**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-Q**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF1934

**Forthe quarterly period ended September 30, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF1934

**Forthe transition periodfrom            to            **

**Commissionfile number:  000-31121**

**AVISTAR COMMUNICATIONS CORPORATION**

(Exact name of registrantas specified in its charter)

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

 

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

(Address of PrincipalExecutive Offices) (Zip Code)

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

**Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities and Exchange Act of 1934 during thepreceding 12 months (or for shorter period that the registrant was required tofile such reports); and (2) has been subject to such filing requirements forthe past 90 days.**

**Yes **x      No o

**Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated fileror a non-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (check one):**

**Large accelerated filer  **o                Accelerated filer  o           Non-accelerated filer  x

**Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes **o     No x

**At November 6, 2006, 35,219,768 shares of common stockof the Registrant were outstanding.**

 

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** **

**AVISTAR COMMUNICATIONSCORPORATION**

**INDEX**
| PART I.    |   | FINANCIAL INFORMATION                                                                       |   | 3      |
|------------|--------|---------------------------------------------------------------------------------------------|--------|--------|
|       |   |                                                                                        |   |   |
| Item 1.    |   | Financial Statements  (unaudited)                                                           |   | 3      |
|       |   | Condensed  Consolidated Balance Sheets                                                      |   | 3      |
|       |   | Condensed  Consolidated Statements of Operations                                            |   | 4      |
|       |   | Condensed  Consolidated Statements of Cash Flows                                            |   | 5      |
|       |   | Notes to  Condensed Consolidated Financial Statements                                       |   | 6      |
| Item 2.    |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   | 18     |
| Item 3.    |   | Quantitative  and Qualitative Disclosures About Market Risk                                 |   | 27     |
| Item 4.    |   | Controls and  Procedures                                                                    |   | 28     |
|       |   |                                                                                        |   |   |
| PART II.   |   | OTHER INFORMATION                                                                           |   | 28     |
|       |   |                                                                                        |   |   |
| Item 1.    |   | Legal Proceedings                                                                           |   | 28     |
| Item 1A.   |   | Risk Factors                                                                                |   | 29     |
| Item 6.    |   | Exhibits                                                                                    |   | 40     |
|       |   |                                                                                        |   |   |
| SIGNATURES |   | 41                                                                                          |

 

2

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**PART I - FINANCIAL INFORMATION**

**Item 1. *Financial Statements***

**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETSas of September 30, 2006 and December 31, 2005(in thousands, except share and per share data)**
| ** **                                                                                                                                                                                                                          | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                          | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                                                                          | ** ** | **(unaudited)**        | ** ** |
| **Assets:**                                                                                                                                                                                                                         | ** ** | ** **             | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                                                     |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                                          |       | $                      | 7,520      |                  | $          | 8,216 |   |
| Short-term  investments                                                                                                                                                                                                             |       | 899                    |       | 2,995                 |       |
| Total cash, cash  equivalents and short-term investments                                                                                                                                                                            |       | 8,419                  |       | 11,211                |       |
| Accounts receivable,  net of allowance for doubtful accounts of $66 and $121 at September 30,  2006 and December 31, 2005, respectively                                                                                   |       | 1,236                  |       | 1,428                 |       |
| Inventories,  including inventory shipped to customers’ sites, not yet installed of $43 and  $28 at September 30, 2006 and December 31, 2005, respectively                                                           |       | 873                    |       | 675                   |       |
| Deferred  settlement and patent licensing costs                                                                                                                                                                                     |       | 1,256                  |       | 1,256                 |       |
| Prepaid expenses  and other current assets                                                                                                                                                                                          |       | 420                    |       | 463                   |       |
| Total current  assets                                                                                                                                                                                                               |       | 12,204                 |       | 15,033                |       |
| Long-term  investments                                                                                                                                                                                                              |       | —                 |       | 958                   |       |
| Property and  equipment, net                                                                                                                                                                                                        |       | 305                    |       | 311                   |       |
| Long-term  deferred settlement and patent licensing costs                                                                                                                                                                           |       | 2,709                  |       | 3,685                 |       |
| Other assets                                                                                                                                                                                                                        |       | 187                    |       | 371                   |       |
| Total assets                                                                                                                                                                                                                        |       | $                      | 15,405     |                  | $          | 20,358 |   |
|                                                                                                                                                                                                                                |       |                   |       |                  |       |
| **Liabilities and Stockholders’  Deficit:**                                                                                                                                                                                    | ** ** | ** **             | ** ** | ** **            | ** ** |
| Current  liabilities:                                                                                                                                                                                                               |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                                                                    |       | $                      | 1,602      |                  | $          | 1,004 |   |
| Deferred income  from settlement and patent licensing                                                                                                                                                                               |       | 5,520                  |       | 5,520                 |       |
| Deferred  services revenue and customer deposits                                                                                                                                                                                    |       | 1,069                  |       | 712                   |       |
| Accrued  liabilities and other                                                                                                                                                                                                      |       | 2,836                  |       | 1,491                 |       |
| Total current  liabilities                                                                                                                                                                                                          |       | 11,027                 |       | 8,727                 |       |
| Long-term  liabilities:                                                                                                                                                                                                             |       |                   |       |                  |       |
| Long-term  deferred income from settlement and patent licensing                                                                                                                                                                     |       | 11,681                 |       | 15,789                |       |
| Total  liabilities                                                                                                                                                                                                                  |       | 22,708                 |       | 24,516                |       |
| Commitments and  contingencies (Note 7)                                                                                                                                                                                             |       |                   |       |                  |       |
| Stockholders’ equity  (deficit):                                                                                                                                                                                               |       |                   |       |                  |       |
| Common stock,  $0.001 par value; 250,000,000 shares authorized at September 30, 2006  and December 31, 2005; 35,191,030 and 34,939,124 shares issued at September 30,  2006 and December 31, 2005, respectively |       | 35                     |       | 35                    |       |
| Less: treasury  common stock, 1,181,625 shares at September 30, 2006 and December 31,  2005, at cost                                                                                                                      |       | (53                    | )          | (53                   | )          |
| Additional  paid-in-capital                                                                                                                                                                                                         |       | 92,319                 |       | 90,519                |       |
| Other  comprehensive income (loss)                                                                                                                                                                                                  |       | 1                      |       | (12                   | )          |
| Accumulated  deficit                                                                                                                                                                                                                |       | (99,605                | )          | (94,647               | )          |
| Total  stockholders’ equity (deficit)                                                                                                                                                                                          |       | (7,303                 | )          | (4,158                | )          |
| Total liabilities and  stockholders’ equity (deficit)                                                                                                                                                                          |       | $                      | 15,405     |                  | $          | 20,358 |   |

 

Theaccompanying notes are an integral part of these financial statements.

3

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** **

**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONSfor the three and nine months ended September 30, 2006 and 2005(in thousands, except per share data)**
| ** **                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                         | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | **(unaudited)**                  | ** ** | **(unaudited)**                 | ** ** |
| ** **                                         | ** ** | ** **                       | ** ** | **Restated (1)**           | ** ** | ** ** | ** ** | **Restated (1)** | ** ** |
| Revenue:                                           |       |                             |       |                            |       |   |   |   |   |
| Product                                            |       | $                                | 1,448      |                            | $          | 842 |   | $ | 3,295 |   | $ | 2,504 |   |
| Licensing                                          |       | 5,000                            |       | —                          |       | 5,071 |   | — |   |
| Services, maintenance and support                  |       | 828                              |       | 992                             |       | 2,522 |   | 2,598 |   |
| Total revenue                                      |       | 7,276                            |       | 1,834                           |       | 10,888 |   | 5,102 |   |
| Costs and  Expenses:                               |       |                             |       |                            |       |   |   |   |   |
| Cost of product revenue                            |       | 998                              |       | 531                             |       | 2,351 |   | 1,299 |   |
| Cost of services, maintenance and support revenue* |       | 374                              |       | 616                             |       | 1,366 |   | 1,588 |   |
| Income from settlement and patent licensing        |       | (1,057                           | )          | (1,057                          | )          | (3,171 | ) | (3,171 | ) |
| Research and development*                          |       | 1,517                            |       | 905                             |       | 4,234 |   | 2,252 |   |
| Sales and marketing*                               |       | 1,394                            |       | 782                             |       | 4,173 |   | 2,299 |   |
| General and administrative*                        |       | 2,280                            |       | 1,621                           |       | 7,106 |   | 4,256 |   |
| Total costs and expenses                           |       | 5,506                            |       | 3,398                           |       | 16,059 |   | 8,523 |   |
| Income (loss) from operations                      |       | 1,770                            |       | (1,564                          | )          | (5,171 | ) | (3,421 | ) |
| Other income  (expense):                           |       |                             |       |                            |       |   |   |   |   |
| Interest income                                    |       | 54                               |       | 144                             |       | 234 |   | 365 |   |
| Other expense, net                                 |       | (6                               | )          | (5                              | )          | (21 | ) | (16 | ) |
| Total other income, net                            |       | 48                               |       | 139                             |       | 213 |   | 349 |   |
| Net income  (loss)                                 |       | $                                | 1,818      |                            | $          | (1,425 | ) | $ | (4,958 | ) | $ | (3,072 | ) |
|                                               |       |                             |       |                            |       |   |   |   |   |
| Net income  (loss) per share - basic and diluted   |       | $                                | 0.05       |                            | $          | (0.04 | ) | $ | (0.15 | ) | (0.09 | ) |
| Weighted average  shares used in calculating:      |       |                             |       |                            |       |   |   |   |   |
| Basic net income (loss) per share                  |       | 33,965                           |       | 33,687                          |       | 33,893 |   | 33,554 |   |
| Diluted net income (loss) per share                |       | 34,860                           |       | 33,687                          |       | 33,893 |   | 33,554 |   |

 

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| *Including  stock-based compensation of:          |   |   |   |   |   |   |   |   |   |
|---------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Cost of services, maintenance and support revenue |   | $      | 40     |   | $      | — |   | $      | 113    |   | $ | — |   |
| Research and development                          |   | 164    |   | — |   | 461    |   | — |   |
| Sales and marketing                               |   | 133    |   | — |   | 365    |   | — |   |
| General and administrative                        |   | 200    |   | 20     |   | 571    |   | 69     |   |
|                                              |   | $      | 537    |   | $      | 20     |   | $      | 1,510  |   | $ | 69 |   |

 

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

Theaccompanying notes are an integral part of these financial statements.

4

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** **

**AVISTARCOMMUNICATIONS CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWSfor the nine months ended September 30, 2006 and 2005(in thousands)**
| ** **                                                                   | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                   | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** |
| ** **                                                                   | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | **(unaudited)**                 | ** ** |
| ** **                                                                   | ** ** | ** **                      | ** ** | **Restated(1)** | ** ** |
| Cash Flows from  Operating Activities:                                       |       |                            |       |   |   |
| Net loss                                                                     |       | $                               | (4,958     | ) | $ | (3,072 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                            |       |   |   |
| Depreciation                                                                 |       | 285                             |       | 139 |   |
| Compensation on options issued to consultants and  employees                 |       | 1,510                           |       | 69 |   |
| Provision for doubtful accounts                                              |       | (55                             | )          | 65 |   |
| Changes in assets and liabilities:                                           |       |                            |       |   |   |
| Accounts receivable                                                          |       | 247                             |       | (161 | ) |
| Inventories                                                                  |       | (198                            | )          | 2 |   |
| Prepaid expenses and other current assets                                    |       | 43                              |       | (7 | ) |
| Deferred settlement and patent licensing costs                               |       | 976                             |       | 976 |   |
| Other assets                                                                 |       | 184                             |       | (1 | ) |
| Accounts payable                                                             |       | 598                             |       | (493 | ) |
| Deferred income from settlement and patent licensing                         |       | (4,108                          | )          | (4,108 | ) |
| Deferred services revenue and customer deposits                              |       | 357                             |       | 383 |   |
| Accrued liabilities and other                                                |       | 1,345                           |       | 105 |   |
| Net cash used in operating activities                                        |       | (3,774                          | )          | (6,103 | ) |
|                                                                         |       |                            |       |   |   |
| Cash Flows from  Investing Activities:                                       |       |                            |       |   |   |
| Purchase of short and long-term marketable  securities                       |       | —                          |       | (2,363 | ) |
| Maturities of short-term investments                                         |       | 3,067                           |       | — |   |
| Purchase of property and equipment                                           |       | (279                            | )          | (293 | ) |
| Net cash provided by (used in) investing activities                          |       | 2,788                           |       | (2,656 | ) |
|                                                                         |       |                            |       |   |   |
| Cash Flows from  Financing Activities:                                       |       |                            |       |   |   |
| Proceeds from issuance of common stock                                       |       | 290                             |       | 376 |   |
| Net cash provided by financing activities                                    |       | 290                             |       | 376 |   |
| Net decrease in cash and cash equivalents                                    |       | (696                            | )          | (8,383 | ) |
| Cash and cash equivalents, beginning of period                               |       | 8,216                           |       | 21,656 |   |
| Cash and cash equivalents, end of period                                     |       | $                               | 7,520      |   | $ | 13,273 |   |
|                                                                         |       |                            |       |   |   |
| Supplemental  Cash Flow Information:                                         |       |                            |       |   |   |
| Cash paid for income taxes                                                   |       | $                               | —     |   | $ | 315 |   |
| Cash paid for  interest                                                      |       | $                               | 2          |   | $ | — |   |

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

The accompanying notes are anintegral part of these financial statements.

5

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** **

**AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS(UNAUDITED)**

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

**Business**

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

**Basis ofPresentation**

The unaudited condensedconsolidated balance sheet as of September 30, 2006 presents theconsolidated financial position of Avistar and its two wholly-owned operatingsubsidiaries, Avistar Systems U.K. Limited (“ASUK”) and CPI, after theelimination of all intercompany accounts and transactions. The unauditedcondensed consolidated balance sheet of Avistar as of December 31, 2005was derived from audited financial statements, but does not contain alldisclosures required by accounting principles generally accepted in the UnitedStates of America. The consolidated results are referred to, collectively, asthose of Avistar or the Company in these notes.

