**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**
| **x** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|-----------------------------------------------------------------------------------------------------|

For the fiscal year ended December 31,2006

or
| **o** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|--------------------------------------------------------------------------------------------------------------|

**Commission File Number: 001-33041**

**ACME PACKET, INC.**

*(Exact name of registrant as specified in itscharter)*

| **Delaware**                                                    |   | **04-3526641**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

**71 Third Avenue**

**Burlington, MA 01803**

(Address of principalexecutive offices) (zip code)

**(781) 328-4400**

(Registrant’s telephonenumber, including area code)

**Securities registered pursuant toSection 12(b) of the Act:**

| Title of each class                 |   | Name of each  exchange on which registered |
|-------------------------------------|--------|--------------------------------------------|
| **Common  Stock, $0.001 par value** |   | **The  Nasdaq Stock Market LLC**           |

 

Securities registered pursuant to Section 12(g) of the Act:  None.

Indicate by check mark whether the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes o  No x

Indicate by check mark whether the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act.    Yes o  No x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.    Yes x  No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.    x

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act. (Check one):

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

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Act).    Yes  o  No x

Theaggregate market value of common stock held by nonaffiliates of the registrant(19,217,882 shares) based on the closing price of the registrant’s common stockas reported on the NASDAQ National Market on October 13, 2006, which was thefirst business day on which the registrant’s common stock was publicly traded,was $305,756,503. Shares of voting and non-voting stock held by executiveofficers, directors and holders of more than 5% of the outstanding stock havebeen excluded from this calculation because such persons or institutions may bedeemed affiliates. This determination of affiliate status is not a conclusivedetermination for other purposes.

58,648,031 shares of the registrant’s common stock wereoutstanding as of March 13, 2007.

**DOCUMENTS INCORPORATED BYREFERENCE**

The registrant intends tofile a definitive Proxy Statement pursuant to Regulation 14A within120 days of the end of the fiscal year ended December 31, 2006.  Portions of such Proxy Statement areincorporated by reference into Part III of this Form 10-K.

 

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**Tableof Contents**

| **PART I**   |   |                                                                                                                |   |   |
|-------------------|--------|---------------------------------------------------------------------------------------------------------------------|--------|--------|
| Item 1.      |   | Business                                                                                                            |   | 3      |
| Item 1A.     |   | Risk  Factors                                                                                                       |   | 19     |
| Item 1B.     |   | Unresolved Staff Comments                                                                                           |   | 35     |
| Item 2.      |   | Properties                                                                                                          |   | 35     |
| Item 3.      |   | Legal  Proceedings                                                                                                  |   | 35     |
| Item 4.      |   | Submission of Matters to a Vote of Security Holders                                                                 |   | 35     |
| **PART II**  |   |                                                                                                                |   |   |
| Item 5.      |   | Market for Registrant’s Common Equity, Related  Stockholder Matters and  Issuer Purchases of Equity Securities |   | 36     |
| Item 6.      |   | Selected  Financial Data                                                                                            |   | 39     |
| Item 7.      |   | Management’s Discussion and Analysis of Financial  Condition and Results  of Operations                        |   | 40     |
| Item 7A.     |   | Quantitative and Qualitative Disclosure About Market  Risk                                                          |   | 58     |
| Item 8.      |   | Financial Statements and Supplementary Data                                                                         |   | 59     |
| Item 9.      |   | Changes in and Disagreements with Accountants on Accounting  and  Financial Disclosure                              |   | 83     |
| Item 9A.     |   | Controls and Procedures                                                                                             |   | 84     |
| Item 9B.     |   | Other  Information                                                                                                  |   | 84     |
| **PART III** |   |                                                                                                                |   |   |
| Item 10.     |   | Directors and  Executive Officers of the Registrant                                                                 |   | 85     |
| Item 11.     |   | Executive Compensation                                                                                              |   | 85     |
| Item 12.     |   | Security Ownership of Certain Beneficial Owners and  Management and  Related Stockholder Matters                    |   | 85     |
| Item 13.     |   | Certain Relationships and Related Transactions and Director Independence                                            |   | 85     |
| Item 14.     |   | Principal Accountant Fees and Services                                                                              |   | 85     |
| **PART IV**  |   |                                                                                                                |   |   |
| Item 15.     |   | Exhibits, Financial Statement Schedules                                                                             |   | 86     |
| SIGNATURES        |   | 88                                                                                                                  |

 

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**SPECIAL NOTEREGARDING FORWARD-LOOKING STATEMENTS**

The information inthis Annual Report contains forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended (“Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (“Exchange Act”). Suchstatements are based upon current expectations that involve risks anduncertainties. Any statements contained herein that are not statements ofhistorical facts may be deemed to be forward-looking statements. We may, insome cases, use words such as “project,” “believe,” “anticipate,” “plan,” “expect,”“estimate,” “intend,” “continue,” “should,” “would,” “could,” “potentially,” “will,”“may” or similar words and expressions that convey uncertainty of future eventsor outcomes to identify these forward-looking statements. Forward-lookingstatements in this Annual Report may include statements about:

·       our ability to attract andretain customers;

·       our financial performance;

·       our development activities;

·       our position in the sessionborder controller market;

·       the benefits of ourproducts, services, or programs;

·       the advantages of ourtechnology as compared to that of others;

·       our ability to establishand maintain intellectual property rights;

·       our ability to retain andhire necessary employees and appropriately staff our operations; and

·       our cash needs.

The outcome of the events described in theseforward-looking statements is subject to known and unknown risks, uncertaintiesand other factors that could cause actual results to differ materially from theresults anticipated by these forward-looking statements. These importantfactors include our financial performance, difficulties in attracting andretaining customers, difficulties in meeting customer needs through ourdevelopment activities, difficulties leveraging market opportunities, poorproduct sales, long sales cycles, difficulties in developing new products,difficulties in our relationships with vendors and partners, risks associated withinternational operations, difficulty in managing rapid growth and increasedcompetition, and those factors we discuss in this Annual Report under thecaption “Risk Factors” and the risks discussed in our other SEC filings. Weundertake no obligation to publicly release any revisions to the forward-lookingstatements after the date of this Annual Report other than as required by law.You should read these factors and the other cautionary statements made in thisAnnual Report as being applicable to all related forward-looking statementswherever they appear in this Annual Report. These risk factors are notexhaustive and other sections of this Annual Report may include additionalfactors which could adversely impact our business and financial performance.

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**PART I**

**Item 1.   Business**

**Overview**

Acme Packet is the leading provider of session bordercontrollers, or SBCs, that enable interactive communications service providersto deliver secure and high quality interactive communications—voice, video andother real-time multimedia sessions—across defined border points where InternetProtocol networks connect, known as network borders. Interactive communicationsservice providers, which we refer to generally as service providers, includecable service providers, wireline and mobile wireless telecommunicationsservice providers, information service providers and data transport serviceproviders. The Internet Protocol, or IP, is a standardized method oftransmitting information, such as interactive communications, from one device,such as a personal computer, server, IP telephone and personal digital advisor,to another device over any type of physical private or public network,including the Internet. Our Net-Net products, which consist of our hardware andproprietary software, serve as a central element in unifying the separate IPnetworks that comprise wireline, wireless and cable networks. Interactivecommunications service providers can use our products to create a premiumservice tier that delivers next-generation interactive communications services,such as Voice over IP, or VoIP, with the same quality assurance and security asthey historically have offered for voice services over their legacy telephonenetworks.

SBCs are deployed at the borders between IP networks,such as between two service providers or between a service provider and itsbusiness, residential or mobile customers as more fully described below in thesections entitled “Industry Background,” “The Need for a New IP Element,” “OurSolution” and “Our Technology.” SBCs are the only network element currentlycapable of integrating the control of signaling messages and media flows. Thiscapability complements the roles and functionality of routers, softswitches anddata firewalls that operate within the same network. Our Net-Net productssupport a broad range of communications applications at multiple network borderpoints, providing key control functions in the areas of security, service reachmaximization, service level agreement assurance, revenue and profit protectionand regulatory compliance, while also supporting next-generation servicearchitectures such as IP Multimedia Subsystem, or IMS. IMS provides ablueprint for building a network capable of delivering IP-based voice, videoand multimedia services to subscribers.

We began shipping our Net-Net products in 2002. Sincethat time, over 360 interactive communications service providers in 75countries have purchased our products.

We sell our products and support services throughapproximately 30 distribution partners and our direct sales force. Ourdistribution partners include many of the largest networking andtelecommunications equipment vendors throughout the world.

We were founded in 2000under the name Primary Networks, Inc. and changed our name to Acme Packet, Inc.in January 2001. Our principal executive offices are located at 71 ThirdAvenue, Burlington, MA 01803. Our telephone number is (781) 328-4400. Ourwebsite address is www.acmepacket.com. Through a link on the InvestorRelations section of our Website, we make available the following filings afterthey are electronically filed with or furnished to the SEC: our Annual Reporton Form 10-K, Quarterly Reports on Form 10-Q, CurrentReports on Form 8-K, and any amendments to those reports filed orfurnished pursuant to Section 13 or 15(d) of the Exchange Act. Allsuch filings are available free of charge.

**Industry Background**

Since the advent of the Internet, interactivecommunications service providers have delivered voice and data services separatelyover the Public Switched Telephone Network, or PSTN, and the Internet. The 

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PSTN, also known as thevoice or traditional telephone network, was created decades ago to provideseamless, reliable and secure global voice communications services. Users areaccustomed to the high reliability and security of the PSTN, and have highconfidence in utilizing it to share personal information and engage inactivities such as banking and commerce. The PSTN is limited, however, in itsability to support high bandwidth video and other interactive multimediaservices.

The Internet is acollection of IP networks that provides global reach for a broad range ofinformation services such as e-mail, web browsing, electronic commerce andresearch. IP is a data-oriented protocol which provides communicable uniqueglobal addressing among computers. Internet service quality, while adequate forthese types of information services, can vary significantly depending upon,among other factors, available bandwidth, how busy a particular web site maybe, how many people are using the network at a particular time and the activitybeing performed. Although the Internet is capable of cost-effectivelytransmitting any form of traffic that is IP-based, including interactive voice,video and data, it transmits only on a best-efforts basis, because all forms oftraffic have the same priority. The Internet, therefore, attempts to deliverall traffic without distinction, which can result in significantly varyingdegrees of service quality for the same or similar types of traffictransmissions. In addition, Internet communications, unlike those over thePSTN, are subject to disruptive and fraudulent behavior, including identitytheft, viruses, unwanted and excessively large input data known as SPAM,unauthorized use, and attempts to circumvent or bypass security mechanismsassociated with those services, known as hacking. Although Internet users haveadopted many security measures to protect themselves, their networks and theirwebsites, these measures currently are not adequate to provide highly secure,real-time interactive communications.

*Evolution to aConverged IP Network*

In recent years, interactive communications serviceproviders have experienced a significant decrease in wireline voice revenue dueto the competition from voice over IP, or VoIP, and mobile voice services. VoIPtechnology allows the routing of voice conversations over the Internet. Thisphenomenon has challenged service providers’ business models, causing a declinein profitability and a significant reduction in capital expenditure budgets.Interactive service providers are focusing their efforts on introducing newrevenue-generating opportunities, while rationalizing capital and networkoperations costs.

IP networks can be designedand operated more cost-effectively than the PSTN. In addition, IP networks arecapable of delivering converged voice, video and data service packages tobusinesses and consumers. Service providers are seeking to provide thesenext-generation services to enhance their profitability by generatingincremental revenue and by reducing subscriber turnover. However, managing twodistinct networks—the PSTN and an IP network—is not a viable economicalternative. As a result, service providers are beginning to migrate to asingle IP network architecture to serve as the foundation for theirnext-generation service offerings. In order to successfully transition to asingle IP network, however, service providers must maintain the samereliability and security that have for decades exemplified their delivery ofvoice services.

*Challenges of IPNetworks in Delivering Session-Based Communications*

IP networks were designed initially to providereliable delivery of data services such as file downloads and web site trafficthat are not sensitive to latency, or time delay. If data packets are lost ormisdirected, an IP network exhibits tremendous resiliency in re-transmittingand eventually executing the desired user request, which generally is anacceptable result for these types of data services. However, IP networkshistorically have not been capable of guaranteeing real-time, secure deliveryof high quality sessions-based communications such as interactive voice andvideo.

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A session is acommunications interaction that has a defined beginning and end, and iseffective only when transmitted in real-time without latency or delays. Inorder to enable a session-based communication, a service provider must be ableto control the session from its origination point to its defined end point. Nosingle service provider’s IP network extends far enough to enable that level ofcontrol, however, and the Internet lacks the fundamental quality of service andsecurity mechanisms necessary to consistently deliver the security and qualityof real- time multimedia communications that consumers and businesses require.In order to gain the trust of consumer and business customers, serviceproviders must be able to assure secure and high quality interactivecommunications across multiple customer networks, access networks and otherservice provider networks.

**The Need for a NewIP Network Element**

*Managingsession-based communications*

In order to providesecure and high quality interactive communications, IP networks must be able tomanage and integrate the communication flows that comprise a session. Eachsession includes three sets of bidirectional communication flows:

·       *Session signaling messages*, which are used to initiate, modify or terminate a session;

·       *Media streams*,which are data packets containing the actual media being exchanged; and

·       *Media control messages*,which are used to compile information used to report on quality of servicelevels.

A session is initiated using signaling messages. Thesemessages establish a virtual connection between the participants’ personalcomputers, IP phones or other IP devices. In addition, they negotiate the IPaddresses used for the session’s media streams and control messages as well asthe algorithms, referred to as codecs, used to digitize analog voice and video.Various codecs are required for voice and video, and they involve trade-offsbetween quality and bandwidth efficiency. Once the call is initiated, mediastreams and control messages flow in both directions between participants.Signaling messages also are used to transfer a call, place a call on hold andterminate a session.

The management ofsession-based communications is complicated by the following characteristics oftoday’s IP networks:

·       The identities of theparticipants are difficult to ascertain and security needs are complex.

·       The number of sessionsignaling protocols, codecs and related standards continues to grow.

·       Addressing schemes are notconsistent or compatible across networks.

·       Bandwidth and signalingelement resources are finite.

·       Interactive communicationsservice provider business models and regulatory compliance requirementscontinue to evolve and require network flexibility.

Additionally, unliketypical data communications, not all session-based communications can be treatedwith the same priority. For example, a 911 call or a high quality enterprisevideo conference should take priority over a person calling into a reality TVprogram.

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*Limitations ofExisting Network Elements*

Successfulsession-based communications require tight integration between signaling andmedia control. However, existing network elements such as softswitches, routersand data firewalls do not provide the control functions required forsession-based communications.

·       Softswitches, includingSession Initiation Protocol, or SIP, servers, H.323 gatekeepers and MediaGateway Control Protocol, or MGCP, call agents, process only signaling messageswhile performing a variety of signaling-based functions, such as subscriberregistration, authentication, authorization and session routing based upontelephone numbers or SIP addresses. Softswitches currently do not providefunctions relating to, for example, media control for interactive communicationsessions or protection against signaling-based denial of**service and distributed denial ofservice, or DoS/DDoS, attacks. DoS/DDoS attacks prevent network equipment fromreceiving legitimate network traffic by overloading network equipment withunrequested information.

·       Routers make simple routingdecisions for IP packets based upon IP addresses. Routers do not participate incall signaling, and therefore, are unable to recognize the multiple individualdata packets that comprise a single voice call or multi-media session. Withoutsignaling intelligence, routers currently are unable to perform key bordercontrol functions such as softswitch overload prevention or call routing basedupon quality and cost requirements. Routers may use a number of quality ofservice technologies, such as Multi-Protocol Label Switching or MPLS,Differentiated Services or DiffServ, and Resource Reservation Protocol or RSVP,to provide preferential treatment to certain IP packets. However, routersusing these technologies are currently incapable of classifying all thecommunications flows associated with a single voice call and handling thosecommunications flows correctly as a single entity. Without the ability toidentify the multiple individual packets that compromise a session, controlcall signaling, or understand the access link capacity and utilization, therouter is unable to make any call admission or rejection decisions. As aresult, the router will continue to send packets along a path even though thesession should have been rejected because the quality was insufficient for therequested session. When this overloading of a path occurs, not only is thequality of the session associated with that packet insufficient to support thesession, but other sessions using that same path also will suffer degradation.

·       Data firewalls are the mostcommon security element in IP networks. Firewalls work by allowing into thenetwork only traffic that has been requested from inside the network and bypresenting a single IP address for all of the personal computers, phones andother devices behind it. The firewall effectively blocks session-basedcommunications because it does not allow incoming calls from unknown endpoints.Furthermore, firewalls are not capable of identifying and protecting againstservice overloads or DoS/DDoS attacks on other signaling elements such as thesoftswitch.

**Our Solution**

We provide a new category of network equipment calledthe session border controller, or SBC, to enable interactive communicationsservice providers to offer secure and high quality interactive communicationsacross multiple IP networks, including the separate IP networks that comprisewireline, wireless and cable networks. Prior to the advent of the SBC, IPnetwork infrastructure equipment, such as softswitches, routers and datafirewalls, were able to initiate and route undifferentiated data, but lackedthe ability to target specifically the management of interactive communicationssessions. The development of the SBC, unlike many emerging networking products,was not catalyzed by standards bodies, but rather by the pragmatic needs ofservice providers.

To date, SBCs have been deployed around the worldprincipally to deliver VoIP services, or the routing of voice conversationsover the Internet. We believe that there is a significant demand for SBCs thatcan assure delivery of secure and high quality real-time interactivecommunications across all IP 

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network borders.Infonetics Research, a market research and consulting firm specializing in datanetworking and telecommunications, projects that worldwide revenue for SBCswill increase from $143 million in 2006 to $592 million in 2010.

SBCs are deployedat the borders of IP networks, such as between two service providers, referredto as an interconnect border, between a service provider and its business,residential or mobile customers, referred to as access-backbone borders, orbetween a carrier’s network and its data center, referred to as a data centerborder. SBCs act as the source and destination for all signaling messages andmedia streams entering and exiting the provider’s network. To that end, SBCscomplement rather than replace softswitches, data firewalls or routers. At allborders, SBCs sit in front of softswitches and make call acceptance orrejection decisions. This function protects the softswitch from both malicioussignaling attacks initiated by hackers and non-malicious overloads as well asensures calls are only accepted when adequate network quality and softswitchresources are available. At many borders, SBCs sit alongside data firewalls.The data firewalls protect web and application servers and PCs from attackswhile the SBC protects the softswitch. SBCs augment the simple and differentpacket-by-packet routing decisions routers make. Unlike routers that makesimple and different routing decisions on a packet by packet basis, SBCs areable to classify these flows as a single interactive communication session andmake more intelligent routing decisions to use the best path across the networkto ensure secure, high quality communications.

·       *Security.* SBCs protect themselves, softswitches and otherelements of the service delivery infrastructure, as well as customer networks,systems and relationships. They protect customer networks and session privacy,and provide DoS/DDoS protection from malicious attacks and non-maliciousoverloads.

·       *Service reach maximization.*SBCs extend the reach of offeredservices by maximizing the different types of networks and devices supported.Support is provided for enabling sessions to traverse existing data firewalland cross network translation, or NAT, devices, bridging private networks usingoverlapping IP addresses and virtual private networks, or VPNs, mediatingbetween different signaling, transport and encryption protocols, convertingbetween incompatible codecs, and translating signaling-layer telephone numbers,addresses and response codes.

·       *Service level agreement assurance.* SBCs play a critical rolein assuring session capacity and quality. They perform admission control toensure that both the network and service infrastructure has the capacity tosupport a session with high quality. SBCs also monitor and report actualsession quality to determine compliance with performance specifications setforth in service level agreements between service providers and theircustomers.

·       *Revenue and profit protection.* SBCs can help serviceproviders increase revenues and profits by protecting against both bandwidthand quality of service theft, by routing sessions to minimize costs, and byproviding accounting and related mechanisms to maximize billable sessions.

·       *Regulatory compliance.*SBCs support compliance withgovernment-mandated regulations worldwide, including emergency services such asE-9-1-1 and lawful intercept, which involves law enforcementagencies’ electronic surveillance of circuit and packet-mode communications asauthorized by judicial or administrative order, such as the CommunicationsAssistance for Law Enforcement Act, or CALEA.

Our SBCs utilizeour proprietary technology to process session-based communications at networkborders, and are designed to ensure that critical security and qualitystandards are met. Our key advantages include the following:

·       *Significant experience in service provider deployments.* Wehave significant experience in production deployments of SBCs by largeinteractive communications service providers, including deployments at 23 ofthe top 25 and 72 of the top 100 wireline, wireless and cable service providersin the world, 

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based on 2006 revenues.Our product functionality and quality have continually improved based on theknowledge about network challenges and complexities that we have acquiredthrough deployments with over 360 large and small wireline, wireless and cableproviders across the globe.

·       *Breadth of applications and standards support.* Our productsare capable of processing the most widely used real-time interactive voice,video and multimedia communications sessions at wireline, wireless and cable IPnetwork borders. We support a broad range of IP signaling protocols, such asSIP, H.323 and MGCP/NCS, transport protocols, encryption protocols, codecs, andaddressing methods.

·       *Depth of border control features.* We offer a deep set ofsession border control features for security, service reach maximization,service level agreement assurance, revenue and profit protection, andregulatory compliance. In addition, our flexible product architecturefacilitates rapid adoption of new control features required by emergingservices, applications, business models and regulatory requirements.

