**UNITED STATESSECURITIES 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**

 

**For the quarterly period ended June 30,2004**

 

**OR**

 

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

 

**For the transition period from               to               **

 

**Commission file number:  000-31121**

 

**AVISTAR COMMUNICATIONS CORPORATION**

(Exact name of registrant as specified in itscharter)

 

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

 

| **555 TWIN DOLPHIN DRIVE, SUITE 360, REDWOOD  SHORES, CA 94065**             |
|------------------------------------------------------------------------------|
| (Address of Principal Executive  Offices) (Zip Code)                         |
|                                                                         |
| Registrant’s telephone number,  including area code: **(650) 610-2900** |

 

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

 

**Yes****ý      No****o**

 

**Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Act).**

 

**Yes****o      No****ý**

 

**AtJune 30, 2004, 33,277,038 shares of common stock of the Registrant wereoutstanding.**

 

 

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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 4.    | Submission of Matters to a Vote of Security  Holders                                        |   |
| Item 5.    | Other Information                                                                           |   |
| Item 6.    | Exhibits                                                                                    |   |
|       |                                                                                        |   |
| SIGNATURES |                                                                                        |

 

2

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**PART I - FINANCIAL INFORMATION**

 

**Item 1****.*****FinancialStatements***

 

**AVISTAR COMMUNICATIONS CORPORATIONAND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**as****of June 30, 2004 and December 31, 2003**

**(in thousands, except share and per share data)**

 
| ** **                                                                                                                                                                                                                | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                | ** ** | **(unaudited)**         | ** ** |
| **Assets:**                                                                                                                                                                                                               |       |                    |       |                        |       |
| Current assets:                                                                                                                                                                                                           |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                 |       | $                       | 5,896      |                        | $          | 5,438 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $29 at June 30, 2004 and $44 at December 31,  2003                                                                                              |       | 764                     |       | 695                         |       |
| Inventories, including inventory shipped to  customers’ sites, not yet installed of $39 at June 30, 2004 and $41 at  December 31, 2003                                                                     |       | 731                     |       | 937                         |       |
| Prepaid expenses and other current assets                                                                                                                                                                                 |       | 325                     |       | 515                         |       |
| Total current assets                                                                                                                                                                                                      |       | 7,716                   |       | 7,585                       |       |
| Property and equipment, net                                                                                                                                                                                               |       | 346                     |       | 352                         |       |
| Other assets                                                                                                                                                                                                              |       | 291                     |       | 291                         |       |
| Total assets                                                                                                                                                                                                              |       | $                       | 8,353      |                        | $          | 8,228 |   |
|                                                                                                                                                                                                                      |       |                    |       |                        |       |
| **Liabilities and  Stockholders’ Equity:**                                                                                                                                                                           |       |                    |       |                        |       |
| Current liabilities:                                                                                                                                                                                                      |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                                                          |       | $                       | 1,114      |                        | $          | 941 |   |
| Deferred revenue and customer deposits                                                                                                                                                                                    |       | 1,082                   |       | 671                         |       |
| Accrued liabilities and other                                                                                                                                                                                             |       | 1,332                   |       | 1,125                       |       |
| Total current liabilities                                                                                                                                                                                                 |       | 3,528                   |       | 2,737                       |       |
| Stockholders’ equity:                                                                                                                                                                                                |       |                    |       |                        |       |
| Common stock, $0.001 par value; 250,000,000  shares authorized at June 30, 2004 and December 31, 2003;  34,456,663 and 31,390,383 shares issued at June 30, 2004 and  December 31, 2003, respectively |       | 34                      |       | 31                          |       |
| Less: treasury common stock, 1,179,625  shares at June 30, 2004 and December 31, 2003, at cost                                                                                                                  |       | (51                     | )          | (51                         | )          |
| Additional paid-in-capital                                                                                                                                                                                                |       | 89,930                  |       | 86,278                      |       |
| Accumulated deficit                                                                                                                                                                                                       |       | (85,088                 | )          | (80,767                     | )          |
| Total stockholders’ equity                                                                                                                                                                                           |       | 4,825                   |       | 5,491                       |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                           |       | $                       | 8,353      |                        | $          | 8,228 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

3

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**AVISTAR COMMUNICATIONSCORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

**for****the three and six months ended June 30, 2004 and2003**

**(in thousands, except per sharedata)**

 
| ** **                                                                           | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                           | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
| ** **                                                                           | ** ** | **(unaudited)**         | ** ** | **(unaudited)**         | ** ** |
| Revenue:                                                                             |       |                    |       |                    |       |   |   |   |   |
| Product                                                                              |       | $                       | 914        |                    | $          | 569 |   | $ | 1,476 |   | $ | 1,370 |   |
| Services, maintenance and support                                                    |       | 762                     |       | 916                     |       | 1,604 |   | 1,778 |   |
| Total revenue                                                                        |       | 1,676                   |       | 1,485                   |       | 3,080 |   | 3,148 |   |
| Cost of revenue:                                                                     |       |                    |       |                    |       |   |   |   |   |
| Product                                                                              |       | 364                     |       | 314                     |       | 656 |   | 700 |   |
| Services, maintenance and support                                                    |       | 461                     |       | 562                     |       | 943 |   | 1,129 |   |
| Total cost of revenue                                                                |       | 825                     |       | 876                     |       | 1,599 |   | 1,829 |   |
| Gross margin                                                                         |       | 851                     |       | 609                     |       | 1,481 |   | 1,319 |   |
| Operating Expenses:                                                                  |       |                    |       |                    |       |   |   |   |   |
| Research and development                                                             |       | 632                     |       | 615                     |       | 1,256 |   | 1,311 |   |
| Sales and marketing                                                                  |       | 669                     |       | 944                     |       | 1,277 |   | 1,915 |   |
| General and administrative                                                           |       | 1,794                   |       | 1,480                   |       | 3,299 |   | 3,182 |   |
| Amortization of deferred stock compensation  *****                                   |       | —                  |       | 45                      |       | — |   | 90 |   |
| Total operating expenses                                                             |       | 3,095                   |       | 3,084                   |       | 5,832 |   | 6,498 |   |
| Loss from operations                                                                 |       | (2,244                  | )          | (2,475                  | )          | (4,351 | ) | (5,179 | ) |
| Other income (expense):                                                              |       |                    |       |                    |       |   |   |   |   |
| Interest income                                                                      |       | 16                      |       | 9                       |       | 29 |   | 28 |   |
| Other income (expense), net                                                          |       | (5                      | )          | (5                      | )          | 1 |   | (10 | ) |
| Total other income, net                                                              |       | 11                      |       | 4                       |       | 30 |   | 18 |   |
| Net loss                                                                             |       | $                       | (2,233     | )                       | $          | (2,471 | ) | $ | (4,321 | ) | $ | (5,161 | ) |
|                                                                                 |       |                    |       |                    |       |   |   |   |   |
| Net loss per share - basic and diluted                                               |       | $                       | (0.07      | )                       | $          | (0.10 | ) | $ | (0.14 | ) | $ | (0.20 | ) |
| Weighted average shares used in calculating  basic and diluted net loss per share    |       | 33,277                  |       | 25,343                  |       | 31,864 |   | 25,332 |   |
|                                                                                 |       |                    |       |                    |       |   |   |   |   |
|                                                                                      |       |
| * Amortization of deferred stock  compensation excluded from the following expenses: |       |                    |       |                    |       |   |   |   |   |
| Cost of revenue                                                                      |       | $                       | —     |                    | $          | 5 |   | $ | — |   | $ | 10 |   |
| Research and development                                                             |       | —                  |       | 4                       |       | — |   | 8 |   |
| Sales and marketing                                                                  |       | —                  |       | 35                      |       | — |   | 70 |   |
| General and administrative                                                           |       | —                  |       | 1                       |       | — |   | 2 |   |
|                                                                                 |       | $                       | —     |                    | $          | 45 |   | $ | — |   | $ | 90 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

4

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**AVISTAR COMMUNICATIONS CORPORATIONAND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**for****the six months endedJune 30, 2004 and 2003**

**(in thousands)**

 
| ** **                                                                   | ** ** | **Six Months Ended**    | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                   | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
| ** **                                                                   | ** ** | **(unaudited)**         | ** ** |
|                                                                         |       |                    |       |   |   |
| Cash Flows from Operating Activities:                                        |       |                    |       |   |   |
| Net loss                                                                     |       | $                       | (4,321     | ) | $ | (5,161 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                    |       |   |   |
| Depreciation                                                                 |       | 141                     |       | 105 |   |
| Stock-based compensation                                                     |       | —                  |       | 90 |   |
| Compensation on options issued to  consultants                               |       | 12                      |       | 19 |   |
| Provision for doubtful accounts                                              |       | 25                      |       | 65 |   |
| Changes in current assets and liabilities:                                   |       |                    |       |   |   |
| Accounts receivable                                                          |       | (94                     | )          | (368 | ) |
| Inventories                                                                  |       | 206                     |       | 131 |   |
| Prepaid expenses and other current assets                                    |       | 190                     |       | 300 |   |
| Accounts payable                                                             |       | 173                     |       | 407 |   |
| Deferred revenue and customer deposits                                       |       | 411                     |       | 187 |   |
| Accrued liabilities and other                                                |       | 207                     |       | (78 | ) |
| Net cash used in operating activities                                        |       | (3,050                  | )          | (4,303 | ) |
|                                                                         |       |                    |       |   |   |
| Cash Flows from Investing Activities:                                        |       |                    |       |   |   |
| Sale of short-term investments                                               |       | —                  |       | 2,400 |   |
| Purchase of property and equipment                                           |       | (135                    | )          | (32 | ) |
| Net cash provided by (used in) investing  activities                         |       | (135                    | )          | 2,368 |   |
|                                                                         |       |                    |       |   |   |
| Cash Flows from Financing Activities:                                        |       |                    |       |   |   |
| Proceeds from issuance of common stock                                       |       | 3,643                   |       | 48 |   |
| Proceeds from draw on line of credit                                         |       | —                  |       | 750 |   |
| Net cash provided by financing activities                                    |       | 3,643                   |       | 798 |   |
| Net increase (decrease) in cash and cash  equivalents                        |       | 458                     |       | (1,137 | ) |
| Cash and cash equivalents, beginning of  period                              |       | 5,438                   |       | 4,783 |   |
| Cash and cash equivalents, end of period                                     |       | $                       | 5,896      |   | $ | 3,646 |   |
|                                                                         |       |                    |       |   |   |
| Supplemental Cash Flow Information:                                          |       |                    |       |   |   |
| Cash paid for income taxes                                                   |       | $                       | 14         |   | $ | — |   |

 

The accompanying notes are anintegral part of these financial statements.

