, our means of protecting our proprietaryrights may not be adequate. It may be possible for a third party to copy orotherwise obtain and use our technology without authorization and without ourdetection.  In the eventthat we believe a third party is infringing our intellectual property rights,an infringement claim brought by us could, regardless of the outcome, result insubstantial cost to us, divert our management’s attention and resources, betime consuming to prosecute and result in unpredictable damage awards.  A thirdparty may also develop similar technology independently, without infringingupon our patents and copyrights.  Inaddition, the laws of some countries in which we sell our system may notprotect our software and intellectual property rights to the same extent as thelaws of the United States.  Unauthorizedcopying, use or reverse engineering of our system could harm our business,financial condition or results of operations.

 

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**Infringementclaims could require us to expend significant financial and managerialresources.**

 

A third partycould claim that our technology infringes upon its proprietary rights.  As the number of software systems in ourtarget market increases and the functionality of these systems overlap, webelieve that the number of infringement suits filed by software developers mayincrease.  At a hearing held on March 7,2003, the judge in the existing lawsuit in which CPI is claiming that Polycominfringes four CPI patents granted Polycom’s motion to amend its counterclaimsto include claims of alleged infringements by Avistar Communications of fourPictureTel patents that Polycom has told us it has had assigned to it.  Three of the four counterclaims for patentinfringement related to equipment provided to Avistar by a third-party. Thesethree counterclaims involving the third party were dropped on June 23, 2003,subsequent to an agreement between Polycom and the third party.  

 

Briefings onclaims construction issues and a hearing before the presiding judge (Markmanhearing) took place on March 8, 2004, and the presiding judge issued her rulingon March 23, 2004.  A trial date for CPI’s claims against Polycom andPolycom’s remaining counterclaim has been set for January 10, 2005.  Prosecuting and defending against anyinfringement claims, even those that are not meritorious, could result in theexpenditure of significant financial and managerial resources, could take yearsto resolve and may require us to obtain additional financing. In addition, ifwe are found liable for infringement, it could require CPI or Avistar to paysubstantial compensation and/or damages to Polycom, and we may not be able tocontinue offering that portion of our system that is found to be infringing.Redesigning our system components to avoid alleged or actual infringement couldresult in the expenditure of significant and managerial resources and diminishthe value of our system, which could harm our business, financial position andresults of operations,and cause our stock price to decline substantially.  

 

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

 

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

 

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

 

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

 

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

 

**Theloss of any of our outside contract manufacturers or third party equipmentsuppliers that produce key components of our system could significantly disruptour manufacturing and new product development process.**

 

We depend on outside contract manufacturers to produce components ofour systems.  A significant portion ofour compression and decompression product, or gateway product, is currentlysupplied by a single source, Tandberg, Inc. In addition, we depend on various third party suppliers for the cameras,microphones, speakers and monitors that we install at desktops and inconference rooms as a part of each video communications network system.  Two of these contract manufacturers, SAEMaterials Inc. and Pacific Corporation, are single source suppliers for keycomponents of our products.  Anothersupplier, Equator Technologies Inc., is our only

 

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currentsource of a component used in our I.P gateway product. Our reliance on thesethird 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; and

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

 

If these manufacturers or suppliers cease to provide us with theassistance or the components necessary for the operation of our business, wemay not be able to identify alternate sources in a timely fashion.  Any transition to alternate manufacturers orsuppliers would likely result in operational problems and increased expensesand could cause delays in the shipment of or otherwise limit our ability toprovide our products.  We cannot assureyou that we would be able to enter into agreements with new manufacturers orsuppliers on commercially reasonable terms, or at all.  Any disruption in product flow may limit ourrevenue, delay our product development, seriously harm our competitive positionand/or result in additional costs or cancellation of orders by our customers.

 

**Ifwe are unable to expand our direct sales force and/or add distributionchannels, our business will suffer.**

 

To increase our revenue, we must increase the size of our direct salesforce and add indirect distribution channels, such as systems integrators,product partners and/or value-added resellers, and/or effect sales through ourcustomers.  If we are unable to maintainor increase our direct sales force or add indirect distribution channels due toour own cost constraints, limited availability of qualified personnel or otherreasons, our future revenue growth may be limited and our future operatingresults 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 new hire becomes a productive member of oursales force.  The loss of existingdirect and/or indirect salespeople, or the failure of new salespeople and/orindirect sales partners to develop the necessary skills in a timely manner,could reduce our revenue growth.

 

**Wemay not be able to retain our existing key personnel, or hire and retain theadditional personnel that we need to sustain and grow our business.**

 

Our productsand technologies are complex, and to successfully implement our businessstrategy and manage our business, an in-depth understanding of videocommunication and collaboration technologies and their potential uses isrequired.  We depend on the continuedservices of our executive officers and other key personnel.  We do not have long-term employmentagreements with our executive officers or other key personnel and we do notcarry any “key man” life insurance.  Theloss of the services of any of our executive officers or key personnel couldharm our business, financial condition and results of operations.