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

The Company’s fiscal year end isDecember 31.

**Risks andUncertainties**

The markets for the Company’s products and servicesare in a formative stage of development. Some of the Company’s products utilizechanging and emerging technologies. As is typical in industries of this nature,demand and market acceptance are subject to a high level of uncertainty,particularly when there are adverse conditions in the economy. Acceptance ofthe Company’s products over time is critical to the Company’s success. TheCompany’s prospects must be evaluated in light of difficulties encountered byit and its competitors in further developing this evolving marketplace. TheCompany has generated losses since inception and had an accumulated deficit of$99.6 million as of September 30, 2006. The Company’s operatingresults may fluctuate significantly in the future as a result of a variety offactors, including, but not limited to, the economic environment, the adoptionof different distribution channels, the timing of new product announcements bythe Company or its competitors, and the timing of licensing and settlementagreements.

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

6

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** **

**2. Correction of an Error**

In September 2005, the Company received a commentletter from the U. S. Securities and Exchange Commission (“SEC”) relating tothe Company’s 2004 Form 10-K, which included a question regarding the Company’saccounting for the November 2004 settlement and patent cross-license agreementwith Polycom, Inc. (“Polycom”). The settlement and patent cross-licenseagreement resulted in a $27.5 million one time payment by Polycom toAvistar and a payment by Avistar to its litigation counsel of $6.4 millionin contingent legal fees. The Company previously reported on Form 10-Q for thethree and nine months ended September 30, 2005 the one time payment byPolycom as revenue, to be recognized ratably over a five-year period, net ofcontingent legal fees. As a result of the SEC’s inquiry as to whether thePolycom transaction should be characterized as revenue, and after discussionswith the SEC, the Company concluded that a reclassification of license revenuesfrom revenue to a component of operating expenses, and presentation as “Incomefrom settlement and patent licensing”, still netted with contingent legal feesand still recognized over a five year period, was necessary for previously filedfinancial reports. The restatement of the net proceeds and expenses from thePolycom settlement and patent cross-license agreement had no effect on reportednet loss, loss per share, stockholders’ equity (deficit) or net cash flow fromoperating, investing or financing activities, but did have the effect ofoverstating revenues and operating expenses for previously issued interimcondensed consolidated financial statements, as of and for the three and ninemonths ended September 30, 2005. In addition, the balance sheet as of September 30,2005 has been restated to reflect the gross effect of the $27.5 millionpayment by Polycom to Avistar, and the payment of $6.4 million ofcontingent legal fees by Avistar, which was previously reported on a net basis asdeferred revenue. See Notes 3 and 6 regarding significant concentrations,revenue recognition, segment reporting and the unaudited interim results whichhave been restated to reclassify the Polycom proceeds from license revenue to“Income from settlement and patent licensing,” to be consistent with thepresentation of the net proceeds from the Polycom settlement and patentcross-license agreement in the Statement of Operations for the three and ninemonths ended September 30, 2006. The presentation within operations issupported by a determination that the Polycom licensing transaction is centralto the activities that constitute the Company’s ongoing major or centraloperations, but that the proceeds may also contain a gain element related tothe settlement, which is not considered revenue under the Financial AccountingStandards Board (“FASB”) Concepts Statement No. 6, *Elements of Financial Statements.*The Company did not havesufficient historical evidence to support a reasonable determination of value forpurposes of segregating the proceeds from Polycom into revenue related to thepatent licensing, and an operating or non-operating gain upon settlement oflitigation, resulting in the determination that the entire transaction is moreappropriately classified as “Income from settlement and patent licensing”within operations, as opposed to revenue.

The following table presents the impact of theadjustment to the condensed consolidated statements of operations and cashflows for the three and nine months ended September 30, 2005 (inthousands):
| ** **                                   | ** ** | **Three Month Ended September 30, 2005** | ** ** | **Nine Months Ended September 30, 2005** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **(Unaudited)**                                                   | ** ** | **(Unaudited)**                                                   | ** ** |
| ** **                                   | ** ** | **As**                                                            | ** ** | ** **                                                        | ** ** | ** ** | ** ** | **As** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Previously**                                                    | ** ** | ** **                                                        | ** ** | **As** | ** ** | **Previously** | ** ** | ** ** | ** ** | **As** | ** ** |
| **Statement of Operations**        | ** ** | **Reported**                                                      | ** ** | **Adjustment**                                                    | ** ** | **Restated** | ** ** | **Reported** | ** ** | **Adjustment** | ** ** | **Restated** | ** ** |
| Revenues:                                    |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Licensing revenue                            |       | $                                                                 | 1,057      |                                                              | $          | (1,057 | ) | $ | — |   | $ | 3,171 |   | $ | (3,171 | ) | $ | — |   |
| Total revenue                                |       | 2,891                                                             |       | (1,057                                                            | )          | 1,834 |   | 8,273 |   | (3,171 | ) | 5,102 |   |
| Costs and expenses:                          |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Income from settlement and  patent licensing |       | —                                                            |       | (1,057                                                            | )          | (1,057 | ) | — |   | (3,171 | ) | (3,171 | ) |
| Net loss                                     |       | $                                                                 | (1,425     | )                                                                 | $          | — |   | $ | (1,425 | ) | $ | (3,072 | ) | $ | — |   | $ | (3,072 | ) |

 

7

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|                                                       | ** ** | **Nine Months Ended September 30, 2005** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                            | ** ** | **(Unaudited)**                                                   | ** ** |
| ** **                                            | ** ** | **As**                                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                            | ** ** | **Previously**                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Statement of Cash Flows**            | ** ** | **Reported**                                                      | ** ** | **Adjustment** | ** ** | **As Restated** | ** ** |
| Cash flows from operating activities:                 |       |                                                              |       |   |   |   |   |
| Deferred settlement and patent  licensing costs       |       | $                                                                 | —     |   | $ | 976 |   | $ | 976 |   |
| Deferred license revenue                              |       | (3,132                                                            | )          | 3,132 |   | — |   |
| Deferred income from  settlement and patent licensing |       | —                                                            |       | (4,108 | ) | (4,108 | ) |
| Net cash used in operating activities                 |       | $                                                                 | (6,103     | ) | $ | — |   | $ | (6,103 | ) |

 

**3. Summary of Significant Accounting Policies**

**Unaudited InterimFinancial Information**

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

In the opinion of management,the unaudited financial statements furnished in this report reflect alladjustments (consisting of normal recurring adjustments) necessary for a fairpresentation of the results of operations for the interim periods covered andof the Company’s financial position as of the interim balance sheet date. Theresults of operations for the interim periods are not necessarily indicative ofthe results 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, 2005, included inthe Company’s annual report on Form 10-K filed with the Securities and ExchangeCommission on April 28, 2006.

**Reclassifications**

Certain reclassifications, noneof which affected the net loss, have been made to prior year amounts to conformto the current year presentation.

**Use of Estimates**

The preparation of financialstatements in conformity with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements, and the reported amounts of revenuesand expenses during the period. Actual results could differ from thoseestimates.

**Cash and CashEquivalents and Short and Long-term Investments**

The Company considers all investment instrumentspurchased with an original maturity of three months or less to be cashequivalents. Investment securities with original or remaining maturities ofmore than three months but less than one year are considered short-terminvestments. Auction rate securities with original or remaining maturities ofmore than three months are considered short-term investments even if they aresubject to re-pricing within three months. Investment securities held with the intentto reinvest or hold for longer than a year, or with remaining maturities of oneyear or more, are considered long-term investments. The Company’s cashequivalents at December 31, 2005 and September 30, 2006 consisted ofmoney market funds and short-term commercial paper with original maturities ofthree months or less.

The Company accounts for its short-term and long-terminvestments in accordance with Statement of Financial Accounting Standards(“SFAS”) No. 115, *Accounting**for Certain Investments in Debt and Equity Securities*. TheCompany’s short and long-term investments in securities are classified asavailable-for-sale and are reported at fair

8

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value, with unrealizedgains and losses, net of tax, recorded in other comprehensive income (loss).Realized gains or losses and declines in value judged to be other than temporary,if any, on available-for-sale securities are reported in other income, net. TheCompany reviews the securities for impairments considering current factorsincluding the economic environment, market conditions and the operationalperformance, and other specific factors relating to the business underlying thesecurities. The Company records impairment charges equal to the amount that thecarrying value of its available-for-sale securities exceeds the estimated fairmarket value of the securities as of the evaluation date. The fair value forpublicly held securities is determined based on quoted market prices as of theevaluation date. In computing realized gains and losses on available-for-salesecurities, the Company determines cost based on amounts paid, including directcosts such as commissions, to acquire the security using the specificidentification method. The Company had a net unrealized gain of $1,000 at September 30,2006 and losses of $12,000 at December 31, 2005 on its short and long-terminvestment securities.

Cash, cash equivalents, short and long-terminvestments consisted of the following at September 30, 2006 and December 31,2005 (in thousands):

|                                                                                                                                                | ** **   | **September 30,** | ** **   | **December 31,** | ** **   |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------------|------------------------|--------------|-----------------------|--------------|
| ** **                                                                                                                                     | ** **   | **2006**               | ** **   | **2005**              | ** **   |
| ** **                                                                                                                                     | ** **   | **(Unaudited)**        | ** **   |
| ***Description***                                                                                                                              | *** *** | *** ***           | *** *** | *** ***          | *** *** |
| Cash and cash equivalents:                                                                                                                     |         |                   |         |                  |         |
| Cash                                                                                                                                           |         | $                      | 2,470        |                  | $            | 549 |   |
| Commercial paper cash  equivalents                                                                                                             |         | 5,050                  |         | 7,667                 |         |
| Total cash and cash  equivalents                                                                                                               |         | 7,520                  |         | 8,216                 |         |
| Short-term investments:                                                                                                                        |         |                   |         |                  |         |
| Short-term investments  (average 18 and 60 remaining days to maturity as of September 30, 2006  and December 31, 2005, respectively) |         | 899                    |         | 2,995                 |         |
| Total cash and cash  equivalents and short term-investments                                                                                    |         | 8,419                  |         | 11,211                |         |
| Long-term-investments(average 390 days to maturity as of  December 31, 2005)                                                              |         | —                 |         | 958                   |         |
| Total cash, cash equivalents and short- term and long-term investments                                                                         |         | $                      | 8,419        |                  | $            | 12,169 |   |

 

**Comprehensive Loss**

The Company applies the provisions of SFAS No. 130,*Reporting Comprehensive Income*, whichestablishes standards for reporting and displaying comprehensive income (loss)and its components in the consolidated financial statements. Comprehensiveincome (loss) is defined as the change in equity of a business enterpriseduring a period from transactions and other events and circumstances fromnon-owner sources. The only components of comprehensive loss reported by theCompany are net unrealized gains and losses fromavailable-for-sale-investments, and are as follows for the three and ninemonths ended September 30, 2006 and 2005 (in thousands):

|                                                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                    | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                    | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                    | ** ** | **(Unaudited)**                  | ** ** | **(Unaudited)**                 | ** ** |
| Net income (loss)                                             |       | $                                | 1,818      |                            | $          | (1,425 | ) | $ | (4,958 | ) | $ | (3,072 | ) |
| Unrealized gain  on available-for-sale-investments adjustment |       | 5                                |       | —                          |       | 13 |   | — |   |
| Comprehensive income  (loss)                                  |       | $                                | 1,823      |                            | $          | (1,425 | ) | $ | (4,945 | ) | $ | (3,072 | ) |

 

**SignificantConcentrations**

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

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|             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **  | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **  | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **  | ** ** | **(Unaudited)**                  | ** ** | **(Unaudited)**                 | ** ** |
| Customer  A |       | 69                               | %          | *%                              |       | 46 | % | *% |   |
| Customer  B |       | 15                               | %          | 44                              | %          | 22 | % | 41 | % |
| Customer C  |       | *%                               |       | 49                              | %          | 18 | % | 43 | % |

----

*                    Less than 10%

Any change in the relationshipwith these customers could have a potentially adverse effect on the Company’sfinancial position.

Financial instruments that potentially subject theCompany to concentrations of credit risk consist primarily of temporary cashinvestments and trade receivables. The Company has cash and investment policiesthat limit the amount of credit exposure to any one financial institution orrestrict placement of these investments to financial institutions evaluated ashighly credit worthy. As of September 30, 2006, the Company had cash andcash equivalents on deposit with a major financial institution that were inexcess of FDIC insured limits. Historically, the Company has not experiencedany loss of its cash and cash equivalents due to such concentration of creditrisk. Concentrations of credit risk with respect to trade receivables relate tothose trade receivables from both United States and foreign entities, primarilyin the financial services industry. As of September 30, 2006,approximately 77% of gross accounts receivable was concentrated with twocustomers, each of whom represented more than 10% of the Company’s total grossaccounts receivable balance. As of December 31, 2005, approximately 97% ofaccounts receivable was concentrated with three customers each of whomrepresented more than 10% of the Company’s total gross accounts receivablebalance. 

**Inventories**

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

|                                                         | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                              | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                                              | ** ** | **(Unaudited)**        | ** ** |
| Raw  materials and subassemblies                        |       | $                      | 29         |                  | $          | 43 |   |
| Finished goods                                          |       | 801                    |       | 604                   |       |
| Inventory shipped to  customer sites, not yet installed |       | 43                     |       | 28                    |       |
|                                                    |       | $                      | 873        |                  | $          | 675 |   |

 

Inventory shipped to customer sites, not yetinstalled, represents product shipped to customer sites pending completion ofthe installation process by the Company. As of September 30, 2006 andDecember 31, 2005, the Company had billed approximately $43,000 and $28,000,respectively, to customers related to these shipments, but did not record therevenue, as the installations had not been completed and confirmed by thecustomer. Although customers are billed in accordance with customer agreements,these deferred revenue amounts are netted against accounts receivable until thecustomer confirms installation.