 

5

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**AVISTAR COMMUNICATIONSCORPORATION AND SUBSIDIARIES**

**NOTES TO CONDENSED****CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

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

 

# **Business**

 

Avistar Communications Corporation (“Avistar”or the “Company”) provides the Avistar vBusiness integrated suiteof video-enabled applications, includingnetworked video communications software and hardware products and services.Avistar’s products include applications for interactive video calling, contentcreation and publishing, broadcast video and video-on-demand, as well as datasharing, directory services and network management. Avistar designs, develops,markets, sells, manufactures and/or assembles and installs and supports itsproducts. Avistar’s real-time and non-real-time products are based upon itsarchitecture and Video Operating System (AvistarVOSTM) platform, whichfacilitates distribution over local and wide area networks using telephony orInternet services as appropriate. Avistar’s services include software development, consulting, implementation,training, maintenance and support.  Inaddition, Avistar seeks to prosecute, maintain, support and license theintellectual property developed by the Company through its wholly-ownedsubsidiary, Collaboration Properties, Inc., a Nevada corporation (CPI).

 

# **Basisof Presentation**

 

The unaudited balance sheet as ofJune 30, 2004 presents the consolidated financial position of Avistar andits two 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.

 

Thefunctional currency of ASUK is the United States dollar. Accordingly, all gainsand losses resulting from those transactions denominated in currencies otherthan the United States dollar are included in the statements of operations.

 

The Company’s fiscal year end is December 31.

 

# **Risksand Uncertainties**

 

Themarkets for the Company’s products and services are still in the early stagesof development.  Some of the Company’sproducts utilize changing and emerging technologies. As is typical inindustries of this nature, demand and market acceptance are subject to a highlevel of uncertainty, particularly when there are adverse conditions in the economy.  Acceptance of the Company’s products overtime is critical to the Company’s success. The Company’s prospects must be evaluated in light of difficultiesencountered by it and its competitors in further developing this evolvingmarketplace. The Company has generated losses since inception and had anaccumulated deficit of $85.1 million as of June 30, 2004.  The Company’s operating results may fluctuatesignificantly in the future as a result of a variety of factors, including, butnot limited to, the economic environment, the adoption of differentdistribution channels, and the timing of new product announcements by theCompany or its competitors.

 

The Company’s future liquidity and capital requirements will dependupon numerous factors, including, but not limited to, the costs and timing ofits expansion of product development efforts and the success of thesedevelopment efforts, the costs and timing of its expansion of sales andmarketing activities, the extent to which its existing and new products gainmarket acceptance, competing technological and market developments, the costsinvolved in maintaining, enforcing and defending patent claims and otherintellectual property rights, especially the costs associated with theCompany’s current litigation with Polycom, Inc., the level and timing ofrevenue and other factors.  The Companymay need to raise additional funds in the future, and additional financing maynot be available on favorable terms, if at all. If the Company cannot raise funds, if needed, on acceptable terms, theCompany may not be able to develop or enhance its products, take advantage offuture opportunities or respond to competitive pressures or unanticipatedrequirements, which could seriously harm the Company’s business, financial condition,results of operations and ability to continue operations. If additional fundsare raised through the issuance of equity securities, the Company’s nettangible book value per share is likely to decrease, the percentage ownershipof then current stockholders may be diluted and such equity securities may haverights, preferences or privileges senior to those of the holders of theCompany’s common stock.  Debt financing,if available, may involve significant fees, interest payment obligations andrestrictive covenants. Strategic arrangements, if necessary to raise additionalfunds, may require us to relinquish our rights to certain of our technologiesor products.

 

6

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

# ** **

# **UnauditedInterim Financial Information**

 

The financial statements filed in this report have been prepared by theCompany, without audit, pursuant to the rules and regulations of the Securitiesand Exchange Commission. Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America have beencondensed or omitted pursuant to such rules and regulations. TheDecember 31, 2003 Condensed Consolidated Balance Sheet was derived fromaudited financial statements, but does not include all disclosures required byaccounting principles generally accepted in the United States of America.

 

In the opinion of management, the unauditedfinancial statements furnished in this report reflect all adjustments(consisting of normal recurring adjustments) necessary for a fair presentationof the results of operations for the interim periods covered and of theCompany’s financial position as of the interim balance sheet date. The resultsof operations for the interim periods are not necessarily indicative of theresults for the entire year. These financial statements should be read inconjunction with the Company’s audited consolidated financial statements andthe accompanying notes for the year ended December 31, 2003, included inthe Company’s annual report on Form 10-K/A filed with the Securities andExchange Commission on March 26, 2004.

 

**Use of Estimates**

 

The preparation of financial statements inconformity with generally accepted accounting principles requires management tomake estimates and assumptions that affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities at the date ofthe financial statements, and the reported amounts of revenues and expensesduring the period.  Actual results coulddiffer from those estimates.

 

# **Cashand Cash Equivalents and Short Term Investments**

 

The Company considers all investmentinstruments purchased with a remaining maturity of three months or less to becash equivalents. The Company’s cash equivalents at June 30, 2004 andDecember 31, 2003 consisted of money market funds and short-termsecurities.  The fair value of theCompany’s investments was determined based on quoted market prices at thereporting date for those instruments.  Asof June 30, 2004, there was no difference between the cost and fair valueof the Company’s investments.

 

# **SupplementalCash Flow Information**

 

Duringthe six months ended June 30, 2004, the Company paid approximately $14,000in income taxes. During the six months ended June 30, 2004, no cash waspaid for interest. During the three months ended June 30, 2003, no cashwas paid for income taxes or interest.

 

# **SignificantConcentrations**

 

A relatively small number of customersaccounted for a significant percentage of the Company’s net sales. Sales tothese customers as a percentage of total sales were as follows for the threeand six months ended June 30, 2004 and 2003:

 

| ** ** | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** | **SIX MONTHS ENDED  JUNE 30,** | ** ** |
|------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** ** | ** ** | **(UNAUDITED)**                       | ** ** | **(UNAUDITED)**                     | ** ** |
| Customer A |       | 51                                    | %          | 64                                  | %          | 55 | % | 61 | % |
| Customer B |       | 11                                    | %          | *                                   |       | 13 | % | * |   |
| Customer C |       | *                                     |       | 11                                  | %          | * |   | * |   |

 

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* Less than 10%

 

Any change in the relationship with thesecustomers could have a potentially adverse effect on the Company’s financialposition.

 

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

 

7

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financial institution and restrictplacement of these investments to financial institutions evaluated as highlycredit worthy.  Concentration of creditrisk with respect to trade receivables relate to those trade receivables fromboth United States and foreign customers of Avistar.  As of June 30, 2004, approximately 78%of accounts receivable were concentrated with four customers, each of whomrepresented more than 10% of the Company’s total accounts receivable balance.As of December 31, 2003, approximately 89% of accounts receivable wereconcentrated with one customer. No other customers individually accounted forgreater than 10% of total accounts receivable as of December 31, 2003.

 

# **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):

 

| ** **                                              | ** ** | **JUNE 30,  2004** | ** ** | **DECEMBER 31, 2003** | ** ** |
|---------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                              | ** ** | **(UNAUDITED)**         | ** ** |
| Raw materials  and subassemblies                        |       | $                       | 68         |                       | $          | 83 |   |
| Finished goods                                          |       | 624                     |       | 813                        |       |
| Inventory shipped to customer sites, not  yet installed |       | 39                      |       | 41                         |       |
|                                                    |       |                    |       |                       |       |
|                                                    |       | $                       | 731        |                       | $          | 937 |   |

 

Inventory shipped to customer sites, not yet installed,represents product shipped to customer sites pending completion of theinstallation process by the Company. As of June 30, 2004 and December 31, 2003, the Companyhad billed approximately $75,000 and $57,000, respectively, to customersrelated to these shipments, but did not record the revenue, as theinstallations had not been completed and confirmed by the customer.  Although customers are billed in accordancewith customer agreements, these deferred revenue amounts are netted againstaccounts receivable until the customer confirms installation.

 

**Revenue Recognition and Deferred Revenue**

 

The Company recognizes revenue in accordancewith Statement of Position (“SOP”) 97-2, “Software Revenue Recognition”, andSOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, with Respectto Certain Transactions.”  The Companyrecognizes revenue from product sales when all of the following conditions aremet: the product has been shipped, an arrangement exists with the customer at afixed price and the Company has the right to invoice the customer, collectionof the receivable is probable, and the Company has fulfilled all of itsmaterial contractual obligations to the customer.

 

When the Company provides installationservices, the product and installation revenue is recognized upon completion ofthe installation process and receipt of customer confirmation, subject to thesatisfaction of the revenue recognition criteria described above.  When the customer or a third party providesinstallation services, the product revenue is recognized upon shipment, subjectto satisfaction of the revenue recognition criteria described above.  Payment for product is due upon shipment,subject to specific payment terms. Payment for installation and professional services are due uponproviding the services, subject to specific payment terms.  If payments for systems are made in advanceof the completion of installation, such amounts are deferred and recorded asdeferred revenue and customer deposits in the accompanying balance sheets untilinstallation has occurred and the customer has provided confirmation.  Reimbursements received forout-of-pocket expenses incurred duringinstallation and support services have not been significant to date. Theseexpenses are recognized as revenue in accordance with Emerging Issues TaskForce (EITF) Issue No. 01-14 (EITF 01-14), “Income Statement Characterizationof Reimbursements Received for “Out of Pocket” Expenses Incurred.”

 

The price charged for maintenance and/orsupport is defined in the product contract, and is based on a fixed price forboth hardware and software components as stipulated in the customeragreement.  Customers have the option torenew the maintenance and/or support arrangement in subsequent periods at thesame rate as paid in the initial year. Revenue from maintenance and support services is deferred and recognizedpro-rata over the maintenance and/or support term, which is typically one yearin length.  Payments for services made inadvance of the provision of services are recorded as deferred revenue andcustomer deposits in the accompanying balance sheets.  Training services are offered together withand independently of the purchase of product. The value of training services provided with the purchase of product isdetermined based on the price charged when such services are sold separately.Training revenue is recognized upon performance of the service.