 

We need toattract and retain highly skilled technical and managerial personnel for whomthere 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 newpersonnel to develop the necessary skills in a timely manner could harm ourbusiness.

 

**Ourplans call for growth in our business, and our inability to achieve or managegrowth could harm our business.**

 

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

 

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**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 withoperations principally in Western Europe and Asia,  comprised 55% of total revenue for the threemonths ended March 31, 2004 and 50% for the three months ended March 31,2003.  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.

 

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

 

Increasedinternational political instability, evidenced by the threat or occurrence ofterrorist attacks, enhanced national security measures and/or sustainedmilitary action may halt or hinder our ability to do business, may increase ourcosts and may adversely affect our stock price. This increased instability hashad and may continue to have negative effects on financial markets, includingsignificant price and volume fluctuations in securities markets. If thisinternational political instability continues or escalates, our business andresults of operations could be harmed and the market price of our common stockcould decline.  

 

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

 

We believethat establishing and maintaining brand and name recognition is critical forattracting and expanding our targeted customer base.  We also believe that the importance of reputation and namerecognition will increase as competition in our market increases.  Promotion and enhancement of our name willdepend on the success of our marketing efforts, and on our ability to continueto provide high quality systems and services, neither of which can beassured.  If our customers do notperceive our system or services to be effective or of high quality, our brandand name recognition will suffer, which would harm our business.

 

**Wemay not meet the continued listing criteria for the NASDAQ SmallCap Market,which could materially adversely affect the price and liquidity of our stock,our business and our financial condition.**

 

For continuedlisting of our common stock on The NASDAQ SmallCap Market, we are required to,among other things (i) maintain stockholders’ equity of at least $2.5 million,and (ii) maintain a minimum closing bid price of our common stock of at least$1.00.  As of March 31, 2004, we hadstockholders’ equity of $7.1 million and the closing price of our common stockon May 3, 2004 was $0.95.  If ourstockholders’ equity declines below $2.5 million or the closing bid price ofour common stock remains below $1.00 for 30 or more consecutive trading days,our common stock could be subject to delisting from trading on The NASDAQSmallCap Market.  In the event of aviolation of the $1.00 bid price continued listing requirement, we may beafforded up to two years in order to regain compliance.  The availability of any such “grace period”extensions would be subject to our meeting the other continued listing criteriadelineated in NASDAQ’s Marketplace Rules, as updated from time to time.  There can be no assurance that we willcontinue to meet all requirements for continued listing on The NASDAQ SmallCapMarket, including the minimum bid price requirement, the requirement for aminimum stockholder’s equity of $2.5 million or the other continued listingstandards of such market.

 

If we areunable to continue to list our common stock for trading on The NASDAQ SmallCapMarket, there may be an adverse impact on the market price and liquidity of ourcommon stock, and our stock may be subject to the “penny stock rules” containedin Section 15(g) of the Securities Exchange Act of 1934, as amended, and therules promulgated there under. Delisting of our common

 

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stock from The NASDAQ SmallCapMarket could also materially adversely affect our business, including, amongother things: our ability to raise additional financing to fund our operations;our ability to attract and retain customers; and our ability to attract andretain personnel, including management personnel.  In addition, if we were unable to list our common stock fortrading on NASDAQ, many institutional investors would no longer be able toretain their interests in and/or make further investments in our common stockbecause of their internal rules and protocols. 

 

**Ourcommon stock has been and will likely continue to be subject to substantialprice and volume fluctuations due to a number of factors, many of which will bebeyond our control, that may prevent our stockholders from reselling our commonstock at a profit.**

 

The tradingprice of our common stock has in the past been and could in the future besubject to significant fluctuations in response to:

 

•                  quarterly variations in our results ofoperations;

•                  announcements regarding our product developments;

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

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

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

•                  developments or disputes concerning patents orproprietary rights, including our litigation with Polycom, or other events.

 

If our revenueand results of operations are below the expectations of public marketsecurities analysts or investors, then significant fluctuations in the marketprice 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.  These broad market fluctuations, as well asgeneral economic, political and market conditions, may negatively affect themarket price of our common stock.  

 

**If our share price isvolatile, we may be the target of securities litigation, which is costly andtime-consuming to defend.**

 

In the past, following periods of market volatility in the price of acompany’s securities, security holders have often instituted class actionlitigation. Many technology companies have been subject to this type oflitigation.  Our share price has, in thepast, experienced price volatility, and may continue to do so in the future. Ifthe market value of our common stock experiences adverse fluctuations and webecome involved in this type of litigation, regardless of the merits oroutcome, we could incur substantial legal costs and our management’s attentioncould be diverted, causing our business, financial condition and operatingresults to suffer.