·       *Responsive service and support.* Our responsiveness to ourcustomers’ and distribution partners’ new feature requirements andinteroperability testing, as well as our commitment to swift problemresolution, has been critical in deployments of our products.

·       *Carrier-class platform.* Interactive communications serviceproviders operate complex, mission-critical networks that require securityprotection; high degrees of reliability, availability and maintainability,scalable performance and capacity, space and power-saving hardware design; andcomprehensive network management. Products or platforms that satisfy theserequirements are known as carrier-class. We have designed our products to becarrier-class.

·       *Proven interoperability.* We have demonstrated the ability ofour SBCs to interoperate with key products being deployed by major vendors fornext-generation services, such as softswitches, application servers, mediagateways, media servers, policy servers and other communications infrastructureelements.

We believe that these keyadvantages of our products and services, together with our deployment of ourproducts in approximately 360 service provider networks, make Acme Packet theleading provider of SBCs.

**Our Strategy**

Our objective is togrow our market and technology leadership in the SBC market. Principal elementsof our strategy include:

·       *Continue to satisfy the evolving border requirements of large serviceproviders.* By continuing to work closely with Tier-1 and otherlarge service providers as they deploy and scale their services, we arewell-positioned to gain valuable knowledge that we can use to expand andenhance our products’ features and functionality. Our experience hasdemonstrated that new services, applications, business models and regulatoryrequirements will drive the need for supporting new interfaces, protocols andcontrol features. For example, in January 2006, we began deliveringsupport for media using TCP, a transport protocol used for many real-time,interactive gaming applications.

·       *Exploit new technologies to enhance product performance andscalability.* Our purpose-built hardware platforms incorporateleading edge hardware and proprietary software technology. We will seek toleverage new technologies as they become available to increase the performance,capacity and functionality of our product family, as well as to reduce ourcosts. For example, our Net-Net 9000 series can increase signaling performanceby four to eight times over previously available levels and incorporatesessential transcoding, or the ability to change data from one format toanother.

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·       *Invest in quality and responsive support.* Our professionalservices team, dedicated to product quality and responsive support, ensuresthat our customers successfully deploy our**productsand efficiently transition their subscribers to a converged IP networkinfrastructure. As we broaden our product platform and increase our productcapabilities, we will continue to provide comprehensive service and supporttargeted at maximizing customer satisfaction and retention.

·       *Facilitate and promote service interconnects among our customers.*We facilitate and encourage business relationships and interconnections amongour customers to extend the reach of their services and, consequently, toincrease the value of their services to their customers. We expect that theseinterconnections, in turn, will lead to increased demand for both our customers’services and for our products.

·       *Leverage distribution partnerships to enhance market penetration.*We have approximately 30 distribution partners, which provide us with access toadditional customers and increase our market penetration. As we invest intraining and tools for our distribution partners’ sales, systems engineeringand support organizations, we expect the overall efficiency and effectivenessof these partnerships to increase, which will allow us to dedicate more of ourresources to further penetrating the global market for our products andservices.

·       *Actively contribute to architecture and standards definition processes.*As the result of our breadth and depth of experience with actual productiondeployments of SBCs, we are poised to contribute significantly to organizationsdeveloping standards and architectures for next-generation IP networks, such asthe Internet Engineering Task Force, 3GPP, ETSI, ATIS, MultiService Forum andPacketCable. We believe that the evolution of these standards and architectureswill increasingly be driven by the realities learned from the pragmatic needsof service providers, not by theories.

**Our Technology**

Our SBCs aredesigned specifically to make networks “session aware” by enabling them torecognize, manage and integrate the various communication flows that comprise asingle session and then treat those media flows as a single session with theappropriate priority, security and routing among other different networks. AcmePacket Session Aware Networking, our technology architecture, enables thedelivery of secure and high quality interactive communication sessions acrossIP network borders. Implemented by the tight integration of our Net-Net OSsoftware and Net-Net hardware platforms, our technology combines five elementsthat make the network session aware:

·       session routing policy;

·       session signaling service;

·       session media control;

·       session monitoring andreporting; and

·       session security service.

Session Aware Networking is designed to enable thesefive elements to share information dynamically. The session routing policyelement collects the information necessary to guide the session signalingservice in the selection of the optimal route across multiple IP networks. Themedia control element moves voice packets in compliance with security, qualityof service, bandwidth and regulatory requirements. The session monitoring andreporting element updates the routing policy element with information aboutactual signaling element load, bandwidth availability and route performance.The session security service element protects the SBC, service infrastructure,customer networks and sessions among customers’ subscribers. 

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We believe that thecombination of these elements creates a comprehensive solution required todeliver secure and high quality interactive communications services across IPnetwork borders.

*Sessionrouting policy.*   Thissoftware-based element defines and collects the information needed to makerouting and related decisions. Session routing policy includes the following:

·       *Admission control*,which determines whether session initiation requests should be accepted basedupon signaling element availability and load, bandwidth availability andobserved session quality;

·       *Routing*,which determines the next signaling element on the network based upon multiplemetrics, including source, destination, service provider preference, prefix,cost, time-of-day and time-of-week;

·       *Load balancing*,which determines how sessions should be load balanced across multiple signalingelements on the network utilizing round-robin, hunt, least busy or proportionalallocations;

·       *Number translations*,which specifies how telephone numbers should be manipulated when beingforwarded; and

·       *Call limiting*,which limits number or rate of calls to prevent overloads from less valuablesources or destinations.

*Sessionsignaling service.*   This software-based element supports a broad range ofsignaling protocols such as SIP, H.323, MGCP/NCS and H.248. Based oninformation received from the session routing policy element, the signalingservice element selects the best path through the network for each session. Itselects the next signaling element in the network, such as user devices,softswitches, gateways and application servers, that each session should visit.To initiate the session, this element signals the next device along the path.If no acceptable path is available, the signaling service rejects theinitiation request. It performs network address and port translations foraddresses exposed in the signaling messages for security and bridgingincompatible networks, strips previous routing information to hide customers orsuppliers and adds or strips codecs to ensure codec compatibility. It alsodetermines if the media flows should be released peer-to-peer between endpointsor relayed through the media control element. For relayed sessions, it passesaddress information for the next signaling element in the path to the mediacontrol element. The signaling service also performs protocol repair andinterworking by, for example, converting one protocol into another. Lastly,this element is able to track sessions for reporting and billing purposes.

*Sessionmedia control.*   Oncethe session is established, this hardware-based element controls the mediaflows that are not released peer-to-peer between endpoints. Media controlperforms network address and port translations for security and bridgingincompatible networks. It relays media to support the ability to address thecross network address translation and firewall devices, applies quality ofservice markings such as DiffServ bits and virtual area network, or VLAN, tags,performs transcoding between codecs when needed, and polices bandwidth usage inorder to prevent, for example, a 64-Kbps voice session from switching to384-Kbps video without permission. Media control also can extract touchtones embedded in the media flows, replicate the media flows for lawfulintercept when required, and detect and repair certain session faults based onlimits for items such as call length and maximum idle time. For example, if asignaling message terminating a session is lost, the session media controlelement notices and terminates the errant connection, freeing resources forother use.

*Sessionmonitoring and reporting.  **This element compiles signaling andmedia performance information on a per session basis. Media qualitymeasurements may include objective network attributes, such as delay, jitterand packet loss, or subjective measurements using mean opinion score algorithms.Signaling performance information includes signaling element availability, loadand call completion ratios. The reported information is used in fault andperformance management and in service level agreement reporting, and is inputto subsequent routing and admission control policy decisions.*

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*Sessionsecurity service.*   This element exploits integrated hardware and softwarecapabilities to secure the SBC, the service infrastructure and subscribersessions with respect to signaling and media flows. Static and dynamic accesscontrol lists for signaling messages are enforced by the SBC’s networkprocessing subsystem to protect the signaling processor from DoS/DDoS attackand overload. DoS/DDoS attacks prevent network equipment from receivinglegitimate media flows by overloading the network equipment with unrequestedinformation. To avoid such attacks, subscriber endpoints must earn trustthrough successful registrations or calls to gain trusted access. For mediaflows, an SBC acts as a media firewall, permitting access for authorizedsessions and blocking other traffic. All internal bandwidth consumed by allsignaling and media flows are policed in hardware for optimum scalability inDoS/DDoS protection.

DoS/DDoS attack preventionentails blocking all attacks and overloads at the SBC. Many of the sessionrouting policies described above prevent signaling and media overloads on theservice infrastructure from legitimate subscribers. A hardware-based encryptionengine can ensure confidentiality of both signaling and media flows forsubscriber sessions.

**Our Products**

Our Net-Net family of products consists of the Net-NetOS, 4000, 4000 PAC, 9000 and EMS. The brand name “Net-Net” reflects the role ofthese products in interconnecting IP networks for voice, video and multimediaservices. Our Net-Net products serve as a central element in unifying theseparate IP networks that comprise wireline, wireless and cable networks. Ourproducts include our hardware platforms and proprietary software. They deliverhigh quality session border control functionality, performance, capacity,scalability, availability and manageability, while allowing interactivecommunications service providers to create a premium service tier ofnext-generation real-time, interactive communications.

Our hardware and softwareproducts are designed to work in conjunction with each other. Our Net-Net OSsoftware platform will only operate on our Net-Net SBC hardware platforms and,accordingly, our Net-Net SBC hardware platforms will only operate with ourembedded software installed. Customers can purchase our SBCs in either astandalone or high-availability configuration and can license our software invarious configurations depending on customers’ requirements for sessioncapacity, feature groups and protocols.

*Acme Packet Net-NetOS*

The Acme Packet Net-Net OS is our software platform.It operates on all of the Net-Net 4000 and 9000 series SBC hardware platforms.It offers rich border control functionality in terms of architecturalflexibility, signaling protocol breadth, control feature depth, andcarrier-class availability and manageability.

Net-Net OS supportsall five required SBC control functions:

·       *Security.* Net-SAFE, our SBC security framework, protects theservice delivery infrastructure and customer/subscriber networks, systems andrelationships with support for SBC DoS/DDoS protection, access control,topology hiding, session privacy, virtual private network separation, serviceinfrastructure DoS/DDoS prevention and fraud prevention.

·       *Service reach maximization.*Our SBCs extend the reach ofoffered services by maximizing the different types of networks and devicessupported. Critical features include: NAT traversal, which is the ability toenable communication sessions to be carried over existing data firewall and NATdevices; bridging of private and public address spaces including VPNs,signaling, encryption and transport protocol interworking; transcoding; andnumber, address and response code translations.

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·       *Service level agreement assurance.* Our SBCs support a numberof features designed to guarantee session capacity and quality. These featuresinclude: admission control based upon signaling element load, bandwidthavailability (including policy server interfaces) and observed quality ofservice; quality of service marking and mapping; and quality of servicereporting.

·       *Revenue and profit protection.* Net-Net OS includes a numberof features that help customers generate incremental revenues and protectagainst revenue leakage by service theft, including bandwidth policing, qualityof service theft protection, accounting, session timers, routing and loadbalancing.

·       *Regulatory compliance.*Our SBCs support compliance withgovernment-mandated regulations worldwide, including emergency services such asE-9-1-1 and lawful intercept such as CALEA in the UnitedStates.

Other Net-Net OSfeatures include the following:

·       *Multi-protocol support.*Net-Net OS provides support for abroad range of signaling protocols for interworking, load balancing androuting, and decomposed SBC control.

·       *High availability.*Our high availability configurationsprotect against loss of service in the event of hardware or software failures.The checkpointing of media, signaling and configuration state is designed toensure no loss of active calls, or support for new call requests.

·       *Management*. Our SBCs include support for a comprehensivecollection of element management tools and operational support systeminterfaces.

·       *SBC architectural flexibility.* Our SBCs support differentarchitectural models. They can be configured as an integrated solution withsignaling service and media control (each of which is described above)supported on a single hardware platform or a decomposed solution with mediacontrol and signaling service supported on two separate hardware platforms. Thechoice of integrated or decomposed SBC solutions provides our distributionpartners and customers with increased flexibility and scalability inimplementing next-generation architectures. An integrated SBC solution offersmore session border control functionality and simplifies the evaluation,deployment and on-going support of the product. A decomposed solution enablesscaling the signaling and media control elements independently for optimumperformance and capacity. Our products also support both subscriber access andservice provider interconnect applications.

*Acme Packet Net-NetSBC Platforms*

TheAcme Packet Net-Net 4000, 4000 PAC and 9000 hardware platformsaddress a broad range of interactive communications service providerrequirements for performance, capacity and bandwidth. Each of these hardwareplatforms may be configured to support an SBC integrated with our proprietarysoftware, although our hardware platforms are not designed to be used withsoftware platforms from other SBC software providers. Our integrated SBCsinclude our hardware platform with our proprietary software, and customers maypurchase our proprietary software separately to obtain new features or increasethe capacity of their existing SBCs. We also offer decomposed SBCs withsignaling service and media control (each of which is described above)supported on two separate hardware platforms. The choice of integrated ordecomposed SBC solutions provides our distribution partners and customers withincreased flexibility and scalability in implementing next-generation networkarchitectures. An integrated SBC solution offers more session border controlfunctionality and simplifies the evaluation, deployment, and on-going supportof the product. A decomposed solution enables scaling the signaling and mediacontrol elements independently for optimum performance and capacity.Configurations supporting subscriber access in each case are available with andwithout IMS signaling control functionality to 

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complement the IMS products offered by ourdistribution partners. Our SBC hardware platforms consist of:

·       *Acme Packet Net-Net 4000*, a carrier-class product that isthe industry’s most widely deployed SBC, satisfies most border requirements forperformance, capacity and availability.

·       *Acme Packet Net-Net 4000 PAC*, a highly scalable,full-featured SBC hardware platform, offers higher levels of SIP performance,availability and capacity than the Net-Net 4000. The Net-Net 4000 PAC is a rackof three to nine Net-Net 4000 units that perform as a single, fully integratedSBC.

·       *Acme Packet Net-Net 9000*, our next-generation SBC platform,offers our highest levels of performance, capacity and availability in a singleSBC hardware platform. The Net-Net 9000 supports transcoding between a wideselection of wireline codecs and wireless codecs.

Thefollowing table outlines the differentiating features of our SBC hardwareplatforms:

| ** **                                                             | ** ** | **Net-Net 4000** | ** ** | **Net-Net 4000 PAC** | ** ** | **Net-Net 9000**  | ** ** |
|------------------------------------------------------------------------|------------|-----------------------|------------|--------------------------------|------------|------------------------|------------|
| Signaling  performance (relative sessions/second)                      |       | 1                     |       | 2-8                            |       | 4-8                    |       |
| Media capacity  with quality of service reporting (number of sessions) |       | 32,000                |       | 64,000-256,000                 |       | 128,000                |       |
| Transcoding  capacity (number of sessions)                             |       | n/a                   |       | n/a                            |       | 16,000                 |       |
| Network  interfaces (number of active 1Gbps Ethernet)                  |       | 4                     |       | 8-32                           |       | 8                      |       |
| High availability  configuration                                       |       | Inter-system          |       | Inter-system                   |       | Intra- or inter-system |       |
| Size of high  availability configuration (rack units)                  |       | 2                     |       | 6-18                           |       | 7                      |       |

 

*Acme Packet Net-Net EMS*

The Acme Packet Net-NetElement Management System, or Net-Net EMS, is a network element managementapplication for our Net-Net family of SBCs. Net-Net EMS is designed to enableinteractive communications service providers to rapidly deploy and easilymanage single or multiple Net-Net SBCs. As a standalone management system,Net-Net EMS is designed to support all required configuration, fault,performance and security management functions through an easy-to-use,browser-based graphical user interface. Net-Net EMS can efficiently integrateinto existing and next-generation operational support systems, through industry-standardinterfaces.

*General*

Our SBCs supportnext-generation, converged fixed-mobile service architectures. They supportboth subscriber access and network interconnect border requirements inwireline, cable and wireless networks.

The pricing of our SBCsdepends upon the hardware platform (4000 or 9000) and related options, thesignaling protocols used (for, example, SIP or H.323), the number of activesessions, and the software feature group options.

**Support and Services**

We believe that theprovision of a broad range of professional support services is an integral partof our business model. We offer services designed to deliver comprehensivesupport to our customers and 

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distributionpartners through every stage of our products’ deployment. Our services can becategorized as follows:

*ProfessionalServices.*   Ourprofessional services group provides pre-installation services, such asplanning and consulting and network engineering and design, as well asinstallation and network integration services.

*TechnicalAssistance Center.*   From our headquarters in Burlington, Massachusetts, weoperate a technical assistance center to provide our customers withpost-installation services such as support and maintenance, informationalservices, and technical support services. We provide remote assistance tocustomers worldwide, including periodic updates to our software and productdocumentation. To respond to our customers’ needs, our technical assistancegroup is available 24 hours a day, 7 days a week and accessible byphone, by e-mail and, when required, on site.

*Training.*   We offer an array of trainingservices to our customers, including, a five-day course about configuration andadministrative basics and a three-day course about troubleshooting maintenance.We present these courses monthly at our headquarters, and we also can delivercustomized versions of the courses at customer sites.

We had 63 employeesdedicated to providing these services as of December 31, 2006. We believeour commitment to servicing our products and our customers provides us with acompetitive advantage by helping us to retain customers and to identify newproduct opportunities.

**Sales and Marketing**

We market and sell our products and support servicesindirectly through our distribution partners and directly through our salesforce. Our sales and marketing team consisted of 66 employees and full timecontractors as of December 31, 2006.

*Marketingand Product Management.**  *In addition to building brand awareness and broadlymarketing our products, our marketing team actively supports our sales processand team and works to influence next-generation service architectures andinteractive communications service provider requirements globally by activelycontributing to industry-related standards organizations, conferences, tradesshows, publications and analyst consulting services.

*Direct Sales.**  *Our direct sales team, withassistance from marketing, sells directly to large, individual serviceproviders worldwide. We maintain sales offices in Burlington, Massachusetts;Madrid, Spain; and Tokyo, Japan. We also have sales and support personnel in Australia,Belgium, Brazil, Canada, China, France, Germany, Hong Kong, Israel, Italy,Korea, Malaysia, Mexico, Peru, Russia and the United Kingdom and throughout theUnited States.

**DistributionPartners**

We enter into non-exclusive distribution or reselleragreements with distribution partners around the globe to acquire newcustomers. These agreements typically have a duration of one to two years andprovide for a full spectrum of sales and marketing services, implementationservices, technical and training support, and warranty protection. They do notcontain minimum sales requirements. We may seek to add distribution partnersselectively, particularly in additional countries outside the United States, inorder to complement or expand our business.

We follow a standard contracting process with ourdistribution partners. The first time a distribution partner places an orderfor any of our products, we enter into a master agreement that contains generalterms and conditions applicable to all purchases of our products by thedistribution partner. By entering into this type of distribution partneragreement with us, a distribution partner does not become obligated 

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to order or purchase anyfixed or minimum quantities of our products. Our distribution partners generallyorder products from us by submitting purchase orders that describe, among otherthings, the type and quantities of our products that they desire to order andthe delivery date and other applicable delivery terms that are applicable tothese products. We typically do not offer contractual rights of return, stockbalancing or price protection to our distribution partners, and actual productreturns from distribution partners have been insignificant to date.

Our sales fulfillment typically is provided throughour distribution partners. While we may provide fulfillment services throughour direct sales force from time to time at the request of a customer, weintend to continue to provide substantially all of our sales fulfillmentthrough our distribution partners.

As of December 31,2006, we had approximately 30 distribution partners and resellers. Our partnersinclude many of the largest networking and telecommunications equipment vendorsin the world, as well as regionally focused system and network integrators.

**Customers**

Our products and services have been sold to over 360customers in 75 countries. These companies consist of legal entities thathave either purchased products and services directly from us or have purchasedour products through us or one of our distribution partners. Our customersinclude incumbent and competitive local exchange and long distance providers,international service providers, cable operators, Internet telephony serviceproviders, voice application service providers, and wireless service providers.In addition to these many different service provider profiles, our customersreflect different services and applications, network types, business models andcountries.

Revenuefrom customers located outside the United States and Canada represented 43% ofour total revenue in 2006, 41% of our total revenue in 2005 and 50% of ourtotal revenue in 2004 (of which revenues from customers in Italy and Japanrepresented 17% and 12% of total revenue, respectively). The following is alist of our customers who accounted for at least 10% of our net revenue for theapplicable period indicated below:

| **Year Ended December 31,** |
|----------------------------------|
| **2006**                         | ** ** | **2005** | ** ** | **2004** | ** ** |
| Sprint—16%                  |   | Sprint—14% |   | Italtel—15% |   |
| Siemens—11%                 |   | Lucent Technologies—14% |   | Alcatel—13% |   |
|                             |   | Time Warner Cable—12% |   | Nissho Electronics—11% |   |
|                             |   | Alcatel—11% |   |   |   |

 

We follow a standardcontracting process with all of our direct customers. The first time a directcustomer places an order for any of our products we enter a master agreementthat contains general terms and conditions applicable to all purchases of ourproducts by such direct customer. By entering into an end-user agreement withus, a direct customer does not become obligated to order or purchase any fixedor minimum quantities of our products. Our direct customers generally orderproducts from us by submitting purchase orders that describe, among otherthings, the type and quantities of our products that they desire to order andthe delivery date and other applicable delivery terms that are applicable to products.