**Revenue Recognition and Deferred Revenue**

The Company recognizes productand services revenue in accordance with Statement of Position (“SOP”) 97-2, *Software Revenue Recognition* (“SOP 97-2”), as amended by SOP98-9, *Modification of SOP 97-2, Software RevenueRecognition, With Respect to Certain Transactions* (“SOP 98-9”). TheCompany derives product revenue from the sale and licensing of a set of desktop(endpoint) products (hardware and software) and infrastructure products(hardware and software) that combine to form an Avistar video-enabledcollaboration solution. Services revenue includes revenue from installationservices, post-contract customer support, training and software development.The installation services that the Company offers to customers relate to thephysical set-up

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andconfiguration of desktop and infrastructure components of the Company’ssolution. The fair value of all product, installation services, post-contractcustomer support and training offered to customers is determined based on theprice charged when such products or services are sold separately.

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

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

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

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

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

If there are any undeliveredelements, the Company defers revenue for those elements, as long as VendorSpecific Objective Evidence (“VSOE”) exists for the undelivered elements.Additionally, per paragraph 14 of SOP 97-2, 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. The Companybelieves that the fee associated with the delivered product elements does notmeet the collectibility criteria if the installation services have not beencompleted. Customer confirmation is obtained and documented by means of astandard form indicating the installation services have been provided and thehardware and software components installed. When the customer or a third partyprovides installation services, the product revenue is recognized uponshipment, subject to satisfaction of the revenue recognition criteria describedabove.

Payment for product is due uponshipment, subject to specific payment terms. Payment for installation andprofessional services is due upon providing the services, subject to specificpayment terms. Reimbursements received for out-of-pocket expenses and shippingcosts incurred during installation and support services, which have not beensignificant to date, are recognized as revenue in accordance with EmergingIssues Task Force (“EITF”) Issue No. 01-14 (“EITF 01-14”), *IncomeStatement Characterization of Reimbursements Received for “Out of Pocket”Expenses Incurred*.

The price charged formaintenance and/or support is defined in the contract, and is based on a fixedprice for both hardware and software components as stipulated in the customer agreement.Customers have the option to renew the maintenance and/or support arrangementin subsequent periods at the same or similar rate as paid in the initial yearsubject to contractual adjustments for inflation in some cases. Revenue frommaintenance and support services is deferred and recognized pro-rata over themaintenance and/or support term, which is typically one year in

11

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length.Payments for services made in advance of the provision of services are recordedas deferred revenue and customer deposits in the accompanying balance sheets.Training services are offered independently of the purchase of product. Thevalue of these training services is determined based on the price charged whensuch services are sold separately. Training revenue is recognized uponperformance of the service.

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

The Company also derives revenue from the licensing ofits intellectual property portfolio. TheCompany recognizes revenue from the licensing of its intellectual propertyportfolio according to SOP 97-2, based on the terms of the royalty, partnershipand cross-licensing agreements involved. In the event that a license to theCompany’s intellectual property is granted after the commencement of litigationproceedings between the Company and the licensee, the proceeds of suchtransaction are recognized as licensing revenue by us only if sufficienthistorical evidence exists for the determination of fair value of the licensedpatents to support the segregation of the proceeds between a gain on litigationsettlement and patent license revenues consistentwith Financial Accounting Standards Board (“FASB”) Concepts Statement No. 6, *Elements of Financial Statements*. As of September 30,2006, these criteria for recognizing license revenue following the commencementof litigation had not been met.

On July 17, 2006, Avistar and CPI entered into aPatent License Agreement with Sony Corporation (“Sony”), a Japanesecorporation, and Sony Computer Entertainment, Inc. (“SCEI”), a Japanesecorporation. Under the license agreement, CPI granted Sony and its subsidiariesa license to all of CPI’s patents with a filing date on or before January 1,2006 for a specific field of use relating to video conferencing. The licensecovers Sony’s video conferencing apparatus as well as other products, includingvideo-enabled personal computer products and certain SCEI PlayStation products.The $5.0 million upfront payment was recognized by the Company aslicensing revenue in the three months ending September 30, 2006 and futureroyalty payments, if any, will be recognized as they occur in accordance withSOP 97-2.

**Income from Settlement and Patent Licensing**

The Company recognizes theproceeds from settlement and patent licensing agreements based on the termsinvolved. When litigation has been filed prior to a settlement and patentlicensing agreement, and insufficient historical evidence exists for thedetermination of fair value of the patents licensed to support the segregationof the proceeds between a gain on litigation settlement and patent licenserevenues, the Company reports all proceeds in “income from settlement andpatent licensing” within operating costs and expenses. The gain portion of theproceeds, when sufficient historical evidence exists to segregate the proceeds,is reported in other income according to SFAS No. 5, *Accountingfor Contingencies*.

**Stock-Based Compensation**

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

The Company previously appliedAccounting Principles Board (“APB”) Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related interpretations, andprovided the required pro forma disclosures of SFAS No. 123, *Accounting for Stock-Based Compensation* (“SFAS No. 123”).Prior to the adoption of SFAS No. 123R, the

12

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Companyprovided the disclosures required under SFAS No. 123 as amended by SFASNo. 148, *Accounting for Stock-Based Compensation —Transition and Disclosures.* The pro-forma information for the threeand nine months ended September 30, 2005 was as follows (in thousands,except per share data):

|                                                                                                                   | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                        | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
| ** **                                                                                                        | ** ** | **(unaudited)**                  | ** ** | **(unaudited)**                  | ** ** |
| Net  loss, as reported                                                                                            |       | $                                | (1,425     | )                                | $          | (3,072 | ) |
| Add  stock — based employee compensation expense included in reported net loss,  net of tax                  |       | 2                                |       | 2                                |       |
| Deduct  total stock-based employee compensation expense under fair-value-based method  for all awards, net of tax |       | (636                             | )          | (1,815                           | )          |
| Pro  forma net loss                                                                                               |       | $                                | (2,059     | )                                | $          | (4,885 | ) |
|                                                                                                              |       |                             |       |                             |       |
| Basic  and diluted loss per share:                                                                                |       |                             |       |                             |       |
| As reported                                                                                                       |       | $                                | (0.04      | )                                | $          | (0.09 | ) |
| Pro  forma                                                                                                        |       | $                                | (0.06      | )                                | $          | (0.15 | ) |

 

*Impact of theAdoption of SFAS No. 123R*

The Company adopted the modified prospectiveapplication method as provided by SFAS No. 123R effective January 1, 2006.The effect of recording stock-based compensation for the three and nine monthsended September 30, 2006 was as follows (in thousands, except per sharedata):

|                                                     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                          | ** ** | **September 30, 2006** | ** ** | **September 30, 2006** | ** ** |
| ** **                                          | ** ** | **(unaudited)**                  | ** ** | **(unaudited)**                  | ** ** |
| Stock-based  compensation expense by type of award: |       |                             |       |                             |       |
| Employee stock options                              |       | $                                | 481        |                             | $          | 1,344 |   |
| Non-employee stock options                          |       | 26                               |       | 66                               |       |
| Employee stock purchase plan                        |       | 30                               |       | 100                              |       |
| Total stock-based compensation                      |       | 537                              |       | 1,510                            |       |
| Tax  effect on stock-based compensation             |       | —                           |       | —                           |       |
| Net effect of stock-based compensation on net  loss |       | $                                | 537        |                             | $          | 1,510 |   |

 

As of September 30, 2006, the Company had anunrecognized stock-based compensation balance related to stock options ofapproximately $5.1 million before estimated forfeitures. SFASNo. 123R requires forfeitures to be estimated at the time of grantand revised if necessary in subsequent periods if actual forfeitures differfrom those estimates. Based on the Company’s historical experience of optionpre-vesting cancellations, the Company has assumed an annualized forfeiturerate of 7% for its executive options and 29% for non-executive options.Accordingly, as of September 30, 2006, the Company estimated that thestock-based compensation for the awards not expected to vest was approximately$1.3 million and therefore, the unrecognized deferred stock-basedcompensation balance related to stock options was adjusted to approximately $3.8 millionafter estimated forfeitures. This amount will be recognized over an estimatedweighted average amortization period of 2.2 years. The Company granted 37,000and 1,403,000 stock options to employees, with an estimated total grant-datefair value of $1.51 and $1.27, during the three and nine months ended September 30,2006, respectively.

*ValuationAssumptions*

The Company estimated the fair value of stock optionsgranted during the three and nine months ended September 30, 2006, using aBlack-Scholes-Merton valuation model, consistent with the provisions of SFASNo. 123R, SEC Staff Accounting Bulletin (“SAB”) No. 107, and theCompany’s prior period pro forma disclosures of stock-based compensation forthe three and nine months ended September 30, 2005, (determined under afair value method as prescribed by SFAS No. 123). The fair value of eachoption grant is estimated on the date of grant

13

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using the Black-Scholes-Mertonoption valuation model and the straight-line attribution approach with thefollowing weighted-average assumptions:

**Employee StockOption Plan**

|                                  | ** ** | **Three and Nine Months** | ** ** |
|----------------------------------|------------|------------------------------------------|------------|
| ** **                       | ** ** | **Ended September 30,**        | ** ** |
| ** **                       | ** ** | **2006**                                 | ** ** | **2005** | ** ** |
| Expected  dividend               |       | —                                   | %          | — | % |
| Average  risk-free interest rate |       | 4.8                                      | %          | 3.9 | % |
| Expected  volatility             |       | 141                                      | %          | 220 | % |
| Expected term (years)            |       | 6.1                                      |       | 4.0 |   |

 

**Employee Stock Purchase Plan**

|                                  | ** ** | **Three and Nine Months** | ** ** |
|----------------------------------|------------|------------------------------------------|------------|
| ** **                       | ** ** | **Ended September 30,**        | ** ** |
| ** **                       | ** ** | **2006**                                 | ** ** | **2005** | ** ** |
| Expected  dividend               |       | —                                   | %          | — | % |
| Average  risk-free interest rate |       | 4.0                                      | %          | 3.3 | % |
| Expected  volatility             |       | 89                                       | %          | 96 | % |
| Expected term (months)           |       | 6.0                                      |       | 6.0 |   |

 

The dividend yield of zero is based on the fact thatthe Company has never paid cash dividends and has no present intention to paycash dividends. The risk-free interest rates are taken from the Daily FederalYield Curve Rates as of the grant dates as published by the Federal Reserve,and represent the yields on actively traded Treasury securities for terms equalto the expected term of the options. Expected volatility is based on thehistorical volatility of the Company’s common stock over a period consistentwith the expected term of the stock option. The expected term calculation isbased on an average prescribed by SAB No. 107, based on the vesting periods,which is generally four years, and the term of the option, which is generally10 years, divided by 2.

**4. Related PartyTransactions**

Robert P. Latta, a member of thelaw firm Wilson Sonsini Goodrich & Rosati, Professional Corporation(“WSGR”), has served as a director of the Company since February 2001. Mr.Latta and WSGR have represented the Company and its predecessors as corporatecounsel since 1997. During the nine months ended September 30, 2006 and2005, payments of approximately $99,000 and $98,000, respectively, were made toWSGR for legal services provided to the Company.

**5. Net Loss PerShare**

Basic and diluted net loss pershare of common stock is presented in conformity with SFAS No. 128 (“SFAS No. 128”),*Earnings Per Share*, for all periodspresented.

In accordance with SFAS No. 128,basic net loss per share has been computed using the weighted average number ofshares of common stock outstanding during the period, less shares subject torepurchase, less treasury shares. Diluted net loss per share is computed on thebasis of the weighted average number of shares and potential common sharesoutstanding during the period. Potential common shares result from the assumedexercise of outstanding stock options that have a dilutive effect when applyingthe treasury stock method. For the three months ended September 30, 2006,due to the Company’s net income for the period, the Company included the neteffect of the weighted average number of shares and potential common sharesoutstanding during the period in the calculation of diluted net income pershare. The Company excluded all outstanding stock options and shares subject torepurchase from the calculation of diluted net loss per share for the ninemonths ended September 30, 2006and for the three and nine months ended September 30, 2005, because allsuch securities are antidilutive (owing to the fact that the Company is in aloss position). Accordingly, diluted net loss per share is equal to basic netloss per share for those loss periods presented.

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The following table set forththe computation of basic and diluted net income (loss) per share:

|                                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                    | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                    | ** ** | **(Unaudited)**                  | ** ** | **(Unaudited)**                 | ** ** |
| Numerator:                                    |       |                             |       |                            |       |   |   |   |   |
| Net income (loss)                             |       | $                                | 1,818      |                            | $          | (1,425 | ) | $ | (4,958 | ) | $ | (3,072 | ) |
|                                          |       |                             |       |                            |       |   |   |   |   |
| Denominator:                                  |       |                             |       |                            |       |   |   |   |   |
| Basic weighted average  shares outstanding    |       | 33,965                           |       | 33,687                          |       | 33,893 |   | 33,554 |   |
| Add: dilutive  employee stock options         |       | 895                              |       | —                          |       | — |   | — |   |
| Diluted weighted  average shares outstanding  |       | 34,860                           |       | 33,687                          |       | 33,893 |   | 33,554 |   |
|                                          |       |                             |       |                            |       |   |   |   |   |
| Basic and diluted net income (loss) per share |       | $                                | 0.05       |                            | $          | (0.04 | ) | $ | (0.15 | ) | $ | (0.09 | ) |

 

The total number of potential common shares excludedfrom the calculations of diluted net loss per share was 2,111,885 and 4,039,592for the three months ended September 30, 2006 and 2005, and 2,982,082 and4,176,524 for the nine months ended September 30, 2006 and 2005,respectively.

