UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549FORM 10-Q(Mark One)x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended September 30, 2010oro
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934For the transition period from _________________ to _______________________Commission file number: 000-31121AVISTAR COMMUNICATIONS CORPORATION(Exact name of registrant as specified in its charter)DELAWARE
88-0463156(State or other jurisdiction of

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

Identification Number)1875 South Grant Street,

10THFloor, San Mateo, CA
94402(Address of principal executive offices)
(Zip Code))Registrant's telephone number, including area code: (650) 525-3300Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.Yes  x   No  oIndicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).Yes  oNo  oIndicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of "accelerated filer," "large accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.  (check one):Large accelerated filer  o

Non-accelerated filer  o

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

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

Yes  o    No  xAt October 27, 2010, 39,121,360 shares of common stock of the Registrant were outstanding.








AVISTAR COMMUNICATIONS CORPORATION




INDEX





PagePART I.
FINANCIAL INFORMATION
1Item 1.
Financial Statements (unaudited)
1Condensed Consolidated Balance Sheets
1Condensed Consolidated Statements of Operations
2Condensed Consolidated Statements of Cash Flows
3Notes to Condensed Consolidated Financial Statements
4Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
18Item 3.
Quantitative and Qualitative Disclosures about Market Risk
24Item 4T.
Controls and Procedures
24PART II.
OTHER INFORMATION
25Item 1.
Legal Proceedings
25Item 1A.
Risk Factors
25Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
34Item 3.
Defaults Upon Senior Securities
34Item 4.
Removed and Reserved
34Item 5.
Other Information
35Item 6.
Exhibits
35SIGNATURES

36





-i-





PART I - FINANCIAL INFORMATION




Item 1.              Financial Statements







AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARY




CONDENSED CONSOLIDATED BALANCE SHEETS


as of September 30, 2010 and December 31, 2009


(in thousands, except share and per share data)





September 30,

2010


December 31,

2009(unaudited)Assets:Current assets:Cash and cash equivalents

$
354


$
294Accounts receivable, net of allowance for doubtful accounts of $9 and $13 at September 30, 2010 and December 31, 2009, respectively


1,556



1,027Inventories


29



56Prepaid expenses and other current assets


692



300Total current assets


2,631



1,677Property and equipment, net


195



147Other assets


133



132Total assets

$
2,959


$
1,956Liabilities and Stockholders’ Equity (Deficit):Current liabilities:Line of credit

$
6,000


$
11,250Accounts payable


806



807Deferred services revenue and customer deposits


1,163



2,008Income taxes payable


80



23Accrued liabilities and other


1,105



1,409Total current liabilities


9,154



15,497Long-term liabilities:Other liabilities


51



73Total liabilities


9,205



15,570Commitments and contingencies (Note 9)Stockholders’ equity (deficit):Common stock, $0.001 par value; 250,000,000 shares authorized at September 30, 2010 and December 31, 2009; 40,304,235 and 40,159,466 shares issued and outstanding at September 30, 2010 and December 31, 2009, respectively


40



40Less: treasury common stock, 1,182,875 shares at September 30, 2010 and December 31, 2009, at cost


(53
)


(53
)Additional paid-in-capital


103,544



102,504Accumulated deficit


(109,777
)


(116,105
)Total stockholders’ equity (deficit)


(6,246
)


(13,614
)Total liabilities and stockholders’ equity (deficit)

$
2,959


$
1,956







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


-1-







AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARY




CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


for the three and nine months ended September 30, 2010 and 2009


(in thousands, except per share data)







Three Months EndedSeptember 30,

Nine Months Ended September 30,2010

2009

2010

2009(unaudited)

(unaudited)Revenue:Product

$
1,249

$
289

$
1,640

$
3,235Licensing and sale of patents

379

350

14,736

572Services, maintenance and support

609

790

1,659

3,130Total revenue

2,237

1,429

18,035

6,937Costs and expenses:Cost of product revenues*

131

263

369

926Cost of services, maintenance and support revenues*

387

737

1,053

2,400Income from settlement and patent licensing

—

(1,057
)
—

(3,171
)Research and development*

1,579

891

5,083

2,777Sales and marketing*

739

629

2,048

1,992General and administrative*

1,143

1,709

3,280

4,143Total costs and expenses

3,979

3,172

11,833

9,067Income (loss) from operations

(1,742)

(1,743
)
6,202

(2,130
)Other income (expense), net

(20
)
(126
)
(37
)
(358
)Income (loss) before provision for (benefit from) income taxes


(1,762
)

(1,869
)
6,165

(2,488
)Provision for (benefit from) income taxes


(262
)

16

(163
)
(37
)Net income (loss)

$
(1,500
)
$
(1,885
)
$
6,328

$
(2,451
)Net income (loss) per share - basic

$
(0.04
)
$
(0.05
)
$
0.16

$
(0.07
)Net income (loss) per share - diluted

$
(0.04
)
$
(0.05
)
$
0.16

$
(0.07
)Weighted average shares used in calculatingbasic net income (loss) per share

39,090

38,970

39,040

36,759Weighted average shares used in calculatingdiluted net income (loss) per share

39,090

38,970

39,572

36,759







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

$
15

$
53

$
31

$
175Research and development

86

110

288

435Sales and marketing

67

48

152

155General and administrative

241

218

524

642









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


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AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARY




CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


for the nine months ended September 30, 2010 and 2009


(in thousands)







Nine Months Ended September 30,2010


2009(unaudited)Cash Flows from Operating Activities:Net income (loss)

$
6,328


$
(2,451
)Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:Depreciation


181



182Compensation on equity awards issued to consultants and employees


995



1,407Provision for doubtful accounts


(4
)


(7
)Changes in assets and liabilities:Accounts receivable


(525
)


1,547Inventories


27



171Prepaid expenses and other current assets


(392
)


68Deferred settlement and patent licensing costs


—



955Other assets


(1
)


—Accounts payable


(1
)


98Deferred income from settlement and patent licensing and other


(22
)


(4,076
)Deferred services revenue and customer deposits


(845
)


(2,459
)Income taxes payable


57



17Accrued liabilities and other


(304
)


255Net cash provided by (used in) operating activities


5,494



(4,293
)Cash Flows from Investing Activities:Purchase of property and equipment


(229
)


(47
)Net cash used in investing activities


(229
)


(47
)Cash Flows from Financing Activities:Line of credit payments


(11,250
)


(5,049
)Proceeds from line of credit


6,000



4,700Net proceeds from issuance of common stock


45



173Net cash used in financing activities


(5,205
)


(176
)Net increase (decrease) in cash and cash equivalents


60



(4,516
)Cash and cash equivalents, beginning of period


294



4,898Cash and cash equivalents, end of period

$
354


$
382Non-cash financing activities:Debt converted to equity

$
—


$
2,940









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


-3-







AVISTAR COMMUNICATIONS CORPORATION AND SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(UNAUDITED)




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




Business




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




Basis of Presentation




The unaudited condensed consolidated balance sheet as of September 30, 2010, the unaudited condensed consolidated statements of operations for the three and nine months ended September 30, 2010 and 2009 and the unaudited condensed consolidated statements of cash flows for the nine months ended September 30, 2010 and 2009 present the consolidated financial position of Avistar and ASUK after the elimination of all intercompany accounts and transactions. The unaudited condensed consolidated balance sheet of Avistar as of December 31, 2009 was derived from audited financial statements, but does not contain all disclosures required by accounting principles generally accepted in the United States of America (GAAP), and certain information and footnote disclosures normally included have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (SEC).  Because all of the disclosures required by GAAP are not included, as permitted by the rules of the SEC, these interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.  The consolidated results are referred to, collectively, as those of Avistar or the Company in these notes.




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




The Company’s fiscal year end is December 31.




Risks and Uncertainties




The markets for the Company’s products, services and patented technologies are in the early stages of development. Some of the Company’s products and patented technologies utilize changing and emerging technologies. As is typical in industries of this nature, demand and market acceptance are subject to a high level of uncertainty, particularly when there are adverse conditions in the economy. Acceptance of the Company’s products and patented technologies, over time, is critical to the Company’s success. The Company’s prospects must be evaluated in light of difficulties encountered by it and its competitors in further developing this evolving marketplace. The Company has generated annual losses since inception and had an accumulated deficit of $109.8 million as of September 30, 2010. The Company’s operating results may fluctuate significantly in the future as a result of a variety of factors, including, but not limited to, the economic environment, the adoption of different distribution channels, and the timing of new product announcements by the Company or its competitors.