 

The Company recognizes service revenue fromdevelopment contracts in accordance with SOP 81-1, “Accounting for Performanceof Construction-Type and Certain Production-Type Contracts.” Revenue related tocontracts for development is recognized using the

 

8

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percentage of completion method, when all of the followingconditions are met: a contract exists with the customer at a fixed price, theCompany has fulfilled all of its material contractual obligations to thecustomer for each deliverable of the contract, verification of completion ofthe deliverable has been received, and collection of the receivable isprobable.  The amounts billed tocustomers in excess of revenues earned to date are deferred and recorded asdeferred revenue and customer deposits in the accompanying balance sheets.  Assumptions used for recording revenue andearnings are adjusted in the period of change to reflect revisions in contractvalue and estimated costs to complete the contract.  Any anticipated losses on contracts inprogress are charged to earnings when identified.

 

**Stock-Based Compensation**

 

TheCompany applies the intrinsic-value-based method of accounting for stock-basedcompensation prescribed by Accounting Principles Board (APB) Opinion No. 25,“Accounting for Stock Issued to Employees”, and related interpretationsincluding Financial Accounting Standards Board (FASB) InterpretationNo. 44, “Accounting for Certain Transactions involving Stock Compensation,an interpretation of APB Opinion No. 25”, to account for its fixed-planstock options. Under this method, compensation expense is recorded on the dateof grant only if the current market price of the underlying stock exceeded theexercise 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, andas amended by SFAS 148, Accounting for Stock-Based Compensation - Transitionand Disclosure — An Amendment of FASB Statement No. 123”, the Company haselected to continue to apply the intrinsic-value-based method of accountingdescribed above, and has adopted only the disclosure requirements of SFASNo. 123 and SFAS No. 148. The following table illustrates the effect onnet income if the fair-value-based method had been applied to all outstandingand unvested awards in each period (in thousands, except per share data).

 
| ** **                                                                                                                   | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                   | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss, as  reported                                                                                                       |       | $                                     | (2,233     | )                                   | $          | (2,471 | ) | $ | (4,321 | ) | $ | (5,161 | ) |
| Add stock –  based employee compensation expense included in reported net loss, net of tax                              |       | —                                |       | 45                                  |       | — |   | 90 |   |
| Deduct total  stock-based employee compensation expense determined under fair-value-based  method for all awards, net of tax |       | (471                                  | )          | (1,078                              | )          | (922 | ) | (2,078 | ) |
| Pro forma net  loss                                                                                                          |       | $                                     | (2,704     | )                                   | $          | (3,504 | ) | $ | (5,243 | ) | $ | (7,149 | ) |
|                                                                                                                         |       |                                  |       |                                |       |   |   |   |   |
| Basic and  diluted loss per share                                                                                            |       |                                  |       |                                |       |   |   |   |   |
| As reported                                                                                                                  |       | $                                     | (0.07      | )                                   | $          | (0.10 | ) | $ | (0.14 | ) | $ | (0.20 | ) |
| Pro forma                                                                                                                    |       | $                                     | (0.08      | )                                   | $          | (0.14 | ) | $ | (0.16 | ) | $ | (0.28 | ) |

 

Thefair value of options granted for the three and six months ended June 30,2004 and 2003 is estimated on the date of grant using the followingassumptions: 

 
| ** **                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
| Expected  dividend               |       | 0        | %          | 0        | %          |
| Average  risk-free interest rate |       | 3.5      | %          | 2.9      | %          |
| Expected  volatility             |       | 237      | %          | 187      | %          |
| Expected term  (in years)        |       | 4        |       | 4        |       |

 

# **Recent Accounting Pronouncements**

 

In May 2003, the FASB issued SFAS No. 150,“Accounting for Certain Financial Instruments with Characteristics of BothLiabilities and Equity,” which establishes standards for how an issuerclassifies and measures certain financial instruments with characteristics ofboth liabilities and equity. Financial instruments that are within the scope ofthe statement, which previously were often classified as equity, must now beclassified as liabilities. This statement is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise shall beeffective at the beginning of the first interim period beginning afterJune 15, 2003. The adoption of SFAS No. 150 did not have an impact on theCompany’s condensed consolidated financial statements.

 

InMarch 2004, the FASB issued EITF Issue No. 03-1 (“EITF 03-1”), “TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments”. EITF 03-1 includes new guidance for evaluating and recordingimpairment losses on debt and

 

9

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equity instruments, as well as newdisclosure requirements for investments that are deemed to be temporarilyimpaired. The accounting guidance provided in EITF 03-1 is effective forreporting periods beginning after June 15, 2004, while the disclosurerequirements for debt and equity securities accounted for under FASB StatementNo. 115, “Accounting for Certain Investments in Debt and Equity Securities”,are effective for annual periods ending after December 15, 2003. The Companydoes not expect the adoption of EITF 03-1 will have a material impact on itsfinancial position, results of operations or cash flows.

 

**3. Line of Credit**

 

On February 27, 2002, the Company entered into a Loan and SecurityAgreement with a financial institution for a revolving line of credit.  As collateral under this Loan and SecurityAgreement, the Company granted a first priority interest in all of theCompany’s assets, excluding intellectual property.  On December 16, 2002, Gerald Burnett,Chairman and Chief Executive Officer of the Company, provided a collateralizedguarantee, assuring payment of the Company’s obligations under the agreementand as a consequence, restrictive covenants from the original Loan and Securityagreement were deleted in the amendment, except for a quick ratio and loan tovalue covenant, allowing the Company 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 connectionwith this amendment, Dr. Burnett’s collateralized guarantee was amended toreduce the amount of such guarantee to $3.5 million.  As of June 30, 2004, the Company had nooutstanding borrowings under the line of credit and was eligible to borrow upto $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 theCompany since February 2001.  Mr.Latta and WSGR have represented the Company and its predecessors as corporatecounsel since 1997.  During the sixmonths ended June 30, 2004 and 2003, payments of approximately $51,000 and$150,000, respectively, were made to WSGR for legal services provided to theCompany.

 

During the six months ended June 30, 2003, payments for consulting fees of approximately $100,000 were made to R.Stephen Heinrichs, a former officer of the Company, who is also a member of theBoard of Directors, pursuant to a Separation Agreement between Mr.Heinrichs and the Company dated April 26, 2001. During the six monthsended June 30, 2004, no payments for consulting fees were made to R.Stephen Heinrichs.

 

**5.   Legal Proceedings**

 

OnSeptember 23, 2002, CPI, the Company’s wholly-owned subsidiary, commenceda patent infringement lawsuit against Polycom, Inc. alleging that severalPolycom videoconferencing products infringe four patents held by CPI. The suitwas filed 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 thecomplaint and asserted counterclaims against CPI for non-infringement,invalidity and unenforceability.  OnJanuary 31, 2003, Polycom filed a motion with the court, which wassubsequently 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 these three counterclaims were dropped by Polycom on June 23, 2003,subsequent to an agreement between Polycom and the third party.  On August 9, 2003, CPI and Polycom filedmotions for summary judgment with the court, seeking judgment as a matter oflaw concerning CPI’s ability to qualify for “small entity status” in the filingof its four patents being asserted against Polycom.  On October 17, 2003, the court deniedPolycom’s motion for summary judgment and granted CPI’s motion for summaryjudgment, thereby negating Polycom’s defense of unenforceablity concerningCPI’s having filed these patents as a “small entity.”

 

Briefings on claims construction issues and a hearing before thepresiding judge (Markman hearing) took place on March 8, 2004, and thepresiding judge issued her ruling on March 23, 2004. A trial date forCPI’s claims against Polycom and Polycom’s counterclaim has been set for January 10,2005.  The prosecution of this lawsuitand the defense of the Polycom counterclaim have required and may continue torequire the Company and CPI to expend significant financial and managerialresources and therefore may have a material negative impact on the Company andCPI.  Expenses associated with thelitigation have risen as trial approaches

 

10

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to now comprise a significant portion of ourquarterly operating expense. The duration and ultimate outcome of thislitigation are uncertain.

 

**6.****     Net Loss PerShare**

 

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

 

In accordance with SFAS 128, basic net lossper share has been computed using the weighted average number of shares ofcommon stock outstanding during the period. Diluted net loss per share is computed on the basis of the weightedaverage number of shares and potential common shares outstanding during the period.Potential common shares result from the assumed exercise of outstanding stockoptions that have a dilutive effect when applying the treasury stockmethod.  The Company has excluded alloutstanding stock options from the calculation of diluted net loss per sharefor the three and six months ended June 30, 2004 and 2003, because allsuch securities are antidilutive (owing to the fact that the Company is in lossposition).  Accordingly, diluted net lossper share approximates basic net loss per share for all periods presented.

 

Thetotal number of shares excluded from the calculations ofdiluted net loss per share were 4,218,749 and 1,387,694 for the threemonths ended June 30, 2004 and 2003, respectively, and 3,760,880 and824,191 for the six months ended June 30, 2004 and 2003, respectively.

 

**7. Segment Reporting**

 

Disclosure of segments is presented in accordance with SFAS No. 131,“Disclosures About Segments of an Enterprise andRelated Information.”  SFAS 131establishes standards for disclosures regarding operating segments, productsand services, geographic areas and major customers. The Company is organized and operates as two operating segments: (1) thedesign, development, manufacturing, sale and marketing of networked videocommunications products (Avistar, including ASUK) and (2) theprosecution, maintenance, support and licensing of theintellectual property used in the Company’s products (CPI).  Servicerevenue relates mainly to the maintenance, support, training, softwaredevelopment and installation of products, and is included in the Avistar entityfor purposes of reporting and decision-making. Avistar also performs corporate functions and provides financingand services to its subsidiaries. The Company’s chief operating decision maker,its Chief Executive Officer, monitors the Company’s operations based upon theinformation reflected in the following table (in thousands):

 

| ** **                             | ** ** | **Avistar** | ** ** | **CPI** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|-------------|------------|---------|------------|-----------|------------|
|                                   |       |        |       |    |       |      |       |
| Three  Months Ended June 30, 2004 |       |        |       |    |       |      |       |
| Revenue                                |       | $           | 1,676      |    | $          | —    |       | $ | 1,676 |   |
| Gross margin                           |       | 851         |       | —  |       | 851       |       |
| Depreciation expense                   |       | (73         | )          | —  |       | (73       | )          |
| Total operating expenses               |       | (2,128      | )          | (967    | )          | (3,095    | )          |
| Interest income                        |       | 16          |       | —  |       | 16        |       |
| Net loss                               |       | (1,266      | )          | (967    | )          | (2,233    | )          |
| Total Assets                           |       | 8,344       |       | 9       |       | 8,353     |       |
| Three Months Ended June 30, 2003  |       |        |       |    |       |      |       |
| Revenue                                |       | $           | 1,485      |    | $          | —    |       | $ | 1,485 |   |
| Gross margin                           |       | 609         |       | —  |       | 609       |       |
| Depreciation expense                   |       | (52         | )          | (1      | )          | (53       | )          |
| Total operating expenses               |       | (2,543      | )          | (541    | )          | (3,084    | )          |
| Interest income                        |       | 9           |       | —  |       | 9         |       |
| Net loss                               |       | (1,930      | )          | (541    | )          | (2,471    | )          |
| Total Assets                           |       | 6,484       |       | 176     |       | 6,660     |       |
|                                   |       |        |       |    |       |      |       |
| Six Months Ended June 30, 2004    |       |        |       |    |       |      |       |
| Revenue                                |       | $           | 3,080      |    | $          | —    |       | $ | 3,080 |   |
| Gross margin                           |       | 1,481       |       | —  |       | 1,481     |       |
| Depreciation expense                   |       | (141        | )          | —  |       | (141      | )          |