**Research andDevelopment**

Continued investment in research and development iscritical to our business. We have assembled a team of 85 engineers as of December 31,2006, with expertise in various fields of communications and networkinfrastructure. Our research and development organization is responsible fordesigning, developing and enhancing our software products and hardwareplatforms, performing product testing and quality assurance activities, andensuring the compatibility of our products with third-party hardware and 

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software products. Weemploy advanced software development tools, including automated testing,performance monitoring, source code control and defect tracking systems. Inaddition, we have invested significant time and financial resources into thedevelopment of our Net-Net family of products, including our Net-Net OSsoftware platform.

Research and developmentexpense totaled $13.0 million for 2006, $8.7 million for 2005 and$5.6 million for 2004.

**Manufacturing**

We outsource the manufacturing of our Net-Netproducts. We subcontract all of the manufacturing of our Net-Net 4000 series ofproducts to Jabil Circuit, Inc. and Benchmark Electronics. We subcontractall of the manufacturing of our Net-Net 9000 series of products to Jabil Circuit, Inc.and TTM Technologies, Inc. We do not have a written agreement with any ofthese manufacturers. We submit purchase orders to these manufacturers thatdescribe, among other things, the type and quantities of our products orcomponents to be manufactured by the applicable manufacturer and the deliverydate and other delivery terms applicable to the products or components. Ourmanufacturers do not have any written contractual obligation to accept anypurchase order that we submit for the manufacture of any of our products orcomponents. If one of our manufacturers accepts in writing a purchase ordersubmitted by us, the manufacturer is legally obligated to manufacture theproduct or component covered by such purchase order and we are obligated to purchaseand take delivery of such product or component. Our reliance on outsidemanufacturers involves a number of potential risks, including the absence ofadequate capacity, the unavailability of, or interruptions in access to,necessary manufacturing processes, and reduced control over delivery schedules.In addition, we cannot be certain or provide any assurance that ourmanufacturers will accept all of our purchase orders, or any of them, and agreeto manufacture and supply any or all of our manufacturing requirements for ourproducts or any components. If our manufacturers are unable or unwilling tocontinue manufacturing our products and components in required volumes, we willhave to identify one or more acceptable alternative manufacturers. The use ofnew manufacturers may cause significant interruptions in supply if the newmanufacturers have difficulty manufacturing products to our specifications.

Although there are multiple sources for most of thecomponent parts of our products, some of our network processors, trafficmanagers, microprocessors and network search engines are sourced from singleor, in some cases, limited sources. For example, our contract manufacturerspurchase through electronics distributors various types of network processors,traffic managers, microprocessors and network search engines from variouscomponent manufacturers, including Applied Micro Circuits Corporation, BroadcomCorporation, Freescale Semiconductor, Inc. and Integrated DeviceTechnology, Inc., which are presently our contract manufacturers’ solesources for these particular components. We do not have a written agreementwith any of these component manufacturers to guarantee the supply of the keycomponents used in our products, and we do not require any of our contractmanufacturers to have a written agreement with any of these componentmanufacturers. We regularly monitor the supply of the component parts and theavailability of alternative sources. Also, we have entered into arrangementswith a few electronics distributors which require the electronics distributorsto establish and maintain at least three months’ inventory of certain keycomponents, and, at the request of our contract manufacturers, to supply all ora portion of the key components held pursuant to this arrangement to ourcontract manufacturers for use in the manufacture of our products. Ourcontractual arrangements with the electronics distributors do not provide forthe electronics distributors to enter into any contract with any of thesecomponent manufacturers to guarantee the supply of these key components. Ourcontract manufacturers provide forecasts to the electronics distributors of ourmanufacturers’ requirements of these key components. These electronicsdistributors use the forecasts to source the key components from time to time,to the extent that these key components are available from the applicablecomponent manufacturers, with the 

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objective of maintainingat all times at least three months’ supply of these key components availablefor delivery to our contract manufacturers. When our contract manufacturersrequire certain key components for use in the manufacture of our products, wedirect them to issue purchase orders to the applicable electronics distributorand, if the applicable electronics distributor has the requested quantities ofthese key components on hand, it will accept the purchase order issued by ourcontract manufacturers and supply the quantities of the key components coveredby the purchase order. Despite these arrangements, we cannot be certain orprovide any assurance that the applicable component manufacturers will acceptall of the purchase orders, or any of them, issued by these electronicsdistributors and agree to supply any of the quantities of these components requestedby these electronics distributors. Accordingly, we cannot be certain or provideany assurance that these electronics distributors will have at all times atleast three months’ inventory of these key components or any quantities of thekey components in inventory or that our contract manufacturers will be able tosource their requirements of these key components from other sources in the event that the electronicsdistributors cannot meet our contract manufacturers’ requirements.

If our supply of any keycomponent is disrupted, we may be unable to deliver our products to ourcustomers on a timely basis, which could result in lost or delayed revenue,injury to our reputation, increased manufacturing costs and exposure to claimsby our customers. Even if alternate suppliers are available, we may havedifficulty identifying them in a timely manner, we may incur significantadditional expense in changing suppliers, and we may experience difficulties ordelays in the manufacturing of our products.

**Competition**

The market for SBCsis competitive and continually evolving. While we believe we are currently themarket leader, we expect competition to persist and intensify in the future asthe SBC market grows and gains greater attention. We believe the following factorsare the principal methods of competition in the SBC market:

·       customer traction andexperience;

·       breadth of standardssupport;

·       depth of border controlfeatures;

·       proven interoperability anda carrier-class platform; and

·       competitive costs.

Our primary competitors generally consist of start-upvendors, such as Newport Networks and NexTone and more established networkequipment and component companies, such as Ditech Networks, through itsacquisition of Jasomi, Juniper Networks, through its acquisition of Kagoor andAudioCodes, through its acquisition of Netrake. We also compete with some ofthe companies with which we have distribution partnerships, such as SonusNetworks. We believe we compete successfully with all of these companies basedupon our experience in interactive communications service provider networks,the breadth of our applications and standards support, the depth of our bordercontrol features, the demonstrated ability of our products to interoperate withkey communications infrastructure elements, and our comprehensive servicesupport. We also believe our products are priced competitively with othermarket offerings. As the SBC market opportunity grows, we expect competitionfrom additional networking and telecommunications equipment suppliers,including other of our distribution partners. For example, Cisco Systemsrecently announced a new product for the SBC market.

Our current and potentialcompetitors may have significantly greater financial, technical, marketing andother resources than we do and may be able to devote greater resources to thedevelopment, promotion, sale and support of their products. Our competitors mayhave more extensive customer bases 

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andbroader customer relationships than we do, including relationships with ourpotential customers. In addition, these companies may have longer operatinghistories and greater name recognition than we do. Our competitors may be in astronger position to respond quickly to new technologies and may be able tomarket and sell their products more effectively. Moreover, if one or more ofour competitors were to merge or partner with another of our competitors, thechange in the competitive landscape could adversely affect our ability tocompete effectively.

**Intellectual Property**

Our success as a companydepends upon our ability to protect our core technology and intellectualproperty. To accomplish this, we rely on a combination of intellectual propertyrights, including patents, trade secrets, copyrights and trademarks, as well ascustomary contractual protections.

As of December 31,2006, we have been issued seven U.S. patents, and one U.S. patent has beenallowed. In addition, fourteen U.S. utility patent applications are pending, aswell as counterparts pending in other jurisdictions around the world. Once apatent is “allowed” by the U.S. Patent Office, the patent will be issued uponthe completion of certain administrative procedures. A U.S. provisionalapplication can be filed with the U.S. Patent Office to establish apriority date for potentially inventive intellectual property. To patent theinventive intellectual property disclosed in a provisional filing, aU.S. utility patent application must be filed with the U.S. PatentOffice referencing the U.S. provisional patent within one calendar year.One advantage of filing a provisional patent is the establishment of an earlierpriority date which may have value during a patent infringement lawsuit. Ourthree registered trademarks in the United States are “Acme Packet,” “Net-Net”and “Acme Packet Session Aware Networking.”

In addition to theprotections described above, we generally control access to and use of ourproprietary software and other confidential information through the use ofinternal and external controls, including contractual protections withemployees, contractors, customers and partners, and our software is protectedby U.S. and international copyright laws. We also incorporate a number of thirdparty software programs into our Net-Net appliances pursuant to license agreements.

We may not receivecompetitive advantages from the rights granted under our patents and otherintellectual property rights. Our competitors may develop technologies that aresimilar or superior to our proprietary technologies, duplicate our proprietarytechnologies or design around the patents owned or licensed by us. Our existingand future patents may be circumvented, blocked, licensed to others orchallenged as to inventorship, ownership, scope, validity or enforceability. Itis possible that literature we may be advised of by third parties in the futurecould negatively affect the scope or enforceability of either our present orfuture patents. Furthermore, our pending and future patent applications may notissue with the scope of claims sought by us, if at all, or the scope of claimswe are seeking may not be sufficiently broad to protect our proprietarytechnologies. Moreover, we have adopted a strategy of seeking limited patentprotection with respect to the technologies used in or relating to ourproducts. If our products, patents or patent applications are found to conflictwith any patents held by third parties, we could be prevented from selling ourproducts, our patents may be declared invalid or our patent applications maynot result in issued patents. In foreign countries, we may not receiveeffective patent, copyright and trademark protection. We may be required toinitiate litigation in order to enforce any patents issued to us, or todetermine the scope or validity of a third party’s patent or other proprietaryrights. In addition, in the future we may be subject to lawsuits by thirdparties seeking to enforce their own intellectual property rights, as describedin “Risk Factors—Claims by other parties that we infringe their proprietarytechnology could force us to redesign our products or to incur significantcosts.”

We license our softwarepursuant to agreements that impose restrictions on customers’ ability to usethe software, such as prohibiting reverse engineering and limiting the use ofcopies. We also seek to avoid disclosure of our intellectual property byrequiring employees and consultants with access to our proprietary informationto execute nondisclosure and assignment of intellectual property agreements and

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byrestricting access to our source code. Other parties may not comply with theterms of their agreements with us, and we may not be able to enforce our rightsadequately against these parties.

**Employees**

As of December 31,2006, we had 247 employees and 5 full-time independent contractors, consistingof 61 employees and 5 full-time independent contractors engaged in sales andmarketing, 85 employees in engineering, 63 employees in professional supportservices, 19 employees in manufacturing, and 19 employees in finance, administrationand operations. A total of 49 of those employees and full-time independentcontractors were located outside of the United States. None of our employeesare represented by labor unions or covered by a collective bargainingagreement. We have not experienced any work stoppages, and we consider ourcurrent employee relations to be good.

**ITEM1A.   RISK FACTORS**

*Set forth below and elsewhere in this Annual Reportand in other documents we file with the SEC, are risks and uncertainties thatcould cause actual results to differ materially from the results contemplatedby the forward-looking statements contained in this Annual Report. Because ofthe following factors, as well as other variables affecting our operatingresults, past financial performance should not be considered as a reliableindicator of future performance and investors should not use historical trendsto anticipate results or trends in future periods.*

**Risks Relating to Our Business**

***If the market for SBCs does not develop as weanticipate, our revenue may decline or fail to grow, which would adverselyaffect our operating results.***

We derive, and expect tocontinue to derive, all of our revenue from providing SBCs. The market for SBCsis relatively new and still evolving, and it is uncertain whether theseproducts will achieve and sustain high levels of demand and market acceptance.Our success will depend to a substantial extent on the willingness ofinteractive communications service providers to continue to implement SBCs.

Some service providers maybe reluctant or unwilling to implement SBCs for a number of reasons, includingfailure to perceive the need for improved quality and security of interactivecommunications across IP borders and lack of knowledge about the potentialbenefits that SBCs may provide. Even if service providers recognize the needfor improved quality and security of interactive communications across IPborders, they may not select SBCs such as ours because they choose to wait forthe introduction of products and technologies that serve as a replacement orsubstitute for, or represent an improvement over, our SBCs.

If service providers do not perceive the benefits ofSBCs, the SBC market may not continue to develop or may develop more slowlythan we expect, either of which would significantly adversely affect ourrevenue and profitability. Because the market for SBCs is developing and themanner of its development is difficult to predict, we may make errors inpredicting and reacting to relevant business trends, which could harm ouroperating results.

***We have incurredoperating losses in the past and may not be able to sustain profitability inthe future.***

We have incurredsignificant losses in several fiscal years since inception, which included netlosses of $7.5 million in 2003, $7.0 million in 2004 and $35,000 in 2005. Weexpect to continue to incur significant sales and marketing, productdevelopment, administrative, and other expenses. We have only a limitedoperating history on which you can base your evaluation of our business,including our ability to increase our revenue. We commenced operations in August 2000and began recognizing revenue in 2003. We will need to generate significantrevenue to maintain profitability, and we cannot be sure that we will remainprofitable for any substantial period of time. If we are unable to remainprofitable, the market price of our common stock will probably fall.

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***The unpredictability of our quarterlyresults may adversely affect the trading price of our common stock.***

If ourquarterly revenue, earnings or other operating results fall below theexpectations of securities analysts or investors, the price of our common stockcould fall substantially. Our operating results can vary significantly fromquarter to quarter due to a number of factors, many of which are outside of ourcontrol. Generally, a service providers’ purchases of communications equipmenthave been unpredictable and clustered, rather than steady and predictable, asservice providers frequently build out and update their communications networksin stages. In addition, the following factors, among others, can contribute tothe unpredictability of our operating results:

·       fluctuationsin demand for our products, and the timing and size of customer orders;

·       the lengthand variability of the sales and deployment cycles for our products, and thecorresponding timing of recognizing revenue;

·       newproduct introductions and enhancements by our competitors and us;

·       changes inour pricing policies or the pricing policies of our competitors;

·       changes inour third-party manufacturing costs or in the prices of components andmaterials used in our products;

·       our abilityto develop, introduce and deploy new products and product enhancements thatmeet customer requirements in a timely manner;

·       ourability to obtain sufficient supplies of limited source components ormaterials;

·       ourability to attain and maintain production volumes and quality levels for ourproducts; and

·       generaleconomic conditions, as well as those specific to the communications,networking and related industries.

As with other communications equipmentsuppliers, we may recognize a substantial portion of our revenue in a givenquarter from sales booked and shipped in the last month of that quarter. As aresult, a delay in customer orders is likely to result in a delay in shipmentsand recognition of revenue beyond the end of a given quarter. Since a relativelysmall number of customers may account for a substantial portion of our revenuein any quarter, any such delay in an order from a customer could have amaterial adverse effect on our revenue for that quarter.

Our operating expenses are largely based onour anticipated organizational and revenue growth. Most of our expenses, suchas employee compensation, are relatively fixed in the short term. As a result,any shortfall in revenue in relation to our expectations, whether for thereasons set forth above, the reasons identified below or any other reason,could cause significant changes in our operating results from quarter toquarter and could result in increased quarterly losses.

Webelieve that quarter-to-quarter comparisons of our operating results are not agood indication of our future performance. It is likely that in some futurequarters, our operating results will be below the expectations of securitiesanalysts and investors. In this event, the price of our common stock maydecrease substantially.

***We depend on a limited number ofcustomers for a substantial portion of our revenue in any fiscal period, andthe loss of, or a significant shortfall in orders from, key customers couldsignificantly reduce our revenue.***

We derive a substantial portion of ourtotal revenue in any fiscal period from a limited number of customers as aresult of the nature of our target market and the relatively early stage of ourdevelopment. During any given fiscal quarter, a small number of customers mayeach account for 10% or more of our revenue. For example, four such customersaccounted for 51% of our total revenue in 2005 and two such 

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customersaccounted for 27% of our total revenue in 2006. Additionally, we do not haveand we do not enter into long-term purchase contracts with our customers, andhave no contractual arrangements to ensure future sales of our products to ourexisting customers. Our inability to generate anticipated revenue from our keyexisting or targeted customers, or a significant shortfall in sales to them,would significantly reduce our revenue and adversely affect our business. Ouroperating results in the foreseeable future will continue to depend on ourability to effect sales to existing and other large customers.

***Our revenue growth may be constrainedby our product concentration and lack of revenue diversification.***

We havederived all of our revenue to date from sales of our SBCs, and we expect thatour SBCs will account for substantially all of our total revenue for theforeseeable future. Continued market acceptance of these products is criticalto our future success. As a result, our business, operating results, financialcondition and cash flows could be adversely affected by:

·       anydecline in demand for our existing products;

·       the failureof our existing products to achieve continued market acceptance;

·       theintroduction of products and technologies that serve as a replacement orsubstitute for, or represent an improvement over, our existing products;

·       technologicalinnovations or new standards that our existing products do not address; and

·       ourinability to release enhanced versions of our existing products on a timelybasis.

***The long and variable sales anddeployment cycles for our products may cause our operating results to varymaterially, which could result in a significant unexpected revenue shortfall inany given quarter.***

Our products have lengthy sales cycles,which typically extend from six to twelve months and may take up to two years.A customer’s decision to purchase our products often involves a significantcommitment of its resources and a product evaluation and qualification processthat can vary significantly in length. The length of our sales cycles alsovaries depending on the type of customer to which we are selling, the productbeing sold and the type of network in which our product will be utilized. Wemay incur substantial sales and marketing expenses and expend significantmanagement effort during this time, regardless of whether we make a sale.

Even after making the decision to purchaseour products, our customers may deploy our products slowly. Timing ofdeployment can vary widely among customers. The length of a customer’sdeployment period may directly affect the timing of any subsequent purchase ofadditional products by that customer.

As a result of the lengthy and uncertainsales and deployment cycles for our products, it is difficult for us to predictthe quarter in which our customers may purchase additional products or featuresfrom us, and our operating results may vary significantly from quarter toquarter, which may negatively affect our operating results for any givenquarter.

***Our revenue growth will belimited if we are unable to continue to sell our products to large interactivecommunications service providers.***

Our future success depends in part on ourability to sell our products to large interactive communications serviceproviders operating complex networks that serve large numbers of subscribersand transport high volumes of traffic. The communications industry historicallyhas been dominated by a relatively small number of service providers. Whilederegulation and other market forces have led to an increasing number ofservice providers in recent years, large service providers continue toconstitute a significant portion of the market for communications equipment. Ifwe fail to sell additional SBCs to our large customers or to expand ourcustomer base to include additional customers that deploy our products inlarge-scale networks serving significant numbers of subscribers, our revenuegrowth will be limited.

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***Our large customers havesubstantial negotiating leverage, which may require that we agree to terms andconditions that could result in increased cost of sales and decreased revenuesand could adversely affect our operating results.***

Many of our customers are large interactivecommunications service providers that have substantial purchasing power andleverage in negotiating contractual arrangements with us. These customers mayrequire us to develop additional features and require penalties for performanceobligations, such as delivery, outages and response time. As we seek to sellmore products to large service providers, we may be required to agree toadditional performance-based terms and conditions, which may affect the timingof revenue recognition and may adversely affect our operating results.

***Future interpretations ofexisting accounting standards could adversely affect our operating results.***

Generally accepted accounting principles inthe United States are subject to interpretation by the Financial AccountingStandards Board, or FASB, the American Institute of Certified PublicAccountants, or AICPA, the SEC and various other bodies formed to promulgateand interpret appropriate accounting principles. A change in these principlesor interpretations could have a significant effect on our reported financialresults, and could affect the reporting of transactions completed before theannouncement of a change.

Forexample, we recognize our product software license revenue in accordance withAICPA Statement of Position, or SOP, 97-2,*Software Revenue Recognition* , and related amendments andinterpretations contained in SOP 98-9,*  Software Revenue Recognition with Respect toCertain Transactions* . The AICPA and its Software RevenueRecognition Task Force continue to issue interpretations and guidance forapplying the relevant accounting standards to a wide range of sales contractterms and business arrangements that are prevalent in software licensing arrangements.Future interpretations of existing accounting standards, including SOP 97-2and SOP 98-9, or changes in our business practices could result in futurechanges in our revenue recognition accounting policies that have a materialadverse effect on our results of operations. We may be required to delayrevenue recognition into future periods, which could adversely affect ouroperating results. In the future we may have to defer recognition for licensefees due to several factors, including whether a transaction involves:

·       softwarearrangements that include undelivered elements for which we do not have vendorspecific objective evidence of fair value;

·       requirementsthat we deliver services for significant enhancements and modifications tocustomize our software for a particular customer; or

·       materialacceptance criteria.

Because of these factors and other specificrequirements under accounting principles generally accepted in the UnitedStates for software revenue recognition, we must have very precise terms in oursoftware arrangements in order to recognize revenue when we initially deliversoftware or perform services. Negotiation of mutually acceptable terms andconditions can extend our sales cycle, and we sometimes accept terms andconditions that do not permit revenue recognition at the time of delivery.

In December 2004, the FASB issuedStatement of Financial Accounting Standards, or SFAS, No. 123(R),*Share Based Payment*. SFAS No. 123(R) requiresmeasurement of all employee stock-based compensation awards using a fair-valuemethod and the recording of such expense in the consolidated financialstatements. In addition, the adoption of SFAS No. 123(R) requiresadditional accounting related to the income tax effects and disclosureregarding the cash flow effects resulting from share-based paymentarrangements. In January 2005, the SEC issued Staff Accounting Bulletin No. 107,which provides supplemental implementation guidance for SFAS No. 123(R).We have selected the Black-Scholes option-pricing model as the most appropriatefair-value method for our awards and are recognizing compensation 

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costs on astraight-line basis over our awards’ vesting periods. We adopted SFAS No. 123(R) onJanuary 1, 2006, and in fiscal 2006 recognized stock-based compensationexpense of $867,000.