The Company’s future liquidity and capital requirements will depend upon numerous factors, including, but not limited to, the ability to become profitable or generate positive cash flow from operations, the Company’s cost reduction efforts,  Dr. Burnett’s personal guarantee to Avistar to support an extension of the revolving line of credit through March 31, 2011, the Company’s ability to obtain a renewal of its existing line of credit or a new line of credit with another bank, the costs and timing of its expansion of product development efforts and the success of these development efforts, the costs and timing of its expansion of sales and marketing activities, the extent to which its existing and new products gain market acceptance, competing technological and market developments, the costs involved in maintaining, enforcing and defending patent claims and other intellectual property rights, the level and timing of revenue, and other factors.If adequate funds are not available on acceptable terms or at all, the Company’s ability to achieve or sustain positive cash flows, maintain current operations, fund any potential expansion, take advantage of unanticipated opportunities, develop or enhance products or services, or otherwise respond to competitive pressures would be significantly limited.




-4-





2. Summary of Significant Accounting Policies







Unaudited Interim Financial Information




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




In the opinion of management, the unaudited condensed consolidated financial statements furnished in this report reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the results of operations for the interim periods covered and of the Company’s financial position as of the interim balance sheet date. The results of operations for the interim periods are not necessarily indicative of the results for the entire year. These condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and the accompanying notes for the year ended December 31, 2009, included in the Company’s Annual Report on Form 10-K filed with the SEC on March 30, 2010.




Use of Estimates




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




Cash and Cash Equivalents and Short and Long-term Investments




The Company considers all investment instruments purchased with an original maturity of three months or less to be cash equivalents. Investment securities with original or remaining maturities of more than three months but less than one year are considered short-term investments. Auction rate securities with original or remaining maturities of more than three months are considered short-term investments even if they are subject to re-pricing within three months.  The Company was not invested in any auction rate securities as of September 30, 2010 and December 31, 2009. Investment securities held with the intent to reinvest or hold for longer than a year, or with remaining maturities of one year or more, are considered long-term investments. The Company’s cash equivalents at September 30, 2010 and December 31, 2009 consisted of money market funds with original maturities of three months or less, and are therefore classified as cash and cash equivalents in the accompanying balance sheets.




See Note 3 for further information on fair value.




-5-





Significant Concentrations




A relatively small number of customers accounted for a significant percentage of the Company’s revenues for the three and nine months ended September 30, 2010 and 2009. Revenues from these customers as a percentage of total revenues were as follows for the three and nine months ended September 30, 2010 and 2009:




Three Months Ended September 30,

Nine Months Ended September 30,2010

2009

2010

2009(unaudited)

(unaudited)Customer A
30.5%

30.9%

*%

14.6%Customer B
30.2%

*%

*%

37.5%Customer C
16.9%

24.5%

*%

*%Customer D
11.8%

*%

*%

*%Customer E
*%

*%

61.0%

*%Customer F
*%

*%

16.6%

*%Customer G
*%

31.0%

*%

18.4%


* Less than 10%




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




Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of temporary cash investments and trade receivables. The Company has cash and investment policies that limit the amount of credit exposure to any one financial institution, or restrict placement of these investments to financial institutions evaluated as highly credit worthy. As of September 30, 2010, the Company had cash and cash equivalents on deposit with a major financial institution that were above the Federal Deposit Insurance Corporation (FDIC) insured limits. Concentrations of credit risk with respect to trade receivables relate to those trade receivables from both United States and foreign entities. As of September 30, 2010, approximately 88% of the Company’s gross accounts receivable was concentrated with three customers, each of whom represented more than 10% of the total gross accounts receivable. As of December 31, 2009, approximately 87% of the Company’s gross accounts receivable was concentrated with four customers, each of whom represented more than 10% of the total gross accounts receivable. No other customer individually accounted for greater than 10% of total accounts receivable as of September 30, 2010 and December 31, 2009.




Allowance for Doubtful Accounts




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




Fair Value of Financial Instruments




The carrying amounts of the Company’s financial assets and liabilities, including cash and cash equivalents, accounts receivable, line of credit, and accounts payable at September30, 2010and December 31, 2009, approximate fair value because of the short maturity of these instruments.




-6-







Inventories




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




September 30, 2010


December 31, 2009(unaudited)Raw materials and subassemblies

$
—


$
1Finished goods


29



55Total inventories

$
29


$
56








Revenue Recognition and Deferred Revenue





The Company recognizes product and services revenue in accordance with Accounting Standards Codification (ASC) 985-605, Revenue Recognition - Software,or ASC 605-25, Revenue Recognition – Multiple-Element Arrangements. The Company 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-enabled collaboration solution. Services revenue includes revenue from post-contract customer support, training and software development. The fair value of all product, post-contract customer support and training offered to customers is determined based on the price charged when such products or services are sold separately.





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





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




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




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




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




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





-7-


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





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





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





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





On September 8, 2008 and on September 9, 2008, the Company entered into a Licensed Works Agreement, Licensed Works Agreement Statement of Work and a Patent License Agreement with International Business Machines Corporation, or IBM, under which the Company agreed to integrate the Company’s bandwidth management technology and related intellectual property into future Lotus Unified Communications offerings by IBM, and to provide maintenance support services. An initial cash payment of $3.0 million was made by IBM to the Company on November 7, 2008, a second and third non-refundable payment of $1.5 million and $750,000 was made on August 31, 2009 and June 30, 2010, respectively.   The Company expects IBM to make the remaining non-refundable payment of $750,000 in December 2010.  In addition, IBM has agreed to make future royalty payments to the Company equal to two percent of the world-wide net revenue derived by IBM from Lotus Unified Communications products sold that exceeds a contractual base amount, and maintenance payments received from existing customers, which incorporate the Company’s technology.  The agreements have a five year term and are non-cancelable except upon material default by either party.  The agreements convey to IBM a non-exclusive world-wide license to the Company’s patent portfolio existing at the time of the agreements and for all subsequent patents issued with an effective filing date of up to five years from the date of the agreements.  The agreements also provide for a release of each party for any and all claims of past infringement.  In April 2009, the agreements were amended to extend the initial term from five years to six years.  The Company has determined the value of maintenance based on VSOE, and allocated the residual portion of the initial $6.0 million to the integration project.  The residual portion is being recognized under the percentage of completion method, in accordance with the “Input Method”, and the maintenance revenue will be recognized over the future maintenance service period.  As the Company believes there are no future deliverables associated with the intellectual property patent licenses, no additional provision for this element has been made.  For the three and nine months ended September 30, 2010, the Company has recognized $545,000 in product revenue and $131,000 in service revenue.  For the year ended December 31, 2009, the Company recognized $2.4 million in product revenue and $655,000 in service revenue. The integration project was fully completed and delivered as of September 30, 2010, with maintenance support services being the only undelivered element.




-8-


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




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




Income from Settlement and Patent Licensing




The Company recognizes the proceeds from settlement and patent licensing agreements based on the terms involved. When litigation has been filed prior to a settlement and patent licensing agreement, and insufficient historical evidence exists for the determination of fair value of the patents licensed to support the segregation of the proceeds between a gain on litigation settlement and patent license revenues, the Company reports all proceeds in “income from settlement and patent licensing” within operating costs and expenses. The gain portion of the proceeds, when sufficient historical evidence exists to segregate the proceeds, would be reported according to ASC 450, Contingencies. When a patent license agreement is entered into prior to the commencement of litigation, the Company reports the proceeds of such transaction as licensing revenue in the period in which such proceeds are received, subject to the revenue recognition criteria described above.