 

11

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| ** **                          | ** ** | **Avistar** |   | **CPI** | ** ** | **Total** | ** ** |
|-------------------------------------|------------|-------------|--------|---------|------------|-----------|------------|
|                                |       |        |   |    |       |      |       |
| Total operating expenses            |       | (4,120      | )      | (1,712  | )          | (5,832    | )          |
| Interest income                     |       | 29          |   | —  |       | 29        |       |
| Net loss                            |       | (2,609      | )      | (1,712  | )          | (4,321    | )          |
| Six Months Ended June 30, 2003 |       |        |   |    |       |      |       |
| Revenue                             |       | $           | 3,148  |    | $          | —    |       | $ | 3,148 |   |
| Gross margin                        |       | 1,319       |   | —  |       | 1,319     |       |
| Depreciation expense                |       | (104        | )      | (1      | )          | (105      | )          |
| Total operating expenses            |       | (5,300      | )      | (1,198  | )          | (6,498    | )          |
| Interest income                     |       | 28          |   | —  |       | 28        |       |
| Net loss                            |       | (3,963      | )      | (1,198  | )          | (5,161    | )          |
|                                     |            |             |        |         |            |           |            |  |  |  |

 

International revenue, which consists of sales to customers withoperations principally in Western Europe and Asia, comprised 52% and 65% oftotal revenue for the three months ended June 30, 2004 and 2003,respectively.  International revenuecomprised 53% and 57% of total revenue for the six months ended June 30, 2004and 2003, respectively.  For the threemonths ended June 30, 2004 and 2003, international revenues from customersin the United Kingdom accounted for 28% and 47%, respectively, of totalrevenue.  For the six months endedJune 30, 2004 and 2003, international revenues from customers in theUnited Kingdom accounted for 34% and 22%, respectively, of total revenue.  All of the Company’s sales are currentlybilled in United States dollars. The Company had no significant long-livedassets in any country other than in the United States for any period presented.

 

12

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**Item 2****.**** *Management’s Discussion and Analysis of FinancialCondition and Results of Operations***

 

The following discussion should be read in conjunction with theUnaudited Condensed Consolidated Interim Financial Statements and the Notesthereto included elsewhere herein, and the Audited Consolidated FinancialStatements contained in our Annual Report on Form 10-K/A for the year endedDecember 31, 2003, as filed with the Securities and Exchange Commission onMarch 26, 2004.

 

Certain statements in this “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” areforward looking statements. These statements relate to future events or ourfuture financial performance and involve known and unknown risks, uncertaintiesand other factors that may cause our or our industry’s actual results, levelsof activity, performance or achievements to be materially different from anyfuture results, levels of activity, performance or achievements expressed orimplied by the forward looking statements. These risks and other factorsinclude those listed under “Factors Affecting Future Operating Results”elsewhere in this report on Form 10-Q. In some cases, you can identify forwardlooking statements by terminology such as “may”, “will”, “should”, “expects”,“intends”, “plans”, “anticipates”, “believes”, “estimates”, “predicts”,“potential”, “continue” or the negative of these terms, or other comparableterminology. These statements are only predictions. Actual events or resultsmay differ materially. In evaluating these statements, you should specificallyconsider various factors, including the risks outlined under “Factors AffectingFuture Operating Results.”  These factorsmay cause our actual results to differ materially from any forward lookingstatement.

 

Although we believe that the expectations reflected in the forwardlooking statements are reasonable, we cannot guarantee future results, levelsof activity, performance or achievements. We are under no duty to update any of the forward-looking statementsafter the date of this report on Form 10-Q in order to conform our priorstatements to actual results.

 

**Overview**

 

We develop, market and support an integratedsuite of video-enabled vBusiness applications, all powered by our AvistarVOS(video operating system) software.  Fromthe desktop, we deliver TV-quality interactive video calling, content creationand publishing, broadcast origination and distribution, video-on-demand andintegrated data sharing.  Our customersuse our system to improve productivity and communication within theirenterprise, and between enterprises to enhance relationships with colleagues,customers, suppliers and partners.  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 two segments.  Weengage in the design, development, manufacturing, sale and marketing ofnetworked video communications products, and associated support services, andCollaboration Properties, Inc. (CPI), our wholly-owned subsidiary, engages inthe prosecution, maintenance,support and licensing of the intellectual property that we have developed, someof which is used in our products. Although several separate negotiations are inprocess, as of June 30, 2004, CPI had not entered into any such thirdparty licensing agreements.

 

**Critical Accounting Policies**

 

Thepreparation of our Condensed Consolidated Financial Statements in accordancewith accounting principles generally accepted in the United States requires usto make estimates 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 Condensed Consolidated Financial Statements:

 

•                  Revenuerecognition;

•                  Valuation ofaccounts receivable; and

•                  Valuation ofinventories.

 

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Revenue Recognition

 

We derive product revenue principally from the sale andlicensing of our video-enabled networked communications system, consisting of asuite of Avistar-designed software and hardware products, including third partycomponents.  In addition, we deriverevenue from fees for installation, maintenance, support, training services andsoftware development.

 

We recognize revenue from productsales when all of the following conditions are met:  the product has been shipped, an arrangementexists with the customer at a fixed price and we have the right to invoice thecustomer, collection of the receivable is probable, and we have fulfilled allof our material contractual obligations to the customer.  When we provide installation services, theproduct and installation revenue is recognized upon completion of installationand 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.  The price charged for maintenanceand/or support is defined in the product contract, and is based on a fixedprice for both hardware and software components as stipulated in the customeragreement.  Customers have the option torenew the maintenance and/or support services in subsequent periods at the samerate 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.”

 

# **Valuation ofAccounts Receivable**

 

Estimates are used in determining our allowance for doubtful accountsand are based on our historical collection experience, historical write-offs,current trends and the credit quality of our customer base and thecharacteristics of our accounts receivable by aging category.  If the allowance for doubtful accounts wasunderstated, our operating income could be reduced. The impact of any suchchange or deviation may be increased by our reliance on a relatively smallnumber of customers for a large portion of our total revenue. As ofJune 30, 2004, approximately 78% of our accounts receivable balance wasconcentrated with four customers, each of whom represented more than 10% of ourtotal accounts receivable.  As ofDecember 31, 2003, approximately 89% of our accounts receivable wereconcentrated with one customer.

 

Valuation ofInventories

 

We record a provision for obsolete or excess inventory for models orcomponents that are no longer manufactured or are at risk of being replacedwith new versions of our product. In determining the allowance for obsolete orexcess inventory, we look at our forecasted demand versus quantities on handand commitments.  Any significantunanticipated changes in demand or technological developments could have asignificant impact on the value of our inventory and commitments and ourreported results.  If actual marketconditions are less favorable than those projected, additional inventorywrite-downs, provision for purchase commitments and charges against earningsmay be required, which would negatively affect our operating income for suchperiod.

 

EmergingAccounting Developments

 

On March 31, 2004, the Financial Accounting Standards Board, orFASB, issued its exposure draft, “Share-Based Payment,” which is a proposedamendment to the FASB’s Statement No. 123, “Accounting for Stock-BasedCompensation,” or SFAS 123.  Generally,the approach in the exposure draft is similar to the approach described in SFAS123.  However, the exposure draft wouldrequire all share-based payments to employees, including grants of employeestock options and the right to purchase shares under our employee stockpurchase plan, to be recognized in our income statement based on their fairvalues.  There are a number of issuesthat are not resolved in the exposure draft, including the final methodologyfor calculating fair value.  The FASBexpects to issue a final standard late in 2004 that would be effective in2005.  The pro forma impact of the adoptionof SFAS 123 on our historical financial statements is included in the condensednotes to the condensed consolidated financial statements presented elsewhere inthis Form 10-Q.  We expect to continue togrant stock-based compensation to employees. The impact of the new standard,when and if issued, may have a material impact on our future results ofoperations.

 

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**Results of Operations**

 

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

 
| ** **                                   | ** ** | **PERCENTAGE OF TOTAL REVENUE**       | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                   | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** | **SIX MONTHS ENDED  JUNE 30,** | ** ** |
| ** **                                   | ** ** | **2004**                              | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue:                                     |       |                                  |       |   |   |   |   |   |   |
| Product                                      |       | 55                                    | %          | 38 | % | 48 | % | 44 | % |
| Services,  maintenance and support           |       | 45                                    |       | 62 |   | 52 |   | 56 |   |
| Total revenue                                |       | 100                                   |       | 100 |   | 100 |   | 100 |   |
| Cost of  revenue:                            |       |                                  |       |   |   |   |   |   |   |
| Product                                      |       | 22                                    |       | 21 |   | 21 |   | 22 |   |
| Services,  maintenance and support           |       | 28                                    |       | 38 |   | 31 |   | 36 |   |
| Total cost of  revenue                       |       | 49                                    |       | 59 |   | 52 |   | 58 |   |
| Gross margin                                 |       | 51                                    |       | 41 |   | 48 |   | 42 |   |
| Operating  expenses:                         |       |                                  |       |   |   |   |   |   |   |
| Research and  development                    |       | 38                                    |       | 41 |   | 41 |   | 42 |   |
| Sales and  marketing                         |       | 40                                    |       | 64 |   | 41 |   | 61 |   |
| General and  administrative                  |       | 107                                   |       | 100 |   | 107 |   | 101 |   |
| Amortization  of deferred stock compensation |       | —                                |       | 3 |   | — |   | 3 |   |
| Total  operating expenses                    |       | 185                                   |       | 208 |   | 189 |   | 206 |   |
| Loss from  operations                        |       | (134                                  | )          | (167 | ) | (141 | ) | (165 | ) |
| Other income  (expense):                     |       |                                  |       |   |   |   |   |   |   |
| Interest  income                             |       | 1                                     |       | 1 |   | 1 |   | 1 |   |
| Other income  (expense), net                 |       | —                                |       | — |   | — |   | — |   |
| Total other  income                          |       | 1                                     |       | 1 |   | 1 |   | 1 |   |
| Net loss                                     |       | (133                                  | )%         | (166 | )% | (140 | )% | (164 | )% |

 

**COMPARISON OF THE THREE AND SIXMONTHS ENDED JUNE 30, 2004 AND 2003**

 

## ***Revenue***

 

Totalrevenue increased by 13% to $1.7 million for the three months endedJune 30, 2004 from $1.5 million for the three months ended June 30,2003 and remained level at $3.1 million for the six months ended June 30,2004 and June 30, 2003. The increase in the three-month period endedJune 30, 2004 was due primarily to an increase in product sales,specifically from new customers, offset by the reduction in softwaredevelopment revenue as a result of a software development contract completedduring the three months ended June 30, 2003.