**6. SegmentReporting**

Disclosure of segments is presented in accordance withSFAS No. 131 (“SFAS No. 131”), *Disclosures About Segmentsof an Enterprise and Related Information*. SFAS No. 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, manufacture, sale and marketing of networked videocommunications products (Avistar) and (2) the prosecution,maintenance, support and licensing of the intellectual property, some of whichis used in the Company’s products (CPI). Servicerevenue relates mainly to the maintenance, support, training, softwaredevelopment and installation of products, and is included in Avistar forpurposes of reporting and decision-making. Avistar also engages incorporate functions and provides financing and other services to itssubsidiaries. The Company’s Chief Executive Officer, the Company’s chiefoperating decision maker, considers income from settlement and patent licensingto be equivalent to revenue for purposes of monitoring the Company’soperations. A reconciliation of the revenue and expense classification used bythe Company’s CEO with the classification of revenue, other income and expensesas set forth in the Company’s unaudited financial statements included elsewhereherein is indicated in the following table(in thousands):

15

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| ** **                                       | ** ** | **CPI**    | ** ** | **Avistar** | ** ** | **Reconciliation** | ** ** | **Total**  | ** ** |
|--------------------------------------------------|------------|------------|------------|-------------|------------|--------------------|------------|------------|------------|
| **Three  Months Ended September 30,  2006** | ** ** | ** ** | ** ** | ** **  | ** ** | ** **         | ** ** | ** ** | ** ** |
| Revenue                                          |       | $          | 6,057      |        | $          | 2,276              |       | $          | (1,057     | ) | $ | 7,276 |   |
| Depreciation expense                             |       | —     |       | (95         | )          | —             |       | (95        | )          |
| Total costs and expenses                         |       | (1,334     | )          | (5,229      | )          | 1,057              |       | (5,506     | )          |
| Interest income                                  |       | —     |       | 54          |       | —             |       | 54         |       |
| Net income (loss)                                |       | 4,723      |       | (2,905      | )          | —             |       | 1,818      |       |
| Assets                                           |       | 4,699      |       | 10,706      |       | —             |       | 15,405     |       |
| **Three  Months Ended September 30,  2005** | ** ** | ** ** | ** ** | ** **  | ** ** | ** **         | ** ** | ** ** | ** ** |
| **(as restated)**                                | ** ** | ** ** | ** ** | ** **  | ** ** | ** **         | ** ** | ** ** | ** ** |
| Revenue                                          |       | $          | 1,057      |        | $          | 1,834              |       | $          | (1,057     | ) | $ | 1,834 |   |
| Depreciation expense                             |       | —     |       | (51         | )          | —             |       | (51        | )          |
| Total costs and expenses                         |       | (853       | )          | (3,602      | )          | 1,057              |       | (3,398     | )          |
| Interest income                                  |       | —     |       | 144         |       | —             |       | 144        |       |
| Net income (loss)                                |       | 204        |       | (1,629      | )          | —             |       | (1,425     | )          |
| Assets                                           |       | 5,316      |       | 18,352      |       | —             |       | 23,668     |       |
| ** **                                       | ** ** | ** ** | ** ** | ** **  | ** ** | ** **         | ** ** | ** ** | ** ** |
| **Nine  Months Ended September 30,  2006**  | ** ** | ** ** | ** ** | ** **  | ** ** | ** **         | ** ** | ** ** | ** ** |
| Revenue                                          |       | $          | 8,242      |        | $          | 5,817              |       | $          | (3,171     | ) | $ | 10,888 |   |
| Depreciation expense                             |       | —     |       | (285        | )          | —             |       | (285       | )          |
| Total costs and expenses                         |       | (4,120     | )          | (15,110     | )          | 3,171              |       | (16,059    | )          |
| Interest income                                  |       | —     |       | 234         |       | —             |       | 234        |       |
| Net income (loss)                                |       | 4,122      |       | (9,080      | )          | —             |       | (4,958     | )          |
| Assets                                           |       | 4,699      |       | 10,706      |       | —             |       | 15,405     |       |
| **Nine  Months Ended September 30,  2005**  | ** ** | ** ** | ** ** | ** **  | ** ** | ** **         | ** ** | ** ** | ** ** |
| **(as  restated)**                               | ** ** | ** ** | ** ** | ** **  | ** ** | ** **         | ** ** | ** ** | ** ** |
| Revenue                                          |       | $          | 3,171      |        | $          | 5,102              |       | $          | (3,171     | ) | $ | 5,102 |   |
| Depreciation expense                             |       | —     |       | (139        | )          | —             |       | (139       | )          |
| Total costs and expenses                         |       | (1,752     | )          | (9,942      | )          | 3,171              |       | (8,523     | )          |
| Interest income                                  |       | —     |       | 365         |       | —             |       | 365        |       |
| Net income (loss)                                |       | 1,419      |       | (4,491      | )          | —             |       | (3,072     | )          |
| Assets                                           |       | 5,316      |       | 18,352      |       | —             |       | 23,668     |       |

 

International revenue, which consists of sales tocustomers with operations principally in Western Europe and Asia, comprised 88%and 73% of total revenues for the three months ended September 30, 2006and 2005, respectively. International revenue comprised 77% and 63% of totalrevenues for the nine months ended September 30, 2006 and 2005,respectively. For the three months ended September 30, 2006 and 2005,international revenues from customers in the United Kingdom accounted for 12%and 35%, respectively, of total product and services revenue. For the ninemonths ended September 30, 2006 and 2005, international revenues fromcustomers in the United Kingdom accounted for 15% and 31%, respectively, oftotal revenues. The Company had no significant long-lived assets in any countryother than in the United States for any period presented.

**7. Commitments andContingencies**

**Legal Proceedings**

On May 11, 2005, CPI, Avistar’s wholly-ownedpatent prosecution and licensing subsidiary, commenced a patent infringementlawsuit against Tandberg ASA and Tandberg, Inc., alleging that numerousTandberg videoconferencing products infringe three patents held by CPI. Thesuit was filed in the United States District Court for the Northern District ofCalifornia. The three patents involved are U.S. Patent Nos. 5,867,654;5,896,500; and 6,212,547. These patents cover technologies relating to videoand data conferencing over unshielded twisted pair (“UTP”) networks,distributed call-state management, and separate monitors for simultaneouscomputer-based data sharing and videoconferencing. These technologies are corecomponents of the AvistarVOS video operating system. In this action, CPI hasrequested injunctive relief, damages to compensate for past and presentinfringement, treble damages, costs associated with the litigation and suchfurther relief as the Court deems just and proper. Both of the

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Tandberg entitiesanswered the complaint on July 15, 2005, at which time they asserted that theydid not infringe the patents and that the patents were invalid andunenforceable.

On January 30, 2006, Tandberg Telecom AS, awholly-owned subsidiary of Tandberg ASA, filed a patent infringement lawsuitagainst Avistar in the United States District Court for the Eastern District ofTexas. The suit alleges that Avistar videoconferencing products infringe onepatent purchased by Tandberg Telecom AS. The patent involved is U.S. Patent No. 6,621,515,which claims a method and system for routing video calls. In the Texaslitigation, Tandberg Telecom AS has requested injunctive relief, monetarydamages to compensate for its actual damages, costs associated with thelitigation and such further relief as the Court deems just and proper. Avistarresponded to the complaint on March 23, 2006, at which time Avistarasserted that Avistar did not infringe the patent, that the patent was invalid,and that the claim was without merit. Avistar has requested that the TandbergTelecom AS claim be dismissed and that Tandberg pay all of Avistar’s attorney’sfees in such action. The court has not yet ruled on these requests. On May 18,2006, Tandberg filed a motion to dismiss one of Avistar’s defenses, which theTexas court summarily denied on July 13, 2006.

Tandberg ASA and Tandberg, Inc. sought to add twodefenses, and provisionally filed two motions for summary judgment in theCalifornia litigation on January 13, 2006 and February 24, 2006,respectively. Each proposed defense asserts that Avistar is subject to adifferent contractual provision that either totally precludes or limits CPI’sremedies in the California litigation. Specifically, Tandberg alleged that (1)it had a license to the subject patents and (2) that Avistar had released itsclaims against Tandberg with respect to the subject patents. Both motions forsummary judgment were determined to be procedurally defective in that Tandberghad not previously pled the contractual provisions as defenses to CPI’s claims.

In the first matter, on January 13, 2006,Tandberg voluntarily filed a motion to amend its complaint to add a licensedefense. On March 29, 2006, the court conditionally granted Tandberg’smotion, subject to the transfer and addition of the Texas suit to theCalifornia litigation. Tandberg filed a motion for reconsideration of thecourt’s ruling on May 17, 2006, which was denied by the court on June 28,2006. As of October 17, 2006, Tandberg has not dismissed its Texaslitigation, thereby precluding the further consideration of its motion forsummary judgment on the basis of a “license” defense.

During a hearing on March 20, 2006 concerning Tandberg’s“release” defense, the court refused to permit Tandberg to amend its complaint,holding that Tandberg could not prevail on that defense, thereby prohibitingTandberg from pursuing this defense in the California case. 

A third motion for summary judgment in the Californialitigation was filed by Tandberg on April 17, 2006, claiming that CPI’s patentswere invalid based on the ruling of IPXL Holdings, LLC v. Amazon.com, Inc. Thecourt denied Tandberg’s motion on June 23, 2006.

The Markman hearing for the CPI claims, a pivotalstage of the litigation process at which time definitions are determined forthe meaning of the patent claims language, was held on May 24, 2006, andthe judge issued her ruling on June 23, 2006. A non-binding mediationrelated to the California case was held on May 12, 2006 without resolution.A second non-binding mediation was conducted on August 15, 2006, alsowithout resolution. Discovery is on-going in the California litigation with acourt-scheduled conclusion of discovery set for February 9, 2007, and ajury trial date scheduled for May 7, 2007. The Texas case remains in itsinitial phases, and a jury trial date has not yet been scheduled.

The prosecution of this lawsuit and the defense of theTandberg Telecom AS claim requires Avistar and CPI to expend significantfinancial and managerial resources, and therefore may have a material negativeimpact on Avistar’s business, financial condition and results of operations.The duration and ultimate outcome of these litigation proceedings areuncertain.

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** **

**SoftwareIndemnifications**

Avistar enters into standard indemnificationagreements in the ordinary course of business. Pursuant to these agreements,Avistar indemnifies, holds harmless, and agrees to reimburse the indemnifiedparty for losses suffered or incurred by the indemnified party, generallyAvistar’s business partners or customers, in connection with any patent,copyright or other intellectual property infringement claim by any third partywith respect to its products. The term of these indemnification agreements isgenerally perpetual. The maximum potential amount of future payments Avistarcould be required to make under these indemnification agreements is unlimited.Avistar has never incurred costs to defend lawsuits or settle claims related tothese indemnification agreements. Accordingly, Avistar has no liabilitiesrecorded for these agreements as of September 30, 2006. 

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

The following discussion should be read in conjunctionwith the unaudited Condensed Consolidated Financial Statements and the Notes toCondensed Consolidated Financial Statements elsewhere herein, and the AuditedConsolidated Financial Statements contained in our Annual Report on Form 10-Kfor the year ended December 31, 2005, as filed with the Securities andExchange Commission on April 28, 2006.

Certain statements in this“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” are forward looking statements. These statements relate to futureevents or our future financial performance and involve known and unknown risks,uncertainties and other factors that may cause our or our industry’s actualresults, levels of activity, performance or achievements to be materiallydifferent from any future results, levels of activity, performance orachievements expressed or implied by the forward looking statements. Theserisks and other factors include those listed under “Risk Factors” elsewhere inthis Quarterly Report on Form 10-Q. In some cases, you can identify forwardlooking statements by terminology such as “may”, “will”, “should”, “expects”,“intends”, “plans”, “anticipates”, “believes”, “estimates”, “predicts”,“potential”, “continue” or the negative of these terms, or other comparableterminology. These statements are only predictions. Actual events or resultsmay differ materially. In evaluating these statements, you should specificallyconsider various factors, including the risks outlined under “Risk Factors.”These factors may cause our actual results to differ materially from anyforward-looking statement.

Although we believe that theexpectations reflected in the forward-looking statements are reasonable, wecannot guarantee future results, levels of activity, performance orachievements. We are under no duty to update any of the forward-lookingstatements after the date of this Quarterly Report on Form 10-Q to conform ourprior statements to actual results.

**Overview**

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

We operate in two segments. Avistar CommunicationsCorporation engages in the design, development, manufacture, sale and marketingof networked video communications products and associated support services.Collaboration Properties, Inc., or CPI, our wholly owned subsidiary, engages inthe prosecution, maintenance, support and licensing of the intellectualproperty that we have developed, some of which is used in our products.

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Since inception, we have recognized the innovativevalue of our research and development efforts, and have invested in securingprotection for these innovations through domestic and foreign patentapplication and issuance. As of September 30, 2006, we hold 71 U.S. andforeign patents, which have been licensed to third parties. We continue topursue opportunities to license these patents to others in the collaborationtechnology marketplace.

**CriticalAccounting Policies**

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

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

·    Revenue recognition;

·    Income from settlement and patent licensing;

·    Valuation of accounts receivable; and

·    Valuationof inventories.

In light of the recent adoption of Statement ofFinancial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment,” (“SFAS No. 123R”), we have also included our stock-basedcompensation policy as a critical accounting policy, as set forth below.

**RevenueRecognition**

We derive product revenue from the sale and licensingof our video-enabled networked communications system, consisting of a suite ofAvistar-designed software and hardware products, including third partycomponents. We also derive revenue from fees for installation, maintenance, support,training services and software development. In addition, we derive revenue fromthe licensing of our intellectual property portfolio. In the three months endedSeptember 30, 2006, we licensed all of CPI’s patents with a filing date onor before January 1, 2006 for a specific field of use relating to videoconferencing to Sony Corporation and Sony Computer Entertainment, Inc. (SCEI)for an upfront license payment of $5.0 million and future royalty paymentsrelating to the sale in certain countries, including the United States, ofcertain products sold by SCEI. Product revenue as a percentage of total revenuewas 20% and 46% for the three months ended September 30, 2006 and 2005,respectively. Product revenue as a percentage of total revenue was 30% and 49%for the nine months ended September 30, 2006 and 2005, respectively.