On November 12, 2004, the Company entered into a settlement and a patent cross-license agreement with Polycom Inc., thus ending litigation against Polycom, Inc. for patent infringement. As part of the settlement and patent cross-license agreement with Polycom, Inc, the Company granted Polycom, Inc. a non-exclusive, fully paid-up license to its entire patent portfolio. The settlement and patent cross-license agreement included a five-year capture period from the date of the settlement, adding all new patents with a priority date extending up to five years from the date of execution of the agreement. Polycom, Inc., as part of the settlement and patent cross-licensing agreement, made a one-time payment to the Company of $27.5 million and the Company paid $6.4 million in contingent legal fees to the Company’s litigation counsel upon completion of the settlement and patent cross-licensing agreement. The contingent legal fees were payable only in the event of a favorable outcome from the litigation with Polycom, Inc.  The Company recognized the gross proceeds of $27.5 million from the settlement and patent cross-license agreement as income from settlement and patent licensing within operations over the five-year capture period, due to a lack of evidence necessary to apportion the proceeds between an implied punitive gain element in the settlement of the litigation, and software license revenues from the cross-licensing of the Company’s patented technologies for prior and future use by Polycom, Inc. Additionally, the $6.4 million in contingent legal fees was deferred and was amortized to income from settlement and patent licensing over the five year capture period, resulting in a net of $21.1 million being recognized as income within operations over the five year capture period. As of December 31, 2009, the deferred net income from settlement and patent licensing with Polycom, Inc. was fully recognized.




-9-




Warranty




The Company accrues the estimated costs of fulfilling the warranty provisions of its contracts over the warranty period, which is typically 90 days. There was no warranty accrual as of September 30, 2010 and December 31, 2009.




Research and Development




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




Stock-Based Compensation




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




The effect of recording stock-based compensation for the three and nine months ended September 30, 2010 and 2009 was as follows (in thousands):




Three Months EndedSeptember 30,


Nine Months EndedSeptember 30,2010


2009


2010


2009(unaudited)


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

$
234


$
421


$
636


$
1,385Employee restricted stock units


127



—



278



—Non-employee stock options


—



4



—



9Non-employee restricted stock units


32



—



46



—Employee stock purchase plan


16



4



35



13Total stock-based compensation


409



429



995



1,407Tax effect of stock-based compensation


—



—



—



—Net effect of stock-based compensation

$
409


$
429


$
995


$
1,407







Valuation Assumptions for Stock-Based Compensation




The Company estimated the fair value of stock options granted under the 2000 Stock Option Plan, the 2000 Director Stock Option Plan and the 2009 Equity Incentive Plan (the “Stock Plans”), and rights to acquire stock granted under the employee stock purchase plans (“ESPP”) using a Black-Scholes-Merton valuation model, consistent with the provisions of ASC 718 and SEC Staff Accounting Bulletin (SAB) No. 107. The following weighted-average assumptions and the straight-line attribution approach were used in estimating the fair value of employee stock option grants (excluding options granted in connection with the Exchange Program, as shown below) and ESPP shares for the three and nine months ended September 30, 2010 and 2009, respectively:







-10-







Three Months Ended September 30,


Nine Months Ended September 30,2010


2009


2010


2009(unaudited)


(unaudited)Stock Option PlansExpected dividend


—
%


—
%


—
%


—
%Average risk-free interest rate


1.3
%


1.9
%


2.0
%


1.7
%Expected volatility


139
%


109
%


137
%


109
%Expected term (years)


4.2



4.0



4.3



4.0ESPPExpected dividend


—
%


—
%


—
%


—
%Average risk-free interest rate


0.2
%


0.3
%


0.2
%


0.3
%Expected volatility


140
%


115
%


177
%


132
%Expected term (months)


6.0



6.0



6.0



6.0





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




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




Summary of Stock Options and Stock Option Exchange Program




Information regarding stock options outstanding at September 30, 2010 is summarized below (unaudited):




Number of Shares

Weighted Average Exercise price

Weighted Average Remaining Contractual Life (years)
Aggregate Intrinsic Value (thousands)As of September 30, 2010Options outstanding
8,239,817

$
0.70

8.46
$
2,885Options vested and expected to vest
7,133,340

$
0.72

8.31
$
2,445Options exercisable
1,893,359

$
1.05

5.27
$
349




The pretax intrinsic value of outstanding options is the difference between the closing price of Avistar stock as quoted on the Pink Sheets, an over-the-counter securities market, on September 30, 2010 and the exercise price, multiplied by the number of in-the-money options. The intrinsic value of options changes based on the fair market value of Avistar stock.




In June 2010, the Company completed an offer to exchange eligible outstanding options granted to eligible employees (including executive officers) and directors after June 16, 2000 under either the 2000 Stock Option Plan or the 2000 Director Option Plan with an exercise price of $0.68 per share or higher for a new grant of a lesser number of new options under the 2009 Equity Incentive Plan (the “Exchange Program”).  Pursuant to the Exchange Program, options to purchase 6,754,823 million shares of the Company’s common stock were canceled on June 15, 2010, and in exchange, new options to purchase 4,438,108 shares of the Company’s common stock were granted with an exercise price per share of $0.55, the closing price of our common stock as reported on the over-the-counter market on June 15, 2010. The new options have a contractual term of 10 years. A total of 36 employees (including executive officers) and four directors participated in the Exchange Program. Total grant-date fair value of the new options was estimated at approximately $2.1 million, or $0.46 per share. The Exchange Program resulted in a total incremental compensation cost of approximately $46,000 which will be recognized over the vesting periods of the new options in addition to recognizing any remaining unrecognized expense for the stock options surrendered in the exchange. The vesting periods of new options range from two to three years. The total incremental compensation cost was measured based upon the difference between the estimated fair value of the new options on the grant date and the estimated fair value of the surrendered options immediately before the modification, at the individual grant level. The incremental expense recorded in the three months and nine months ended September 30, 2010 is immaterial.




-11-


For the three months ended September 30, 2010 and 2009, the Company granted 7,500 and 1,507,500 stock options to employees, with an estimated total grant date fair value of approximately $4,000 and $886,000, or $0.47 and $0.59 per share, respectively. For the nine months ended September 30, 2010 and 2009, the Company granted 395,000 (excluding options granted in connection with the Exchange Program) and 2,842,928 stock options to employees, with an estimated total grant-date fair value of approximately $165,000 and $1.8 million, or $0.42 and $0.64 per share, respectively.




For the three and nine months ended September 30, 2009, the Company had recognized stock-based compensation expense of $131,000 associated with the extension of the exercise period for the vested stock options under the separation agreement entered into by the Company and Simon Moss, the Company’s former Chief Executive Officer, in July 2009. The amount was measured based upon the difference between the fair value of the vested options immediately before and after the modification.





As of September 30, 2010, the Company had an unrecognized stock-based compensation balance related to stock options of approximately $1.6 million before estimated forfeitures and after actual cancellations. ASC 718 requires forfeitures to be estimated at the time of grant and revised if necessary in subsequent periods if actual forfeitures differ from those estimates. Based on the Company’s historical experience of option pre-vesting cancellations,  the Company estimated that the stock-based compensation for the awards not expected to vest was approximately $471,000 as of September 30, 2010 and therefore, the unrecognized deferred stock-based compensation balance related to stock options was adjusted to approximately $1.2 million after estimated forfeitures and after actual cancellations. This amount will be recognized over an estimated weighted average period of 2.09 years. In subsequent periods, if actual forfeitures differ from those estimates, an adjustment to stock-based compensation expense will be recognized at that time.




Summary of Restricted Stock Units




Information regarding the restricted stock units outstanding as of September 30, 2010 is summarized below (unaudited):




Number of Shares


Weighted Average Remaining Contractual Life (years)


Aggregate Intrinsic Value (thousands)As of September 30, 2010Restricted stock units outstanding


2,180,000



1.27


$
2,180Restricted stock units vested and expected to vest


2,081,154



1.27


$
2,081




The intrinsic value of the restricted stock units is calculated as the market value at end of the fiscal period, based on the closing price of Avistar shares as quoted on the Pink Sheets as of September 30, 2010 of $1.00.




The Company granted 200,000 and 580,000 restricted stock units for the three and nine months ended September 30, 2010, respectively, to employees and a non-employee consultant. There were no restricted stock units granted for the three and nine months ended September 30, 2009.




As of September 30, 2010, the Company had an unrecognized stock-based compensation balance related to restricted stock units to employees and a non-employee consultant of approximately $623,000, adjusted for estimated forfeitures, which will be recognized over a weighted average period of 1.27 years.