 

For the three months ended June 30,2004, revenue from two customers accounted for 62% of total revenue, each ofwhom accounted for greater than 10% of total revenue. For the three monthsended June 30, 2003, revenue from two customers accounted for 75% of totalrevenue, each of whom accounted for greater than 10% of our totalrevenue. For the six months endedJune 30, 2004, revenue from two customers accounted for 68% of totalrevenue, each of whom accounted for greater than 10% of total revenue. For thesix months ended June 30, 2003, revenue from one customers accounted for61% of total revenue. No other customers individually accounted forgreater than 10% of our total revenue for the six months ended June 30,2003.  The level of sales to any customer may vary from quarter to quarter.  We expect that there will be significantcustomer concentration in future quarters. The loss of any one of those customers would have a material adverseimpact on our financial condition and operating results.

 

## ***Costof Revenue***

 

Thetotal cost of revenue declined slightly by 6% to $0.8 million for the threemonths ended June 30, 2004 from $0.9 million for the three months endedJune 30, 2003 and decreased by 13% to $1.6 million for the six monthsended June 30, 2004 from $1.8 million for the six months endedJune 30, 2003.  Cost of productrevenue increased by 16% to $0.4 million for the three months endedJune 30, 2004 from $0.3 million for the three months ended June 30,2003 and decreased slightly by 6% to $656,000 for the six months endedJune 30, 2004 from $700,000 for the six months ended June 30, 2004.  This increase in cost of product revenue forthe three month period ended June 30, 2004 was primarily due to theincreased level of product sales and the associated direct product costs,

 

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offset, to a lesser extent, by a reductionin the fixed component of product costs, due in part to our reduced occupancycosts. Cost of service revenue decreased by 18% to $0.5 million for the threemonths ended June 30, 2004 from $0.6 million for the three months endedJune 30, 2003 and decreased by 16% to $0.9 million for the six monthsended June 30, 2004 from $1.1 million for the six months endedJune 30, 2003.  This decline in costof service revenue for the three and six month periods ended June 30, 2004was primarily due to the reduction in software development contract costsassociated with the decrease in software development revenue. In addition, thedecline in cost of service revenue for the three and six month periods endedJune 30, 2004 was due to a reduction in maintenance and support costs causedby the consolidation of our support center operations into our corporateheadquarters and the associated closure of two outlying facilities.

 

## ***GrossMargin***

 

Grossmargin as a percentage of revenue increased to 51% for the three months endedJune 30, 2004 from 41% for the three months ended June 30, 2003 andincreased to 48% for the six months ended June 30, 2004 from 42% for thesix months ended June 30, 2003. The increase was due primarily to theincrease in product gross margin. Product gross margin as a percentage of totalproduct revenue increased to 60% for the three-month period ended June 30,2004 compared to 45% for the three-month period ended June 30, 2003 and56% for the six-month period ended June 30, 2004 compared to 49% for thesix-month period ended June 30, 2003. The increase in product gross margin for the three and six month periodsended June 30, 2004 was due primarily to the increased product revenue,which resulted in greater coverage of the fixed component of the cost ofproduct sales. Services gross margin as a percentage of total service revenueincreased slightly to 40% for the three months June 30, 2004 from 39% forthe three months ended June 30, 2003 and increased to 41% for the sixmonths ended June 30, 2004 from 37% for the six months ended June 30,2003. The increase in services gross margin during the six months endedJune 30, 2004 was due to the decrease in software development contractmargin, which is generally at a lower rate than product or other servicesmargins, and 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.

 

## ***Operatingexpenses***

 

*Researchand development.*****Researchand development expenses remained level at $0.6 million and $1.3 million forthe three and six months ended June 30, 2004 and 2003, respectively.

 

*Salesand marketing.* Sales and marketing expenses decreased by 29% to $0.7 million for thethree months ended June 30, 2004 from $0.9 million for the three monthsended June 30, 2003 and decreased by 33% to $1.3 million for the sixmonths ended June 30, 2004 from $1.9 million for the six months endedJune 30, 2003. The decrease was due to the reduction in personnel and personnelrelated expenses, as a result of a 30% reduction in staffing levels in salesand marketing, and a reduction in property lease costs.

 

*Generaland administrative.* General and administrative expenses increased by 21% to $1.8 million forthe three months ended June 30, 2004 from $1.5 million for the threemonths ended June 30, 2003 and increased slightly by 4% to $3.3 millionfor the six months ended June 30, 2004 from $3.2 million for the sixmonths ended June 20, 2003. The increase was due primarily to legal feesassociated with ongoing litigation with Polycom, Inc.

 

*Amortizationof deferred stock compensation.* Amortization of deferred stock compensationdecreased by 100% to $0 for the three months ended June 30, 2004 from$45,000 for the three months ended June 30, 2003 and decreased by 100% to$0 for the six months ended June 30, 2004 from $90,000 for the six monthsended June 30, 2003. The decrease was due to the completion of pre-IPOoption award amortization and the forfeitures of stock options by employees nolonger with our company.

 

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

 

Otherincome, net increased by 175% to $11,000 for the three months endedJune 30, 2004 from $4,000 for the three months ended June 30, 2003and increased by 67% to $30,000 for the six months ended June 30, 2004from $18,000 for the six months ended June 30, 2003. The increases weredue primarily to increases in our cash and cash equivalents as a result of ourprivate equity financing activities completed in October 2003 andMarch 2004.

 

**Liquidity and Capital Resources**

 

Wehave funded our operations since inception primarily from product and servicesrevenue, the net proceeds of $31.3 million from our August 2000 initialpublic offering of common stock, lines of credit with related parties andfinancial institutions, the

 

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proceeds of approximately $6.4 million fromthe sale of Series B preferred stock in December 1999 and the proceeds ofapproximately $5.7 million and $3.6 million from the private sale of our commonstock in October 2003 and March 2004, respectively.

 

We hadcash and cash equivalents of $5.9 million as of June 30, 2004 compared tocash and cash equivalents of $5.4 million as of December 31, 2003.  For the six months ended June 30, 2004we had an overall net cash inflow of $0.5 million, resulting primarily from netcash proceeds from issuance of common stock of $3.6 million, offset by net cashused in operations of $3.1 million.  Thenet cash proceeds from issuance of common stock is dueto the private sale of 3,000,000 shares of our common stock to Fuller & Thaler Asset Management, Inc., ata price per share of $1.20 in March 2004. The net cash used inoperating activities of $3.1 million resulted from a net loss of $4.3 million,an increase in accounts receivable of $0.1 million, offset by an increase indeferred revenue and customer deposits of $0.4 million, an increase in accountspayable and accrued liabilities and other of $0.4 million, a decrease ininventories of $0.2 million and a decrease in prepaid expenses of $0.2 million.

 

AtJune 30, 2004, we had open purchase orders and other contractualobligations of approximately $0.6 million, primarily related to inventorypurchases. We also have commitments that consist of obligations under our operatingleases. These purchase order commitments and contractual obligations arereflected in our financial statements once goods or services have been receivedor payments related to the obligations become due.

 

The following table represents our future commitments under minimumannual operating lease payments as of June 30, 2004 (in thousands):

 

| **Year Ending December 31,** | ** ** | **Amount** | ** ** |
|-----------------------------------|------------|------------|------------|
| Third and  fourth Quarter of 2004 |       | $          | 381        |   |
| 2005                              |       | 720        |       |
| 2006                              |       | 682        |       |
| 2007                              |       | 300        |       |
| 2008                              |       | 230        |       |
| Thereafter                        |       | 566        |       |
| Total minimum  lease payments     |       | $          | 2,879      |   |

 

In July 2003, we entered into a non-cancelableoperating lease to remain at our current office facility in Redwood Shores,California. The new operating lease commenced on October 1, 2003 andexpires on September 30, 2007. The commitments for this new lease arereflected in the table above. The previous operating lease expired onSeptember 30, 2003.

 

On February 27, 2002, we entered into a Loan and SecurityAgreement with a financial institution for a revolving line of credit.  As collateral under this Loan and SecurityAgreement, we granted a first priority security interest in all of our assets,excluding intellectual property.  OnDecember 16, 2002, Gerald Burnett, our Chairman and Chief ExecutiveOfficer provided a collateralized guarantee, assuring payment of ourobligations 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 us greater accessto the full amount of the facility.  OnFebruary 27, 2004, the Loan and Security Agreement was amended to changethe maximum borrowings under the line to $3.5 million, subject to certain quickratio and loan to value covenants, and to extend the term of the Loan andSecurity Agreement to February 27, 2005. In connection with this amendment, Dr. Burnett’s collateralizedguarantee was amended to reduce the amount of such guarantee to $3.5 million.  As of June 30, 2004, we had nooutstanding borrowings under the line of credit and we were eligible to borrowup to $3.5 million. On February 27, 2004, Dr. Burnett provided us with afurther commitment to provide us with a loan of up to $2.0 million in the eventthat at least $2.0 million was not available to us under the line of credit oran alternate financing arrangement.  Thisadditional commitment was subject to dollar for dollar reduction in the eventthat a financing event would occur providing us with comparable funding, orother net addition to our working capital.

 

On October 15, 2003, we completed the private sale of 4,615,385shares of our common stock to Gerald 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 outstandingcommon stock not beneficially owned by Dr. Burnett.

 

On March 26, 2004, wecompleted the private sale of 3,000,000 shares of our common stock to fundsaffiliated with Fuller & Thaler Asset Management, Inc., at a price pershare of $1.20.  The net proceeds of thisprivate 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

 

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with a loan of up to $2.0 million in the event that at least $2.0million was not available to us under the line of credit was automaticallyterminated by its terms and the number of shares held by Dr. Burnett from theOctober 15, 2003 financing that had voting restrictions was reducedproportionally from 1,602,847 shares to 141,152 shares.