We recognize product and services revenue inaccordance with Statement of Position (“SOP”) *97-2,Software Revenue Recognition*(“SOP 97-2”), as amended by SOP 98-9,Modification of SOP 97-2, *Software RevenueRecognition, With Respect to Certain Transactions* (“SOP 98-9”).We derive product revenue from the sale and licensing of a set of desktop(endpoint) products (hardware and software) and infrastructure products(hardware and software) that combine to form an Avistar video-enabledcollaboration solution. Services revenue includes revenue from installationservices, post-contract customer support, training, out of pocket expenses,freight and software development. The installation services that we offer tocustomers relate to the physical set-up and configuration of desktop andinfrastructure components of our solution. The fair value of all product,installation services, post-contract customer support and training offered tocustomers is determined based on the price charged when such products orservices are sold separately.

Arrangements that include multiple product and serviceelements may include software and hardware products, as well as installationservices, post-contract customer support and training. Pursuant to SOP 97-2,when an arrangement includes multiple elements, we recognize revenue when allof the following criteria are met: (i) persuasive evidence of anarrangement exists, (ii) delivery has occurred, (iii) the fee is fixedor determinable, and

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(iv) collectibilityis probable. We apply these criteria as discussed below:

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

·    Delivery has occurred. We deliver softwareand hardware to our customers physically. Our standard delivery terms are FOBshipping point.

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

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

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

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

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

We recognize service revenue from software developmentcontracts in accordance with SOP 81-1, *Accounting for Performanceof Construction-Type and Certain Production-Type Contracts.* Revenuerelated to contracts for software development is recognized using thepercentage of completion method, when all of the following conditions are met:a contract exists with the customer at a fixed price, we have fulfilled all ofour material contractual obligations to the customer for each deliverable ofthe contract, verification of completion of the

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deliverable has beenreceived, and collection of the receivable is probable. Amounts billed tocustomers in excess of revenues recognized to date are deferred and recorded asdeferred revenue and customer deposits in the accompanying balance sheets.Assumptions used for recording revenue and earnings are adjusted in the periodof change to reflect revisions in contract value and estimated costs tocomplete the contract. Any anticipated losses on contracts in progress arecharged to earnings when identified.

We also derive revenue from the licensing of ourintellectual property portfolio. We recognize revenue from the licensing of ourintellectual property portfolio accordingto SOP 97-2, based on the terms of the royalty, partnership andcross-licensing agreements involved. In the event that a license to our intellectualproperty is granted after the commencement of litigation proceedings between usand the licensee, the proceeds of such transaction are recognized as licensingrevenue by us only if sufficient historical evidence exists for thedetermination of fair value of the licensed patents to support the segregationof the proceeds between a gain on litigation settlement and patent licenserevenues consistent with FASB ConceptsStatement No. 6, *Elements of Financial Statements*.As of September 30, 2006, these criteria for recognizing license revenuefollowing the commencement of litigation had not been met.

On July 17, 2006, Avistar and CPI entered into aPatent License Agreement with Sony Corporation (“Sony”), a Japanesecorporation, and Sony Computer Entertainment, Inc. (“SCEI”), a Japanesecorporation. Under the license agreement, CPI granted Sony and its subsidiariesa license to all of CPI’s patents with a filing date on or before January 1,2006 for a specific field of use relating to video conferencing. The licensecovers Sony’s video conferencing apparatus as well as other products, includingvideo-enabled personal computer products and certain SCEI PlayStation products.As consideration for the licenses granted under the agreement, Sony agreed tomake an upfront license payment of $5.0 million and SCEI has agreed tomake future royalty payments relating to the sale, in certain countries, ofcertain SCEI products. The $5.0 million upfront payment was recognized byus as licensing revenue in the three months ended September 30, 2006 andfuture royalty payments, if any, will be recognized as they occur in accordancewith SOP 97-2.

To date, a significant portion of our revenue hasresulted from sales to a limited number of customers, particularly Sony,Deutsche Bank AG and UBS Warburg LLC and their affiliates, which have accountedfor approximately 46%, 22% and 18%, respectively, of total revenue for the ninemonth period ended September 30, 2006. Deutsche Bank AG and UBS WarburgLLC and their affiliates accounted for approximately 41% and 43%, respectively,of total revenue for the nine month period ended September 30, 2005. Sony,Deutsche Bank AG and UBS Warburg LLC and their affiliates accounted forapproximately 69%, 15% and 7%, respectively, of total revenue for the threemonth period ended September 30, 2006. Deutsche Bank AG and UBS WarburgLLC and their affiliates accounted for approximately 44% and 49%, respectively,of total revenue for the three month period ended September 30, 2005. Asof September 30, 2006, approximately 77% of our gross accounts receivablewas concentrated with two of these three customers. No other customersrepresented more than 10% of our gross accounts receivable. 

International revenue, which consists of sales tocustomers with operations principally in Western Europe and Asia, comprised 88%and 73% of total revenues for the three months ended September 30, 2006and 2005, respectively. International revenue comprised 77% and 63% of totalrevenues for the nine months ended September 30, 2006 and 2005,respectively.

**Income fromSettlement and Patent Licensing**

We recognize the proceeds from settlement and patentlicensing agreements based on the terms involved. When litigation has beenfiled prior to a settlement and patent licensing agreement, and insufficienthistorical evidence exists for the determination of fair value of the patentslicensed to support the segregation of the proceeds between a gain on litigationsettlement and patent license revenues, we report all proceeds in “income fromsettlement and patent licensing” within operating costs and expenses. The gainportion of the proceeds, when sufficient historical evidence exists tosegregate the proceeds, is reported in other income according to SFAS No. 5,Accounting for Contingencies.

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In September 2005, we received a comment letterfrom the U. S. Securities and Exchange Commission (“SEC”) relating to our 2004 Form 10-K,which included a question regarding our accounting for the November 2004settlement and patent cross-license agreement with Polycom, Inc.. Thesettlement and patent cross-license agreement resulted in a $27.5 millionone time payment by Polycom to us and a payment by us to our litigation counselof $6.4 million in contingent legal fees. We previously reported on Form 10-Qfor the three and nine months ended September 30, 2005 the one timepayment by Polycom as revenue, to be recognized ratably over a five-yearperiod, net of contingent legal fees. As a result of the SEC’s inquiry as towhether the Polycom transaction should be characterized as revenue, and afterdiscussions with the SEC, we concluded that a reclassification of Polycomlicense revenues from revenue to a component of operating expenses presented as“Income from settlement and patent licensing” was necessary for previouslyfiled financial reports. The restatement of the net proceeds and expenses fromthe Polycom settlement and patent cross-license agreement had no effect on reportednet loss, loss per share, stockholders’ equity (deficit) or net cash flows fromoperating, investing or financing activities, but did have the effect ofoverstating revenues and operating expenses for previously issued interimcondensed consolidated financial statements, as of and for the three and ninemonths ended September 30, 2005. In addition, the balance sheet as of September 30,2005 has been restated to reflect the gross effect of the $27.5 millionpayment by Polycom to Avistar, and the payment of $6.4 million ofcontingent legal fees by us, which was previously reported on a net basis asdeferred revenue. See Note 2“Correction of an Error” of the Notes to Condensed Consolidated FinancialStatements in Part I, Item 1.

**Valuation ofAccounts Receivable**

Estimates are used in determining our allowance fordoubtful accounts and are based on our historical collection experience,historical write-offs, current trends, and the credit quality of our customerbase and the characteristics of our accounts receivable by aging category. Ifthe allowance for doubtful accounts were to be understated, our operatingresults would be negatively affected. The impact of any such change ordeviation may be increased by our reliance on a relatively small number of customersfor a large portion of our total revenue. As of December 31, 2005, threecustomers represented 48%, 32% and 17% of our gross accounts receivablebalance. As of September 30, 2006, two customers represented 52% and 25% ofour gross accounts receivable.

**Valuation ofInventories**

We record a provision for obsolete or excess inventoryfor systems and components that are no longer manufactured or are at risk ofbeing replaced with new versions of our product. In determining the allowancefor obsolete or excess inventory, we look at our forecasted demand versusquantities on hand and commitments. Any significant unanticipated changes indemand or technological developments could have a significant impact on thevalue of our inventory, commitments, and our reported 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 results for thatperiod.

**Stock Compensation**

We adopted SFAS No. 123R effectiveJanuary 1, 2006. SFAS No. 123R is a new and very complex accountingstandard, the application of which requires significant judgment and the use ofestimates, particularly surrounding Black-Scholes-Merton assumptions such asstock price volatility and expected option terms, as well as expected optionforfeiture rates used to value equity-based compensation. There is littleexperience or guidance with respect to developing these assumptions and models.SFAS No. 123R requires the recognition of the fair value of stockcompensation in net income (loss). Refer to Note 3 — Stock-BasedCompensation in the Notes to our Unaudited Condensed Consolidated FinancialStatements included elsewhere in this Quarterly Report of Form 10-Q formore information.

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**Results of Operations**

The following table sets forthdata expressed as a percentage of total revenue for the periods indicated.
| ** **                                        | ** ** | **Percentage of Total Revenue** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                        | ** ** | **Three Months Ended**               | ** ** | **Nine Months Ended** | ** ** |
| ** **                                        | ** ** | **September 30,**                         | ** ** | **September 30,** | ** ** |
| ** **                                        | ** ** | **2006**                                       | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                        | ** ** | ** **                                     | ** ** | **Restated(1)** | ** ** | ** ** | ** ** | **Restated(1)** | ** ** |
| Revenue:                                          |       |                                           |       |   |   |   |   |   |   |
| Product                                           |       | 20                                             | %          | 46 | % | 30 | % | 49 | % |
| Licensing                                         |       | 69                                             |       | — |   | 47 |   | — |   |
| Services, maintenance and support                 |       | 11                                             |       | 54 |   | 23 |   | 51 |   |
| Total revenue                                     |       | 100                                            |       | 100 |   | 100 |   | 100 |   |
| Costs  and Expenses:                              |       |                                           |       |   |   |   |   |   |   |
| Cost of product revenue                           |       | 14                                             |       | 29 |   | 22 |   | 25 |   |
| Cost of services, maintenance and support revenue |       | 5                                              |       | 34 |   | 12 |   | 31 |   |
| Income from settlement and patent licensing       |       | (14                                            | )          | (58 | ) | (29 | ) | (62 | ) |
| Research and development                          |       | 21                                             |       | 49 |   | 39 |   | 44 |   |
| Sales and marketing                               |       | 19                                             |       | 43 |   | 38 |   | 45 |   |
| General and administrative                        |       | 31                                             |       | 88 |   | 65 |   | 84 |   |
| Total costs and expenses                          |       | 76                                             |       | 185 |   | 147 |   | 167 |   |
| Income  (loss) from operations                    |       | 24                                             |       | (85 | ) | (47 | ) | (67 | ) |
| Other  income (expense):                          |       |                                           |       |   |   |   |   |   |   |
| Interest income                                   |       | 1                                              |       | 8 |   | 2 |   | 7 |   |
| Other expense, net                                |       | —                                         |       | (1 | ) | — |   | — |   |
| Total other income, net                           |       | 1                                              |       | 7 |   | 2 |   | 7 |   |
| Net income (loss)                                 |       | 25                                             | %          | (78 | )% | (45 | )% | (60 | )% |

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

**COMPARISON OF THE THREE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005**

***Revenue***

Total revenues increased by $5.4 million, or297%, to $7.3 million for the three months ended September 30, 2006,compared to $1.8 million for the three months ended September 30,2005. The increase was attributable to the licensing of CPI’s patents to Sonyand SCEI for an upfront license payment of $5.0 million and the increasein total revenue was also due in part to increased revenues from product sales,which were partially offset by a slight decrease in services, maintenance andsupport revenues. For the three monthsended September 30, 2006, revenue from two customers accounted for 84% oftotal revenue, each of whom accounted for greater than 10% of total revenue.For the three months ended September 30, 2005, revenue from two customersaccounted for 93% of total revenue, each of whom accounted for greater than 10%of total revenue. We expect that there will be significant customerconcentration in future quarters. The loss of any one of those customers wouldhave a material adverse impact on our financial condition and operating results.

·                     Productrevenue increased by $606,000, or 72%, to $1.4 million for the threemonths ended September 30, 2006, from $842,000 for the three months ended September 30,2005. The increase was due to increased purchasing of additional products amongour existing customer base, product revenue recognition in the quarter upon thecompletion of installation services on previous sales, and increased sales tonew customers in the current quarter.

·                     Licensingrevenue, which reflects the licensing of our patent portfolio, increased to$5.0 million for the three months ended September 30, 2006, comparedto no licensing revenues for the three months ended September 30, 2005.The increase was attributable to the licensing of CPI’s patents to Sony andSCEI for an

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upfront license payment of $5.0 million plus future royalty rights.Licensing revenue in future quarters may dramatically increase or decreasedependent on the magnitude and timing of third party licenses to our patentportfolio and subsequent royalty payments, if any, associated with the sale ofcertain SCEI products.

·                     Services,maintenance and support revenues, which include our installation services,funded software development and maintenance and support, decreased by $164,000,or 17%, to $828,000 for the three months ended September 30, 2006, from$992,000 for the three months ended September 30, 2005. The decrease wasprimarily due to a decrease in revenue from installation services and the lackof funded software development projects. Revenue from installation services andfunded software development projects may dramatically increase or decreasedependent on the magnitude and timing of these services provided to ourcustomers.