***If the migration to an IP networkarchitecture for real-time interactive communications does not continue, theSBC market may not expand as predicted, and our ability to obtain new customersmay decrease and our revenue will decrease.***

We derive our revenue by providing SBCs tointeractive communications service providers seeking to deliver premiuminteractive communications over IP networks. Our success depends on thecontinued migration of service providers’ networks to a single IP networkarchitecture. The migration of voice traffic from the PSTN to IP networks is inits early stages, and the continued migration to IP networks depends on anumber of factors outside of our control. Among other things, existing networksinclude switches and other equipment that may have estimated useful lives oftwenty or more years and therefore may continue to operate reliably for alengthy period of time. Other factors that may delay the migration to IPnetworks include service providers’ concerns regarding initial capital outlayrequirements, available capacity on legacy networks, competitive and regulatoryissues, and the implementation of an enhanced services business model. As aresult, service providers may defer investing in products, such as ours, thatare designed to migrate interactive communications to IP networks. If themigration to IP networks does not occur for these or other reasons, or if itoccurs more slowly than we expect, the SBC market may not expand as predicted,if at all, and we will not be able to gain new customers. In addition, even ifthere is a successful migration to an IP network for interactivecommunications, new unforseen technologies may render the SBC unnecessary. As aresult, our sales and revenues will decrease and our operating results will beharmed.

***If functionality similar to thatoffered by our SBCs is added to existing network infrastructure elements,organizations may decide against adding our SBCs to their network which wouldcause the market for standalone SBC systems to decrease resulting in fewercustomers for and decreased sales of standalone SBC systems.***

Other providers of network infrastructureelements are offering or proposing to offer functionality aimed at addressingthe problems addressed by our products. The inclusion of, or the announcementof an intent to include, functionality perceived to be similar to that offeredby our products in infrastructure elements that are already generally acceptedas necessary components of network architecture may cause the market not togrow as predicted, which would have an adverse effect on our ability to marketand sell certain of our products. Furthermore, even if the functionalityoffered by other network infrastructure elements is more limited than our products,a significant number of customers may elect to accept such limitedfunctionality in lieu of adding additional equipment from an additional vendor,which could also have a material adverse effect on the market for standaloneSBC systems. Many organizations have invested substantial personnel andfinancial resources to design and operate their networks and have establisheddeep relationships with other providers of network infrastructure elements,which may make them reluctant to add new components to their networks,particularly from new vendors. In addition, an organization’s existing vendorsor new vendors with a broad product offering may be able to offer concessionsthat we are not able to match because we currently offer only a single line ofproducts and may have fewer financial resources than some of our competitors.If organizations are reluctant to add additional network infrastructure fromnew vendors or otherwise decide to work with their existing vendors, the marketfor our products may prove smaller than predicted and our business, operatingresults and financial condition will be adversely affected.

***The market for SBCs iscompetitive and continually evolving, and if we are not able to competeeffectively, we may not be able to continue to expand our business as expectedand our business may suffer.***

Although relatively new, the market forSBCs is competitive and continually evolving. We expect competition to persistand intensify in the future as the SBC market grows and new and existing competitorsdevote considerable resources to introducing and enhancing products. Ourprimary 

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competitorsgenerally consist of start-up vendors, such as Newport Networks and NexTone,and more established network equipment and component companies, such as DitechNetworks, through its acquisition of Jasomi, Juniper Networks, through itsacquisition of Kagoor, and AudioCodes, through its acquisition of Netrake. Inaddition, we compete with some of the companies with which we have distributionpartnerships, such as Sonus Networks. We compete on the basis of customertraction and experience in interactive communications service providernetworks, breadth of applications and standards support, depth of bordercontrol features, demonstrated ability of products to interoperate with keycommunications infrastructure elements, comprehensive service support, andprice.

Networking and telecommunications equipmentsuppliers without competitive solutions today, such as Cisco Systems, mayintroduce solutions in the future, either through internal development oracquisition. These additional competitors may include some of our distributionpartners. Any new entrant would be likely to devote significant sales andmarketing resources to establish its position in the SBC market and may bewilling to price its products at a discount or bundle its products with otherequipment or services in an attempt to rapidly gain market share. New productintroductions or new market entrants could cause service providers to delaypurchase decisions or reopen bidding processes. If new product enhancements andintroductions are superior to ours, and we are unable to make comparableenhancements to our products, our competitive advantage would be compromisedand the condition of our business would be harmed.

We may not be able to compete effectivelyagainst current and potential competitors, especially those with significantlygreater resources and market leverage. Our competitors may have more extensivecustomer bases and broader customer relationships than we do, includingrelationships with our potential customers. In addition, these companies mayhave longer operating histories and greater name recognition than we do. Thesecompetitors may be in a position to respond more quickly than we do to new or emergingtechnologies or changes in customer requirements or may foresee the course ofmarket developments more accurately than we do. As a result, we may experienceprice reductions for our products, order cancellations and increased expenses.Accordingly, our business may not grow as expected and our business may suffer.

***If we do not timely deliver newand enhanced products that respond to customer requirements and technologicalchanges, interactive communications service providers may not buy our productsand our revenue may decline.***

To achieve market acceptance for ourproducts, we must effectively anticipate, and adapt in a timely manner to,customer requirements and must offer products that meet changing customerdemands. Prospective customers may require product features and capabilitiesthat our current products do not have. For example, our most recent productintroduction, the Net-Net 9000 Series, may not adequately respond to newcustomer demands, and, therefore, demand for our products may decrease or mayfail to increase to the extent contemplated by our business plan. If we fail todevelop products that satisfy customer requirements, our ability to create orincrease demand for our products will be harmed, and we may lose current andprospective customers.

The market for SBCs is characterized byrapid technological change, frequent new product introductions and evolvingindustry requirements. We may be unable to respond quickly or effectively tothese developments. We may experience difficulties with software development,hardware design, manufacturing or marketing that could delay or prevent ourdevelopment, introduction or implementation of new products and enhancements.The introduction of new products by competitors, the emergence of new industrystandards, or the development of entirely new technologies to replace existingproduct offerings could render our existing or future products obsolete. If ourproducts become technologically obsolete, customers may purchase solutions fromour competitors and we may be unable to sell our products in the marketplaceand generate revenue.

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***If our products do notinteroperate with our customers’ existing networks, the demand for our productswill decrease and our operating results will be harmed.***

Our products must interface with ourcustomers’ existing networks, each of which may have different specifications.An unanticipated lack of interoperability may result in significant support andrepair costs and harm our relations with customers. If our products do notinteroperate with those of our customers’ networks, installations could bedelayed or orders for our products could be cancelled, which would result inlosses of revenue and customers that could significantly impair our businessand operating results.

***We rely on many distributionpartners to assist in selling our products, and if we do not develop and managethese relationships effectively, our ability to generate revenue and controlexpenses will be adversely affected.***

As of December 31, 2006, we had approximately30 distribution partners. Our success is highly dependent upon our ability tocontinue to establish and maintain successful relationships with thesedistribution partners from whom, collectively, we derive a significant portionof our revenue. Revenue derived through distribution partners accounted for 52%of our total revenue in 2005 and 48% of our total revenue in 2006. Although wehave entered into contracts with each of our distribution partners, ourcontractual arrangements are not exclusive and do not obligate our distributionpartners to order, purchase or distribute any fixed or minimum quantities ofour products. Accordingly, our distribution partners, at their sole discretion,may choose to purchase SBCs from our competitors rather than from us. Under ourcontracts with our distribution partners, our distribution partners generallyorder products from us by submitting purchase orders that describe, among otherthings, the type and quantities of our products desired, delivery date and otherdelivery terms applicable to the ordered products. Accordingly, our ability tosell our products and generate significant revenue through our distributionpartners is highly dependent on the continued desire and willingness of ourdistribution partners to purchase and distribute our products and on thecontinued cooperation between us and our distribution partners. Some of ourdistribution partners may develop competitive products in the future or mayalready have other product offerings that they may choose to offer and supportin lieu of our products. Divergence in strategy, change in focus, competitiveproduct offerings, potential contract defaults, and changes in ownership ormanagement of a distribution partner may interfere with our ability to market,license, implement or support our products with that party, which in turn couldharm our business. Some of our competitors may have stronger relationships withour distribution partners than we do, and we have limited control, if any, asto whether those partners implement our products rather than our competitors’products or whether they devote resources to market and support our competitors’products rather than our offerings.

Moreover, if we are unable to leverage oursales and support resources through our distribution partner relationships, wemay need to hire and train additional qualified sales and engineeringpersonnel. We cannot be assured, however, that we will be able to hireadditional qualified sales and engineering personnel in these circumstances,and our failure to do so may restrict our ability to generate revenue orimplement our products on a timely basis. Even if we are successful in hiringadditional qualified sales and engineering personnel, we will incur additionalcosts and our operating results, including our gross margin, may be adverselyaffected.

***Our international operationsexpose us to additional business risks, and failure to manage these risks mayadversely affect our revenue generated in foreign countries, and our overalloperating results.***

We haveemployees in Australia, Belgium, Brazil, Canada, China, France, Germany, HongKong, Israel, Italy, Japan, Korea, Malaysia, Mexico, Peru, Russia, SouthAfrica, Spain and the United Kingdom. In the coming years, we may find that thesuccess of our business may depend, in part, on our ability to expand furtherinto international markets. Any continued expansion into international marketswill require significant resources and management attention and will subject usto new regulatory, economic and political risks. Given our limited experiencein international markets, we cannot be sure that any further internationalexpansion will be successful. In addition, we will face new risks in doingbusiness 

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internationally. These risks could reduce demand for our products,lower the prices at which we can sell our products or otherwise have an adverseeffect on our operating results. Among the risks we believe are most likely toaffect us are:

·       ourability to comply with differing technical standards and certificationrequirements outside North America;

·       difficultiesand costs of staffing and managing foreign operations;

·       greaterdifficulty collecting accounts receivable and longer payment cycles;

·       unexpectedchanges in regulatory requirements;

·       reducedprotection for intellectual property rights in some countries;

·       new anddifferent sources of competition;

·       fluctuationsin currency exchange rates;

·       adversetax consequences; and

·       politicaland economic instability and terrorism.

***Because we derive all of ourrevenue from interactive communications service providers, our operatingresults will suffer if the interactive communications industry experiences aneconomic downturn.***

We derive all of our revenue from thecommunications industry. Our future success depends upon the continued demandfor communications equipment by interactive communications service providers.The communications industry is cyclical and reactive to general economicconditions. In the recent past, worldwide economic downturns, pricing pressuresand deregulation have led to consolidations and reorganizations. Thesedownturns, pricing pressures and restructurings have been causing delays andreductions in capital and operating expenditures by many interactivecommunications service providers. These delays and reductions, in turn, havebeen reducing demand for communications products like ours. A continuation orsubsequent recurrence of these industry patterns, as well as general domesticand foreign economic conditions and other factors that reduce spending bycompanies in the communications industry, could harm our operating results inthe future.

***The loss of key personnel or aninability to attract and retain additional personnel may impair our ability togrow our business.***

We are highly dependent upon the continuedservice and performance of our senior management team and key technical,marketing and production personnel, including our founders, Andrew D. Ory, whois also our President and Chief Executive Officer, and Patrick MeLampy, who isalso our Chief Technology Officer. Neither of these officers is a party to anemployment agreement with us, and either of them therefore may terminateemployment with us at any time with no advance notice. The replacement ofeither of these two officers likely would involve significant time and costs,and the loss of either of these officers may significantly delay or prevent theachievement of our business objectives.

We face intense competition for qualifiedindividuals from numerous technology, marketing, financial services,manufacturing and e-commerce companies. For example, our competitors may beable attract and retain a more qualified engineering team by offering morecompetitive compensation packages. If we are unable to attract new engineersand retain our current engineers, we may not be able to develop and service ourproducts at the same levels as our competitors and we may, therefore, losepotential customers and sales penetration in certain markets. Our failure toattract and retain suitably qualified individuals could have an adverse effecton our ability to implement our business plan and as a result, our ability tocompete effectively in the SBC market would decrease, our operating resultswould suffer and our revenues would decrease.

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***We will incur significantincreased costs as a result of operating as a public company, and ourmanagement will be required to devote substantial time to public companycompliance initiatives. If we are unable to absorb these increased costs or maintainmanagement focus on development and sales of our product offerings andservices, we may not be able to achieve our business plan.***

As a public company, we will incursignificant legal, accounting and other expenses that we did not incur as aprivate company. In addition, the Sarbanes-Oxley Act, as well as rules subsequentlyimplemented by the SEC and the Nasdaq Stock Market, have imposed a variety ofnew requirements on public companies, including requiring changes in corporategovernance practices. Our management and other personnel will need to devote asubstantial amount of time to these new compliance initiatives. Moreover, theserules and regulations will increase our legal and financial compliancecosts and will make some activities more time-consuming and costly. Forexample, we expect these new rules and regulations have made it moredifficult and expensive for us to obtain director and officer liabilityinsurance, and we have incurred substantial costs to maintain the same orsimilar coverage.

In addition, the Sarbanes-Oxley Actrequires, among other things, that we maintain effective internal controls forfinancial reporting and disclosure controls and procedures. In particular,commencing in fiscal 2007, we must perform system and process evaluation andtesting of our internal controls over financial reporting to allow managementand our independent registered public accounting firm to report on theeffectiveness of our internal controls over financial reporting, as required bySection 404 of the Sarbanes-Oxley Act. Our testing, or the subsequenttesting by our independent registered public accounting firm, may revealdeficiencies in our internal controls over financial reporting that are deemedto be material weaknesses. Our compliance with Section 404 will requirethat we incur substantial accounting expense and expend significant managementefforts. We currently do not have an internal audit group, and we will need tohire additional accounting and financial staff with appropriate public companyexperience and technical accounting knowledge. Moreover, if we are not able tocomply with the requirements of Section 404 in a timely manner, or if weor our independent registered public accounting firm identifies deficiencies inour internal controls over financial reporting that are deemed to be materialweaknesses, the market price of our stock could decline and we could be subjectto sanctions or investigations by Nasdaq, the SEC or other regulatoryauthorities, which would require additional financial and management resources.

The increased costs associated withoperating as a public company may decrease our net income or increase our netloss, and may require us to reduce costs in other areas of our business orincrease the prices of our products or services. Additionally, if theserequirements divert our management’s attention from other business concerns,they could have a material adverse effect on our business, financial conditionand results of operations.

***If we are unable to manage ourgrowth and expand our operations successfully, our business and operatingresults will be harmed and our reputation may be damaged.***

We significantly expanded our operations in2005 and 2006. For example, during the period from December 31, 2004through December 31, 2006, we increased the number of our employees andfull-time independent contractors by 142%, from 104 to 252, and we opened newsales offices in Japan and Spain. In addition, our total operating expenses forthe year ended December 31, 2005 increased by 58% as compared to thefiscal year ended December 31, 2004, and for the year ended December 31,2006 were 59% higher than for the year ended December 31, 2005. Weanticipate that further expansion of our infrastructure and headcount will berequired to achieve planned expansion of our product offerings, projectedincreases in our customer base and anticipated growth in the number of productdeployments. Our rapid growth has placed, and will continue to place, asignificant strain on our administrative and operational infrastructure. Ourability to manage our operations and growth will require us to continue torefine our operational, financial and management controls, human resourcepolicies, and reporting systems and procedures.

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We may not be able to implementimprovements to our management information and control systems in an efficientor timely manner and may discover deficiencies in existing systems andcontrols. If we are unable to manage future expansion, our ability to providehigh quality products and services could be harmed, which would damage ourreputation and brand and substantially harm our business and results ofoperations.

***Our ability to compete and thesuccess of our business could be jeopardized if we are unable to protect ourintellectual property adequately.***

Our success depends to a degree upon theprotection of our software, hardware designs and other proprietary technology.We rely on a combination of patent, copyright, trademark and trade secret laws,and confidentiality provisions in agreements with employees, distributionpartners, consultants and customers to protect our intellectual propertyrights. Other parties may not comply with the terms of their agreements withus, and we may not be able to enforce our rights adequately against theseparties. In addition, unauthorized parties may attempt to copy or otherwiseobtain and use our products or technology. Monitoring unauthorized use of ourproducts is difficult, and we cannot be certain that the steps we have takenwill prevent unauthorized use of our technology, particularly in foreigncountries where the laws may not protect our proprietary rights as fully as inthe United States. If competitors are able to use our technology, our abilityto compete effectively could be harmed. For example, if a competitor were togain use of certain of our proprietary technology, it might be able tomanufacture similarly designed and equipped SBCs at a reduced cost, which wouldresult in a decrease in demand for our products. Furthermore, we have adopted astrategy of seeking limited patent protection both in the United States and inforeign countries with respect to the technologies used in or relating to ourproducts. Others may independently develop and obtain patents for technologiesthat are similar to or superior to our technologies. If that happens, we mayneed to license these technologies and we may not be able to obtain licenses onreasonable terms, if at all, thereby causing great harm to our business. Inaddition, if we resort to legal proceedings to enforce our intellectualproperty rights, the proceedings could become burdensome and expensive, even ifwe were to prevail.

***Claims by other parties that weinfringe upon their proprietary technology could force us to redesign ourproducts or to incur significant costs.***

We maybecome involved in litigation as a result of allegations that we infringe uponintellectual property rights of others. Any parties asserting that our productsinfringe upon their proprietary rights would force us to defend ourselves, andpossibly our customers, distribution partners or contract manufacturers,against the alleged infringement. These claims and any resulting lawsuit, ifsuccessful, could subject us to significant liability for damages andinvalidation of our proprietary rights. Any potential intellectual propertylitigation also could force us to do one or more of the following:

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

·       obtainfrom the owner of the infringed intellectual property right a license to sellor use the relevant technology, which license may not be available onreasonable terms, or at all;

·       redesignthose products that use any allegedly infringing technology; or

·       refunddeposits and other amounts.

Any lawsuits regarding intellectualproperty rights, regardless of their success, could be time-consuming, could beexpensive to resolve, and would divert our management’s time and attention.

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***Compliance with regulations and standards applicable to our productsmay be time consuming, difficult and costly, and if we fail to comply, ourproduct sales will decrease.***

In order to achieve and maintain marketacceptance, our products must continue to meet a significant number ofregulations and standards. In the United States, our products must comply withvarious regulations defined by the Federal Communications Commission andUnderwriters Laboratories.

As these regulations and standards evolve,and if new regulations or standards are implemented, we will be required tomodify our products or develop and support new versions of our products, andthis will increase our costs. The failure of our products to comply, or delaysin compliance, with the various existing and evolving industry regulations andstandards could prevent or delay introduction of our products, which could harmour business. User uncertainty regarding future policies may also affect demandfor communications products, including our products. Moreover, distributionpartners or customers may require us, or we may otherwise deem it necessary oradvisable, to alter our products to address actual or anticipated changes inthe regulatory environment. Our inability to alter our products to addressthese requirements and any regulatory changes could have a material adverseeffect on our business, financial condition and operating results.

***Regulations affecting IP networkscould reduce demand for our products.***

Laws and regulations governing the Internetand electronic commerce are emerging but remain largely unsettled, even in theareas where there has been some legislative action. Regulations may focus on,among other things, assessing access or settlement charges, or imposing tariffsor regulations based on the characteristics and quality of products, either ofwhich could restrict our business or increase our cost of doing business.Government regulatory policies are likely to continue to have a major impact onthe pricing of existing and new network services and, therefore, are expectedto affect demand for those services and the communications products, includingour products, supporting those services.

Any changes to existing laws or theadoption of new regulations by federal or state regulatory authorities or anylegal challenges to existing laws or regulations affecting IP networks couldmaterially adversely affect the market for our products. In addition, theconvergence of the PSTN and IP networks could become subject to governmentalregulation, including the imposition of access fees or other tariffs, thatadversely affects the market for services and equipment, including ourproducts, for interactive communications across IP networks. User uncertaintyregarding future policies may also affect demand for communications products,including our products. Moreover, distribution partners or customers mayrequire us, or we may otherwise deem it necessary or advisable, to alter ourproducts to address actual or anticipated changes in the regulatoryenvironment. Our inability to alter our products or address any regulatorychanges could have a material adverse effect on our business, financialcondition or operating results.

***We are subject to environmental and occupational health and safetyregulations that may increase our costs of operations or limit our activities.***

We are subject to environmental andoccupational health and safety regulations relating to matters such asreductions in the use of harmful substances, comprehensive risk management inmanufacturing activities and final products, the use of lead-free soldering,and the recycling of products and packaging materials. The European Parliamentand the Counsel of the European Union have published directives on wasteelectrical and electronic equipment and on the restriction of the use of certainhazardous substances in electrical and electronic equipment. These directivesgenerally require electronics producers to bear the cost of collection,treatment, recovery and safe disposal of past and future products fromend-users and to ensure that new electrical and electronic equipment does notcontain specified hazardous substances. While the cost of these directives tous cannot be determined before regulations are adopted in individual memberstates of the European Union, it may be substantial and may divert resources,which could detract from our ability to develop new products. We may not beable to comply in all cases with applicable 

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environmentaland other regulations, and if we do not, we may incur remediation costs or wemay not be able to offer our products for sale in certain countries, whichcould adversely affect our results.