-12-


2009 Equity Incentive Plan and 2000 Director Option Plan




The Company’s 2009 Equity Incentive Plan (“2009 Plan”), which replaced the 2000 Stock Option Plan, provides for annual increases in the number of shares of common stock available for issuance under the 2009 Plan, effective as of the first day of each fiscal year January 1, 2010, equal to the lesser of (a) 6,000,000 shares; (b) 4 percent of the outstanding shares of common stock on the last day of the prior fiscal year; or (c) such lesser amount as the Board of Directors or a committee of the Board may determine.  On April 21, 2010, the Board of Directors determined that no increase would be implemented under the 2009 Plan for fiscal year 2010.




The Company’s 2000 Director Option Plan (“Director Plan”) provides for annual increases in the number of shares of common stock available for issuance under the Director Plan, effective as of the first day of each fiscal year January 1, 2001, equal to the lesser of (a) 175,000 shares; (b) 1 percent of the outstanding shares of common stock on the last day of the prior fiscal year; or (c) such lesser amount as the Board may determine.  On April 21, 2010, the Board of Directors determined that no increase would be implemented under the Director Plan for fiscal year 2010.




On April 21, 2010, pursuant to the pending expiration of the Director Plan, the Board of Directors approved the automatic issuance under the 2009 Plan, effective as of the first day of each fiscal year commencing on January 1, 2011, of (a) a nonqualified stock option to purchase 25,000 shares of the Company’s common stock to each non-employee director and (b) a nonqualified stock option to purchase an additional 5,000 shares of the Company’s common stock to the chairperson of the Audit Committee.  The options shall have the same terms as the automatic annual grants previously issued under the Director Plan.




2010 Employee Stock Purchase Plan




In April 2010, the Board approved and the Company adopted the 2010 Employee Stock Purchase Plan (“2010 ESPP”) which replaced the 2000 Employee Stock Purchase Plan.  The 2010 ESPP was approved by the stockholders at the 2010 annual meeting of stockholders held in June 2010.   Under the 2010 ESPP, qualified employees are entitled to purchase shares of the Company’s common stock at the lower of 85 percent of the fair market value of the common stock at the date of commencement of the six-month offering period or at the last day of the offering period.  Purchases are limited to 15 percent of an employee’s eligible compensation.   A total of 1,148,660 shares of the Company’s common stock will be reserved for issuance under the 2010 ESPP.




3. Fair Value Measurement




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




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




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




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




In accordance with ASC 820, the following table represents the Company’s fair value hierarchy for its financial assets (cash equivalents) as of September 30, 2010 (in thousands):




Fair Value


Level 1


Level 2


Level 3Cash Equivalents (unaudited):Money market funds

$
5


$
5


$
—


$
—Total cash equivalents

$
5


$
5


$
—


$
—





-13-


4. Related Party Transactions




UBS Warburg LLC, which is an affiliate of UBS AG, is a stockholder of the Company and is also a customer of the Company. As of September 30, 2010 and December 31, 2009, UBS Warburg LLC held less than 5% of the Company’s stock. Revenue from UBS Warburg LLC and its affiliates represented 3% and 6% of the Company’s total revenue for the three months ended September 30, 2010 and 2009, respectively, and 2% and 6% of the Company’s total revenue for the nine months ended September 30, 2010 and 2009, respectively.  Management believes the transactions with UBS Warburg LLC and its affiliates are at terms comparable to those provided to unrelated third parties. As of September 30, 2010 and December 31, 2009, the Company had accounts receivable outstanding from UBS Warburg LLC and its affiliates of approximately $10,000 and $191,000, respectively.




5. Net Income (Loss) Per Share





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




For the nine months ended September 30, 2010, due to the Company’s net income for the period, the Company included the net effect of the weighted average number of shares and potential common shares outstanding during the period in the calculation of diluted net income per share. Approximately 10.0 million weighted average stock options and 54,212 weighted average restricted stock units were anti-dilutive  and excluded from the diluted net income per share calculation for the nine months ended September 30, 2010.




The Company excluded all outstanding stock options and restricted stock units from the calculation of diluted net loss per share for the three months ended September 30, 2010 and 2009 and the nine months ended September 30, 2009, because all such securities were anti-dilutive (owing to the fact that the Company was in a loss position during these periods). Accordingly, diluted net loss per share is equal to basic net loss per share for those periods. The total number of potential dilutive common shares excluded from the calculation of diluted net loss per share for the three months ended September 30, 2010 and 2009 was 765,123 and 50,686, respectively. The total number of potential dilutive common shares excluded from the calculation of diluted net loss per share for the nine months ended September 30, 2009 was 162,279.




The following table sets forth the computation of basic and diluted net income (loss) per share (in thousands, except per share data):




Three Months Ended September 30,


Nine Months Ended September 30,2010


2009


2010


2009(unaudited)


(unaudited)Numerator:Net income (loss) – basic and diluted

$
(1,500
)

$
(1,885
)

$
6,328


$
(2,451
)Denominator:Basic weighted average shares outstanding


39,090



38,970



39,040



36,759Add: dilutive stock options


—



—



27



—Add: dilutive restricted stock units


—



—



505



—Diluted weighted average shares outstanding


39,090



38,970



39,572



36,759Net income (loss) per share – basic

$
(0.04
)

$
(0.05
)

$
0.16


$
(0.07
)Net income (loss) per share – diluted

$
(0.04
)

$
(0.05
)

$
0.16


$
(0.07
)







-14-





6. Income Taxes




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




Deferred tax assets and liabilities are determined based on the difference between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are provided if based upon the weight of available evidence, it is considered more likely than not that some or all of the deferred tax assets will not be realized.




The Company accounts for uncertain tax positions according to the provisions of ASC 740.  ASC 740 contains a two-step approach for recognizing and measuring uncertain tax positions. Tax positions are evaluated for recognition by determining if the weight of available evidence indicates that it is probable that the position will be sustained on audit, including resolution of related appeals or litigation. Tax benefits are then measured as the largest amount which is more than 50% likely of being realized upon ultimate settlement. The Company considers many factors when evaluating and estimating tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes.  No material changes to the Company’s tax positions taken as of December 31, 2009 have occurred during the nine months ended September 30, 2010. As of December 31, 2009, the Company had a net deferred tax asset of $27.5 million and an unrecognized tax benefit under ASC 740 of $913,000.  A valuation allowance has been provided for the entire net deferred tax asset.




The benefit from income taxes was approximately $163,000 for the nine months ended September 30, 2010 which consist primarily of $238,000 in tax refund receivable for 2004 federal alternative minimum tax paid, due to a net operating loss carry-back election made under the Workers, Homeownership and Business Assistance Act of 2009, offset by estimated state alternative minimum taxes and foreign tax expense for the current year. The benefit from income taxes was approximately $262,000 for the three months ended September 30, 2010 primarily attributable to the federal tax refund receivable described above. The benefit from income taxes of $37,000 for the nine months ended September 30, 2009 reflected the realization of foreign corporate income tax benefit related to prior tax years. The provision for income taxes of $16,000 for the three months ended September 30, 2009 consisted primarily of foreign tax expense.




7. Segment Reporting




Disclosure of segments is presented in accordance with ASC 280, Segment Reporting (ASC 280). ASC 280 establishes standards for disclosures regarding operating segments, products and services, geographic areas and major customers. The Company is organized and operates as two operating segments: (1) the design, development, manufacturing, sale and marketing of networked video communications products (products division) and (2) the prosecution, maintenance, support and generation of licensing revenue through license or sale of the Company’s intellectual property and technology, some of which is used in the Company’s products (intellectual property division). Service revenue relates mainly to the maintenance, support, training and software development, and is included in the products division for purposes of reporting and decision-making. The products division also engages in corporate functions, and provides financing and services to its intellectual property division. The Company’s chief operating decision-maker, its Chief Executive Officer (CEO), monitors the Company’s operations based upon the information reflected in the following table (in thousands). The table includes a reconciliation of the revenue and expense classification used by the CEO with the revenue, other income and expenses reported in the Company’s condensed consolidated financial statements included elsewhere herein. The reconciliation for the revenue category reflects the fact that the CEO views activity recorded in the account “income from settlement and patent licensing” as revenue within the intellectual property division.