***Costs and Expenses***

*Cost of product revenue*.Our costs of products include inventory and personneland related expenses for the assembly, testing and shipping of productssold. Cost of product revenues increased by $467,000, or 88%, to $998,000 forthe three months ended September 30, 2006, from $531,000 for the threemonths ended September 30, 2005. Theincrease was primarily attributable to increased sales of our products and anincrease in personnel and related expenses for the assembly, and testing of theincreased products sold.

*Cost of services, maintenance andsupport revenues*. Our cost of services, maintenance and support revenues includes personneland related expenses for our maintenance and support services, an overheadallocation consisting primarily of that portion of our facilities,communications and depreciation expenses that is attributable to providingthese services, and personnel and related expenses for performing installationservices for our customers. Cost of services,maintenance and support revenues decreased by $242,000, or 39%, to $374,000for the three months ended September 30, 2006 from $616,000 for the threemonths ended September 30, 2005. The decrease was primarily attributableto reduced installation and professional services activities, and the lack offunded software development projects during the quarter.

*Income fromsettlement and patent licensing*. Incomefrom settlement and patent licensing was $1.1 million for the three monthperiods ended September 30, 2006 and September 30, 2005, reflectingthe amortization of the net proceeds from the November 2004 Polycom settlementand cross-license agreement over a five year period beginning in November 2004and ending in November 2009.

*Research anddevelopment*. Research and development expenses increased by$612,000, or 68%, to $1.5 million for the three months ended September 30,2006 from $905,000 for the three months ended September 30, 2005. Theincrease was primarily attributable to an increase in personnel, outsidecontractors and related expenses, and to a lesser extent, an increase instock-based compensation of $164,000.

*Sales andmarketing*. Sales and marketingexpenses increased by $612,000, or 78%, to $1.4 million for the threemonths ended September 30, 2006 from $782,000 for the three months ended September 30,2005. The increase was primarily attributable to an increase in personnel andrelated expenses, and to a lesser extent, an increase in stock-basedcompensation of $133,000.

*General andadministrative*. General and administrativeexpenses increased by $659,000, or 41% to $2.3 million for the threemonths ended September 30, 2006 from $1.6 million for the threemonths ended September 30, 2005. The increase was due primarily tothe legal fees associated with our litigation against Tandberg for patentinfringement, and to a lesser extent, an increase in stock-based compensationof $180,000.

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*** ***

***Other Income, Net***

*Other income, net*. Other income,net decreased by $91,000, or 65% to $48,000 for the three months ended September 30,2006 from $139,000 for the three months ended September 30, 2005. The decreasewas due a decrease in the balances of cash equivalents and short-terminvestments on which we earned interest, offset by increased interest ratesearned on our balances of cash equivalents and short-term investments.

**COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005**

***Revenue***

Total revenue increased by $5.8 million, or 113%,to $10.9 million for the nine months ended September 30, 2006, from$5.1 million for the nine months ended September 30, 2005. Theincrease was primarily the result of the licensing of CPI’s patents to Sony andSCEI for an upfront license payment of $5.0 million plus future royaltyrights and also the result of increased product sales. For the nine months ended September 30, 2006, revenue from threecustomers accounted for 86% of total revenue, each of whom accounted forgreater than 10% of total revenue. For the nine months ended September 30,2005, revenue from two customers accounted for 84% of total revenue, each ofwhom accounted for greater than 10% of total revenue. We expect that there willbe significant customer concentration in future quarters. The loss of any oneof those customers would have a material adverse impact on our financialcondition and operating results.

·                     Productrevenue increased by $791,000, or 32%, to $3.3 million for the nine monthsended September 30, 2006, from $2.5 million for the nine months endedSeptember 30, 2005. The increase was due to increased purchasing of additionalproducts among our existing customer base, and increased sales to new customersin the nine month period ended September 30, 2006, as compared to the sameperiod in 2005.

·                     Licensingrevenue, relating to the licensing of our patent portfolio, increased to $5.1 millionfor the nine months ended September 30, 2006, compared to no licensingrevenue for the nine months ended September 30, 2005. The increase wasprimarily attributable to the licensing of CPI’s patents to Sony and SCEI foran upfront license payment of $5.0 million plus future royalty rights.

·                     Services,maintenance and support revenue, which includes our installation services,funded software development and maintenance and support, decreased by $76,000,or 3%, to $2.5 million for the nine months ended September 30, 2006,from $2.6 million for the nine months ended September 30, 2005. The decreasewas primarily due to a decrease in revenue from installation services and fundedsoftware development projects, and a slight decrease in the dollar value ofrenewals of annual maintenance and support contracts.

***Costs and Expenses***

*Cost of product revenue*.Cost of product revenue increased by $1.1 million, or 81%, to $2.4 millionfor the nine months ended September 30, 2006, from $1.3 million forthe nine months ended September 30, 2005. The increase was primarily attributable to increased sales of ourproducts and an increase in personnel and related expenses for the assembly andtesting of our products.

*Cost of services, maintenance andsupport revenues*. Cost of services, maintenance and support revenues decreased by$222,000, or 14%, to $1.4 million for the nine months ended September 30,2006 from $1.6 million for the nine months ended September 30, 2005. Thenine months ended September 30, 2006 reflected a decrease in softwaredevelopment costs associated with a decrease in funded software developmentrevenue, offset by an increase in stock-based compensation of $113,000.

*Income fromsettlement and patent licensing*. Incomefrom settlement and patent licensing was $3.2 million for the nine monthperiods ended September 30, 2006 and September 30, 2005, reflectingthe amortization of the net proceeds from the November 2004 Polycom settlementand cross-license agreement over a five year period beginning in November 2004and ending in November 2009.

*Research anddevelopment*. Research and development expenses increased by$2.0 million, or 88%, to

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$4.2 millionfor the nine months ended September 30, 2006 from $2.3 million forthe nine months ended September 30, 2005. The increase was primarilyattributable to an increase in personnel, outside contractors and relatedexpenses, and to a lesser extent, an increase in stock-basedcompensation of $461,000.

*Sales andmarketing*. Sales and marketingexpenses increased by $1.9 million, or 82%, to $4.2 million for thenine months ended September 30, 2006 from $2.3 million for the ninemonths ended September 30, 2005. The increase was primarily attributableto an increase in personnel and related expenses, and to a lesserextent, an increase in stock-based compensation of $365,000.

*General andadministrative*. General and administrativeexpenses increased by $2.9 million, or 67% to $7.1 million for thenine months ended September 30, 2006 from $4.3 million for the ninemonths ended September 30, 2005. The increase was due primarily tothe legal fees associated with our litigation against Tandberg ASA andTandberg, Inc. for patent infringement, and to a lesser extent, an increase in stock-basedcompensation of $502,000.

***Other Income, Net***

*Other income, net*. Other income,net decreased by $136,000, or 39% to $213,000 for the nine months ended September 30,2006 from $349,000 for the nine months ended September 30, 2005. Thedecrease was due to a decrease in the balances of cash equivalents andshort-term investments on which we earned interest, offset in part by increasedinterest rates earned on our balances of cash equivalents and short-terminvestments.

**Liquidity and Capital Resources**

We had cash, cash equivalents and short and long-terminvestments of $8.4 million as of September 30, 2006, and $12.2 millionas of December 31, 2005. For the nine months ended September 30, 2006, wehad a net decrease in cash, cash equivalents and short and long-terminvestments of $3.8 million resulting primarily from a net loss of $5.0 millionand a decrease in deferred income from settlement and patent licensing of $4.1 million,offset by an increase in accrued liabilities of $1.3 million, deferredservices revenue and customer deposits of $357,000 and accounts payable of$598,000, a decrease in deferred settlement and patent licensing costs of $1.0 millionand accounts receivable of $247,000, and non-cash expenses of $1.7 million,which included $1.5 million in non-cash stock-based compensation.

We had cash and cash equivalents of $7.5 millionas of September 30, 2006 compared to cash and cash equivalents of $8.2 millionas of December 31, 2005. For the nine months ended September 30,2006, we had an overall net cash outflow of $696,000, resulting primarily fromnet cash used in operations of $3.8 million offset by cash inflows frominvesting activities of $3.1 million due to maturities of short-termmarketable securities. The net cash used in operations of $3.8 millionresulted from a net loss $5.0 million and a decrease in deferred incomefrom settlement and patent licensing of $4.1 million, offset by anincrease in accrued liabilities of $1.3 million, deferred services revenueand customer deposit of $357,000 and accounts payable of $598,000, a decreasein deferred settlement and patent licensing costs of $1.0 million andaccounts receivable of $247,000, and non-cash expenses of $1.7 million.The net cash inflow from investing activities of $2.8 million was due tomaturities of short-term marketable securities offset by the purchase ofequipment and leasehold improvements. The net cash inflow from financingactivities was $290,000, due to proceeds from issuance of common stock throughour employee stock option and purchase plans.

At September 30, 2006, we had open purchaseorders and other contractual obligations of approximately $459,000, primarilyrelated to inventory purchases. We also have commitments that consist ofobligations under our operating leases. These purchase order commitments andcontractual obligations are reflected in our financial statements once goods orservices have been received or payments related to the obligations become due.

On March 15, 2006, we signed a new lease for 2,500square feet of office space in London, United Kingdom to house our sales and supportpersonnel. The new office space replaces similar facilities vacated in March2006. The new lease requires minimum payments of approximately $112,000,$144,000, $144,000 and $80,000 for fiscal years 2006, 2007, 2008 and 2009,respectively.

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On May 11, 2005, CPI, our wholly-owned subsidiary,commenced a patent infringement lawsuit against Tandberg ASA and Tandberg, Inc.alleging that several Tandberg videoconferencing products infringe threepatents held by CPI. The suit was filed in the United States District Court forthe Northern District of California. Tandberg Telecom AS, a wholly-ownedsubsidiary of Tandberg ASA, subsequently filed suit in Texas against Avistarand CPI. The prosecution of this lawsuit and the defense of the Tandberg claimsrequire us to expend significant financial and managerial resources andtherefore may have a material negative impact on our business and financialcondition. We have entered into an agreement with our attorneys representing usin the this matter for deferral of a portion of fees for work associated withthese actions done after July 1, 2006, excluding out of pocket expenses. Thisagreement provides that these fees will be deferred until a settlement orfavorable outcome in the litigation is achieved. In the event of a settlementor favorable outcome, we will be obligated to pay our attorneys the amount offees deferred plus a performance bonus, with such amounts to be paid out ofactual funds received by us from Tandberg. If the outcome of the litigation isnot favorable to us, the deferred fees are forfeited by our attorneys.

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

**Item 3. *Quantitative and Qualitative DisclosuresAbout Market Risk***

We develop products primarily inthe United States and sell those products primarily in North America, Europeand Asia. International revenue, which consists of sales to customers withoperations principally in Western Europe and Asia, comprised 88% and 73% oftotal revenues for the three months ended September 30, 2006 and 2005,respectively. International revenue comprised 77% and 63% of total revenues forthe nine months ended September 30, 2006 and 2005, respectively. As aresult, our financial condition could be affected by factors such as changes inforeign currency exchange rates or weak economic conditions in foreign markets.As all of our sales are currently made in United States dollars, astrengthening of the United States dollar could make our products lesscompetitive in foreign markets. We do not use derivative financial instrumentsfor speculative or trading purposes, nor do we currently engage in any foreigncurrency hedging transactions.

Our interest income is sensitiveto changes in the general level of United States interest rates, particularlysince the majority of our investments are in short-term instruments. There hasnot been a material change in our exposure to interest rate and foreigncurrency risk since the date of our annual report on Form 10-K for the yearended December 31, 2005, filed with the Securities and Exchange Commissionon April 28, 2006.

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

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

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

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|                                                     | ** ** | ** **              | ** ** | **Weighted Average** | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|---------------------------|------------|
| ** **                                          | ** ** | **Amounts**             | ** ** | **Interest Rate**    | ** ** |
| ** **                                          | ** ** | **(in thousands)** | ** ** | **(%)**                   | ** ** |
| **Description**                                     |       |                    |       |                      |       |
| Cash,  cash equivalents and short-term investments: |       |                    |       |                      |       |
| Cash                                                |       | $                       | 2,470      |                      | —     |   |
| Commercial Paper and US Government Agency Notes     |       | 5,949                   |       | 5.2                       | %          |
| Fair Value at September 30, 2006               |       | $                       | 8,419      |                      |       |   |

 

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

(a) Evaluation of disclosurecontrols and procedures: Our management, with the participation of our ChiefExecutive Officer and Chief Financial Officer, evaluated the effectiveness ofour disclosure controls and procedures as of the end of the period covered bythis Quarterly Report on Form 10-Q (the “Evaluation Date”). Based on thisevaluation, our Chief Executive Officer and Chief Financial Officer haveconcluded that, as of the Evaluation Date, our disclosure controls andprocedures (as defined in Rules13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934 (the Exchange Act)) were effective to providereasonable assurance that information required to be disclosed by us in reportsthat we file or submit under the Exchange Act (i) is accumulated andcommunicated to our management, including our chief executive officer and chieffinancial officer, as appropriate to allow timely decisions regarding requireddisclosure, and (ii) is recorded, processed, summarized and reportedwithin the time periods specified in Securities and Exchange Commissionrules and forms.

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

**PART II - OTHER INFORMATION**

**Item 1. *Legal Proceedings***

On May 11, 2005, CPI, our wholly-owned patentprosecution and licensing subsidiary, commenced a patent infringement lawsuitagainst Tandberg ASA and Tandberg, Inc., alleging that numerous Tandbergvideoconferencing products infringe three patents held by CPI. The suit wasfiled in the United States District Court for the Northern District ofCalifornia. The three patents involved are U.S. Patent Nos. 5,867,654;5,896,500; and 6,212,547. These patents cover technologies relating to video anddata conferencing over unshielded twisted pair (UTP) networks, distributedcall-state management, and separate monitors for simultaneous computer-baseddata sharing and videoconferencing. These technologies are core components ofthe AvistarVOS video operating system. In this action, CPI has requestedinjunctive relief, damages to compensate for past and present infringement,treble damages, costs associated with the litigation and such further relief asthe Court deems just and proper. Both of the Tandberg entities answered thecomplaint on July 15, 2005, at which time they asserted that they did notinfringe the patents and that the patents were invalid and unenforceable.