 

Weintend to continue to invest in the development of new products andenhancements to our existing products. We may need to arrange for the availability of additional funding beforeor upon the expiration of the Loan and Security Agreement on February 27,2005, either through the execution of an extension of the Loan and SecurityAgreement or through other means, in order to meet our operating and capitalrequirements for the next twelve months. Additional funds and additional financing may not be available onfavorable terms, or at all. If we are unable to obtain additional funding onacceptable terms, we may not be able to develop or enhance our products, takeadvantage of future opportunities, or respond to competitive pressures orunanticipated requirements, which could seriously harm our business, financialcondition, results of operations and ability to continue 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.

 

Ourfuture liquidity and capital requirements will depend upon numerous factors,including without limitation, general economic conditions and conditions in thefinancial services industry in particular, the level and timing of revenue, thecosts and timing of our product development efforts and the success of thesedevelopment efforts, the costs and timing of our sales and marketingactivities, the extent to which our existing and new products gain marketacceptance, competing technological and market developments, the costs involvedin maintaining and enforcing patent claims and other intellectual propertyrights including, without limitation, the costs and result of CPI’s litigationwith Polycom and other factors, all of which may impact our ability to achieveand maintain profitability.

 

On July 27, 2004, we announced that our Board of Directorsapproved the reactivation of a share repurchase plan approved and implementedin March of 2001.  Under that plan,our management was authorized to repurchase up to $2.0 million dollars ofAvistar stock in the open market from time to time. Actual purchases to datehave not been significant.  There-authorization allows us to acquire shares with an aggregate purchase priceof up to $100,000 dollars under the prior program, through the month ofAugust 2004, as deemed appropriate by our management.

 

**Recent Accounting Pronouncements**

 

In May 2003, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards (SFAS) No. 150, “Accounting forCertain Financial Instruments with Characteristics of Both Liabilities andEquity,” which establishes standards for how an issuer classifies and measurescertain financial instruments with characteristics of both liabilities andequity. 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 ourcondensed consolidated financial statements.

 

In March 2004, the FASB issued EITFIssue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairmentand Its Application to Certain Investments”. EITF 03-1 includes new guidancefor evaluating and recording impairment losses on debt and equity instruments,as well as new disclosure requirements for investments that are deemed to betemporarily impaired. The accounting guidance provided in EITF 03-1 iseffective for reporting periods beginning after June 15, 2004, while thedisclosure requirements for debt and equity securities accounted for under FASBStatement No. 115, “Accounting for Certain Investments in Debt and EquitySecurities”, are effective for annual periods ending after December 15,2003. We do not expect the adoption of EITF 03-1 to have a material impact onour financial position, results of operations or cash flows.

 

**Factors Affecting Future Operating Results**

 

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

 

Our ability to achieve profitability dependsin part on the widespread adoption of networked video communications systemsand the adoption of our video operating system in particular.  If the market for our system fails to grow orgrows more slowly than we anticipate, we may not be able to increase revenue orachieve profitability. The market for our system is relatively new andevolving.  We have to devote substantialresources to educating prospective customers about the uses and benefits of oursystem.  Our efforts to educate potentialcustomers may not result in our system achieving broad market acceptance.  In addition, businesses thathave

 

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invested or may invest substantial resources in othervideo products may be reluctant or slow to adopt our system.  Similarly, customers using existinginformation systems in which they have made significant investments may refuseto adopt our system if they perceive that our offerings will not complementtheir existing systems.  Consequently,the conversion from traditional methods of communication to the extensive useof networked video may not occur as rapidly as we wish.

 

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

 

We incurred net losses of $4.3 million forthe six months ended June 30, 2004, $8.6 million for the year 2003, and$7.6 million for the year 2002.  As ofJune 30, 2004, our accumulated deficit was $85.1 million.  Our revenue may not increase, or even remainat its current level.  In addition, ouroperating expenses may increase as we continue to develop our business in thefuture.  As a result, to becomeprofitable, we will need to increase our revenue by increasing sales toexisting customers and by attracting additional customers.  If our expenses increase more rapidly thanour revenue, or if revenue and expense levels remain the same, we may neverbecome profitable.  We cannotpredict whether or when we will become profitable.  If we do become profitable, we may not beable to sustain or increase profitability on a quarterly or annual basis.  In addition, if we fail to reachprofitability or to sustain or grow our profits within the time frame expectedby investors, the market price of our common stock may be adversely impacted.

 

**Generaleconomic conditions have and may continue to impact our revenues and harm ourbusiness.**

 

The international economic slowdown and thedownturn in the investment banking industry that began in the year 2000 hasnegatively affected our business in 2001, 2002, 2003 and 2004, and may continueto do so in the future.  During thisperiod, the investment banking industry suffered a sharp decline, which causedmany of our existing and potential customers to cancel or delay orders for ourproducts.  If our customers and potentialcustomers continue to delay ordering our products, we will fall short of ourrevenue expectations for 2004 and beyond. The outlook for the video communications industry is uncertain.  Slower growth among our customers, tighteningof customers’ operating budgets, retrenchment in the capital markets and othergeneral economic factors all have had and could in the future have a materiallyadverse effect on our revenue, capital resources, financial condition andresults of operations.

 

**We havefiled a complaint alleging patent infringement against Polycom, Inc.  The prosecution of this lawsuit could requireus to expend significant financial and managerial resources and may have amaterial negative impact on our business.**

 

OnSeptember 23, 2002, CPI, our 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 thecomplaint and asserted counterclaims against CPI for non-infringement, invalidityand unenforceability. On January 31, 2003, Polycom filed a motion with thecourt, which was subsequently granted by the court on March 7, 2003,requesting permission to amend its counterclaims to incorporate claims ofalleged infringements by Avistar Communications of four PictureTel patents thatPolycom has told us it has had assigned to it. Three of the four counterclaimsinvolved a third party, and Polycom dropped these three counterclaims onJune 23, 2003, subsequent to an agreement between Polycom and the thirdparty.  On August 9, 2003, CPI andPolycom filed motions for summary judgment with the court, seeking judgment asa matter of law concerning CPI’s ability to qualify for “small entity status”in the filing of its four patents being asserted against Polycom.  On October 17, 2003, the court deniedPolycom’s motion for summary judgment and granted CPI’s motion for summaryjudgment, thereby negating Polycom’s defense of unenforceability concerningCPI’s having filed these patents as a “small entity.”

 

Briefingson claims construction issues and a hearing before the presiding judge (Markmanhearing) took place on March 8, 2004, and the presiding judge issued herruling on March 23, 2004. A trial date for CPI’s claims against Polycomand 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 requireAvistar and CPI to expend significant financial and managerial resources andtherefore may have a material negative impact on Avistar and CPI.  Expenses associated with the litigation haverisen as trial approaches to now comprise a significant portion of ourquarterly operating expense. We anticipate this higher rate of spending tocontinue until final adjudication of the respective claims of the parties. Theduration and ultimate outcome of this litigation are uncertain.

 

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

 

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Our future liquidity and working capital requirements will depend uponnumerous factors, including:

 

•                  general economic conditions and conditions in the financialservices industry in particular;

•                  the level and timing of our revenue;

•                  the costs and timing of product development efforts and thesuccess of these development efforts;

•                  the costs and timing of sales and marketing activities;

•                  the extent to which our existing and new products gainmarket 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

•                  available borrowings under line of credit arrangements andother factors.

 

We may need to arrange for the availability of additional funding inorder to meet our future business requirements. If we are unable to obtain additional funding when needed on acceptableterms, we may not be able to develop or enhance our products, take advantage offuture opportunities, respond to competitive pressures or unanticipatedrequirements, or finance our litigation with Polycom, which could seriouslyharm our business, financial condition, results of operations and ability tocontinue operations.  There can be noassurance that such funding will be available on terms attractive to us, or atall.  Furthermore, any additional equityfinancing may be dilutive to stockholders and such equity securities may haverights, preferences or privileges senior to those of the holders of our commonstock, and debt financing, if available, may involve restrictive covenants.Strategic arrangements, if necessary to raise additional funds, may require usto relinquish our rights to certain of our technologies or products.

 

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

 

Wehave generally 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 investment decisionsthat 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 capital expenditure approvals beforepurchasing our system. Recent economic conditions have contributed toadditional deliberation, and an associated delay inthe sales cycle.

 

Our lengthy sales cycle is one of the factorsthat has caused, and may in the future continue to cause, our operating resultsto vary significantly from quarter to quarter and year to year.  This makes it difficult for us to forecastrevenue, and could cause volatility in the market price of our commonstock.  A lost or delayed order couldresult in lower revenue than expected in a particular quarter or year.

 

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

 

Our customers typically place limited initialorders for our networked video communications system, as they seek to evaluateits usefulness and value.  Our strategyis to pursue additional and larger follow-on orders after these initialorders.  Revenue generated from follow-onorders accounted for approximately 81% and 94% of our revenue for the sixmonths ended June 30, 2004 and 2003, respectively.  Economic conditions have contributed todecreases in our clients’ capital spending in the past, and we have experienceda decrease in the size and number of follow-on orders.  Our future financial performance depends onsuccessful initial installations of our system and successful generation offollow-on orders as the Avistar network expands within a customerorganization.  If our system does notmeet the needs and expectations of customers, we may not be able to generatefollow-on orders.

 

**Because we depend on a few customers for amajority of our revenue, the loss of one or more of them could cause asignificant decrease in our revenue.**

 

Wehave historically 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 68% of our revenue for the six months endedJune 30, 2004. No other customers individually contributed great than 10%of our total revenue for the six months ended June 30,

 

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2004.  For the six months endedJune 30, 2003, Deutsche Bank AG and its affiliates accounted for 61% ofour revenue. No other customer individually contributed greater than 10% of ourtotal revenue for the six months ended June 30, 2003. These contributionsreflects the acquisition by Deutsche Bank and UBS Warburg LLC of otherfinancial services firms that were previously Avistar customers, as well as thepurchase of Avistar technology by Deutsche Bank for new accounts as part ofDeutsche Bank’s client connectivity program and/or joint ventures. We expect tocontinue to depend upon a limited number of customers for a substantial portionof our revenue.  As of June 30, 2004,approximately 78% of our accounts receivable were concentrated with fourcustomers, 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 thereduction, delay or cancellation of orders from one or more of our significantcustomers could cause our revenue to decline and our losses to increase.  Because we currently depend on a limitednumber of customers with lengthy budgeting cycles and unpredictable buyingpatterns, our revenue from quarter to quarter or year to year may bevolatile.  Adverse changes in our revenueor operating results as a result of these budgeting cycles or any otherreduction in capital expenditures by our large customers could substantiallyreduce the trading price of our common stock.