-15-










Intellectual Property Division

Products Division

Reconciliation

TotalThree Months Ended September 30, 2010 (unaudited)Revenue

$
379

$
1,858

$
—

$
2,237Depreciation expense

—

68

—

68Stock-based compensation

(79)

(330)

—

(409)Total costs and expenses

(206
)
(3,773
)
—

(3,979
)Other income (expense), net

—

(20
)
—

(20
)Net income (loss)

172

(1,672
)
—

(1,500
)Assets

667

2,292

—

2,959Three Months Ended September 30, 2009 (unaudited)Revenue

$
1,407

$
1,079

$
(1,057
)
$
1,429Depreciation expense

—

(62
)
—

(62
)Stock-based compensation

(41)

(388)

—

(429)Total costs and expenses

(532
)
(3,697
)
1,057

(3,172
)Other income (expense), net

—

(126
)
—

(126
)Net income (loss)

875

(2,760
)
—

(1,885
)Assets

808

1,600

—

2,408Nine Months Ended September 30, 2010 (unaudited)Revenue

$
14,736

$
3,299

$
—

$
18,035Depreciation expense

—

181

—

181Stock-based compensation

(217)

(778)

—

(995)Total costs and expenses

(1,131
)
(10,702
)
—

(11,833
)Other income (expense), net

—

(37
)
—

(37
)Net income (loss)

13,604

(7,276
)
—

6,328Assets

667

2,292

—

2,959Nine Months Ended September 30, 2009 (unaudited)Revenue

$
3,743

$
6,365

$
(3,171
)
$
6,937Depreciation expense

—

(182
)
—

(182
)Stock-based compensation

(200)

(1,207)

—

(1,407)Total costs and expenses

(1,369
)
(10,869
)
3,171

(9,067
)Other income (expense), net

—

(358
)
—

(358
)Net income (loss)

2,374

(4,825
)
—

(2,451
)Assets

808

1,600

—

2,408




International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 48% and 89% of total revenues for the three months ended September 30, 2010 and 2009, respectively, and 30% and 43% of total revenues for the nine months ended September 30, 2010 and 2009, respectively. For the three months ended September 30, 2010 and 2009, international revenues from customers in the United Kingdom accounted for 31% and 64% of total product and services revenue, respectively, and 10% and 34% for the nine months ended September 30, 2010 and 2009, respectively.  The Company had no significant long-lived assets in any country other than in the United States for any period presented.




8.  Borrowings




Line of Credit




On December 23, 2006, the Company entered into a Revolving Credit and Promissory Note and a Security Agreement with a financial institution to borrow up to $10.0 million under a revolving line of credit subject to annual renewal with the consent of the Company and the lender. The Revolving Credit and Promissory Note was renewed and amended on December 22, 2009 which extended the maturity date of the facility by one year to December 21, 2010, and increased the line of credit from $10.0 million to $11.25 million until March 31, 2010 and thereafter the line of credit would decrease to $6.0 million.  The maximum facility amount was further reduced to $5.0 million in March 2010 and then increased to $7.0 million in August 2010 for the remainder of the period through the maturity date.   The amended Security Agreement, amended on January 12, 2010, granted the lender a security interest in and right of setoff against substantially all of the Company’s assets, tangible and intangible, except for substantially all of Avistar’s patents and patent applications sold to Intellectual Ventures pursuant to a patent purchase agreement dated as of December 18, 2009. Gerald Burnett, the Company’s Chairman, provided a collateralized guarantee to the financial institution, assuring payment of the Company’s obligations under the agreement and as a consequence, there are no restrictive covenants, allowing the Company greater access to the full amount of the facility. Dr. Burnett also provided a personal guarantee to the Company assuring the Company a line of credit of $7.0 million with the same terms and mechanisms as the existing revolving line of credit in the event the existing revolving line of credit from the financial institution was unavailable for any reason during the period from its termination on December 21, 2010 to March 31, 2011.




-16-


The renewed line of credit requires monthly interest-only payments based on Adjusted LIBOR plus 0.90% or Prime Rate plus 1.00%. The Company elected Adjusted LIBOR plus 0.90% as of December 31, 2009 and September 30, 2010. The Company repaid $11.25 million from the proceeds of the sale of substantially all of the Company’s patents and patent applications to Intellectual Ventures and subsequently borrowed $6.0 million under the revolving line of credit during the nine months ended September 30, 2010, and had a balance of $6.0 million outstanding as of September 30, 2010.




9.  Commitments and Contingencies




Facilities Leases




The Company leases its facilities under operating leases that expire through March 2017, and has subleased some of its operating facilities to third parties.  The future minimum lease commitments under all facility leases as of September 30, 2010, net of sublease proceeds, are as follows (in thousands):




Minimum Lease Payments


Sublease Proceeds


Net(unaudited)


(unaudited)


(unaudited)Three Months Ending December 31,2010

$
323


$
(127
)

$
196Years Ending December 31,2011


1,333



(372
)


9612012


568



(314
)


2542013


310



(296
)


142014


310



(296
)


14Thereafter


698



(698
)


—Total future minimum lease payments

$
3,542


$
(2,103
)

$
1,439


Software Indemnifications




The Company enters into standard indemnification agreements in the ordinary course of business. Pursuant to these agreements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally the Company’s business partners or customers, in connection with any patent, copyright or other intellectual property infringement claim by any third party with respect to its products. The term of these indemnification agreements is generally perpetual. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is generally limited to the cost of products purchased per customer, but may be material when customer purchases since inception are considered in aggregate. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. Accordingly, the Company has no liabilities recorded for these agreements as of September 30, 2010.




-17-


10. Recent Accounting Pronouncements




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




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





In February 2010, the FASB issued ASU No. 2010-09, Subsequent Events – Amendments to Certain Recognition and Disclosure Requirements (ASU 2010-09).  The update removes the requirement for an SEC filer to disclose the date through which subsequent events have been evaluated.  The change alleviates potential conflicts between ASC 855-10 and the SEC’s requirements.  ASU 2010-09 is effective upon issuance of the final update.  The Company adopted this statement upon its issuance. The adoption of this statement did not have a material impact on the Company’s financial condition and results of operations.




11. Subsequent Events




The Company has evaluated subsequent events and has concluded that no subsequent events have occurred since the quarter ended September 30, 2010 that required additional disclosure in the financial statements.




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




The following discussion and analysis should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and the related Notes thereto included in this Quarterly Report on Form 10-Q and with Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2009, as filed with the SEC on March 30, 2010.




This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains both historical information and forward-looking statements. These forward-looking statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may”, “will”, “should”, “expects”, “intends”, “plans”, “anticipates”, “believes”, “estimates”, “predicts”, “potential”, “continue” or the negative of these terms, or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. In evaluating these statements, you should specifically consider the various risks and other factors that were discussed  under “Risk Factors” and elsewhere in the 2009 Annual Report on Form 10-K and this Quarterly Report on Form 10-Q. These factors may cause our actual results to differ materially from any forward looking statement.   Although we believe that the expectations reflected in the forward looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, we are under no duty to update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform these statements to actual results.  These forward-looking statements are made in reliance upon the safe harbor provision of The Private Securities Litigation Reform Act of 1995.  In addition, historical information should not be considered an indicator of future performance.





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Overview




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




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




Since inception, we have recognized the innovative value of our research and development efforts, and have invested in securing protection for these innovations through domestic and foreign patent applications and issuance. On January 19, 2010, we licensed our patents to Springboard Group S.A.R.L., or SKYPE, for an upfront license payment of $3.0 million. On January 21, 2010, we sold substantially all of our patent portfolio and associated patent applications to Intellectual Ventures Fund 61 LLC for a one time cash payment of $11.0 million.  Nevertheless, we retained royalty rights under our existing patent license agreements as well as a grant back license to the patents and patent applicationsfor our current and future products.  As a result of this sale, we expect our efforts and expenditures on patent prosecution, licensing and settlement activities in future periods to be reduced.  As of September 30, 2010, we held 1 issued U.S. patent and 1 issued Canadian patent, as well as 18 U.S. patent applications and 1 European patent application. We continue an active program to strategically grow and protect our intellectual property portfolio, primarily through the filing of patent applications.In the future, we also plan to generate licensing revenue through the license or sale of our existing patent portfolio and patent applications.




Critical Accounting Policies




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




Management believes that there have been no significant changes to our critical accounting policies during the three and nine months ended September 30, 2010 from those disclosed in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009.