On January 30, 2006, Tandberg Telecom AS, awholly-owned subsidiary of Tandberg ASA, filed a patent infringement lawsuitagainst us and CPI in the United States District Court for the Eastern Districtof Texas. The suit alleges that our videoconferencing products infringe onepatent purchased by Tandberg Telecom AS. The patent involved is U.S. Patent No.6,621,515, which claims a method and system for routing video calls. In theTexas litigation, Tandberg Telecom AS has requested injunctive relief, monetarydamages to compensate for its actual damages, costs associated with thelitigation and such further relief as the Court deems just and proper. Weresponded to the complaint on March 23, 2006, at which time we asserted that wedid not infringe the patent, that the patent was invalid, and that the claimwas without merit. Avistar has requested that the Tandberg Telecom AS claim bedismissed and that Tandberg pay all of our attorney’s fees in such action. Thecourt has not yet ruled on these requests. On May 18, 2006, Tandberg fileda motion to dismiss one of our defenses, which the Texas court summarily deniedon July 13, 2006.

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Tandberg ASA and Tandberg, Inc. sought to add twodefenses, and provisionally filed two motions for summary judgment in theCalifornia litigation on January 13, 2006 and February 24, 2006,respectively. Each proposed defense asserts that we are subject to a differentcontractual provision that either totally precludes or limits CPI’s remedies inthe California litigation. Specifically, Tandberg alleged that (1) it had alicense to the subject patents and (2) that Avistar had released its claimsagainst Tandberg with respect to the subject patents. Both motions for summaryjudgment were determined to be procedurally defective in that Tandberg had notpreviously pled the contractual provisions as defenses to CPI’s claims. In thefirst matter, on January 13, 2006, Tandberg voluntarily filed a motion toamend its complaint to add a license defense. On March 29, 2006, the courtconditionally granted Tandberg’s motion, subject to the transfer and additionof the Texas suit to the California litigation. Tandberg filed a motion forreconsideration of the court’s ruling on May 17, 2006, which was denied bythe court on June 28, 2006. As of October 17, 2006, Tandberg has notdismissed its Texas litigation, thereby precluding the further consideration ofits motion for summary judgment on the basis of a “license” defense.

During a hearing on March 20, 2006 concerningTandberg’s “release” defense, the court refused to permit Tandberg to amend itscomplaint, holding that Tandberg could not prevail on that defense, and therebyprohibiting Tandberg from pursuing this defense in the California case. A thirdmotion for summary judgment was filed by Tandberg on April 17, 2006,claiming that CPI’s patents were invalid based on the ruling of *IPXL Holdings, LLC v. Amazon.com, Inc.* The court deniedTandberg’s motion on June 23, 2006.

The Markman hearing for the CPI claims, a pivotalstage of the litigation process at which time definitions are determined forthe meaning of the patent claims language, was held on May 24, 2006, andthe judge issued her ruling on June 23, 2006. A non-binding mediationrelated to the California case was held on May 12, 2006 withoutresolution. A second non-binding mediation was conducted on August 15,2006, also without a resolution. Discovery is on-going in the Californialitigation with a court-scheduled conclusion of discovery set for February 9,2007 and a jury trial date scheduled for May 7, 2007. The Texas casesremains in it is initial phases, and a jury trial date has not yet beenscheduled.

The prosecution of this lawsuit and the defense of theTandberg Telecom AS claim requires us to expend significant financial andmanagerial resources, and therefore may have a material negative impact on ourbusiness, financial condition and results of operations. The duration andultimate outcome of these litigation proceedings are uncertain.

**Item 1A. Risk Factors**

**Factors Affecting Future Operating Results**

**Our market is in the early stages of development, and our system may notbe widely accepted.**

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

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

We incurred net losses of $5.0 million for the ninemonths ended September 30, 2006, $5.2 million for fiscal year 2005 and$8.7 million for fiscal year 2004. As of September 30, 2006, ouraccumulated deficit was $99.6 million.

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Our revenue and incomefrom settlement and patent licensing may not increase, or even remain at itscurrent level. In addition, our operating expenses may increase as we continueto develop our business in the future. As a result, to become profitable, wewill need to increase our revenue by increasing sales to existing customers andby attracting additional customers. If our expenses increase more rapidly thanour revenue, or if revenue and expense levels remain the same, we may neverbecome profitable. If we do become profitable, as we did during the thirdquarter of 2006, we may not be able to sustain or increase profitability on aquarterly or annual basis. In addition, if we fail to reach profitability or tosustain or grow our profits within the time frame expected by investors, themarket price of our common stock may be adversely impacted.

**General economicconditions have and may impact our revenues and harm our business in thefuture.**

The international economicslowdown and the downturn in the investment banking industry that began in 2000negatively affected our business, and a reoccurrence of a difficult economicenvironment may do so in the future. During this most recent economic downturn,the investment banking industry suffered a sharp decline, which caused many ofour existing and potential customers to cancel or delay orders for ourproducts. Although the U.S. economy has improved, our customers and potentialcustomers may continue to delay ordering our products, and we could fall shortof our revenue expectations for 2006 and beyond. Slower growth among our customers,tightening of customers’ operating budgets, retrenchment in the capital marketsand other general economic factors all have had and could in the future have amaterially adverse effect on our revenue, capital resources, financialcondition and results of operations.

**Our lengthy sales cycle to acquire new customers or large follow-onorders may cause our operating results to vary significantly and make it moredifficult to forecast our revenue.**

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

Our lengthy sales cycle is oneof the factors that has caused, and may continue to cause in the future, ouroperating results to vary significantly from quarter-to-quarter and year-to-year.This makes it difficult for us to forecast revenue, and could cause volatilityin the market price of our common stock. A lost or delayed order could resultin lower revenue than expected in a particular quarter or year.

**Future revenuesand income are difficult to predict for several reasons, including our lengthyand costly licensing cycle, and our failure to predict revenues and incomeaccurately may cause us to miss analysts’ estimates and result in our stockprice declining.**

Because our licensing cycle is a lengthy process, theaccurate prediction of future revenues and income from settlement and patentlicensing from new licensees is difficult. By way of example, the process ofpersuading companies to adopt our technologies or convincing them that theirproducts infringe our intellectual property rights can be lengthy. There isalso a tendency in the technology industry to close business deals at the endof a quarter, thereby increasing the likelihood that a possible material dealwould not be concluded in the current quarter, but slip into a subsequentreporting period. This kind of delay may result in a given quarter's performancebeing below analyst or shareholder expectation. The proceeds of our licensingand enforcement efforts tend to be sporadic and difficult to predict. Recognitionof such proceeds as revenue or income from settlement and licensing activitiesdepends on the terms of the license agreement involved and the circumstancessurrounding the agreement. As a result, our licensing and enforcement effortsare expected to result in significant volatility in our quarterly financialcondition and results of operations, which may result in us missing investorexpectations, which may cause our stock price to decline.

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** **

**Since a majority of our revenue has come from follow-on orders, ourfinancial performance could be harmed if we fail to obtain follow-on orders inthe future.**

Our customers typically placelimited initial orders for our networked video communications system, as theyseek to evaluate value. Our strategy is to pursue additional and largerfollow-on orders after these initial orders. Excluding licensing revenue, revenuegenerated from follow-on orders accounted for approximately 93% and 100% of ourrevenue for the nine months ended September 30, 2006 and 2005, respectively.Our future financial performance depends on successful initial installations ofour system, and successful generation of follow-on orders as the Avistarnetwork expands within a customer organization. If our system does not meet theneeds and expectations of customers, we may not be able to generate follow-onorders.

**Because we depend on a few customers for a majority of our productrevenue, services revenue, and income from settlement and patent licensing, theloss of one or more of them could cause a significant decrease in our operatingresults.**

To date, a significant portion of our revenue hasresulted from sales to a limited number of customers, particularly Sony,Deutsche Bank AG and UBS Warburg LLC and their affiliates, which accounted forapproximately 46%, 22% and 18% of total revenue for the nine month period endedSeptember 30, 2006 respectively. Sony, Deutsche Bank AG and UBS WarburgLLC and their affiliates accounted for approximately 69%, 15% and 7% of totalrevenue for the three month period ended September 30, 2006, respectively.As of September 30, 2006, approximately 77% of our gross accountsreceivable was concentrated with two of these three customers. No othercustomers represented more than 10% of our gross accounts receivable.

The loss of a major customer orthe reduction, delay or cancellation of orders from one or more of oursignificant customers could cause our revenue to decline and our losses toincrease. If we are unable to license our patent portfolio to additional partieson terms equal to or better than our agreements with Polycom prior to thecompletion of our amortization of the Polycom proceeds, our income fromsettlement and licensing will decline, which could cause our losses toincrease. We currently depend on a limited number of customers with lengthybudgeting cycles and unpredictable buying patterns, and as a result, ourrevenue from quarter-to-quarter or year-to-year may be volatile. Adversechanges in our revenue or operating results as a result of these budgetingcycles or any other reduction in capital expenditures by our large customerscould substantially reduce the trading price of our common stock.

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

Future hardware and softwareplatforms embodying new technologies and the emergence of new industrystandards and customer requirements could render our system non-competitive oreven obsolete. The market for our system is characterized by:

·                     rapidtechnological change;

·                     theemergence of new competitors;

·                     significant development costs;

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

·                     evolving industry standards; and

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

Our system is designed to workwith a variety of hardware and software configurations and data networkinginfrastructures used by our customers. The majority of these customer networksrely 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, wemust constantly modify and improve our system to keep pace with changes made toour customers’ platforms, data networking infrastructures, and their evolvingability to transport video and other applications. This may result in uncertainty

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relatingto the timing and nature of our new release announcements, introductions ormodifications, which in turn may cause confusion in the market, with apotentially harmful effect on our business. If we fail to promptly modify orimprove our system in response to evolving industry standards or customers’demands, our system could become less competitive, which would harm ourfinancial condition and reputation.

**Difficulties or delays in installing our products could harm our revenueand margins.**

We recognize revenue upon theinstallation of our system in those cases where we are responsible forinstallation, which often entails working with sophisticated software andcomputing and communications systems. If we experience difficulties with installationor do not meet deadlines due to delays caused by our customers or ourselves, wecould be required to devote more customer support, technical and otherresources to a particular installation. If we encounter delays in installingour products for new or existing customers or installation requires significantamounts of our professional services support, our revenue recognition could bedelayed, our costs could increase and our margins could suffer.

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

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

We expect competition to increase in the future fromexisting competitors, partnerships of competitors, and from new market entrantswith products that may be less expensive than ours or that may provide betterperformance or additional features not currently provided by our products. Manyof our current and potential competitors have substantially greater financial,technical, manufacturing, marketing, distribution and other resources, greatername recognition and market presence, longer operating histories, lower coststructures and larger customer bases than we do. As a result, they may be ableto adapt more quickly to new or emerging technologies and changes in customerrequirements.

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

**Infringement of our proprietary rights could affect our competitiveposition, harm our reputation or cost us money.**

We regard our system as open butproprietary. In an effort to protect our proprietary rights, we rely primarilyon a combination of patent, copyright, trademark and trade secret laws, as wellas licensing, non-disclosure and other agreements with our consultants,suppliers, customers and employees. However, these laws and agreements provideonly limited protection of our proprietary rights. In addition, we may not havesigned agreements in every case and the contractual provisions that are inplace and the protection they produce may not provide us with adequate protectionin all circumstances. Although CPI holds patents and has filed patentapplications covering some of the inventions embodied in our systems, our meansof protecting our proprietary rights may not be adequate. It may be possiblefor a third party to copy or otherwise obtain and use our technology withoutauthorization and without our detection. In the event that we believe athird party is infringing our intellectual property rights, an infringement

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claim brought by us could, regardless of the outcome,result in substantial cost to us, divert our management’s attention andresources, be time consuming to prosecute and result in unpredictable damageawards. A third party may also developsimilar technology independently, without infringing upon our patents andcopyrights. In addition, the laws of some countries in which we sell our systemmay not protect our software and intellectual property rights to the sameextent as the laws of the United States or other countries where we holdpatents. As we move to more of a software based system, unauthorized copying,use or reverse engineering of our system could harm our business, financialcondition or results of operations.

**We have filed acomplaint alleging patent infringement against Tandberg ASA and Tandberg, Inc. Theprosecution of this lawsuit and our defense of Tandberg AS’s claims require usto expend significant financial and managerial resources and may have amaterial negative impact on our business. If we do not prevail, we may berequired to pay monetary damages.**

On May 11, 2005, CPI, our wholly-owned patentprosecution and licensing subsidiary, commenced a patent infringement lawsuitagainst Tandberg ASA and Tandberg, Inc. alleging that several Tandbergvideoconferencing products infringe three patents held by CPI. The suit wasfiled in the United States District Court for the Northern District ofCalifornia. The three patents involved are U.S. Patent Nos. 5,867,654;5,896,500; and 6,212,547. These patents cover technologies relating to videoand data conferencing over unshielded twisted pair (UTP) networks, distributedcall-state management and separate monitors for simultaneous computer-baseddata sharing and videoconferencing. These technologies are core components ofthe AvistarVOS video operating system. In this action, CPI has requestedinjunctive relief, damages to compensate for past and present infringement,treble damages, costs associated with the litigation and such further relief asthe Court deems just and proper. Both of the Tandberg entities answered thecomplaint on July 15, 2005, at which time they asserted that they did notinfringe the patents and that the patents were invalid and unenforceable. Theprosecution of this lawsuit and our defense of Tandberg AS’s claims require usand CPI to expend significant financial and managerial resources, and thereforemay have a material negative impact on our business, financial condition andresults of operations. The duration and ultimate outcome of these litigationproceedings are uncertain.