 

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

 

Future hardware and software platformsembodying new technologies and the emergence of new industry standards andcustomer requirements could render our system non-competitive or evenobsolete.  The market for our system ischaracterized by:

 

•                  rapid technological change;

•                  significant development costs;

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

•                  evolvingindustry standards; and

•                  transition to Internet protocol connectivity for video at the desktop, with increasingavailability of bandwidth.

 

Our system is designed to work with a varietyof hardware and software configurations and data networking infrastructuresused by our customers.  The majority ofthese customer networks rely on Microsoft Windows servers.  However, our software may not operatecorrectly on other hardware and software platforms or with other programminglanguages, database environments and systems that our customers use.  Also, we must constantly modify and improveour system to keep pace with changes made to our customers’ platforms, datanetworking infrastructures, and their evolving ability to transport video andother applications.  This may result inuncertainty relating to the timing and nature of our new release announcements,introductions or modifications, which in turn may cause confusion in themarket, with a potentially harmful effect on our business.  If we fail to promptly modify or improve oursystem in response to evolving industry standards or customers’ demands, oursystem could become less competitive, which would harm our financial conditionand reputation.

 

**Difficulties or delays ininstalling our products, fulfilling software development, or delivering otherprofessional service contracts could harm our revenue and margins.**

 

We recognize revenue upon the installation ofour system in those cases where we are responsible for installation, whichoften entails working with sophisticated software and computing andcommunications systems. If we experience difficulties with installation or donot meet deadlines due to delays caused by our customers or ourselves, we couldbe required to devote more customer support, technical and other resources to aparticular installation.  If we encounterdelays in installing our products for new or existing customers or installationrequires significant amounts of our professional services support, our revenuerecognition could be delayed, our costs could increase and our margins couldsuffer.

** **

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

 

Currently, our competition comes from manyother kinds of companies, including communication equipment, integratedsolution, broadcast video and stand-alone point solution providers. Within thevideo-enabled network communications market, we compete primarily againstPolycom, Tandberg Inc. and VCON Telecommunications Ltd. We believe we may faceincreasing competition in the future from alternative video communicationssolutions that employ new technologies or new combinations of technologies fromcompanies such as Cisco Systems, Inc., Hewlett-Packard Company, MicrosoftCorporation, RealNetworks, Inc. and WebEx Communications, Inc., that enableweb-based or network-based video communications with low-cost digital camerasystems. The market in which we operate is highly competitive.  In addition, because our industry isrelatively new and one which is characterized

 

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by rapid technological change, evolving user needs,developing industry standards and protocols and the frequent introduction ofnew products and services, it is difficult for us to predict whether or whennew competing technologies or new competitors will enter our market.

 

Weexpect competition to increase in the future from existing competitors and fromnew market entrants with products that may be less expensive than ours or thatmay provide better performance or additional features not currently provided byour products.  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 morequickly to new or emerging technologies and changes in customer requirements.

 

We maybe required 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 be harmed.  We cannot assure you that we will be able tocompete successfully against current and future competitors, or thatcompetitive pressures faced by us will not harm our business, financialcondition and results of operations.

 

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

 

We regard our system as open but proprietary.In an effort to protect our proprietary rights, we rely primarily on acombination of patent, copyright, trademark and trade secret laws, as well aslicensing, non-disclosure and other agreements with our consultants, suppliers,customers and employees.  However, theselaws and agreements provide only limited protection of our proprietary rights.In addition, we may not have signed agreements in every case and thecontractual provisions that are in place and the protection they produce maynot provide us with adequate protection in all circumstances.  Although CPI holds patents and has filedpatent applications covering some of the inventions embodied in our systems,our means of protecting our proprietary rights may not be adequate. It may bepossible for a third party to copy or otherwise obtain and use our technologywithout authorization and without our detection.  In the event that we believe athird party is infringing our intellectual property rights, an infringementclaim brought by us could, regardless of the outcome, result in substantialcost to us, divert our management’s attention and resources, be time consumingto 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 or other countries where we hold patents.  Unauthorized copying, use or reverseengineering of our system could harm our business, financial condition orresults of operations.

 

**Infringement claims couldrequire us to expend significant financial and managerial resources.**

 

Athird party could claim that our technology infringes upon its proprietaryrights.  As the number of softwaresystems in our target market increases and the functionality of these systemsoverlap, we believe that the number of infringement suits filed by softwaredevelopers may increase.  At a hearingheld on March 7, 2003, the judge in the existing lawsuit in which CPI isclaiming that Polycom infringes four CPI patents granted Polycom’s motion toamend its counterclaims to include claims of alleged infringements by AvistarCommunications of four PictureTel patents that Polycom has told us it has hadassigned to it.  Three of the fourcounterclaims for patent infringement related to equipment provided to Avistarby a third-party. These three counterclaims involving the third party weredropped on June 23, 2003, subsequent to an agreement between Polycom andthe third party.

 

The prosecution of this lawsuit and thedefense of the Polycom counterclaim have required and may continue to requireAvistar and CPI to expend significant financial and managerial resources andtherefore may have a material negative impact on Avistar and CPI.

 

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

 

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

 

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

 

Our license agreements with our customerstypically contain provisions designed to limit our exposure to potentialproduct liability and certain contract claims. Our license agreements also typically limit a customer’s entire remedyto either a refund of the price paid or modification of our system to satisfyour warranty.  However, these provisionsvary as to their terms and may not be effective under the laws of somejurisdictions.  Although we maintainproduct liability (“errors and omissions”) insurance coverage, we cannot assureyou that such coverage will be adequate. A product liability, warranty or other claim could harm our business, financialcondition and/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.

 

Thethird party software we license with our system may also contain errors ordefects for 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 us withrespect to such warranties could, regardless of their merits, harm ourbusiness, financial condition or results of operations.

 

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

 

We depend on outside contract manufacturersto produce components of our systems.  Asignificant portion of our compression and decompression product, or gatewayproduct, is currently supplied by a single source, Tandberg, Inc.  In addition, we depend on various third partysuppliers for the cameras, microphones, speakers and monitors that we installat desktops and in conference rooms as a part of each video communicationsnetwork system.  Two of these contractmanufacturers, SAE Materials Inc. and Pacific Corporation, are single sourcesuppliers for key components of our products. Another supplier, Equator Technologies Inc., is our only current sourceof a component used in our IP gateway product. Our reliance on these thirdparties involves a number of risks, including:

 

•                  the possible unavailability of critical services and components on a timelybasis, on commercially reasonable terms or at all;

•                  if the components necessary for our system were to become unavailable, theneed to qualify new or alternative components for our use or reconfigure oursystem and manufacturing process could be lengthy and expensive;

•                  the likelihood that, if particular components were not available, we wouldsuffer an interruption in the manufacture and shipment of our systems untilthese components or alternatives become available;

•                  reducedcontrol by us over the quality and cost of our system and over our ability torespond to unanticipated changes and increases in customer orders, andconversely, price changes from suppliers if committed volumes are not met; and

•                  the possible unavailability of, or interruption in, access to sometechnologies due to infringement claims, production/supply issues or otherhindrances.

 

If these manufacturers or suppliers cease toprovide us with the assistance or the components necessary for the operation ofour business, we may not be able to identify alternate sources in a timelyfashion.  Any transition to alternate manufacturersor suppliers 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.

 

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

 

To increase our revenue, we must increase thesize of our direct sales force and add indirect distribution channels, such assystems integrators, product partners and/or value-added resellers, and/oreffect sales through our customers.  Ifwe are unable to maintain or increase our direct sales force or add indirectdistribution channels due to our own cost constraints, limited availability ofqualified personnel or other reasons, our future revenue growth may be limitedand our future operating results may suffer. We cannot assure you that we will be successful in attracting, integrating,motivating and retaining sales personnel. Furthermore, it can take several months before a new hire becomes aproductive member of our sales force. The loss of existing direct and/or indirect salespeople, or the failureof new salespeople and/or indirect sales partners to develop the necessaryskills in a timely manner, could reduce our revenue growth.

 

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

 

Ourproducts and technologies are complex, and to successfully implement ourbusiness strategy 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.

 

Weneed to attract and retain highly skilled technical and managerial personnelfor whom there is intense competition. If we are unable to attract and retain qualified technical andmanagerial personnel due to our own cost constraints, limited availability ofqualified personnel or other reasons, our results of operations could sufferand we may never achieve profitability. The failure of new personnel to develop the necessary skills in a timelymanner could harm our business.

 

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

 

Failure to achieve or manage growth effectivelywill harm our business, financial condition and operating results.  Furthermore, in order to remain competitiveor to expand our business, we may find it necessary or desirable in the futureto acquire other businesses, products or technologies. If we identify anappropriate acquisition candidate, we may not be able to negotiate the terms ofthe acquisition successfully, to finance the acquisition or to integrate theacquired businesses, products or technologies into our existing business and operations.  In addition, completing a potentialacquisition and integrating an acquired business may strain our resources andrequire significant management time.

 

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

 

International revenue, which consists ofsales to customers with operations principally in Western Europe and Asia,comprised 53% of total revenue for the sixmonths ended June 30, 2004 and 57% for the six months ended June 30,2003.  Some of the risks we may encounterin conducting international business activities include the following:

 

•                  tariffs and other trade barriers;

•                  unexpected changes in foreign regulatory requirements and laws;

•                  economic and political instability;

•                  increasedrisk of infringement claims;

•                  protection of our intellectual property;

•                  restrictions on the repatriation of funds;

•                  potentially adverse tax consequences;

•                  timing, cost and potential difficulty of adapting our system to the locallanguage standards in those foreign countries that do not use the Englishlanguage;

•                  fluctuations in foreign currencies; and

•                  limitations in communications infrastructures in some foreign countries.

 

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

 

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.

 

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

 

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Webelieve that establishing and maintaining brand and name recognition iscritical for attracting and expanding our targeted customer base.  We also believe that the importance ofreputation and name recognition will increase as competition in our marketincreases.  Promotion and enhancement ofour name will depend on the success of our marketing efforts, and on ourability to continue to provide high quality systems and services, neither ofwhich can be assured.  If our customersdo not perceive our system or services to be effective or of high quality, ourbrand and name recognition will suffer, which would harm our business.