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Results of Operations




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




Percentage of Total RevenueThree Months EndedSeptember 30,


Nine Months EndedSeptember 30,2010


2009


2010


2009Revenue:Product


56
%


20
%


9
%


47
%Licensing and sale of patents


17



25



82



8Services, maintenance and support


27



55



9



45Total revenue


100



100



100



100Costs and Expenses:Cost of product revenues


6



18



2



13Cost of services, maintenance and support revenues


17



52



6



35Income from settlement and patent licensing


—



(74
)


—



(46
)Research and development


71



62



28



40Sales and marketing


33



44



12



29General and administrative


51



120



18



60Total costs and expenses


178



222



66



131Income (loss) from operations


(78
)


(122
)


34



(31
)Other income (expense), net


(1
)


(9
)


—



(5
)Income (loss) before provision for (benefit from) income taxes


(79
)


(131
)


34



(36
)Provision for (benefit from) income taxes


(12
)


1



(1
)


(1
)Net income (loss)


(67
)%


(132
)%


35
%


(35
)%







COMPARISON OF THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009




Revenue




Total revenue increased by $808,000 or 57%, to $2.2 million for the three month period ended September 30, 2010, from $1.4 million for the three months ended September 30, 2009.  This was due to an increase in product revenue of $1.0 million and an increase in licensing revenue of $29,000, partially offset by a decrease in services, maintenance and support revenue of $181,000.




·
Product revenue increased by $1.0 million or 332%, to $1.2 million for the three month period ended September 30, 2010, from $289,000 for the three months ended September 30, 2009.  This was primarily due to the increase in software product revenue recognized relating to the completion of the IBM project, and software revenue from LifeSize and Deustche Bank, for the three months ended September 30, 2010.




·
Licensing revenue, relating to the licensing and sale of our patent portfolio, increased by $29,000 or 8%, to $379,000 for the three month period ended September 30, 2010 from $350,000 for the three months ended September 30, 2009. This was due to an increase in estimated royalty revenue from Sony.




·
Services, maintenance and support revenue, which includes funded software development and maintenance and support, decreased by $181,000, or 23%, to $609,000 for the three months ended September 30, 2010, from $790,000 for the three months ended September 30, 2009. This was due to a decrease in service revenue of $47,000 and a decrease in maintenance revenue of $134,000 due to a decrease in the number of maintenance contract renewals with existing customers.




For the three months ended September 30, 2010, revenue from four customers accounted for 89% of total revenue compared to three customers and 86% of total revenue for the three months ended September 30, 2009. No other customer accounted for greater than 10% of total revenue in either period.  The level of sales to any customer may vary from quarter to quarter. We expect that there will be significant customer concentration in future quarters. The loss of any one of those customers would have a materially adverse impact on our financial condition and operating results.




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Costs and expenses




Cost of product revenues.Cost of product revenues decreased by $132,000 or 50%, to $131,000 for the three months ended September 30, 2010 from $263,000 for the three months ended September 30, 2009, primarily due to lower hardware product sales, a decrease in obsolete inventory write-off and a reduction in personnel related expense.




Cost of services, maintenance and support revenues.Cost of services, maintenance and support revenues decreased by $350,000, or 47%, to $387,000 for the three months ended September 30, 2010, from $737,000 for the three months ended September 30, 2009, primarily due toa reduction in software implementation and enhancement services for customers.




Income from settlement and patent licensing.Income from settlement and patent licensing decreased $1.1 million or 100%, to $0 for the three months ended September 30, 2010 from $1.1 million for the three months ended September 30, 2009. The decrease was due to the completion of recognition of the net proceeds from the Polycom settlement and cross-license agreement in November 2009.




Research and development.Research and development expenses increased by $688,000, or 77%, to $1.6 million for the three months ended September 30, 2010 from $891,000 for the three months ended September 30, 2009.  The increase was primarily due to an increase in engineering headcount and deployment of external labor to accelerate the delivery of our product roadmap, and a lower allocation of engineering employee and external labor expenses to cost of services, maintenance and support revenue associated with software implementation and enhancement services.




Sales and marketing. Sales and marketing expenses increased $110,000 or 17%, to $739,000 for the three months ended September 30, 2010, from $629,000 for the three months ended September 30, 2009, primarily due to an increased headcount in the sales department and personnel related expense.




General and administrative. General and administrative expenses decreased by $566,000, or 33% to $1.1 million for the three months ended September 30, 2010, from $1.7 million for the three months ended September 30, 2009, primarily due to a reduction in severance pay expense, decrease in both general and patent legal fees and the ongoing cost optimization effort.




Other income (expense)




Other income (expense), net. Other income (expense), net, decreased by $106,000, or 84%, to a net expense of $20,000 for the three months ended September 30, 2010, from a net expense of $126,000 for the three months ended September 30, 2009, primarily due to a decrease in interest expense as a result of a lower average debt balance and lower interest rates.




Provision for (benefit from) income taxes




The benefit from income taxes was $262,000 for the three months ended September 30, 2010 primarily attributable to the tax refund receivable for the 2004 federal alternative minimum tax of $238,000 pursuant to the net operating loss carry-back election under the Worker, Homeownership and Business Assistance Act legislation. The provision for income taxes of $16,000 for the three months ended September 30, 2009 consisted primarily of foreign tax expense for ASUK.




COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009




Revenue




Total revenue increased by $11.1 million or 160%, to $18.0 million for the nine month period ended September 30, 2010, from $6.9 million for the nine month period ended September 30, 2009, primarily due to the sale of substantially all of the Company’s patents to Intellectual Ventures for $11.0 million and licensing revenue from SKYPE for $3.0 million, partially offset by a decrease in hardware and software sales revenue, and a decrease in services, maintenance and support revenue.




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·
Product revenue decreased by $1.6 million or 49%, to $1.6 million for the nine month period ended September 30, 2010 from $3.2 million for the nine months ended September 30, 2009. This was primarily due to a decrease in software product revenue recognized related to our agreement with IBM, and a decrease in hardware sales.






·
Licensing and patent sale revenue, relating to the licensing and sale of our patent portfolio, increased by $14.2 million, to $14.7 million for the nine month period ended September 30, 2010 from $572,000 for the nine months ended September 30, 2009.  This was due to the sale of substantially all of our patents to Intellectual Ventures for $11.0 million and licensing revenue from SKYPE in the amount of $3.0 million.







·
Services, maintenance and support revenue, which includes funded software development and maintenance and support, decreased by $1.5 million, or 47%, to $1.7 million for the nine months ended September 30, 2010, from $3.1 million for the nine months ended September 30, 2009. This was primarily due to a decrease in service revenue from software implementation and enhancement services and a decrease in the number of maintenance contract renewals with existing customers during the nine months ended September 30, 2010.




For the nine months ended September 30, 2010, revenue from two customers accounted for 78% of total revenue compared to three customers and 71% for the nine months ended September 30, 2009. No other customer accounted for greater than 10% of total revenue in either period.  The level of sales to any customer may vary from quarter to quarter. We expect that there will be significant customer concentration in future quarters. The loss of any one of those customers would have a materially adverse impact on our financial condition and operating results.




Costs and expenses




Cost of product revenues.Cost of product revenues decreased by $557,000 or 60%, to $369,000 for the nine months ended September 30, 2010 from $926,000 for the nine months ended September 30, 2009.  The decrease was primarily due to lower hardware product sales, a decrease in obsolete inventory write-off, and a reduction in personnel related expense.




Cost of services, maintenance and support revenues.Cost of services, maintenance and support revenues decreased by $1.3 million, or 56%, to $1.1 million for the nine months ended September 30, 2010, from $2.4 million for the nine months ended September 30, 2009, primarily due toa decrease in software implementation and enhancement services for customers.




Income from settlement and patent licensing.Income from settlement and patent licensing decreased $3.2 million or 100%, to $0 for the nine months ended September 30, 2010 from $3.2 million for the nine months ended September 30, 2009. The decrease was due to the completion of recognition of the net proceeds from the Polycom settlement and cross-license agreement in November 2009.