***Because our products are sophisticated and designed to be deployed incomplex environments, they may have errors or defects that we find only afterdeployment, which could result in a loss of customers and adversely affect ourreputation, future sales and operating results.***

Productsas complex as ours may contain undetected errors that result in productfailures. Our products can be fully tested only when deployed in large networkswith high volumes of traffic. Our customers may discover errors or defects inthe software or hardware, or the products may not operate as expected. If weare unable to fix errors or other performance problems identified afterdeployment of our products, we could experience:

·       a loss of,or delay in, revenue;

·       a loss ofcustomers and market share;

·       a failureto attract new customers or achieve market acceptance for our products;

·       increasedservice, support and warranty costs and a diversion of development resources;and

·       costly andtime-consuming legal actions by our customers and injury to our reputation.

Any of these results could have a materialadverse effect on our business and operating results.

***Our dependence on outsidecontractors for critical manufacturing services could result in productdelivery delays, damage our customer relations and adversely affect ouroperating results.***

We outsource the manufacturing of ourNet-Net products. We subcontract all of the manufacturing of our Net-Net 4000series of products to Jabil Circuit, Inc. and Benchmark Electronics. Wesubcontract all of the manufacturing of our Net-Net 9000 series of products toJabil Circuit, Inc. and TTM Technologies, Inc. We do not have awritten agreement with any of these manufacturers. We submit purchase orders tothese manufacturers that describe, among other things, the type and quantitiesof our products or components to be manufactured by the applicable manufacturerand the delivery date and other delivery terms applicable to the products orcomponents. Our manufacturers do not have any written contractual obligation toaccept any purchase order that we submit for the manufacture of any of ourproducts or components. If one of our manufacturers accepts in writing a purchaseorder submitted by us, the manufacturer is legally obligated to manufacture theproduct or component covered by such purchase order and we are obligated topurchase and take delivery of such product or component. Our reliance onoutside manufacturers involves a number of potential risks, including theabsence of adequate capacity, the unavailability of, or interruptions in accessto, necessary manufacturing processes, and reduced control over deliveryschedules. In addition, we cannot be certain or provide any assurance that ourmanufacturers will accept all of our purchase orders, or any of them, and agreeto manufacture and supply any or all of our manufacturing requirements for ourproducts or any components. If our manufacturers are unable or unwilling tocontinue manufacturing our products and components in required volumes, we willhave to identify one or more acceptable alternative manufacturers. The use ofnew manufacturers may cause significant interruptions in supply if the newmanufacturers have difficulty manufacturing products to our specifications.

***Certain component parts used in the manufacture of our products aresourced from single or limited sources. If our contract manufacturers areunable to obtain these components on a timely basis, we will not be able tomeet our customers’ product delivery requirements, which could harm ourreputation and adversely affect our operating results.***

Certainkey components used in the manufacture of our products are sourced from singleor, in some cases, limited sources. For example, the third parties that we hireto manufacture our products, or contract 

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manufacturers, purchase through electronics distributors various typesof network processors, traffic managers, microprocessors and network searchengines. Specifically, Applied Micro Circuits Corporation, BroadcomCorporation, Freescale Semiconductor, Inc. and Integrated DeviceTechnology, Inc., are presently the sole sources for these particularcomponents. We do not have a written agreement with any of these componentmanufacturers to guarantee the supply of the key components used in ourproducts, and we do not require any of our contract manufacturers to have awritten agreement with any of these component manufacturers. We have enteredinto arrangements under which electronics distributors have agreed to establishand maintain at least three months’ inventory of certain key components, and,at the request of our contract manufacturers, to supply all or a portion of thekey components held pursuant to this arrangement to our contract manufacturersfor use in the manufacture of our products. Our contractual arrangements withthe electronics distributors do not provide for these electronics distributorsto enter into any contract with any component manufacturer to guarantee thesupply of these key components. Our contract manufacturers provide forecasts tothe electronics distributors of our contract manufacturers’ requirements of thekey components. These electronics distributors use the forecasts to sourcethese key components from time to time, to the extent that the key componentsare available from the applicable component manufacturers, with the objectiveof maintaining at all times at least three months’ supply of the key componentsavailable for delivery to our contract manufacturers. When our contractmanufacturers require certain key components for use in the manufacture of ourproducts, we direct them to issue purchase orders to the applicable electronicsdistributor and, if the applicable electronics distributor has the requestedquantities of these key components available, it will accept the purchase orderissued by our contract manufacturers and supply the quantities of the keycomponents covered by the purchase order. Despite these arrangements, we cannotbe certain or provide any assurance that the component manufacturers willaccept all of the purchase orders, or any of them, issued by the electronicsdistributors and agree to supply any or all of the quantities requested.Accordingly, we cannot be certain or provide any assurance that theseelectronics distributors will have at all times at least three months’ supplyof these key components or any quantities of the key components in inventory orthat our contract manufacturers will be able to source their requirements ofthe key components from other sources in the event that the electronicsdistributors cannot meet our contract manufacturers’ requirements.Additionally, if our contract manufacturers underestimate our componentrequirements, they may not have an adequate supply, which could interruptmanufacturing of our products and result in delays in shipments and revenue. Ifany of our sole or limited source suppliers experience capacity constraints,work stoppages or other reductions or disruptions in output, they may notbe able to meet, or may choose not to meet, our delivery schedules. Also oursuppliers may:

·       enter intoexclusive arrangements with our competitors;

·       beacquired by our competitors;

·       stopselling their products or components to us at commercially reasonable prices;

·       refuse tosell their products or components to us at any price; or

·       be unableto obtain or have difficulty obtaining components for their products from theirsuppliers.

If our supply of any key components isdisrupted, we may be unable to deliver our products to our customers on atimely basis, which could result in lost or delayed revenue, injury to ourreputation, increased manufacturing costs and exposure to claims by ourcustomers. Even if alternate suppliers are available, we may have difficultyidentifying them in a timely manner, we may incur significant additionalexpense in changing suppliers, and we may experience difficulties or delays inthe manufacturing of our products. For example, we have customized some of ourhardware products to accommodate the design of some key components, and theloss of the sole supplier of a key customized component could require that weredesign related components to accommodate replacement components. Any failureto meet our customers’ delivery requirements could harm our reputation anddecrease our revenue.

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***Product liability claims related to our customers’networks could result in substantial costs.***

Our products are criticalto the business operations of our customers. If one of our products fails,interactive communications service provider may assert a claim for substantialdamages against us, regardless of our responsibility for the failure. Ourproduct liability insurance may not cover claims brought against us. Productliability claims could require us to spend significant time and money inlitigation or to pay significant damages. Any product liability claims, whetheror not successful, could seriously damage our reputation and our business.

***We may undertake acquisitions to further expand ourbusiness, which may pose risks to our business and dilute the ownership of ourexisting stockholders.***

Our business and ourcustomer base have been built through organic growth. While we do not have anypresent plans to acquire businesses, technologies or services, we may enterinto such arrangements in the future in order to expand our capabilities, enternew markets, or increase our market share. We do not have any experience makingsignificant acquisitions. Integrating any newly acquired businesses,technologies or services is likely to be expensive and time consuming. Tofinance any acquisitions, it may be necessary for us to raise additional fundsthrough public or private financings. Additional funds may not be available onterms that are favorable to us, and, in the case of equity financings, wouldresult in dilution to our stockholders. If we do complete any acquisitions, wemay be unable to operate the acquired businesses profitably or otherwiseimplement our strategy successfully. If we are unable to integrate any newlyacquired entities, technologies or services effectively, our business andresults of operations will suffer. The time and expense associated with findingsuitable and compatible businesses, technologies or services could also disruptour ongoing business and divert our management’s attention. Future acquisitionsby us could also result in large and immediate write-offs or assumptions ofdebt and contingent liabilities, any of which could substantially harm ourbusiness and results of operations.

***We may need additional capital in the future, which maynot be available to us, and if it is available, may dilute your ownership ofour common stock.***

We may need toraise additional funds through public or private debt or equity financings inorder to:

·       fundongoing operations;

·       takeadvantage of opportunities, including more rapid expansion of our business orthe acquisition of complementary products, technologies or businesses;

·       developnew products; or

·       respondto competitive pressures.

Any additional capitalraised through the sale of equity may dilute the ownership percentage of ourexisting stockholders. Capital raised through debt financing would require usto make periodic interest payments and may impose potentially restrictivecovenants on the conduct of our business. Furthermore, additional financingsmay not be available on terms favorable to us, or at all. A failure to obtainadditional funding could prevent us from making expenditures that may berequired to grow or maintain our operations.

**Risks RelatingOwnership of Our Common Stock**

***The price of our common stock may be volatile.***

Prior to October 13, 2006, there was no publictrading market for our common stock. The trading market for our common stock istherefore immature, and the trading price of our common stock may 

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fluctuate substantially.These fluctuations could cause investors to lose part or all of the value ofany investment in shares of our common stock.

The followingfactors, most of which are outside of our control, could cause the market priceof our common stock to decrease significantly:

·       lossof any of our major customers;

·       departureof key personnel;

·       variationsin our quarterly operating results;

·       announcementsby our competitors of significant contracts, new products or productenhancements, acquisitions, distribution partnerships, joint ventures orcapital commitments;

·       changesin governmental regulations and standards affecting our business and ourproducts, including implementation of additional regulations relating to IPnetwork communications;

·       decreasesin financial estimates or recommendations by equity research analysts;

·       salesof common stock or other securities by us in the future;

·       decreasesin market valuations of communications equipment companies; and

·       fluctuationsin stock market prices and volumes.

In the past, securitiesclass action litigation often has been initiated against a company following aperiod of volatility in the market price of the company’s securities. If classaction litigation is initiated against us, we will incur substantial costs andour management’s attention will be diverted from our operations. All of thesefactors could cause the market price of our stock to decline, and investors maylose some or all of the value of their investment.

***If equity research analysts do not publish research orreports about our business or if they issue unfavorable commentary or downgradeour common stock, the price of our common stock could decline.***

The trading market for ourcommon stock will rely in part on the research and reports that equity researchanalysts publish about us and our business. We do not control these analysts.The price of our stock could decline if one or more equity research analystsdowngrade our stock or if those analysts issue other unfavorable commentary orcease publishing reports about us or our business.

***Future sales of our common stock by existingstockholders could cause our stock price to decline.***

If our existing stockholders sell substantial amountsof our common stock in the public market, the market price of our common stockcould decrease significantly. The perception in the public market that ourstockholders might sell shares of common stock could also depress the marketprice of our common stock. Substantially all of our stockholders prior to theinitial public offering are subject to lock-up agreements with the underwritersthat restrict their ability to transfer their stock until at least April 2007.Upon expiration of the lock-up agreements, an additional 45,370,278 shares ofour common stock will be eligible for sale in the public market. The marketprice of shares of our common stock may decrease significantly when therestrictions on resale by our existing stockholders lapse and our stockholdersare able to sell shares of our common stock into the market. A decline in theprice of shares of our common stock might impede our ability to raise capitalthrough the issuance of additional shares of our common stock or other equitysecurities, and may cause you to lose part or all of your investment in ourshares of common stock.

In addition, the holders of an aggregate of 26,961,039shares of our common stock as of December 31, 2006 have rights, subject tosome conditions, to require us to file registration statements covering their 

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shares or to include theirshares in registration statements that we may file for ourselves or otherstockholders. We also have registered the issuance of all shares of commonstock that we have issued and may issue under our employee option and purchaseplans. Having registered the issuance of these shares, they can be freely soldin the public market upon issuance, subject to lock-up agreements.

Due to these factors,sales of a substantial number of shares of our common stock in the publicmarket could occur at any time. These sales, or the perception in the marketthat the holders of a large number of shares intend to sell shares, couldreduce the market price of our common stock.

***Insiders continue to have substantial control overAcme Packet and could delay or prevent a change in corporate control.***

Our directors,executive officers and principal stockholders, together with their affiliates,beneficially own, in the aggregate, approximately 62% of our outstanding sharesof common stock based on the number of shares outstanding as of December 31,2006. As a result, these stockholders, if acting together, may have the abilityto determine the outcome of matters submitted to our stockholders for approval,including the election of directors and any merger, amalgamation, consolidationor sale of all or substantially all of our assets. In addition, these persons,acting together, may have the ability to control the management and affairs ofour company. Accordingly, even though such transactions may be in the bestinterests of other stockholders, this concentration of ownership may harm themarket price of our common stock by:

·       delaying,deferring or preventing a change in control of our company;

·       impedinga merger, amalgamation, consolidation, takeover or other business combinationinvolving our company; or

·       discouraging a potentialacquirer from making a tender offer or otherwise attempting to obtain controlof our company.

***Our corporate documents and Delaware law will make atakeover of our company more difficult, which may limit the market price of ourcommon stock.***

Our restatedcharter and bylaws and Section 203 of the Delaware General Corporation Lawwill contain provisions that might enable our management to resist a takeoverof our company. These provisions might discourage, delay or prevent a change inthe control of our company or a change in our management. These provisionscould also discourage proxy contests and make it more difficult for you andother stockholders to elect directors and take other corporate actions. Theexistence of these provisions could limit the price that investors might bewilling to pay in the future for shares of our common stock. Some provisions inour restated charter and bylaws may deter third parties from acquiring us,which may limit the market price of our common stock and may not be in the bestinterests of our stockholders. These include:

·       aclassified board of directors;

·       theability of the board of directors to issue undesignated shares withoutstockholder approval, which could be used to institute a “poison pill” thatwould work to dilute the share ownership of a potential hostile acquirer,effectively preventing acquisitions that have not been approved by the board;

·       limitationson the removal of directors; and

·       advance notice requirementsfor election to the board and for proposing matters that can be acted upon atstockholder meetings.

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***If our earlier involvement in and hyperlinking to fourarticles previously posted on our website, or any other publicity regarding ourcompany or our initial public offering during the waiting period associatedwith the offering were held to violate Section 5 of the Securities Act, wecould be required to repurchase shares sold in the initial***public offering.

We participated in and hyperlinked to a June 7,2006 NewTelephony.com article entitled “Acme Packet’s Ory on Preparing to GoPublic” and an August 2006 TIA PulseOnline Member Spotlight about ourcompany, and we hyperlinked to a June 5, 2006 NetworkingPipeline.com blogarticle entitled “A VoIP IPO That Actually Makes Sense,” and a June 6,2006 Datamonitor.com article entitled “SBC Vendor Acme Seeks $85m in IPO.”

These articles included information regarding our initialpublic offering and our company. The NewTelephony.com article included quotesfrom Andrew D. Ory, our President and Chief Executive Officer, regarding theinitial public offering and our reasons for conducting the offering and the TIAPulseOnline member spotlight included quotes from Mr. Ory regarding thedevelopment of our company and our business strategy. Neither theNetworkingPipeline.com blog entry nor the Datamonitor.com article included anyquotes from us or our employees, but both provided information and commentaryon our financial information. While these articles included some of the factualstatements about us disclosed in our prospectus, they presented thesestatements in isolation, did not disclose many of the related risks anduncertainties described in the prospectus or this Annual Report and providedcommentary expressing the authors’ opinions of our company and the initialpublic offering. Notwithstanding our earlier hyperlinking to the articles, thecommentary expressed therein reflected the opinions of the authors and shouldnot be attributed to us.

It is uncertain whetherour involvement or our participation in publicity related activities could beheld to violate Section 5 of the Securities Act. If so, we could berequired to repurchase the shares sold to purchasers in this offering at theoriginal $9.50 purchase price, plus interest, for a period of one yearfollowing the date of the violation. We would contest vigorously any claim thatsuch a violation of the Securities Act had occurred.

**Item 1B.**               UnresolvedStaff Comments

Not applicable.

**Item 2.**                     Properties

We lease approximately72,000 square feet of office space in Burlington, Massachusetts pursuantto leases that expire in June 2010. We also maintain sales offices inMadrid, Spain and Tokyo, Japan. We believe that our current facilities aresuitable and adequate to meet our current needs. We intend to add newfacilities or expand existing facilities as we add employees, and we believethat suitable additional or substitute space will be available as needed toaccommodate any such expansion of our operations.

**Item 3.**                        LegalProceedings

We are not currently aparty to any material litigation, and we are not aware of any pending orthreatened litigation against us that could have a material adverse effect onour business, operating results or financial condition. The software andcommunications infrastructure industries are characterized by frequent claimsand litigation, including claims regarding patent and other intellectual propertyrights as well as improper hiring practices. As a result, we may be involved invarious legal proceedings from time to time.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders

None.

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**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities.

**Market Informationfor Common Stock**

Our common stock has been quoted on the Nasdaq GlobalMarket under the symbol “APKT” since our initial public offering on October 13,2006. Prior to that time, there was no public market for our common stock.

Thefollowing table sets forth for the indicated periods the high and low salesprices of our common stock as reported by the Nasdaq Global Market.

| ** **                                              | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------------------------------------------|------------|----------|------------|---------|------------|
| Fourth Quarter  2006 (from October 13, 2006)       |       | $        | 21.97      |    | $          | 13.00 |   |
| First Quarter 2007  (through March  13, 2007) |       | $        | 21.43      |    | $          | 14.73 |   |

 

The last reported saleprice for our common stock on the Nasdaq Global Market was $14.79 per share on March 13,2007.

**Dividend Policy**

We have never paid ordeclared any cash dividends on our common stock. We currently intend to retainearnings, if any, to finance the growth and development of our business, and wedo not expect to pay any cash dividends on our common stock in the foreseeablefuture. Payment of future dividends, if any, will be at the discretion of theboard of directors and will depend on our financial condition, results ofoperations, capital requirements, restrictions contained in current or futurefinancing instruments, and other factors the board deems relevant.

**Stockholders**

As of February 28,2007, there were 196 registered stockholders of record of our common stock.

**Stock PerformanceGraph**

The graph set forth below compares the cumulativetotal stockholder return on our common stock between October 13, 2006 (thedate of our initial public offering) and December 29, 2006, with thecumulative total return of (i) the Nasdaq Telecommunications Index and (ii) theNasdaq Composite Index, over the same period. This graph assumes the investmentof $100,000 on October 13, 2006 in our common stock, the NasdaqTelecommunications Index and the Nasdaq Composite Index, and assumes thereinvestment of dividends, if any. The graph assumes our closing sales price onOctober 13, 2006 of $15.91 per share as the initial value of our common stock.

The comparisons shown in the graph below are basedupon historical data. We caution that the stock price performance shown in thegraph below is not necessarily indicative of, nor is it intended to forecast,the potential future performance of our common stock. Information used in thegraph was obtained from FactSet Research Systems, Inc., a financial dataprovider and a source believed to be reliable. We are not responsible for anyerrors or omissions in such information.

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Priorto October 13, 2006 there was no public market for our securities. Assuch, data for the period preceding October 13, 2006 is not presented onthe graph below.

| ** **                       | ** ** | **10/13/2006** | ** ** | **10/31/2006** | ** ** | **11/30/2006** | ** ** | **12/29/2006** | ** ** |
|----------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| Acme Packet                      |       |           | 100.0      |           |       |           | 108.1      |           |       |   | 109.6 |   |   |   | 129.7 |   |   |
| Nasdaq Composite  Index          |       |           | 100.0      |           |       |           | 100.4      |           |       |   | 103.2 |   |   |   | 102.5 |   |   |
| Nasdaq  Telecommunications Index |       |           | 100.0      |           |       |           | 97.9       |           |       |   | 105.2 |   |   |   | 106.5 |   |   |

 

**Equity CompensationInformation**

For information regardingour equity compensation plans, see Note 6 of the notes to our consolidatedfinancial statements included in this Annual Report.

**Recent Sales ofUnregistered Securities**

*(a)**          Salesof Unregistered Securities*

During the year ended December 31, 2006, wegranted stock options to purchase an aggregate of 2,263,000 shares of commonstock to our employees and directors under our 2000 and 2006 Equity IncentivePlans at exercise prices ranging from $1.10 to $18.36 per share. The optionsgranted are typically exercisable over a four year period and 50% of theunvested options will vest upon certain circumstances following a change incontrol of the Company. During this period, we issued an aggregate of 801,276 shares of common stock to employees  pursuant to the exercise of stock options forcash consideration with aggregate exercise proceeds of approximately $213,000.The foregoing stock and option issuances were exempt from registration underthe Securities Act of 1933, either pursuant to Rule 701 under theSecurities Act, as transactions pursuant to a compensatory benefit plan, orpursuant to Section 4(2) under the Securities Act, as a transactionby an issuer not involving a public offering.

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*(b)**          Useof Proceeds from Public Offering of Common Stock*

In October 2006, we completed an initial publicoffering (“IPO”) of our common stock pursuant to a registration statement on Form S-1(Registration No. 333-134683) which the SEC declared effective on October 12,2006. In connection with the IPO, we sold and issued 9.7 million shares of ourcommon stock, including 1.7 million shares sold by us pursuant to theunderwriters’ full exercise of their over-allotment option, and another additional3.5 million shares of our common stock were sold by our selling stockholders. Theoffering did not terminate until after the sale of all of the shares registeredon the registration statement. All of the shares of common stock registeredpursuant to the registration statement, including the shares sold by theselling shareholders, were sold at a price to the public of $9.50 per share. Themanaging underwriters were Goldman, Sachs & Co., JPMorgan, CreditSuisse and Think Equity Partners LLC.