 

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

 

Continuedlisting on The NASDAQ SmallCap Market requires, among other criteria, that theminimum closing bid price of our common stock not fall below $1.00 for 30consecutive trading days. On June 21, 2004, we received notification fromThe NASDAQ Stock Market that we are out of compliance with the minimum closingbid price requirement of $1.00 per share set forth in MarketplaceRule 4310(c)(4). Therefore, our common stock may be delisted from tradingon The NASDAQ SmallCap Market on or about December 20, 2004 if the minimumclosing bid price of our common stock does not equal or exceed $1.00 for aminimum of ten consecutive trading days. If we fail to achieve ten consecutive trading days with a minimumclosing bid price of $1.00, but demonstrate at the end of this grace periodthat we are in compliance with The NASDAQ SmallCap Market initial listingstandards (that is, either $750,000 net income for the most recently completedfiscal year, stockholders’ equity of $5 million or market capitalization of $50million), we may be allowed an additional 180-day grace period to meet the$1.00 minimum closing bid price requirement, or until June 18, 2005.  As of June 30, 2004, we did not meet the initial listing standardsof The NASDAQ SmallCap Market.  In theevent that we are unable to raise additional equity investment, we expect thatmay also be out of compliance with The NASDAQ SmallCap Market’s continuedlisting requirement that we maintain stockholders equity of at least $2.5million, a market capitalization of at least $35 million or annual net incomeof at least $500,000.  If we donot satisfy the continued listing requirements prior to the expiration ofapplicable grace periods, we may attempt to seek review of The NASDAQ StockMarket’s decision to delist our stock, or may apply for quotation of our commonstock on any other organized market on which the shares may be eligible fortrading. There can be no assurance that our common stock will satisfy therequirements for continued listing on The NASDAQ SmallCap Market.

 

If weare unable to continue to list our common stock for trading on The NASDAQSmallCap Market, there may be an adverse impact on the market price andliquidity of our common stock, and our stock may be subject to the “penny stockrules” contained in Section 15(g) of the Securities Exchange Act of 1934,as amended, and the rules promulgated there under.  Delisting of our common stock from The NASDAQSmallCap Market could also materially adversely affect our business, including,among other things: our ability to raise additionalfinancing to fund our operations; our ability to attract and retain customers;and our ability to attract and retain personnel, including managementpersonnel.  In addition, if we wereunable to list our common stock for trading on NASDAQ, many institutionalinvestors would no longer be able to retain their interests in and/or makefurther investments in our common stock because of their internal rules andprotocols.

 

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

 

Thetrading price of our common stock has in the past been and could in the futurebe subject to significant fluctuations in response to:

 

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

•                  quarterly variations in our results of operations;

•                  announcements regarding our product developments;

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

•                  announcements of competitive product introductions by ourcompetitors or our customers;

•                  sales or the perception in the market of possible sales of a large number ofshares of our common stock by our directors, officers, employees or principalstockholders; and

•                  developments or disputes concerning patents or proprietary rights, including ourlitigation with Polycom, or other events.

 

If ourrevenue and 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

 

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companies, and which often are unrelatedand disproportionate 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 is volatile, we may be thetarget of securities litigation, which is costly and time-consuming to defend.**

 

In the past, following periods of marketvolatility in the price of a company’s securities, security holders have ofteninstituted class action litigation. Many technology companies have been subjectto this type of litigation.  Our shareprice has, in the past, experienced price volatility, and may continue to do soin the future. If the market value of our common stock experiences adversefluctuations and we become involved in this type of litigation, regardless ofthe merits or outcome, we could incur substantial legal costs and ourmanagement’s attention could be diverted, causing our business, financialcondition and operating results to suffer.

 

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

 

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

 

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

 

**Our principalstockholders can exercise a controlling influence over our business affairs,and they may make business decisions with which you disagree that will affectthe value of your investment.**

 

Ourexecutive officers, directors and entities affiliated with them, in theaggregate, beneficially owned approximately 65% of our common stock as of June 30, 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.  Theseactions may be taken even if they are opposed by other investors.  This concentration of ownership may also havethe effect of delaying or preventing a change in control of our company, whichcould cause the market price of our common stock to decline.

 

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

 

We develop products primarily in the United States and sell those products primarily in North America, Europe and Asia. International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 53% of total revenue for the three months ended June 30, 2004 and 65% for the three months ended June 30, 2003.  International revenue comprised 53% of total revenue for the six months ended June 30, 2004 and 57% for the six months ended June 30, 2003. As a result, our financial condition could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets.  As all of our sales are currently made in United States dollars, a strengthening of the United States dollar could make our products less competitive in foreign markets.  We do not use derivative financial instruments for speculative or trading purposes, nor do we engage in any foreign currency hedging transactions.

 

Our interest income is sensitive to changes in the general level of United States interest rates, particularly since the majority of our investments are in short-term instruments.  There has not been a material change in our exposure to interest rate and foreign currency risk since the date of our annual report on Form 10-K/A for the year ended December 31, 2003 filed with the Securities and Exchange Commission on March 26, 2004.

 

**Cash and Cash Equivalents**

 

Cash equivalents consist primarily ofcommercial paper and money market and municipal bond funds acquired withremaining maturity periods of three months or less and are stated at cost, plusaccrued interest that approximates market value.  We would not expect our operating results orcash flow to be significantly impacted by the effect of sudden changes inmarket interest rates given the nature of our short-term investments.

 

The following table provides informationabout our investment portfolio.  Forinvestment securities, the table presents cash and cash equivalents and relatedweighted average interest rates by category at June 30, 2004.

 

| ** **                        | ** ** | **Amounts**        | ** ** | **Weighted Average  Interest Rate** | ** ** |
|-----------------------------------|------------|--------------------|------------|-------------------------------------|------------|
| ** **                        | ** ** | **(in thousands)** | ** ** | ** **                          | ** ** |
| **Description**                   |       |               |       |                                |       |
| Cash and cash  equivalents:       |       |               |       |                                |       |
| Cash                              |       | $                  | 195        |                                | —     |   |
| Market  preferreds                |       | 1,000              |       | 1.34                                | %          |
| Other cash  equivalents           |       | 4,700              |       | 1.06                                | %          |
| Fair Value at  June 30, 2004 |       | $                  | 5,896      |                                |       |   |

# ** **

# **Item4**.  *Controlsand Procedures*

 

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

 

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

 

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**PART II****- OTHER INFORMATION**

 

**Item 1.*****LegalProceedings***

 

OnSeptember 23, 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 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 thecomplaint and asserted counterclaims against CPI for non-infringement,invalidity and unenforceability On January 31, 2003, Polycom filed amotion with the court, which was subsequently granted by the court onMarch 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 Polycom dropped these threecounterclaims on June 23, 2003, subsequent to an agreement between Polycomand the third party.  On August 9,2003, 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 thecourt denied Polycom’s motion for summary judgment and granted CPI’s motion forsummary judgment, thereby negating Polycom’s defense of unenforceabilityconcerning CPI’s having filed these patents as a “small entity.”

 

Briefingson claims construction issues and a hearing before the presiding judge (Markmanhearing) took place on March 8, 2004, and the presiding judge issued herruling on March 23, 2004. A trial date for CPI’s claims against Polycomand 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 require theCompany and CPI to expend significant financial and managerial resources andtherefore may have a material negative impact on the Company and CPI.  Expenses associated with the litigation haverisen as trial approaches to now comprise a significant portion of ourquarterly operating expense. We anticipate this higher rate of spending tocontinue until final adjudication of the respective claims of the parties. Theduration and ultimate outcome of this litigation are uncertain.

 

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

 

At our Annual Meeting of Stockholders held June 2, 2004, ourstockholders approved the following matters:

 

1.                    Aproposal to elect seven (7) directors of the Company to serve for theensuing year and until their successors are elected or until such director’searlier resignation or removal. 

 
| **Nominee**          | ** ** | **For**    | ** ** | **Against** | ** ** | **Withheld** | ** ** |
|----------------------|------------|------------|------------|-------------|------------|--------------|------------|
| Gerald J. Burnett    |       | 24,448,617 |       | —      |       | 942,302      |       |
| William L. Campbell  |       | 24,450,947 |       | —      |       | 941,302      |       |
| R. Stephen Heinrichs |       | 40,829,871 |       | —      |       | 2,269,364    |       |
| Robert P. Latta      |       | 23,475,521 |       | —      |       | 942,302      |       |
| Robert M. Metcalfe   |       | 26,629,054 |       | —      |       | 10,300       |       |
| David M. Solo        |       | 26,631,387 |       | —      |       | 9,300        |       |
| James W. Zeigon      |       | 26,629,054 |       | —      |       | 10,300       |       |

 

2.                    Aproposal to ratify the appointment of KPMG LLP as our independent auditors forthe fiscal year ending December 31, 2004. 

 

| **For**    | ** ** | **Against** | ** ** | **Withheld** | ** ** |
|------------|------------|-------------|------------|--------------|------------|
| 27,706,602 |       | —      |       | 7,042        |       |

 

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**Item 5****.*****Other Information***

 

Continuedlisting on The NASDAQ SmallCap Market requires, among other criteria, that theminimum closing bid price of our common stock not fall below $1.00 for 30consecutive trading days. On June 21, 2004, we received notification fromThe NASDAQ Stock Market that we are out of compliance with the minimum closingbid price requirement of $1.00 per share set forth in MarketplaceRule 4310(c)(4). Therefore, our common stock may be delisted from tradingon The NASDAQ SmallCap Market on or about December 20, 2004 if the minimumclosing bid price of our common stock does not equal or exceed $1.00 for aminimum of ten consecutive trading days. If we fail to achieve ten consecutive trading days with a minimumclosing bid price of $1.00, but demonstrate at the end of this grace periodthat we are in compliance with The NASDAQ SmallCap Market initial listingstandards (that is, either $750,000 net income for the most recently completedfiscal year, stockholders’ equity of $5 million or market capitalization of $50million), we may be allowed an additional 180-day grace period to meet the$1.00 minimum closing bid price requirement, or until June 18, 2005.  As of June 30, 2004, we did not meet the initial listing standardsof The NASDAQ SmallCap Market.  In theevent that we are unable to raise additional equity investment, we expect thatmay also be out of compliance with The NASDAQ SmallCap Market’s continuedlisting requirement that we maintain stockholders equity of at least $2.5million, a market capitalization of at least $35 million or annual net incomeof at least $500,000.  If we donot satisfy the continued listing requirements prior to the expiration ofapplicable grace periods, we may attempt to seek review of The NASDAQ StockMarket’s decision to delist our stock, or may apply for quotation of our commonstock on any other organized market on which the shares may be eligible fortrading. There can be no assurance that our common stock will satisfy therequirements for continued listing on The NASDAQ SmallCap Market.

 

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**Item 6****.*****Exhibits***

(a)

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

 

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**SIGNATURES**

 

Pursuant to the requirements of theSecurities and Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized, onthis 16th day of August 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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**EXHIBITINDEX**

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

 

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