 

**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.**

 

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

 

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

 

**Ourprincipal stockholders can exercise a controlling influence over our businessaffairs, and they may make business decisions with which you disagree that willaffect the value of your investment.**

 

Our executive officers, directors andentities affiliated with them, in the aggregate, beneficially ownedapproximately 65% of our common stock as of March 31, 2004.  If they were to act together, thesestockholders would be able to exercise control over most matters requiringapproval by our stockholders, including the election of directors and approvalof significant corporate transactions. These actions may be taken even if they are opposed by otherinvestors.  This concentration ofownership may also have the effect of delaying or preventing a change incontrol of our company, which could cause the market price of our common stockto decline. 

 

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

 

We develop products primarily in the UnitedStates and sell those products primarily in North America, Europe and Asia.International revenue, which consists of sales to customers with operationsprincipally in Western Europe and Asia, comprised 55% of total revenue for thethree months ended March 31, 2004 and 50% for the three months ended March 31,2003.  As a result, our financialcondition could be affected by factors such as changes in foreign currencyexchange rates or weak economic conditions in foreign markets.  As all of our sales are currently made inUnited States dollars, a strengthening of the United States dollar could makeour products less competitive in foreign markets.  We do not use derivative financial instruments for speculative ortrading purposes, nor do we engage in any foreign currency hedging transactions.

 

Our interest income is sensitive to changesin the general level of United States interest rates, particularly since themajority of our investments are in short-term instruments.  We expect that our interest income will benegatively affected by declines in short-term interest rates.  There has not been a material change in ourexposure to interest rate and foreign currency risk since the date of ourannual report on Form 10-K for the year ended December 31, 2003 filed with theSecurities and Exchange Commission on March 16, 2004. 

 

**Cash and CashEquivalents and Short-Term Investments**

 

Cash equivalents consist primarily of commercial paper and money marketand municipal bond funds acquired with remaining maturity periods of threemonths or less and are stated at cost, plus accrued interest that approximatesmarket value.  We would not expect ouroperating results or cash flow to be significantly impacted by the effect ofsudden changes in market interest rates given the nature of our short-terminvestments.

 

The following table provides information about our investmentportfolio.  For investment securities,the table presents cash and cash equivalents and short-term investments andrelated weighted average interest rates by category at March 31, 2004.

 

|                                                   |   | **Amounts**        |   | **Weighted Average  Interest Rate** |   |
|--------------------------------------------------------|--------|--------------------|--------|-------------------------------------|--------|
|                                                   |   | **(in thousands)** |   |                                |   |
| **Description**                                        |   |               |   |                                |   |
| Cash and cash equivalents and  short-term investments: |   |               |   |                                |   |
| Cash                                                   |   | $                  | 457    |                                | — |   |
| Market preferreds                                      |   | 1,000              |   | 1.18                                | %      |
| Other cash equivalents                                 |   | 6,024              |   | 0.80                                | %      |
| Fair Value at March 31, 2004                           |   | $                  | 7,481  |                                |   |   |

 

# **Item 4. *Controls and Procedures***

 

(a) Evaluation of disclosure controls andprocedures: Our management evaluated, with the participation of our ChiefExecutive Officer and Chief Financial Officer, the effectiveness of ourdisclosure controls and procedures as of the end of the period covered by thisQuarterly Report on Form 10-Q. Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer have concluded that our disclosure controlsand procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934 (the Exchange Act)) are effective to ensurethat information required to be disclosed by us in reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in Securities and Exchange Commission rulesand forms. It should be noted that the design of any system of controls isbased in part upon certain assumptions about the likelihood of future events,and there can be no assurance that any design will succeed in achieving itsstated goals under all potential future conditions, regardless of how remote. 

 

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

 

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**PARTII - OTHER INFORMATION**

 

**Item 1. *Legal Proceedings***

 