**Others may bring infringement claims against us, which could betime-consuming and expensive to defend.**

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

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

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

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

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

**Our inability toprotect the intellectual property created by us would cause our business tosuffer.**

We rely on a combination of license, development andnondisclosure agreements, trademark, trade secret and copyright law, andcontractual provisions to protect our other, non-patentable intellectualproperty rights. If we fail to protect these intellectual property rights, ourlicensees, potential licensees and others may seek to use our technologywithout the payment of license fees and royalties, which could weaken ourcompetitive position, reduce our operating results and increase the likelihoodof costly litigation. The growth of our business depends in part on theapplicability of our intellectual property to the products of third parties,and our ability to enforce intellectual property rights against them. Inaddition, effective trade secret protection may be unavailable or limited incertain foreign countries. Although we intend to protect our rights vigorously,if we fail to do so, our business will suffer.

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

Our system may contain errors ordefects, especially when new products are introduced or when new versions arereleased. Despite internal system testing, we have in the past discoveredsoftware errors in some of the versions of our system after their introduction.Errors in new systems or versions could 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 theseevents could result in a loss of revenue or a delay in market acceptance of oursystem and could harm our reputation.

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

Our license agreements with ourcustomers typically contain provisions designed to limit our exposure topotential product liability and certain contract claims. Our license agreementsalso typically limit a customer’s entire remedy to either a refund of the pricepaid or modification of our system to satisfy our warranty. However, theseprovisions vary as to their terms and may not be effective under the laws ofsome jurisdictions. Although we maintain product liability (“errors andomissions”) insurance coverage, we cannot assure you that such coverage will beadequate. A product liability, warranty or other claim could harm our business,financial condition and/or results of operations. Performance interruptions ata customer’s site could negatively affect the demand for our system or giverise to claims against us.

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

**The loss of any of our outside contract manufacturers or third partyequipment suppliers that produce key components of our system couldsignificantly disrupt our manufacturing and new product development process.**

We depend on outside contractmanufacturers to produce components of our systems, such as cameras,microphones, gateway, speakers and monitors that we install at desktops and inconference rooms. One supplier, Pacific Corporation, is a single source supplierfor a key component of our product. Another supplier, Equator TechnologiesInc., is our only current source of a component used in our IP gateway product.In addition, during the first quarter of 2006, we began using an offshorecontract resource in China for product development work. Our

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relianceon these third parties involves a number of risks, including:

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

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

·                     the likelihood that, if particular components werenot available, we would suffer an interruption in the manufacture and shipmentof our systems until these components or alternatives become available;

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

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

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

If these manufacturers or supplierscease to provide us with the assistance or the components necessary for theoperation of our business, we may not be able to identify alternate sources ina timely fashion. Any transition to alternate manufacturers or suppliers wouldlikely result in operational problems and increased expenses, and could causedelays in the shipment of or otherwise limit our ability to provide ourproducts. We cannot assure you that we would be able to enter into agreementswith new manufacturers or suppliers on commercially reasonable terms, or atall. Any disruption in product flow may limit our revenue, delay our productdevelopment, seriously harm our competitive position and/or result inadditional costs or cancellation of orders by our customers.

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

To increase our revenue, we mustincrease the size of our direct sales force and add indirect distributionchannels, such as systems integrators, product partners and/or value-addedresellers, and/or effect sales through our customers. If we are unable tomaintain or increase our direct sales force or add indirect distributionchannels due to our own cost constraints, limited availability of qualifiedpersonnel or other reasons, our future revenue growth may be limited and ourfuture operating results may suffer. We cannot assure you that we will besuccessful in attracting, integrating, motivating and retaining salespersonnel. Furthermore, it can take several months before a new hire becomes aproductive member of our sales force. The loss of existing salespeople, or thefailure of new salespeople and/or indirect sales partners to develop thenecessary skills in a timely manner, could impact our revenue growth.

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

We depend on the continued services of our executiveofficers 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. The loss of the services of any of ourexecutive officers or key personnel could harm our business, financialcondition and results of operations.

Our products and technologies are complex, and tosuccessfully implement our business strategy and manage our business, anin-depth understanding of video communication and collaboration technologiesand their potential uses is required. We need to attract and retain highlyskilled technical and managerial personnel for whom there is intensecompetition. 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 developthe necessary skills in a timely manner could harm our business.

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** **

**Our plans call forgrowth in our business, and our inability to achieve or manage growth couldharm our business.**

Failure to achieve or managegrowth effectively will harm our business, financial condition and operatingresults. Furthermore, in order to remain competitive or to expand our business,we may find it necessary or desirable in the future to acquire otherbusinesses, products or technologies. If we identify an appropriate acquisitioncandidate, we may not be able to negotiate the terms of the acquisitionsuccessfully, to finance the acquisition or to integrate the acquiredbusinesses, products or technologies into our existing business and operations.In addition, completing a potential acquisition and integrating an acquiredbusiness may strain our resources and require significant management time.

**Our international operations expose us to potential tariffs and othertrade barriers, unexpected changes in foreign regulatory requirements and lawsand economic and political instability, as well as other risks that couldadversely affect our results of operations.**

International revenue, which consists of sales tocustomers with operations principally in Western Europe and Asia, comprised 88%and 73% of total revenues for the three months ended September 30, 2006and 2005, respectively. International revenue comprised 77% and 63% of totalrevenues for the nine months ended September 30, 2006 and 2005,respectively. Some of the risks we may encounter in conducting internationalbusiness activities include the following:

·                     tariffs and other trade barriers;

·                     unexpected changes in foreign regulatoryrequirements and laws;

·                     economic and political instability;

·                     increased risk of infringement claims;

·                     protection of our intellectual property;

·                     restrictions on the repatriation of funds;

·                     potentially adverse tax consequences;

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

·                     fluctuations in foreign currencies; and

·                     limitations in communications infrastructures insome foreign countries.

Some of our products are subject to various federal,state and international laws governing substances and materials in products,including those restricting the presence of certain substances in electronicsproducts. We could incur substantial costs, including fines and sanctions, orour products could be enjoined from entering certain jurisdictions, if we wereto violate environmental laws or if our products become non-compliant withenvironmental laws. We also face increasing complexity in our product designand procurement operations as we adjust to new and future requirements relatingto the materials composition of our products, including the restrictions onlead and certain other substances that will apply to specified electronicsproducts sold in the European Union as of July 1, 2006 (Restriction ofHazardous Substances Directive). The ultimate costs under environmental lawsand the timing of these costs are difficult to predict. Similar legislation hasbeen or may be enacted in other regions, including in the United States, thecumulative impact of which could be significant.

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

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

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** **

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

We believe that establishing and maintaining brand andname recognition is critical for attracting and expanding our targeted customerbase. We also believe that the importance of reputation and name recognitionwill increase as competition in our market increases. Promotion and enhancementof our 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 customers do not perceive our system or servicesto be effective or of high quality, our brand and name recognition will suffer,which would harm our business.

**We may not meet the continued listing criteria for the NASDAQ CapitalMarket, which could materially adversely affect the price and liquidity of ourstock, our business and our financial condition.**

For continued listing of our common stock on The NASDAQCapital Market, we are required to, among other things (i) maintainstockholders’ equity of at least $2.5 million, or a market value of listedsecurities of at least $35 million or annual net income from continuingoperations of at least $500,000, and (ii) maintain a minimum closing bidprice of our common stock of at least $1.00. If we do not meet the continuedlisting requirements, our common stock could be subject to delisting fromtrading on The NASDAQ Capital Market. There can be no assurance that we willcontinue to meet all requirements for continued listing on The NASDAQ CapitalMarket.

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

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

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

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

·                     quarterly variations in our results ofoperations;

·                     announcements regarding our product developments;

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

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

·                     announcements of competitive productintroductions by our competitors;

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

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

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

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

In the past, following periodsof market volatility in the price of a company’s securities, security holdershave often instituted class action litigation. Many technology companies havebeen subject to this type of litigation. Our share price has, in the past,experienced price volatility, and may continue to do so in the future. If themarket value of our common stock experiences adverse fluctuations and we becomeinvolved in this type of litigation, regardless of the merits or outcome, wecould incur substantial legal costs and our management’s attention could bediverted, causing our business, financial condition and operating results tosuffer.

**Our expected futureworking capital needs may require that we seek additional debt or equityfunding which, if not available, could cause our business to suffer.**

We may need to arrange for the availability ofadditional funding in order to meet our future business requirements. If we areunable to obtain additional funding when needed on acceptable terms, we may notbe able to develop or enhance our products, take advantage of futureopportunities, respond to competitive pressures or unanticipated requirements,or finance our efforts to protect and enforce our intellectual property rights,which could seriously harm our business, financial condition, results ofoperations and ability to continue operations.

**Provisions of our certificate of incorporation, our bylaws and Delawarelaw may make it difficult for a third party to acquire us, despite the possiblebenefits to our stockholders.**

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

These provisions may have theeffect of delaying, deferring or preventing a change in our control despitepossible benefits to our stockholders, may discourage bids at a premium overthe market price of our common stock, and may adversely affect the market priceof our common stock and the voting and other rights of our stockholders.

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

Our executive officers, directors and entitiesaffiliated with them, in the aggregate, beneficially owned approximately 63% ofour common stock as of September 30, 2006. If they were to act together,these stockholders would be able to exercise control over most mattersrequiring approval by our stockholders, including the election of directors andapproval of significant corporate transactions. These actions may be taken evenif they are opposed by other investors. This concentration of ownership mayalso have the effect of delaying or preventing a change in control of ourcompany, which could cause the market price of our common stock to decline.

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

In December 2004, the FASB issued SFAS No. 123R, *Share-Based Payment*. SFAS No. 123R requires employeestock options and rights to purchase shares under stock participation plans tobe accounted for under the fair value method, and eliminates the ability toaccount for these instruments under the intrinsic value method prescribed byAPB Opinion No. 25, and allowed under the original provisions of SFAS No. 123.SFAS No. 123R requires the use of an option pricing model for estimatingfair value, which is amortized to expense over the service periods. Therequirements of SFAS No. 123R were effective beginning in the firstquarter of an issuer’s first fiscal year commencing after June 15, 2005,which for us was our fiscal quarter beginning January 1, 2006. We haveadopted the provisions of SFAS No. 123R using the modified prospectiveapplication. Under a modified prospective application, SFAS No. 123Rapplies to new awards, unvested awards, and to awards that are outstanding onthe effective date and are subsequently modified or cancelled. Compensationexpense for outstanding awards for which

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the requisite service hadnot been rendered as of December 31, 2005 are expected to be recognized overthe remaining service period using the compensation cost calculated for proforma disclosure purposes under SFAS No. 123. The new method of valuingstock-based compensation, as prescribed in SFAS No.123R, will be applied to thevaluation of stock-based awards granted after our adoption of SFAS No. 123Ron January 1, 2006. The impact of the recognition of compensation expenserelated to such awards was $511,000 and $1,444,000 for the three and ninemonths ended September 30, 2006. The impact of stock-based compensation infuture periods will vary depending on new options granted, and the assumptionsused in the Black-Scholes-Merton model used to determine fair value of optionsgranted, in conjunction with our employee’s historical option exercise andforfeiture behavior. The assumptions include dividend rate, risk-free interestrate, expected term of the option, volatility, exercise price and the price ofour stock on the date of valuation.

The pro forma impact of the adoption of SFAS No. 123on our historical financial statements is included in the notes to thecondensed consolidated financial statements presented in Part 1, Item 1of this Form 10-Q. We expect to continue to grant stock-based compensation toemployees. This new standard will have a material adverse impact on our futureresults of operations.

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** **

**Item 6. *Exhibits***
| 10.5*       |   | Amended and Restated Employee Stock Purchase Plan of  the Company                                                                                                                          |
|-------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                                                                                       |
| 10.15† |   | Patent License Agreement among the Company, Collaboration  Properties, Inc., Sony Corporation and Sony Computer Entertainment, Inc.                                                        |
|        |   |                                                                                                                                                                                       |
| 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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*                    Management contract or compensatory plan orarrangement

†                     Portions of the exhibit have been omittedpursuant to a request for confidential treatment and the omitted portions havebeen separately filed with the Commission.

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** **

**SIGNATURES**

Pursuant to the requirements ofthe Securities and Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized,on this 14th day of November2006.
|        | AVISTAR COMMUNICATIONS  CORPORATION |
|--------|-------------------------------------|
|        |                                     |   |
|   |                                |   |
|        | By:                                 | /s/ GERALD J. BURNETT |   |
|        |                                     | Gerald J. Burnett |
|        |                                     | Chief Executive Officer,  President and |
|        |                                     | Chairman (Principal Executive  Officer) |
|        |                                     |   |
|   |                                |   |
|        | By:                                 | /s/ ROBERT J. HABIG |   |
|        |                                | Robert J. Habig |
|        |                                     | Chief Financial Officer  (Principal |
|        |                                     | Financial and Accounting Officer) |

 

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** **

**EXHIBIT INDEX**
| Exhibit No. | ** ** | **Description**                                                                                                                                                                            |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                                                       |
| 10.5*            |       | Amended and Restated Employee Stock Purchase Plan of  the Company                                                                                                                          |
|             |       |                                                                                                                                                                                       |
| 10.15†      |       | Patent License Agreement among the Company, Collaboration  Properties, Inc., Sony Corporation and Sony Computer Entertainment, Inc.                                                        |
|             |       |                                                                                                                                                                                       |
| 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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*                    Management contract or compensatory plan orarrangement

†                     Portions of the exhibit have been omitted pursuantto a request for confidential treatment and the omitted portions have beenseparately filed with the Commission.

 

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