We raised a totalof $92.4 million in gross proceeds from the IPO, or approximately $83.2 millionin net proceeds after deducting underwriting discounts and commissions of $6.5million and other estimated offering costs of approximately $2.7 million. Nopayments for such expenses were made directly or indirectly to (i) any ofour officers or directors or their associates, (ii) any persons owning 10%or more of any class of our equity securities, or (iii) any of ouraffiliates. We did not receive any proceeds from the sale of shares in the IPOby the selling stockholders. None of our net proceeds from the  IPO have been utilized to support businessoperations. Pending such application, we have invested the remaining netproceeds in money-market mutual funds. None of the remaining net proceeds werepaid, directly or indirectly, to directors, officers, persons owning tenpercent or more of our equity securities, or any of our other affiliates. Therehas been no material change in the planned use of proceeds from our IPO fromthat described in the final prospectus filed with the SEC pursuant to Rule 424(b).

*(c)**           Purchasesof Equity Securities by the Issuer and Affiliated Purchasers*

None.

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**Item 6.**                        SelectedConsolidated Financial Data

You should read the following selected consolidatedfinancial data in conjunction with “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations,” the financial statements andrelated notes, and the other financial information included in this AnnualReport.

We derived theconsolidated financial data for the years ended December 31, 2004, 2005and 2006 and as of December 31, 2005 and 2006 from our consolidatedfinancial statements, which have been audited by Ernst & Young LLP,and are included elsewhere in this Annual Report. We derived the consolidatedfinancial data for the years ended December 31, 2002 and 2003 and as of December 31,2002, 2003, and 2004 from audited financial statements which are not includedin this Annual Report. Historical results are not necessarily indicative of theresults to be expected in future periods.

| ** **                                                                                 | ** ** | **Year Ended December 31,**                                             | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                 | ** ** | **(in thousands, except share and per share data)** | ** ** |
| **Statement  of Operations Data:**                                                         | ** ** | ** **                                                                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                                                                   |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Product                                                                                    |       | $                                                                                      | 71,810     |   | $ | 31,080 |   | $ | 14,641 |   | $ | 3,038 |   | $ | — |   |
| Maintenance, support and service                                                           |       | 12,260                                                                                 |       | 5,040 |   | 1,352 |   | 298 |   | — |   |
| Total revenue                                                                              |       | 84,070                                                                                 |       | 36,120 |   | 15,993 |   | 3,336 |   | — |   |
| Cost of revenue:                                                                           |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Product                                                                                    |       | 14,624                                                                                 |       | 8,026 |   | 5,212 |   | 918 |   | — |   |
| Maintenance, support and service                                                           |       | 2,951                                                                                  |       | 1,201 |   | 583 |   | 177 |   | — |   |
| Total cost of revenue                                                                      |       | 17,575                                                                                 |       | 9,227 |   | 5,795 |   | 1,095 |   | — |   |
| Gross profit                                                                               |       | 66,495                                                                                 |       | 26,893 |   | 10,198 |   | 2,241 |   | — |   |
| Operating  expenses:                                                                       |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Sales and marketing                                                                        |       | 23,759                                                                                 |       | 14,969 |   | 8,558 |   | 3,480 |   | 2,373 |   |
| Research and development                                                                   |       | 12,988                                                                                 |       | 8,705 |   | 5,552 |   | 4,117 |   | 3,517 |   |
| General and administrative                                                                 |       | 6,566                                                                                  |       | 3,602 |   | 2,341 |   | 2,141 |   | 1,959 |   |
| Lease abandonment                                                                          |       | —                                                                                 |       | — |   | 848 |   | — |   | — |   |
| Total operating expenses                                                                   |       | 43,313                                                                                 |       | 27,276 |   | 17,299 |   | 9,738 |   | 7,849 |   |
| Income (loss)  from operations                                                             |       | 23,182                                                                                 |       | (383 | ) | (7,101 | ) | (7,497 | ) | (7,849 | ) |
| Total other  income, net                                                                   |       | 2,239                                                                                  |       | 348 |   | 144 |   | 33 |   | 17 |   |
| Income (loss)  before benefit from income taxes                                            |       | 25,421                                                                                 |       | (35 | ) | (6,957 | ) | (7,464 | ) | (7,832 | ) |
| Benefit from  income taxes                                                                 |       | (3,443                                                                                 | )          | — |   | — |   | — |   | — |   |
| Net income (loss)                                                                          |       | $                                                                                      | 28,864     |   | $ | (35 | ) | $ | (6,957 | ) | $ | (7,464 | ) | $ | (7,832 | ) |
| Net income (loss)  per share applicable to common stockholders:                            |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Basic(1)                                                                                   |       | $                                                                                      | 0.57       |   | $ | 0.00 |   | $ | (0.47 | ) | $ | (0.52 | ) | $ | (0.55 | ) |
| Diluted(1)                                                                                 |       | $                                                                                      | 0.50       |   | $ | 0.00 |   | $ | (0.47 | ) | $ | (0.52 | ) | $ | (0.55 | ) |
| Weighted average  number of common shares used in net income (loss) per share calculation: |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Basic(1)                                                                                   |       | 50,437,801                                                                             |       | 15,240,890 |   | 14,732,597 |   | 14,380,027 |   | 14,121,414 |   |
| Diluted(1)                                                                                 |       | 57,418,796                                                                             |       | 15,240,890 |   | 14,732,597 |   | 14,380,027 |   | 14,121,414 |   |

 

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| ** **                       | ** ** | **As of December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|
| ** **                       | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Balance  Sheet Data:**         | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents       |       | $                                     | 118,714    |   | $ | 15,369 |   | $ | 16,748 |   | $ | 9,560 |   | $ | 6,820 |   |
| Working capital                  |       | 122,844                               |       | 13,783 |   | 15,134 |   | 8,588 |   | 5,210 |   |
| Total assets                     |       | 153,923                               |       | 30,399 |   | 25,902 |   | 12,427 |   | 8,928 |   |
| Indebtedness                     |       | —                                |       | — |   | 210 |   | 696 |   | 1,271 |   |
| Convertible  preferred stock     |       | —                                |       | 33 |   | 33 |   | 24 |   | 16 |   |
| Total stockholders’  equity |       | 130,937                               |       | 17,723 |   | 17,634 |   | 9,997 |   | 6,380 |   |
|                                  |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)  For information regarding the computation of per share amounts, refer tonote 2 of the notes to our consolidated financial statements, included in thisAnnual Report on Form 10-K.

**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

**CautionaryStatement**

*This Annual Report on Form 10-K, includingthe information incorporated by reference herein, contains, in addition tohistorical information, forward-looking statements. We may, in some cases, usewords such as “project,” “believe,” “anticipate,” “plan,” “expect,” “estimate,”“intend,” “continue,” “should,” “would,” “could,” “potentially,” “will,” “may”or similar words and expressions that convey uncertainty of future events oroutcomes to identify these forward-looking statements. Forward-lookingstatements in this Annual  Report on Form 10-Kmay include statements about:*

·       *our abilityto attract and retain customers;*

·       *ourfinancial performance;*

·       *ourdevelopment activities;*

·       *our positionin the session border controller market;*

·       *the benefitsof our products, services, or programs;*

·       *theadvantages of our technology as compared to that of others;*

·       *our abilityto establish and maintain intellectual property rights;*

·       *our abilityto retain and hire necessary employees and appropriately staff our operations;and*

·       *our cashneeds.*

*The outcome of the events described in theseforward-looking statements is subject to known and unknown risks, uncertaintiesand other factors that could cause actual results to differ materially from theresults anticipated by these forward-looking statements. These important factorsinclude our financial performance, difficulties in attracting and retainingcustomers, difficulties in meeting customer needs through our developmentactivities, difficulties leveraging market opportunities, poor product sales,long sales cycles, difficulties developing new products, difficulties in ourrelationships with vendors and partners, risks associated with internationaloperations, difficulty in managing rapid growth and increased competition,  and those factors we discuss in this AnnualReport on Form 10K under the caption “Risk Factors.” You should read thesefactors and the other cautionary statements made in this Annual Report on Form 10-Kas being applicable to all related forward-looking statements wherever theyappear in this Annual Report on Form 10-K. These risk factors arenot exhaustive and other sections of this Annual Report on Form 10-Kmay include additional factors which could adversely impact our business andfinancial performance.*

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**Overview**

Acme Packet, Inc. is the leading providerof session border controllers, or SBCs, that enable service providers todeliver secure and high quality interactive communications—voice, video andother real-time multimedia sessions—across IP network borders. As of December 31,2006, over 360 service providers in 75 countries have deployed our products. Wesell our products and support services through our direct sales force andapproximately 30 distribution partners, including many of the largestnetworking and telecommunications equipment vendors throughout the world.

Our headquarters are located in Burlington,Massachusetts. We maintain sales offices in Burlington, Massachusetts; Madrid,Spain and Tokyo, Japan. We  also havesales personnel in Australia, Belgium, Brazil, Canada, China, France, Germany,Hong Kong, Israel, Italy, Korea, Malaysia, Mexico, Peru, Russia and the UnitedKingdom and throughout the United States. We expect to continue to addpersonnel in the United States and internationally to provide additionalgeographic sales and technical support coverage.

In October 2006, we completed an initial publicoffering (“IPO”) of our common stock in which we sold and issued 9.7 millionshares of our common stock, including 1.7 million shares sold by us pursuant tothe underwriters’ full exercise of their over-allotment option, at an issueprice of $9.50 per share. We raised a total of $92.4 million in gross proceedsfrom the IPO, or $83.2 million in net proceeds after deducting underwritingdiscounts and commissions of $6.5 million and other offering costs of $2.7million. Upon the closing of the IPO, all shares of convertible preferred stockoutstanding automatically converted into 32.2 million shares of commonstock.

Our fiscal year ends on December 31.Reference to 2006, for example, refers to the fiscal year ended December 31,2006.

***Revenue***

We derive product revenue from the sale of our Net-Nethardware and the licensing of our Net-Net software. We generally recognizeproduct revenue at the time of product delivery, provided all other revenuerecognition criteria have been met, pursuant to the requirements of Statementof Position, or SOP, 97-2,*SoftwareRevenue Recognition*, as amended by SOP 98-9,*Software Revenue Recognition with Respect to CertainTransactions*. For arrangements that include customer acceptance orother material non-standard terms, we defer revenue recognition until afterdelivery, and all other criteria for revenue recognition have been met.

We generate maintenance, support and service revenuefrom (a) maintenance associated with software licenses, (b) technicalsupport services for our product software, (c) hardware repair andmaintenance services, (d) implementation, training and consultingservices, and (e) reimbursable travel and other out-of-pocket expenses paidto us by our customers.

We offer our products and services indirectly throughdistribution partners and directly through our sales force. Our distributionpartners include networking and telecommunications equipment vendors throughoutthe world. Our distribution partners generally purchase our products after theyhave received a purchase order from their customers and do not maintain aninventory of our products in anticipation of sales to their customers.Generally, the pricing offered to our distribution partners will be lower thanto our direct customers.

The product configuration, which reflects the mix ofsession capacity and requested features, determines the price for each SBCsold. Customers can purchase our SBCs in either a standalone or high availabilityconfiguration and can license our software in various configurations, dependingon the customers’ requirements for session capacity, feature groups andprotocols. The product software configuration mix will have a direct impact onthe average selling price of the system sold. As the market 

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continues to develop andgrow, we expect to experience increased price pressure on our products andservices.

We believe that ourrevenue and results of operations may vary significantly from quarter toquarter as a result of long sales and deployment cycles, variations in customerordering patterns, and the application of complex revenue recognition rules tocertain transactions. Some of our arrangements with customers include clausesunder which we may be subject to penalties for failure to meet specifiedperformance obligations. We have not incurred any such penalties to date.

***Cost of Revenue***

Cost of product revenue primarily consists of paymentsto third party manufacturers for purchased materials and services, salaries andbenefits related to personnel, provision for inventory obsolescence, andrelated overhead.

Cost of maintenance,support and service revenue consists primarily of (a) salaries andbenefits related to professional services and technical support personnel, (b) billableand non-billable travel, lodging, and other out-of-pocket expenses, (c) relatedoverhead, and (d) contract manufacturer services for repairs and warrantyservices.

***Gross Profit***

Our gross profit has been,and will be, affected by many factors, including (a) the demand for ourproducts and services, (b) the average selling price of our products,which in turn depends in part on the mix of product configurations sold, (c) newproduct introductions, (d) the mix of sales channels through which ourproducts are sold, and (e) the volume and costs of manufacturing of ourhardware products.

***Operating Expenses***

Operating expenses consist of sales and marketing,research and development, and general and administrative expenses.Personnel-related costs are the most significant component of each of theseexpense categories. We grew from 104 employees and full-time independentcontractors at December 31, 2004 to 252 employees and full-timeindependent contractors at December 31, 2006. We expect to continue tohire significant numbers of new employees to support our growth.

Sales and marketing expense consists primarily of (a) salariesand related personnel costs including stock-based compensation, (b) commissions,(c) travel, lodging and other out-of-pocket expenses, (d) marketingprograms such as trade shows, and (e) other related overhead. Commissionsare recorded as expense when earned by the employee. We expect absolute dollarincreases in sales and marketing expense for the foreseeable future as wefurther increase the number of sales professionals and, to a lesser extent,increase our marketing activities with the intent to grow our revenue. Weexpect sales and marketing expense to increase as a percentage of total revenuefor the foreseeable future.

Research and development expense consists primarily of(a) salaries and related personnel costs including stock-basedcompensation, (b) payments to suppliers for design and consultingservices, (c) prototype and equipment costs relating to the design anddevelopment of new products and enhancement of existing products, (d) qualityassurance and testing, and (e) other related overhead. To date, all of ourresearch and development expense has been expensed as incurred. We intend tocontinue to invest significantly in our research and development efforts, whichwe believe are essential to maintaining our competitive position. We expectresearch and development expense to increase in absolute dollars and toincrease as a percentage of total revenue for the foreseeable future. Weanticipate that research and development expense will increase as a percentageof total revenue in the long term.

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General and administrativeexpense consists primarily of (a) salaries and personnel costs related toour executive, finance, human resource and information technologyorganizations, including stock-based compensation (b) facilities expenses,(c) accounting and legal professional fees, and (d) other relatedoverhead. We expect general and administrative expense to continue to increasein absolute dollars and as a percentage of total revenue for the foreseeablefuture as we invest in infrastructure to support continued growth and incuradditional expenses related to being a publicly traded company, includingincreased audit and legal fees, costs of compliance with securities and otherregulations, investor relations expense, and higher insurance premiums.

***Stock-Based Compensation***

Through December 31,2005, cost of revenue and operating expenses include stock-based compensationexpense to the extent the fair value of our common stock exceeded the exerciseprice of stock options granted to employees on the date of grant. Effective inthe first quarter of fiscal 2006, we adopted the requirements of Statement ofFinancial Accounting Standards, or SFAS, No. 123(R),*Share Based Payment*. SFASNo. 123(R) addresses all forms of shared-based payment awards,including shares issued under employee stock purchase plans, stock options,restricted stock and stock appreciation rights. SFASNo. 123(R) requires us to expense share-based payment awards withcompensation cost for share-based payment transactions measured at fair value.We continue to evaluate the effect that the adoption of SFASNo. 123(R) will have on our financial position and results ofoperations. We currently expect that our adoption of SFASNo. 123(R) will adversely affect our operating results to some extentin future periods. For the year ended December 31, 2006, we recordedexpense of $867,000 in connection with share-based payment awards. Based onoptions granted in 2006, a future expense of non-vested options of$6.9 million is expected to be recognized over a weighted-average periodof 3.45 years. The adoption of SFAS No. 123(R) will have noeffect on our financial position or cash flow for any period.

***Other Income (Expense), Net***

Other income (expense)primarily consists of interest income earned on cash balances. We historicallyhave invested our cash in money market funds. Other income (expense) alsoincludes interest expense on our debt facilities and gains (losses) fromforeign currency translation adjustments of our foreign subsidiaries. Thefunctional currency of our foreign operations in Europe and Asia is the U.S.dollar. Accordingly, all assets and liabilities of these foreign subsidiariesare remeasured into U.S. dollars using the exchange rates in effect at thebalance sheet date. Revenue and expenses of these foreign subsidiaries areremeasured into U.S. dollars at the average rates in effect during the year.Any differences resulting from the remeasurement of assets, liabilities andoperations of the European and Asian subsidiaries are recorded within otherincome (expense).

**Application ofCritical Accounting Policies and Use of Estimates**

Our financial statements are prepared in accordancewith accounting principles generally accepted in the United States. Thepreparation of these financial statements requires that we make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during thereporting period. We base our estimates on historical experience and on variousother assumptions that we believe to be reasonable under the circumstances. Weevaluate our estimates and assumptions on an ongoing basis. Our actual resultsmay differ significantly from these estimates under different assumptions orconditions. There have been no material changes to these estimates for theperiods presented in this Annual Report.

We believe that of oursignificant accounting policies, which are described in note 2 of thenotes to our consolidated financial statements included in this Annual Reporton Form 10-K, the following accounting 

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policiesinvolve a greater degree of judgment and complexity. Accordingly, these are thepolicies we believe are the most critical to aid in fully understanding andevaluating our financial condition and results of operations.

***Revenue Recognition***

We recognize revenue in accordance with SOP 97-2,as amended by SOP 98-9, and Emerging Issues Task Force, or EITF, Issue No. 03-5,*Applicability of AICPA Statement of Position 97-2to Nonsoftware Deliverables in an Arrangement Containing More-Than-IncidentalSoftware*. We have determined that the software element of ourproduct is “more than incidental” to the products as a whole. As a result, inaccordance with EITF Issue No. 03-5, we are required to recognizerevenue under SOP 97-2 and SOP 98-9.

In all of ourarrangements, we do not recognize any revenue until we can determine thatpersuasive evidence of an arrangement exists, delivery has occurred, the fee isfixed or determinable, and we deem collection to be probable. In making thesejudgments, we evaluate these criteria as follows:

·       *Evidence of an arrangement.*We consider a non-cancelableagreement signed by the customer and us to be representative of pervasiveevidence of an arrangement.

·       *Delivery has occurred.*We consider delivery to have occurredwhen product has been delivered to the customer and no post-deliveryobligations exist. In instances where customer acceptance is required, deliveryis deemed to have occurred when customer acceptance has been achieved.

·       *Fees are fixed or determinable.*We consider the fee to befixed or determinable unless the fee is subject to refund or adjustment or isnot payable within normal payment terms. If the fee is subject to refund oradjustment, we recognize revenue when the right to a refund or adjustmentlapses. If offered payment terms exceed our normal terms, we recognize revenueas the amounts become due and payable or upon the receipt of cash.

·       *Collection is deemed probable.*We conduct a credit reviewfor all transactions at the inception of an arrangement to determine thecreditworthiness of the customer. Collection is deemed probable if, based uponour evaluation, we expect that the customer will be able to pay amounts underthe arrangement as payments become due. If we determine that collection is notprobable, revenue is deferred and recognized upon the receipt of cash.

A substantial percentage of our revenue is generatedby multiple-element arrangements, such as products, maintenance, professionalservices and training. When arrangements include multiple elements, we allocatethe total fee among the various elements using the residual method. Under theresidual method, revenue is recognized when vendor-specific objective evidence,or VSOE, of fair value exists for all of the undelivered elements of thearrangement, but does not exist for one or more of the delivered elements ofthe arrangement. Each arrangement requires us to analyze the individualelements in the transaction and to estimate the fair value of each undeliveredelement, which typically includes maintenance and services. Revenue isallocated to each of the undelivered elements based on its respective fair value,with the fair value determined by the price charged when that element is soldseparately.

Maintenance and support services include telephonesupport, return and repair services, and unspecified rights to product upgradesand enhancements, and are recognized ratably over the term of the serviceperiod, which is generally 12 months. Maintenance and support revenuegenerally is deferred until the related product has been accepted and all otherrevenue recognition criteria have been met. Professional services and trainingrevenue is recognized as the related service is performed.

Our products and servicesare distributed indirectly through distribution partners and directly throughour sales force. Revenue arrangements with distribution partners are recognizedwhen the above criteria 

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are metand only when we receive evidence that the distribution partner has an orderfrom an end-user customer. We typically do not offer contractual rights ofreturn, stock balancing or price protection to our distribution partners, andactual product returns from them have been insignificant to date. As a result,we do not maintain reserves for product returns and related allowances.

***Allowance for Doubtful Accounts***

We offset gross tradeaccounts receivable with an allowance for doubtful accounts. The allowance fordoubtful accounts is our best estimate of the amount of probable credit lossesin our existing accounts receivable. We review our allowance for doubtfulaccounts on a regular basis, and all past due balances are reviewedindividually for collectibility. Account balances are charged against theallowance after all means of collection have been exhausted and the potentialfor recovery is considered remote. Provisions for allowance for doubtfulaccounts are recorded in general and administrative expense. If our historicalcollection experience does not reflect our future ability to collectoutstanding accounts receivables, our future provision for doubtful accountscould be materially affected. To date, we have not incurred any significantwrite-offs of accounts receivable and have not been required to revise any ofour assumptions or estimates used in determining our allowance for doubtfulaccounts. As of December 31, 2006, the allowance for doubtful accounts was$695,000.