On September23, 2002, CPI, our wholly-owned subsidiary, commenced a patent infringementlawsuit against Polycom, Inc. alleging that several Polycom videoconferencingproducts infringe four patents held by CPI. The suit was filed in the UnitedStates District Court for the Northern District of California.  The four patents involved are U.S. PatentNos. 5,867,654, 5,896,500, 6,212,547 and 6,343,314.  These patents cover technologies relating to video and dataconferencing over unshielded twisted pair (UTP) networks, distributedcall-state management, separate monitors for simultaneous computer-based datasharing and videoconferencing and remote participant hold and disconnectfunctions in multi-party conferencing. Polycom responded to CPI’s claims onNovember 14, 2002, at which time it both answered the complaint and assertedcounterclaims against CPI for non-infringement, invalidity and unenforceabilityOn January 31, 2003, Polycom filed a motion with the court, which was subsequentlygranted by the court on March 7, 2003, requesting permission to amend itscounterclaims to incorporate claims of alleged infringements by AvistarCommunications of four PictureTel patents that Polycom has told us it has hadassigned to it. Three of the four counterclaims involved a third party, andPolycom dropped these three counterclaims on June 23, 2003, subsequent to anagreement between Polycom and the third party. On August 9, 2003, CPI and Polycom filed motions for summary judgmentwith the court, seeking judgment as a matter of law concerning CPI’s ability toqualify for “small entity status” in the filing of its four patents beingasserted against Polycom.  On October17, 2003 the court denied Polycom’s motion for summary judgment and grantedCPI’s motion for summary judgment, thereby negating Polycom’s defense ofunenforceability concerning CPI’s having filed these patents as a “smallentity.”

 

Briefings onclaims construction issues and a hearing before the presiding judge (Markman hearing)took place on March 8, 2004, and the presiding judge issued her ruling on March23, 2004.  A trial date for CPI’s claimsagainst Polycom and Polycom’s counterclaim has been set for January 10, 2005.  The prosecution of this lawsuit and thedefense of the Polycom counterclaim have required and may continue to requireus to expend significant financial and managerial resources and therefore mayhave a material negative impact on our business.  The duration and ultimate outcome of this litigation are uncertain.  In addition, an adverse judgment, if enteredagainst CPI or Avistar, could require CPI or Avistar to pay substantial damagesto Polycom, which could harm our business, financial position and results ofoperations, and cause our stock price to decline substantially. Litigation suchas this suit can take years to resolve and can be expensive to prosecute anddefend.  Regardless of the outcome, theprosecution of CPI’s claims and defense of the counterclaim in this lawsuit mayrequire us to obtain additional financing in the future.  

 

**Item 2. *Changes in Securities and Use of Proceeds***

 

(c)   RecentSales of Unregistered Securities

 

On March 26,2004, we completed the private sale of a total of 3,000,000 shares of ourcommon stock to Fuller & Thaler Avalanche Fund, L.P. and Fuller &Thaler Behavioral Finance Fund, Ltd. at a price per share of $1.20.  The net proceeds of this private financingafter deducting expenses of the financing were approximately $3.6 million. Suchproceeds are expected to be used for working capital and other generalcorporate purposes. Pursuant to the foregoing sale, we agreed to use ourcommercially reasonable efforts to register the shares under the Securities Actof 1933, as amended, as when requested to do so by Fuller & Thaler duringthe two years following the close date of the transaction, unless Fuller &Thaler is able to sell their holdings under rule 144 during any 90 dayperiod.  

 

The foregoingtransaction did not involve any public offering, and we believe that the transactionwas exempt from the registration requirements of the Securities Act by virtueof Section 4(2) thereof or Regulation D promulgated thereunder. The purchasersin the foregoing transaction represented their intention to acquire thesecurities for investment only and not with a view to or for resale inconnection with any distribution thereof. Appropriate legends were affixed tothe share certificates and instruments issued in the foregoing transaction. Allpurchasers had adequate access to information about us.

 

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**Item 6. *Exhibits***

 
| (a)    |   | 10.12  |   | Stock  Purchase Agreement among the Registrant, Fuller & Thaler Behavioral  Finance Fund, Ltd. and Fuller & Thaler Avalanche Fund, L.P. dated March  23, 2004.            |
|--------|--------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |   |                                                                                                                                                                              |
|   |   | 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. |

 

(b)  Reportson Form 8-K.

 
| (i)    | Report on  Form 8-K furnished on January 13, 2004 regarding the Registrant’s expected  financial results for the three months ended December 31, 2003.                   |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                          |
| (ii)   | Report on  Form 8-K furnished on January 28, 2004 regarding the Registrant’s  announcement of its  financial results  for the three months ended December 31, 2003. |
|   |                                                                                                                                                                          |
| (iii)  | Report on  Form 8-K filed on March 26, 2004 regarding the Registrant’s announcement of  the  completion of its financing  activities.                               |

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities and Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned thereunto duly authorized, on this 11th day of May 2004.

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

 

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**EXHIBIT INDEX**

 
| **Exhibit No.** |   | **Description**                                                                                                                                                                   |
|-----------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |   |                                                                                                                                                                              |
| 10.12           |   | Stock  Purchase Agreement among the Registrant, Fuller & Thaler Behavioral  Finance Fund, Ltd. and Fuller & Thaler Avalanche Fund, L.P. dated March  23, 2004.            |
|            |   |                                                                                                                                                                              |
| 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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