Research and development.Research and development expenses increased by $2.3 million, or 83%, to $5.1 million for the nine months ended September 30, 2010 from $2.8 million for the nine months ended September 30, 2009.  The increase was primarily due to the bonus payout to employees of our Intellectual Property division totaling $470,000 as a result of the completion of the sale of substantially all of our  patents to Intellectual Ventures in January 2010,  an increase in engineering headcount and deployment of external labor to accelerate the delivery of our product roadmap,  and a lower allocation of engineering employee and external labor expenses to cost of services, maintenance and support revenue associated with software implementation and enhancement services during the nine months ended September 30, 2010, compared to the same period of the prior year.




Sales and marketing. Sales and marketing expenses increased $56,000 or 3%, to $2.0 million for the nine months ended September 30, 2010, from $2.0 million for the nine months ended September 30, 2009, due to an increase in personnel and personnel related expenses.




General and administrative. General and administrative expenses decreased by $863,000, or 21% to $3.3 million for the nine months ended September 30, 2010, from $4.1 million for the nine months ended September 30, 2009, primarily due to a decrease in severance pay expense, a decrease in both general and patent legal fees and a decrease in company-wide performance bonus accrual.




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Other income (expense)




Other income (expense), net. Other income (expense), net, decreased by $321,000, or 90%, to a net expense of $37,000 for the nine months ended September 30, 2010, from a net expense of $358,000 for the nine months ended September 30, 2009, due to a decrease in interest expense as a result of a lower average debt balance and lower interest rates.




Provision for (benefit from) income taxes




The benefit from income taxes of $163,000 for the nine months ended September 30, 2010 was primarily due to the tax refund receivable for the 2004 federal alternative minimum tax of $238,000 pursuant to the net operating loss carry-back election under the Worker, Homeownership and Business Assistance Act legislation, partially offset by the estimated state alternative minimum taxes and foreign tax expense for 2010. The benefit from income taxes of $37,000 for the nine months ended September 30, 2009 reflected the realization of foreign corporate income tax benefit related to prior tax years for ASUK.




Liquidity and Capital Resources




We had cash and cash equivalents of $354,000 and $294,000 as of September 30, 2010 and December 31, 2009, respectively. For the nine months ended September 30, 2010, we had a net increase in cash and cash equivalents of $60,000. The net cash provided by operations of $5.5 million for the nine months ended September 30, 2010 resulted primarily from the net income of $6.3 million. The net cash used in investing activities of $229,000 for the nine months ended September 30, 2010 was related to the purchase of property and equipment.  The net cash used in financing activities of $5.2 million for the nine months ended September 30, 2010 related primarily to payments made on our line of credit of $11.3 million, partially offset by $6.0 million of borrowings on our line of credit.




At September 30, 2010, we had approximately $1.4 million in minimum commitments under non-cancelable operating leases net of sublease proceeds related to our office space facilities in California and New York. On December 23, 2006, we entered into a Revolving Credit and Promissory Note and a Security Agreement with a financial institution to borrow up to $10.0 million under a revolving line of credit subject to annual renewal with the consent of the Company and the lender. The Revolving Credit and Promissory Note was renewed and amended on December 22, 2009 which extended the maturity date of the facility by one year to December 21, 2010, and increased the line of credit from $10.0 million to $11.25 million until March 31, 2010 and thereafter the line of credit would decrease to $6.0 million. The maximum facility amount was further reduced to $5.0 million in March 2010 and then increased to $7.0 million in August 2010 for the remainder of the period through the maturity date.   The amended Security Agreement, amended on January 12, 2010, granted the lender a security interest in and right of setoff against substantially all of our assets, tangible and intangible, except for substantially all of our patents and patent applications which we sold to Intellectual Ventures Fund 61 LLC pursuant to a patent purchase agreement dated as of December 18, 2009. Gerald Burnett, our Chairman, provided a collateralized guarantee to the financial institution, assuring payment of our obligations under the agreement and as a consequence, there are no restrictive covenants, allowing us greater access to the full amount of the facility. Dr. Burnett also provided a personal guarantee to us assuring us a line of credit of $7.0 million with the same terms and mechanisms as the existing revolving line of credit in the event the existing revolving line of credit from the financial institution was unavailable for any reason during the period from its termination on December 21, 2010 to March 31, 2011. The renewed line of credit requires monthly interest-only payments based on Adjusted LIBOR plus 0.90% or Prime Rate plus 1.00%. We elected Adjusted LIBOR plus 0.90% at September 30, 2010 and December 31, 2009. We repaid $11.25 million from the proceeds of the sale of substantially all of our patents and patent applications to Intellectual Ventures and subsequently borrowed $6.0 million under the revolving line of credit during the nine months ended September 30, 2010, and had a balance of $6.0 million outstanding as of September 30, 2010.




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




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On January 21, 2010, we completed the sale of substantially all of our U.S. patents and patent applications, and related foreign patents and patent applications to Intellectual Ventures related to an agreement that was entered into on December 18, 2009.  We received the purchase price of $11.0 million from Intellectual Ventures on January 21, 2010.  We also obtained a full grant-back royalty-free, irrevocable license to the patent portfolio from Intellectual Ventures to make, use and sell any Avistar product or service covered by the patents sold.




As of September 30, 2010, we had no material off-balance sheet arrangements, other than the operating leases described above.   We enter into indemnification provisions under agreements with other companies in our ordinary course of business, typically with our contractors, customers, landlords and our investors. Under these provisions, we generally indemnify and hold harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of our activities or, in some cases, as a result of the indemnified party's activities under the agreement. These indemnification provisions generally survive termination of the underlying agreement. The maximum potential amount of future payments we could be required to make under these indemnification provisions is generally unlimited. As of September 30, 2010, we have not incurred material costs to defend lawsuits or settle claims related to these indemnifications agreements and therefore, we have no liabilities recorded for these agreements as of September 30, 2010.




Based on the proceeds we received from the license of our patents and the sale of the majority of our patents and patent applications in January 2010, the results of our ongoing cost reduction efforts and Dr. Burnett’s personal guarantee to Avistar to support an extension of the revolving line of credit, we believe that our existing cash and cash equivalents balance and line of credit will provide us with sufficient funds to finance our operations for the next 12 months. We intend to continue to invest in the development of new products and enhancements to our existing products. Our future liquidity and capital requirements will depend upon numerous factors, including without limitation, general economic conditions and conditions in the financial services industry in particular, the level and timing of product, licensing and service revenue, the maintenance of our cost control measures structured to align operations with predictable revenues, the costs and timing of our product development efforts and the success of these development efforts, the costs and timing of our sales, partnering and marketing activities, the extent to which our existing and new products gain market acceptance and competing technological and market developments, all of which may impact our ability to achieve and maintain profitability or generate positive cash flows.




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




Recent Accounting Pronouncements





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




Item 3.              Quantitative and Qualitative Disclosures about Market Risk




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




Item 4T.                      Controls and Procedures




(a)         Evaluation of disclosure controls and procedures: Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q (the Evaluation Date). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded as of the Evaluation Date that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act)) were effective such that information required to be disclosed by us in reports that we file or submit under the Exchange Act (i) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure, and (ii) is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.  In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and executed, can provide only reasonable assurance of achieving the desired control objectives.  In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.




-24-


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




PART II - OTHER INFORMATION




Item 1.              Legal Proceedings




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




Item 1A.Risk Factors




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




Before you invest in our securities, you should be aware that our business faces numerous financial and market risks, including those described below, as well as general economic and business risks.  The following discussion provides information concerning the material risks and uncertainties that we have identified and believe may adversely affect our business, our financial condition and our results of operations.  Before you decide whether to invest in our securities, you should carefully consider these risks and uncertainties, together with all of the other information included in this Quarterly Report on Form 10-Q, our Annual Report on Form 10-K for the year ended December 31, 2009 and in our other public filings.




This risks set forth below supersede the description of the risk factors associated with our business previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2009.




Risks Relating to Our Common Stock




Our stock is quoted on the Pink Sheets, which may decrease the liquidity of our common stock.




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




-25-


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




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




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




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




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




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




•
Quarterly variations in our results of operations;




•
Announcements regarding our product developments;




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




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




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




•
Announcements of competitive product introductions by our competitors;




•
Limited trading volume of shares; and,




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




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




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




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




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




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




Our executive officers, directors and entities affiliated with them, in the aggregate, beneficially owned approximately 65% of our common stock outstanding as of September 30, 2010. If they were to act together, these stockholders would be able to exercise control over most matters requiring approval by our stockholders, including the election of directors and approval of significant corporate transactions. These actions may be taken even if they are opposed by other investors. This concentration of ownership may also have the effect of delaying or preventing a change in control of Avistar, which could cause the market price of our common stock to decline.