***Stock-Based Compensation***

Through December 31, 2005, we accounted for ourstock-based awards to employees using the intrinsic value method prescribed inAccounting Principles Board, or APB, Opinion No. 25,*Accounting for Stock Issued to Employees*,and related interpretations. Under the intrinsic value method, compensationexpense is measured on the date of the grant as the difference between thedeemed fair value of our common stock and the exercise or purchase pricemultiplied by the number of stock options or restricted stock awards granted. Generally,we granted stock-based compensation awards with exercise prices equal to theestimated fair value of our common stock; however, to the extent that thedeemed fair value of the common stock exceeds the exercise or purchase price ofstock-based awards granted to employees on the date of grant, the Companyamortizes the expense over the vesting schedule of the awards, generally fouryears. The fair value of our common stock for periods through December 31,2005 was determined by our board of directors (“the Board”).

Through December 31, 2005, we accounted forstock-based compensation expense for non-employees using the fair value methodprescribed by SFAS No. 123, *Accounting for Stock-BasedCompensation,* and the Black-Scholes option-pricing model, andrecorded the fair value, for financial reporting purposes, of non-employeestock options as an expense over either the vesting term of the option or theservice period.

In December 2004, the Financial Accounting StandardsBoard, or FASB, issued SFAS No. 123(R), which requires companies toexpense the fair value of employee stock options and other forms of stock-basedcompensation. We adopted SFAS No. 123(R) effective January 1,2006. SFAS No. 123(R) requires nonpublic companies that used theminimum value method in SFAS No. 123 for either recognition orpro forma disclosures to apply SFAS No. 123(R) using theprospective-transition method. As such, we will continue to apply APB Opinion No. 25in future periods to equity awards outstanding at the date of SFAS No. 123(R)’sadoption that were measured using the minimum value method. In accordance withSFAS No. 123(R), we will recognize the compensation cost ofstock-based awards on a straight-line basis over the vesting period of theaward. Effective with the adoption of SFAS No. 123(R), we haveelected to use the Black-Scholes option pricing model to determine theweighted-average fair value of stock options granted.

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As there was no public market for our common stockprior to October 13, 2006, we have determined the volatility for optionsgranted in 2006 based on an analysis of reported data for a peer group ofcompanies that issued options with substantially similar terms. The expectedvolatility of options granted has been determined using an average of thehistorical volatility measures of this peer group of companies. The expectedvolatility for options granted during 2006 was 81.44%. The expected life ofoptions has been determined utilizing the “simplified” method as prescribed bythe Securities and Exchange Commission’s Staff Accounting Bulletin No. 107,*Share-Based Payment*. During 2006, theweighted-average risk free interest rate used was 4.79%. The risk-free interestrate is based on a treasury instrument whose term is consistent with theexpected life of the stock options. We have not paid and do not anticipatepaying cash dividends on our common stock; therefore, the expected dividendyield is assumed to be zero. In addition, SFAS No. 123(R) requirescompanies to utilize an estimated forfeiture rate when calculating the expensefor the period, whereas, SFAS No. 123 permitted companies to recordforfeitures based on actual forfeitures, which was our historical policy underSFAS No. 123. As a result, we applied an estimated forfeiture rate of11.25% in 2006 in determining the expense recorded in the accompanyingconsolidated statement of operations.

Prior to our IPO there was no public market for ourcommon stock, and, in connection with our issuance of stock options andrestricted stock awards, the Board, with input from management, determined thefair value of our common stock. The Board exercised judgment in determining theestimated fair value of our common stock on the date of grant based on severalfactors, including the liquidation preferences, dividend rights and votingcontrol attributable to our then-outstanding convertible preferred stock and,primarily, the likelihood of achieving a liquidity event such as an initialpublic offering or sale of our company. In the absence of a public tradingmarket for our common stock, the Board considered objective and subjectivefactors in determining the fair value of our common stock. In addition, incertain instances, the Board engaged an unrelated third-party valuation specialistto assist management in preparing valuation reports for stock options andrestricted stock awards granted by the Board. Based upon our internal peercompany analyses and based on several arm’s-length transactions involving ourcommon stock supportive of the results produced by this valuation methodology,we believe the methodology used was reasonable.

In connection with the preparation for the IPO of ourcommon stock, we reassessed the valuations of our common stock during 2005 and2006, in light of the AICPA’s Practice Aid,*Valuation of Privately-Held-Company Equity Securities Issued as Compensation*.As a result, we reassessed the fair value of our common stock as of December 14,2005, December 23, 2005, February 7, 2006 and March 15, 2006.

Based on these reassessments, we are required torecognize compensation expense of $821,000 to reflect the difference betweenthe reassessed fair value of the our common stock and the grant price for thestock-based awards granted on December 14, 2005 and December 23, 2005and an amount equal to the difference between the value calculated using theBlack-Scholes option pricing model with the initial assessment of fair value ofcommon stock and the value calculated using the Black-Scholes option pricingmodel with the reassessed fair value of common stock for the stock-based awardsgranted on February 7, 2006 and March 22, 2006. The compensationexpense is being recognized over the vesting schedule of the awards. As aresult of these reassessments, we recognized compensation expense ofapproximately $202,000 during the year ended December 31, 2006 to reflectthe difference between the reassessed fair value of our stock and the grantprice for the stock-based awards granted. The compensation expense will continueto be recognized over the vesting schedule of the awards.

Including stock-basedcompensation expense related to the reassessment of the fair value of ourcommon stock, for the year ended December 31, 2006, we recordedstock-based compensation expense of $867,000 in connection with stock-basedpayment awards, respectively. As of December 31 2006, there was $6.9million of unrecognized compensation expense related to non-vested stock optionawards that is expected to be recognized over a weighted-average period of 3.45years.

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***Inventory***

We recognize inventorylosses based on obsolescence and levels in excess of forecasted demand. Inthese cases, inventory is written down to estimated realizable value based onhistorical usage and expected demand. Inherent in our estimates of market valuein determining inventory valuation are estimates related to economic trends,future demand for our products and technical obsolescence of our products. Iffuture demand or market conditions are less favorable than our projections,additional inventory write-downs could be required and would be reflected inthe cost of revenue in the period the revision is made. To date, we have notbeen required to revise any of our assumptions or estimates used in determiningour inventory valuations.

When products have beendelivered, but the product revenue associated with the arrangement has beendeferred as a result of not meeting the revenue recognition criteria requiredby SOP 97-2, we also defer the related inventory costs for the delivereditems.

***Product Warranties***

Substantially all of ourproducts are covered by a standard warranty of 90 days for software andone year for hardware. In the event of a failure of hardware or softwarecovered by this warranty, we must repair or replace the hardware or softwareor, if those remedies are insufficient, provide a refund. Our customerstypically purchase maintenance and support contracts, which encompass ourwarranty obligations. Our warranty reserve reflects estimated material andlabor costs for potential or actual product issues in our installed base thatare not covered under maintenance contracts but for which we expect to incur anobligation. Our estimates of anticipated rates of warranty claims and costs areprimarily based on historical information and future forecasts. We periodicallyassess the adequacy of the warranty allowance and adjust the amount asnecessary. To date, we have not been required to revise any of our assumptionsor estimates used in determining our warranty allowance. If the historical datawe use to calculate the adequacy of the warranty allowance is not indicative offuture requirements, additional warranty reserves may be required.

Some of our arrangementswith customers include clauses whereby we may be subject to penalties forfailure to meet certain performance obligations. We have not incurred any suchpenalties to date.

***Research andDevelopment Expense for Software Products***

Research and developmentexpense includes costs incurred to develop intellectual property. The costs forthe development of new software and substantial enhancements to existingsoftware are expensed as incurred until technological feasibility has beenestablished, at which time any additional costs would be capitalized. We havedetermined that technological feasibility is established at the time a workingmodel of software is completed. Because we believe our current process fordeveloping software will be essentially completed concurrently with theestablishment of technological feasibility, no costs have been capitalized todate.

***Income Taxes***

We are subject to incometaxes in both the United States and foreign jurisdictions, and we use estimatesin determining our provision for income taxes. We account for income taxes inaccordance with SFAS No. 109,*Accounting for Income Taxes*, which is the asset and liability methodfor accounting and reporting for income taxes. Under SFAS No. 109,deferred tax assets and liabilities are recognized based on temporarydifferences between the financial reporting and income tax bases of assets andliabilities using statutory rates. This process requires us to project ourcurrent tax liability and estimate our deferred tax assets and liabilities,including net operating loss (NOL’s) and tax credit carryforwards. In assessingthe need for a valuation allowance, we considered our recent operating results,future taxable income projections and feasible tax planning strategies. In theyear ended December 31, 2005, due to uncertainty 

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surroundingthe Company’s ability to utilize its remaining NOL and credit carryforwards andother deferred tax assets, we provided a full valuation allowance against ourotherwise remaining recognizable deferred tax assets. In the year ended December 31,2006, we utilized a substantial portion of our NOL carryforwards to reduceincome taxes currently payable and determined that it was more likely than notthat we would realize all of our remaining deferred tax assets. Therefore, wereduced the valuation allowance of $4.8 million in December 2006 related to thesedeferred tax assets. The benefit of the release of the valuation allowance wasrealized through a reduction of income tax expense.

As of December 31,2006, we had U.S. federal research and development tax credits of $979,000 thatexpire beginning in 2023 and state research and development tax credits of$868,000 that expire beginning in 2019, and are both subject to review andpossible adjustment by the taxing authorities. The Internal Revenue Codecontains provisions that limit the net operating losses and tax creditcarryforwards available to be used in any given year in the event of certaincircumstances, including significant changes in ownership interests, asdefined.

Our current intention isto reinvest the total amount of our unremitted earnings in the localjurisdiction or to repatriate the earnings only when tax-effective. As such, wehave not provided for U.S. taxes on the unremitted earnings of our foreignsubsidiaries.

**Results ofOperations**

***Comparison of Years Ended December 31, 2006 and2005***

*Revenue*

| ** **                               | ** ** | **Year Ended December 31,** | ** ** | ** **                             | ** ** | ** **                   |
|------------------------------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|------------------------------|
| ** **                               | ** ** | **2006**                                   | ** ** | **2005**                               | ** ** | **Period-to-Period  Change** | ** ** | ** ** |
| ** **                               | ** ** | **Amount**                                 | ** ** | **Percentage  of Total  Revenue** | ** ** | **Amount**                   | ** ** | **Percentage  of Total  Revenue** | ** ** | **Amount** | ** ** | **Percentage** | ** ** | ** ** |
| ** **                               | ** ** | **(dollars in thousands)**                 | ** ** | ** **                             |
| **Revenue by Type:**                     |       |                                       |       |                                   |       |                         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product revenue                          |       | $                                          | 71,810     |                                   |       | 85                           | % |   | $ | 31,080 |   |   | 86 | % |   | $ | 40,730 |   |   | 131 | % |   |   |
| Maintenance, support and service revenue |       | 12,260                                     |       |                                   | 15         |                         |   | 5,040 |   |   | 14 |   |   | 7,220 |   |   | 143 |   |   |   |
| Total revenue                            |       | $                                          | 84,070     |                                   |       | 100                          | % |   | $ | 36,120 |   |   | 100 | % |   | $ | 47,950 |   |   | 133 | % |   |   |
| **Revenue  by Geography:**               |       |                                       |       |                                   |       |                         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| United States and Canada                 |       | $                                          | 47,965     |                                   |       | 57                           | % |   | $ | 21,357 |   |   | 59 | % |   | $ | 26,608 |   |   | 125 | % |   |   |
| International                            |       | 36,105                                     |       |                                   | 43         |                         |   | 14,763 |   |   | 41 |   |   | 21,342 |   |   | 145 |   |   |   |
| Total revenue                            |       | $                                          | 84,070     |                                   |       | 100                          | % |   | $ | 36,120 |   |   | 100 | % |   | $ | 47,950 |   |   | 133 | % |   |   |
| **Revenue  by Sales Channel:**           |       |                                       |       |                                   |       |                         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Direct                                   |       | $                                          | 43,670     |                                   |       | 52                           | % |   | $ | 17,324 |   |   | 48 | % |   | 26,346 |   |   | 152 | % |   |   |
| Indirect                                 |       | 40,400                                     |       |                                   | 48         |                         |   | 18,796 |   |   | 52 |   |   | 21,604 |   |   | 115 |   |   |   |
| Total revenue                            |       | $                                          | 84,070     |                                   |       | 100                          | % |   | $ | 36,120 |   |   | 100 | % |   | $ | 47,950 |   |   | 133 | % |   |   |

 

The $40.7 million increase in product revenue was aresult of an increase in the number of systems sold in 2006 which reflected thegrowth in the worldwide market for our products. This growth was realizedthrough both our United States and Canadian customers and internationalcustomers, as well as through our direct and indirect sales channels. Directproduct revenues increased $22.7 million, of which $19.8 million wasattributable to United States and Canadian customers and $2.9 millionwas attributable to international customers. Indirect product revenuesincreased $18.0 million, of which $2.7 million was attributable toUnited States and Canadian customers and $15.3 million was attributable tointernational customers.

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An increase in the average selling price of oursystems due to changes in our product software configuration mix alsocontributed to the increase in product revenue in 2006. The productconfiguration, which reflects the mix of session capacity and requestedfeatures, determines the price for each SBC sold. Customers can license oursoftware in various configurations, depending on the customers’ requirementsfor session capacity, feature groups and protocols. The product softwareconfiguration mix will have a direct impact on the average selling price of thesystem sold. Systems with higher software content (higher session capacity anda larger number of feature groups) will generally have a higher average sellingprice than those systems sold with lower software content.

The $7.2 millionincrease in maintenance, support and service revenue was attributable primarilyto the $5.5 million increase in maintenance and support fees associatedwith the growth in our installed product base and a $1.7 million increase ininstallation and training revenue, including reimbursable travel expenses.

*Cost of Revenue and Gross Profit*

| ** **                       | ** ** | **Year Ended December 31,**          | ** ** | ** **                               | ** ** |
|----------------------------------|------------|--------------------------------------|------------|------------------------------------------|------------|
|                                  | ** ** | **2006**                             | ** ** | **2005**                                 | ** ** | **Period-to-Period  Change** | ** ** |
| ** **                       | ** ** | **Amount**                           | ** ** | **Percentage  of Related  Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Related  Revenue** | ** ** | **Amount** | ** ** | **Percentage** | ** ** |
| ** **                       | ** ** | **(dollars in thousands)** | ** ** |
| **Cost of Revenue:**             | ** ** | ** **                           | ** ** |                                     | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Product                          |       | $                                    | 14,624     |                                     |       | 20 | % |   | $ | 8,026 |   |   | 26 | % |   | $ | 6,598 |   |   | 82 | % |   |
| Maintenance, support and service |       | 2,951                                |       |                                     | 24         |   |   | 1,201 |   |   | 24 |   |   | 1,750 |   |   | 146 |   |   |
| Total cost of  revenue           |       | $                                    | 17,575     |                                     |       | 21 | % |   | $ | 9,227 |   |   | 26 | % |   | $ | 8,348 |   |   | 90 | % |   |
| **Gross  Profit:**               | ** ** | ** **                           | ** ** |                                     | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Product                          |       | $                                    | 57,186     |                                     |       | 80 | % |   | $ | 23,054 |   |   | 74 | % |   | $ | 34,132 |   |   | 148 | % |   |
| Maintenance, support and service |       | 9,309                                |       |                                     | 76         |   |   | 3,839 |   |   | 76 |   |   | 5,470 |   |   | 142 |   |   |
| Total gross profit               |       | $                                    | 66,495     |                                     |       | 79 | % |   | $ | 26,893 |   |   | 74 | % |   | $ | 39,602 |   |   | 147 | % |   |

 

The $6.6 million increase in product cost of revenuewas attributable to the increase in the number of systems sold in 2006.

Of the $1.8 million increase in cost of maintenance,support and service revenue, $1.2 million was due to higher salaries, benefitsand overhead associated with increases in support and training personnel,including $49,000 attributable to the effect of stock-based compensationexpense.

Product gross marginincreased by 6 percentage points, reflecting the increase in the averageselling price of our systems as a result of the changes in productconfiguration mix reflecting systems sales with a higher software content asnoted above, as well as reduced costs per system paid to our contractmanufacturers. The reduced cost per system paid to our contract manufacturerwas attributable to the ability of our contract manufacturer to purchasecomponents at a lower cost due to the increase in the volume of orders placedwith our contract manufacturers as well as labor and overhead efficienciesrealized as a result of increased manufacturing volume. We expect our grossmargin in the future to decrease, as we expect to experience increased pricepressure on our products as the market for our products continues to developand grow. We cannot predict our ability to continue to realize reduced persystem costs because we cannot predict the pricing of component parts or thevolume of orders to be placed in the future.

49

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Gross margin onmaintenance, support and service revenue remained constant. The increase inmaintenance, support and service revenue associated with the growth in ourinstalled product base was offset by a corresponding increase in costs.

*Operating Expenses*

| ** **                  | ** ** | **Year Ended December 31,**          | ** ** | ** **                             | ** ** |                         |
|-----------------------------|------------|--------------------------------------|------------|----------------------------------------|------------|------------------------------|
| ** **                  | ** ** | **2006**                             | ** ** | **2005**                               | ** ** | **Period-to-Period  Change** | ** ** |   |
|                             | ** ** | **Amount**                           | ** ** | **Percentage  of Total  Revenue** | ** ** | **Amount**                   | ** ** | **Percentage  of Total  Revenue** | ** ** | **Amount** | ** ** | **Percentage** | ** ** |   |
| ** **                  | ** ** | **(dollars in thousands)** | ** ** |
| Sales and  marketing        |       | $                                    | 23,759     |                                   |       | 28                           | % |   | $ | 14,969 |   |   | 41 | % |   | $ | 8,790 |   |   | 59 | % |   |   |
| Research and  development   |       | 12,988                               |       |                                   | 15         |                         |   | 8,705 |   |   | 24 |   |   | 4,283 |   |   | 49 |   |   |   |
| General and  administrative |       | 6,566                                |       |                                   | 8          |                         |   | 3,602 |   |   | 10 |   |   | 2,964 |   |   | 82 |   |   |   |
| Total operating expenses    |       | $                                    | 43,313     |                                   |       | 51                           | % |   | $ | 27,276 |   |   | 75 | % |   | $ | 16,037 |   |   | 59 | % |   |   |
|                             |            |                                      |            |                                        |            |                              |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Of the $8.8 millionincrease in sales and marketing expense (a) $7.0 million was attributableto higher salaries, commissions and benefits associated with a 54% increase insales and marketing personnel, primarily sales and technical sales supportstaff, on a worldwide basis, (b) $337,000 was attributable to the effectof stock-based compensation expense, (c) $264,000 was attributable toincreased third party services and (d) $259,000 was attributable toincreased expenses associated with expanded marketing programs, including tradeshows. We expect sales and marketing expense to continue to increase inabsolute dollars for the foreseeable future as we expand our sales force tocontinue to increase our revenue and market share, and to increase as apercentage of total revenue over the foreseeable future.

Of the $4.3 million increase in research anddevelopment expense, $3.5 million was attributable to higher salaries andbenefits associated with a 47% increase in the number of employees working onthe design and development of new products and enhancement of existingproducts, quality assurance and testing. The increase in research anddevelopment expense also reflected an increase in depreciation expense of$783,000 associated with our investment in equipment to support new productdevelopment and an increase of $296,000 attributable to the effect ofstock-based compensation expense. These factors were offset in part by areduction in payments to suppliers for design and consulting services in theamount of $272,000, which reflected our decision to bring certain developmentactivities in-house as well as the timing of projects. The addition ofpersonnel and our continued investment in research and development were drivenby our strategy of maintaining our competitive position by expanding our productofferings and enhancing our existing products to meet the requirements of ourcustomers and market. We expect research and development expense to increase inabsolute dollars and to increase as a percentage of total revenue for theforeseeable future.

Of the $3.0 millionincrease in general and administrative expense, (a) $909,000 wasattributable to higher salaries and benefits related to a 58% increase ingeneral and administrative headcount, (b) $920,000 was attributable toincreased legal, accounting and professional fees, (c) $269,000 wasattributable to an increase in facilities costs, including rent, utilities anddepreciation expense, associated with the overall increase in our employeeheadcount, and (d) $219,000 was attributable to higher insurance premiumsassociated with being a publicly traded company. The increase in general andadministrative expense also reflected an increase of $158,000 attributable tothe effect of stock-based compensation expense. We expect general andadministrative expense to continue to increase in absolute dollars and as apercentage of total revenue for the foreseeable future as we invest ininfrastructure to support continued growth and incur additional expensesrelated to being a publicly traded company, including increased audit and legalfees, costs of compliance with securities and other regulations, investorrelations expense, and higher insurance premiums.