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




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




Risks Related to Our Business




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




We recorded a net income of $6.3 million for the nine months ended September 30, 2010, a net loss of $4.0 million for fiscal year 2009 and a net loss of $6.4 million for fiscal year 2008. As of September 30, 2010, our accumulated deficit was $109.8 million. Our revenue and income from settlement and patent licensing may not increase, or even remain at its current level. In addition, our operating expenses may increase as we continue to develop our business and pursue licensing opportunities. As a result, to remain profitable, we will need to increase our revenue from product sales and patent licensing or sales by increasing sales to existing customers and by attracting additional new customers, distribution partners and patent licensees. If our revenue does not increase adequately, we may not become profitable. Due to the volatility of our product and licensing revenue and our income from settlement and patent licensing activities, we may not be able to achieve, sustain or increase profitability on a quarterly or annual basis. If we fail to maintain profitability or to sustain or grow our profits within the time frame expected by investors, the market price of our common stock may be adversely impacted.




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




We may need to arrange for the availability of additional funding in order to meet our future business requirements. We have a revolving credit facility that matures on December 21, 2010, which provides us with a maximum line of credit amount of $7.0 million as of September 30, 2010. If we are unable to obtain additional funding when needed on acceptable terms, we may not be able to develop or enhance our products, take advantage of opportunities, respond to competitive pressures or unanticipated requirements, or finance our efforts to protect and enforce our intellectual property rights, which could seriously harm our business, financial condition, results of operations and ability to continue operations.  We have in the past, and may in the future, reduce our expenditures by reducing our employee headcount in order to better align our expenditures with our available resources.  Any such reductions may adversely affect our ability to maintain or grow our business.




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


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




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




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




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




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




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




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







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




For the three months ended September 30, 2010, revenue from four customers accounted for 89% of total revenue. For the nine months ended September 30, 2010, revenue from two customers accounted for 78% of total revenue. No other customer accounted for greater than 10% of total revenue in either period.




The loss of a major customer or the reduction, delay or cancellation of orders from one or more of our significant customers could cause our revenue to decline and our losses to increase.  Additionally, we completed the amortization of the Polycom, Inc. proceeds in 2009. If we are unable to license our current and future patent portfolio to additional parties on terms equal to or better than our agreements with Polycom, Inc. and others, our licensing revenue and our income from settlement and licensing will decline, which could cause our losses to increase. We currently depend on a limited number of customers with lengthy budgeting cycles and unpredictable buying patterns, and as a result, our revenue from quarter-to-quarter or year-to-year may be volatile. Adverse changes in our revenue or operating results as a result of these budgeting cycles or any other reduction in capital expenditures by our large customers could substantially reduce the trading price of our common stock.




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




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




•      Rapid technological change;




•      The emergence of new competitors;




•      Significant development costs;




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




•      Integration of joint solutions in collaboration platforms;




•      Evolving industry standards;




•      Transition from hardware appliances and infrastructure to software; and




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




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




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




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




Competition could reduce our market share and decrease our revenue.




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




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




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




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




The U.S. and global economy has entered a recession and our customers and potential customers, partners and distributors may delay or forego ordering our products, and we could fall short of our revenue expectations for 2010 and beyond. Slower growth among our customers, tightening of customers’ operating budgets, retrenchment in the capital markets and other general economic factors all have had, and could in the future have, a materially adverse effect on our revenue, capital resources, financial condition and results of operations.




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




In prior periods, we have relied on patent licensing revenues and income from settlement and licensing activities to provide significant funding for our operations.  We recognized a total of $4.5 million, $5.2 million, and $21.2 million in licensing revenues and income from settlement and licensing activities for the years ended December 31, 2009, 2008 and 2007, respectively.  In January 2010, we sold substantially all of our patent portfolio and associated patent applications to Intellectual Ventures for a one time cash payment of $11.0 million.  We retained royalty rights under our existing patent license agreements as well as a grant back license to the patents and patent applications for our current and future products.  As a result of this sale, we expect our efforts and expenditures on patent prosecution, licensing and settlement activities in future periods to be substantially reduced and our prospects for revenues from the licensing or sale of patents and patent applications and our prospects for generating new income from settlement and licensing activities to also be substantially reduced.  Accordingly, our ongoing operations will have to be funded directly from operations and from debt and equity financing activities.  Failure to generate cash from operations or from debt or equity financing activities would have a substantial and adverse affect on our business, operations and prospects.




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




Because our licensing cycle is a lengthy process, the accurate prediction of future revenues and income from settlement and patent licensing from new licensees is difficult. The process of persuading companies to adopt our technologies can be lengthy, and other challenges to our patent portfolio may further complicate and delay our patent licensing efforts.  There is also a tendency in the technology industry to close business deals at the end of a quarter, thereby increasing the likelihood that a possible material deal would not be concluded in a current quarter, but slip into a subsequent reporting period. This kind of delay may result in a given quarter’s performance being below analyst or shareholder expectations. The proceeds of our intellectual property licensing efforts tend to be sporadic and difficult to predict. Recognition of those proceeds as revenue or income from settlement and licensing activities depends on the terms of the license agreement involved, and the circumstances surrounding the agreement. To finance litigation to defend or enforce our intellectual property rights, we may enter into contingency arrangements and other strategic transactions with investors, legal counsel or other advisors that would give such parties a significant portion of any future licensing and settlement amounts derived from our patent portfolio. As a result, our licensing and enforcement efforts are expected to result in significant volatility in our quarterly and annual financial condition and results of operations, which may result in us missing investor expectations, which may cause our stock price to decline. As a result of the sale of substantially all of our patents in January 2010, we expect our efforts and expenditures on patent prosecution, licensing, sale and settlement activities in future periods to be reduced.




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




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




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




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




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




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




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




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




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




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




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





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




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




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




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




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




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




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




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




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




We depend on the continued services of our executive officers and other key personnel. We do not have long-term employment agreements with our executive officers or other key personnel and we do not carry any “key man” life insurance. The loss of the services of any of our executive officers or key personnel could harm our business, financial condition and results of operations.




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




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


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




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




International revenue, which consists of sales to customers with operations principally in Western Europe and Asia, comprised 48% and 89% of total revenues for the three months ended September 30, 2010 and 2009, respectively, and 30% and 43% of total revenues for the nine months ended September 30, 2010 and 2009, respectively. Some of the risks we may encounter in conducting international business activities include the following:




•      Tariffs and other trade barriers;




•      Unexpected changes in foreign regulatory requirements and laws;




•      Economic and political instability;




•      Increased risk of infringement claims;




•      Protection of our intellectual property;




•      Restrictions on the repatriation of funds;




•      Potentially adverse tax consequences;




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




•      Fluctuations in foreign currencies; and




•      Limitations in communications infrastructures in some foreign countries.




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




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




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




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




Not applicable.




Item 3.Defaults Upon Senior Securities




Not applicable.




Item 4.Removed and Reserved




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Item 5.              Other Information




Not applicable.




Item 6.Exhibits





Exhibit Number

Description10.1

Second Amendment to Second Amended and Restated Revolving Credit Promissory Note issued by Avistar Communications Corporation to JPMorgan Chase Bank, N.A. dated August 16, 2010.10.2

Reaffirmation of Guaranty issued by Gerald J. Burnett and Marjorie J. Burnett Revocable Trust in favor of JPMorgan Chase Bank, N.A. dated August 16, 2010.31.1

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

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

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





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SIGNATURES




Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized, on the 5th day of November 2010.





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





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EXHIBIT INDEX





Exhibit Number

Description10.1

Second Amendment to Second Amended and Restated Revolving Credit Promissory Note issued by Avistar Communications Corporation to JPMorgan Chase Bank, N.A. dated August 16, 2010.10.2

Reaffirmation of Guaranty issued by Gerald J. Burnett and Marjorie J. Burnett Revocable Trust in favor of JPMorgan Chase Bank, N.A. dated August 16, 2010.31.1

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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