50

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*Operating and Other Income*

| ** **                                      | ** ** | **Year Ended  December 31**, | ** ** | ** **                             | ** ** |
|-------------------------------------------------|------------|-----------------------------------|------------|----------------------------------------|------------|
| ** **                                      | ** ** | **2006**                          | ** ** | **2005**                               | ** ** | **Period-to-Period  Change** | ** ** |
|                                                 | ** ** | **Amount**                        | ** ** | **Percentage  of Total  Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Total  Revenue** | ** ** | **Amount** | ** ** | **Percentage** | ** ** |
| ** **                                      | ** ** | **(dollars in thousands)**        | ** ** |
| Income (loss)  from operations                  |       | $                                 | 23,182     |                                   |       | 28 | % |   |   | $ | (383 | ) |   |   | (1 | )% |   | $ | 23,565 |   |   | * |   |   |
| Interest income,  net                           |       | 2,256                             |       |                                   | 2          |   |   |   | 404 |   |   |   | 1 |   |   | 1,852 |   |   | 458 | % |   |
| Other expense                                   |       | (17                               | )          |                                   | 0          |   |   |   | (56 | ) |   |   | 0 |   |   | 39 |   |   | * |   |   |
| Income (loss)  before benefit from income taxes |       | 25,421                            |       |                                   | 30         |   |   |   | (35 | ) |   |   | 0 |   |   | 25,456 |   |   | * |   |   |
| Benefit from  income taxes                      |       | (3,443                            | )          |                                   | 4          |   |   |   | — |   |   |   | 0 |   |   | 3,443 |   |   | * |   |   |
| Net income (loss)                               |       | $                                 | 28,864     |                                   |       | 34 | % |   |   | $ | (35 | ) |   |   | 0 | % |   | $ | 28,899 |   |   | * |   |   |

 

The $23.6 million increase in income fromoperations resulted from a $39.6 million increase in gross profit, offsetin part by a $16.0 million increase in total operating expenses.

Interest income, net consisted of interest incomegenerated from the investment of our cash balances. The increase in interestincome principally reflected higher average cash balances during 2006, as aresult of our initial public offering in October 2006 and cash provided byoperating activities, as well as higher interest rates during 2006.

Other expense primarily consisted of foreign currencytranslation adjustments of our foreign subsidiaries.

In the year ended December 31,2006, we recorded a net benefit from income taxes in the amount of $3.4 million.Based on a number of factors, including recent operating results, futuretaxable income projections and feasible tax planning strategies, we determinedthat in addition to the utilization of a substantial portion of our NOLcarryforwards to reduce taxable income in 2006, it was more likely thannot that we would realize all of our deferred tax assets, and therefore wereduced our deferred tax asset valuation allowance by $4.8 million. Thisbenefit of the release in the valuation allowance was realized through areduction of income tax expense. As a result, our effective tax rate for 2006decreased to an effective tax benefit of 13.5%.

51

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***Comparison of Years Ended December 31, 2005 and2004***

*Revenue*

| ** **                                | ** ** | **Year Ended December 31,** | ** ** | ** **                             | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|
| ** **                                | ** ** | **2005**                                   | ** ** | **2004**                               | ** ** | **Period-to-Period  Change** | ** ** |
| ** **                                | ** ** | **Amount**                                 | ** ** | **Percentage  of Total  Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Total  Revenue** | ** ** | **Amount** | ** ** | **Percentage** | ** ** |
| ** **                                | ** ** | **(dollars in thousands)**       | ** ** |
| **Revenue  by Type:**                     | ** ** | ** **                                 | ** ** |                                   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Product revenue                           |       | $                                          | 31,080     |                                   |       | 86 | % |   | $ | 14,641 |   |   | 92 | % |   | $ | 16,439 |   |   | 112 | % |   |
| Maintenance,  support and service revenue |       | 5,040                                      |       |                                   | 14         |   |   | 1,352 |   |   | 8 |   |   | 3,688 |   |   | 273 |   |   |
| Total revenue                             |       | $                                          | 36,120     |                                   |       | 100 | % |   | $ | 15,993 |   |   | 100 | % |   | $ | 20,127 |   |   | 126 | % |   |
| **Revenue by Geography:**                 | ** ** | ** **                                 | ** ** |                                   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| United States and  Canada                 |       | $                                          | 21,357     |                                   |       | 59 | % |   | $ | 8,045 |   |   | 50 | % |   | $ | 13,312 |   |   | 165 | % |   |
| International                             |       | 14,763                                     |       |                                   | 41         |   |   | 7,948 |   |   | 50 |   |   | 6,815 |   |   | 86 |   |   |
| Total revenue                             |       | $                                          | 36,120     |                                   |       | 100 | % |   | $ | 15,993 |   |   | 100 | % |   | $ | 20,127 |   |   | 126 | % |   |
| **Revenue by Sales Channel:**             | ** ** | ** **                                 | ** ** |                                   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Direct                                    |       | $                                          | 17,324     |                                   |       | 48 | % |   | $ | 7,160 |   |   | 45 | % |   | $ | 10,164 |   |   | 142 | % |   |
| Indirect                                  |       | 18,796                                     |       |                                   | 52         |   |   | 8,833 |   |   | 55 |   |   | 9,963 |   |   | 113 |   |   |
| Total revenue                             |       | $                                          | 36,120     |                                   |       | 100 | % |   | $ | 15,993 |   |   | 100 | % |   | $ | 20,127 |   |   | 126 | % |   |

 

During 2005, we substantially increased our revenue inthe United States and Canada and other countries as the market for our productsbegan to develop, allowing us to diversify the individual foreign countriesfrom which we generate our revenue. Direct product revenues increased$8.1 million, all of which was attributable to United States andCanadian customers. Indirect product revenues increased $8.3 million, ofwhich $2.8 million was attributable to United States and Canadiancustomers and $5.5 million was attributable to international customers.

The $16.4 million increase in product revenue wasa result of an increase in the number of systems sold in 2005 which reflectedthe growth in the worldwide market for our products. We generated increasedproduct revenue in the United States and Canada and internationally andthrough both direct and indirect sales channels. An increase in the averageselling price of our systems due to changes in our product softwareconfiguration mix also contributed to the increase in product revenue for thisperiod. The product configuration, which reflects the mix of session capacityand requested features, determines the price for each SBC sold. Customers canlicense our software in various configurations, depending on the customers’requirements for session capacity, feature groups and protocols. The productsoftware configuration mix will have a direct impact on the average sellingprice of the system sold. Systems with a higher software content (highersession capacity and a larger number of feature groups) will generally have ahigher average selling price that those systems sold with a lower softwarecontent.

The $3.7 millionincrease in maintenance, support and service revenue was attributable primarilyto the $2.8 million increase in maintenance and support fees associatedwith the growth in our installed product base and the $815,000 increase ininstallation and training revenue.

52

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*Cost of Revenue and Gross Profit*

| ** **                       | ** ** | **Year Ended December 31,** | ** ** | ** **                                           | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                       | ** ** | **2005**                                   | ** ** | **2004**                                             | ** ** | **Period-to-Period  Change** | ** ** |
| ** **                       | ** ** | **Amount**                                 | ** ** | **Percentage   of Related   Revenue** | ** ** | **Amount** | ** ** | **Percentage   of Related   Revenue** | ** ** | **Amount** | ** ** | **Percentage** | ** ** |
| ** **                       | ** ** | **(dollars in thousands)**       | ** ** |
| **Cost of Revenue:**             | ** ** | ** **                                 | ** ** |                                                 | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Product                          |       | $                                          | 8,026      |                                                 |       | 26 | % |   | $ | 5,212 |   |   | 36 | % |   | $ | 2,814 |   |   | 54 | % |   |
| Maintenance, support and service |       | 1,201                                      |       |                                                 | 24         |   |   | 583 |   |   | 43 |   |   | 618 |   |   | 106 |   |   |
| Total cost of  revenue           |       | $                                          | 9,227      |                                                 |       | 26 | % |   | $ | 5,795 |   |   | 36 | % |   | $ | 3,432 |   |   | 59 | % |   |
| **Gross Profit:**                | ** ** | ** **                                 | ** ** |                                                 | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Product                          |       | $                                          | 23,054     |                                                 |       | 74 | % |   | $ | 9,429 |   |   | 64 | % |   | $ | 13,625 |   |   | 144 | % |   |
| Maintenance, support and service |       | 3,839                                      |       |                                                 | 76         |   |   | 769 |   |   | 57 |   |   | 3,070 |   |   | 400 |   |   |
| Total gross profit               |       | $                                          | 26,893     |                                                 |       | 74 | % |   | $ | 10,198 |   |   | 64 | % |   | $ | 16,695 |   |   | 164 | % |   |

 

The $2.8 million increase in product cost ofrevenue was attributable to the increase in the number of systems sold in 2005.

Of the $618,000 increase in cost of maintenance,support and service revenue, $606,000 was due to higher salaries, benefits andoverhead associated with increases in support and training personnel.

Product gross margin increased by 10 percentagepoints, reflecting the increase in the average selling price of our systems asa result of the changes in product configuration mix reflecting systems saleswith a higher software content as noted above, as well as reduced costs persystem paid to our contract manufacturer. The reduced cost per system paid toour contract manufacturer was attributable to the ability of our contractmanufacturer to purchase components at a lower cost due to the increase in thevolume of orders placed with our contract manufacturers as well as labor andoverhead efficiencies realized as a result of increased manufacturing volume.The increased percentage of revenue generated by our direct sales channel wasalso a factor in the increase in gross margin. Generally, our direct salesincur more selling expenses and generate a higher average selling price thanour indirect sales from our distribution channels.

Gross margin onmaintenance, support and service revenue increased by 19 percentage points as aresult of a substantial increase in maintenance, support and service revenueassociated with the growth in our installed product base without acorresponding increase in costs.

*Operating Expenses*

| ** **                  | ** ** | **Year Ended December 31,** | ** ** | ** **                             | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|
| ** **                  | ** ** | **2005**                                   | ** ** | **2004**                               | ** ** | **Period-to-Period   Change** | ** ** |
| ** **                  | ** ** | **Amount**                                 | ** ** | **Percentage  of Total  Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Total  Revenue** | ** ** | **Amount** | ** ** | **Percentage** | ** ** |
| ** **                  | ** ** | **(dollars in thousands)**       | ** ** |
| Sales and  marketing        |       | $                                          | 14,969     |                                   |       | 41 | % |   | $ | 8,558 |   |   | 53 | % |   |   | $ | 6,411 |   |   |   | 75 | % |   |
| Research and  development   |       | 8,705                                      |       |                                   | 24         |   |   | 5,552 |   |   | 35 |   |   |   | 3,153 |   |   |   | 57 |   |   |
| General and  administrative |       | 3,602                                      |       |                                   | 10         |   |   | 2,341 |   |   | 15 |   |   |   | 1,261 |   |   |   | 54 |   |   |
| Lease abandonment           |       | —                                     |       |                                   | —     |   |   | 848 |   |   | 5 |   |   |   | (848 | ) |   |   | 100 |   |   |
| Total operating  expenses   |       | $                                          | 27,276     |                                   |       | 75 | % |   | $ | 17,299 |   |   | 108 | % |   |   | $ | 9,977 |   |   |   | 58 | % |   |

 

53

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Of the $6.4 million increase in sales andmarketing expense (a) $3.9 million was attributable to highersalaries, commissions and benefits associated with a 76% increase in sales andmarketing personnel, primarily sales and technical sales support staff, on aworldwide basis (b) $1.2 million was attributable to an increase intravel expense resulting from the growth in the number of sales personnel, and (c) thebalance was primarily attributable to increased expenses associated withexpanded marketing programs, including trade shows.

Of the $3.2 million increase in research anddevelopment expense, $2.2 million was attributable to higher salaries andbenefits associated with a 45% increase in the number of employees working onthe design and development of new products and enhancement of existingproducts, quality assurance and testing. The increase in research anddevelopment expense also reflected an increase in payments to suppliers fordesign and consulting services of $692,000. The addition of personnel and ourcontinued investment in research and development were driven by our strategy ofmaintaining our competitive position by expanding our product offerings andenhancing our existing products to meet the requirements of our customers andmarket.

Of the $1.3 million increase in general andadministrative expense, (a) $429,000 was attributable to higher salariesand benefits related to a 50% increase in general and administrative headcount,(b) $312,000 was attributable to an increase in facilities costs,including rent, utilities and depreciation expense, associated with the overallincrease in our employee headcount, and (c) $165,000 was attributable toincreased legal and accounting fees.

During 2004, we recorded alease abandonment loss of $848,000 related to the relocation of our corporateheadquarters in January 2005. Of this charge, $760,000 represented a losson the prior facility’s lease and $88,000 related to the abandonment of relatedfixed assets and leasehold improvements.

*Operating and OtherIncome*

| ** **            | ** ** | **Year Ended December 31,** | ** ** | ** **                             | ** ** |
|-----------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|
| ** **            | ** ** | **2005**                                   | ** ** | **2004**                               | ** ** | **Period-to-Period   Change** | ** ** |
| ** **            | ** ** | **Amount**                                 | ** ** | **Percentage  of Total  Revenue** | ** ** | **Amount** | ** ** | **Percentage  of Total  Revenue** | ** ** | **Amount** | ** ** | **Percentage** | ** ** |
| ** **            | ** ** | **(dollars in thousands)**       | ** ** |
| Loss from  operations |       |                                       | $          | (383                                   | )          |   |   | (1 | )% |   | $ | (7,101 | ) |   | (44 | )% |   |   | $ | 6,718 |   |   |   | 95 | % |   |
| Interest income       |       |                                       | 410        |                                   |       |   | 1 |   |   | 177 |   |   | 1 |   |   |   | 233 |   |   |   | 132 |   |   |
| Interest expense      |       |                                       | (6         | )                                      |       |   | 0 |   |   | (33 | ) |   | 0 |   |   |   | 27 |   |   |   | 82 |   |   |
| Other expense         |       |                                       | (56        | )                                      |       |   | 0 |   |   | — |   |   | — |   |   |   | (56 | ) |   |   | * |   |   |
| Net (loss) income     |       |                                       | $          | (35                                    | )          |   |   | 0 | % |   | $ | (6,957 | ) |   | (43 | )% |   |   | $ | 6,922 |   |   |   | 99 | % |   |

----

*                     *Not meaningful.*

The $6.7 million decrease in loss from operationsresulted from a $16.7 million increase in gross profit, offset in part bya $10.0 million increase in total operating expenses.

Interest income, net consisted of interest incomegenerated from the investment of our cash balances. The increase in interestincome principally reflected higher average cash balances during 2005, in partfrom our sale of Series C convertible preferred stock in June 2004and in part from operating activities, as well as higher interest rates during2005.

The reduction in interest expense reflected loweroutstanding balances in 2005 under our equipment line of credit facility.

Other expense primarilyconsisted of foreign currency translation adjustments of our foreignsubsidiaries.

54

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**Liquidity andCapital Resources**

***Resources***

Since 2005, we havefunded our operations principally with cash provided by operations, which wasdriven by growth in revenue. In October 2006, we completed an IPO of ourcommon stock in which we sold and issued 9.7 million shares of our commonstock, including 1.7 million shares sold by us pursuant to the underwriters’full exercise of their over-allotment option, at an issue price of $9.50 pershare. We raised a total of $92.4 million in gross proceeds from the IPO, or$83.2 million in net proceeds after deducting underwriting discounts andcommissions of $6.5 million and other offering costs of $2.7 million.

Key measures of our liquidity are as follows:

| ****                                             | ** ** | **As of and for the Year Ended  December 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                                                           | ** ** |
| Cash and cash  equivalents                       |       | $                                                                                 | 118,714    |   | $ | 15,369 |   | $ | 16,748 |   |
| Accounts  receivable, net                        |       | 14,337                                                                            |       | 6,959 |   | 4,195 |   |
| Working capital                                  |       | 122,844                                                                           |       | 13,783 |   | 15,134 |   |
| Cash provided by  (used in) operating activities |       | 26,331                                                                            |       | 2,326 |   | (4,657 | ) |
| Cash provided by (used  in) financing activities |       | 83,483                                                                            |       | (86 | ) | 14,106 |   |
|                                                  |            |                                                                                   |            |  |  |  |  |  |  |  |

 

*Cashand cash equivalents.**  *Ourcash and cash equivalents at December 31, 2006 were held for workingcapital purposes and were invested primarily in money market funds. We do notenter into investments for trading or speculative purposes. Restricted cash,which totaled $479,000 at December 31, 2006 and $432,000 at December 31,2005, and is not included in cash and cash equivalents, was held incertificates of deposit as collateral for letters of credit related to thelease agreements for our corporate headquarters in Burlington, Massachusetts,our sales office in Madrid, Spain, and our former headquarters in Woburn,Massachusetts.

*Accountsreceivable, net.**  *Ouraccounts receivable balance fluctuates from period to period, which affects ourcash flow from operating activities. The fluctuations vary depending on thetiming of our shipping and billing activity, cash collections, and changes toour allowance for doubtful accounts. In some situations we receive cash paymentfrom a customer prior to the time we are able to recognize revenue on atransaction. We record these payments as deferred revenue, which has a positiveeffect on our accounts receivable balances. We use days sales outstanding, orDSO, calculated on a quarterly basis, as a measurement of the quality andstatus of our receivables. We define DSO as (a) accounts receivable, netof allowance for doubtful accounts, divided by total revenue for the mostrecent quarter, multiplied by (b) 90 days. DSO was 54 days at December 31,2006, 50 days at December 31, 2005 and 60 days at December 31,2004.

*Operatingactivities.**  *Cashprovided by (used in) operating activities primarily consists of net income(loss) adjusted for certain non-cash items including depreciation andamortization, deferred income taxes, the provision for bad debts, stock-basedcompensation expense, and the effect of changes in working capital and otheractivities. Cash provided by operating activities in 2006 was$26.3 million and consisted of $28.9 million of net income, negativenon-cash adjustments of $89,000 (primarily deferred income taxes of $4.8 millionoffset by depreciation and amortization of $3.5 million, $867,000 ofstock-based compensation expense, and $343,000 for provision for bad debts),and $2.4 million used in working capital and other activities. Cash usedin working capital and other activities primarily reflected a $7.7 millionincrease in accounts receivable, a $3.9 million increase in inventory, anda $1.1 million increase in other assets, reflecting an overall increase inbusiness activity, partially offset by a $6.6 million increase in accountspayable and accrued expenses and a $3.9 million increase in deferred revenue.This increase in deferred 

55

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revenue was primarilyattributable to an increase in deferred revenue from our support servicecontracts, which will be recognized as revenue over the twelve-month term ofthe support service period.

Cash provided by operating activities in 2005 was$2.3 million and consisted of $35,000 of net loss and positive non-cashadjustments of $2.4 million (primarily depreciation and amortization).Working capital and other activities remained flat during 2005 but the net activityconsisted of a $3.2 million increase in accounts receivable as a result ofincreased revenues in 2005 and a $1.3 million increase in inventoryto support the overall increase in business activity, offset by a$2.5 million increase in accounts payable and accrued expenses. Workingcapital also reflected a $2.2 million increase in deferred revenueresulting from an increase in payments received from customers prior to thetime revenue could be recognized and an increase in deferred support revenuewhich will be recognized as revenue over the term of the support periods.

Cash used in operating activities in 2004 was$4.7 million and consisted of $7.0 million of net loss, positivenon-cash adjustments of $1.4 million (primarily depreciation andamortization) and $899,000 provided by working capital and other activities.Cash provided by working capital and other activities primarily reflected a$3.5 million increase in accounts payable and accrued expenses and a$2.9 million increase in deferred revenue, offset in part by a$3.7 million increase in accounts receivable as a result of increasedrevenues in 2004 and a $1.6 million increase in inventory to supportthe overall increase in business activity.

*Equityfinancing activities.**  *InOctober 2006, we completed an initial public offering of our common stockin which we sold and issued 9.7 million shares of our common stock, including1.7 million shares sold by us pursuant to the underwriters’ full exercise oftheir over-allotment option, at an issue price of $9.50 per share. We raised atotal of $92.4 million in gross proceeds from the IPO, or $83.2 million in netproceeds after deducting underwriting discounts and commissions of $6.5 millionand other offering costs of $2.7 million. We raised an additional$14.4 million of net proceeds through sales of our Series Cconvertible preferred stock in June 2004. In addition, we receivedproceeds from the issuance of restricted common stock and exercises of commonstock options, net of the amount paid for the repurchase of common stock, inthe amounts of $159,000 in 2004, $64,000 in 2005 and $213,000 in 2006.

*Creditfacility borrowings.**  *Wepreviously maintained an equipment line of credit facility with a commercialbank under which we made borrowings of $1.8 million in 2001 and 2002. Thisequipment line of credit expired in 2003 and was converted into a term loanwhich was repaid in 2005. Additionally, during 2003, 2004 and 2005 wemaintained two lines of credit with a commercial bank in the amount of$2.0 million. We did not draw against these lines of credit and theyexpired unused in July 2005. Based on information currently available tous, we believe that we will be able to enter into such an arrangement with acommercial bank on terms acceptable to us in the event we subsequentlydetermine that such an arrangement is necessary or desirable to provide us withadditional working capital.

We believe our existingcash and cash equivalents and our cash flow from operating activities will besufficient to meet our anticipated cash needs for at least the next twelvemonths. Our future working capital requirements will depend on many factors,including the rate of our revenue growth, our introduction of new products andenhancements, and our expansion of sales and marketing and product developmentactivities. To the extent that our cash and cash equivalents and cash flow fromoperating activities are insufficient to fund our future activities, we mayneed to raise additional funds through bank credit arrangements or public orprivate equity or debt financings. We also may need to raise additional fundsin the event we determine in the future to effect one or more acquisitions ofbusinesses, technologies and products that will complement our existingoperations. In the event additional funding is required, we may not be able toobtain bank credit arrangements or effect an equity or debt financing on termsacceptable to us or at all.

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***Requirements***

*Capitalexpenditures.**  *Wehave made capital expenditures primarily for evaluation systems for customersales opportunities and equipment to support product development, as well asfor leasehold improvements and other general purposes to support our growth.Our capital expenditures totaled $6.4 million in 2006, $3.6 millionin 2005, and $2.1 million in 2004. We are not currently party to anypurchase contracts related to future capital expenditures.

*Contractual obligationsand requirements.**  *We generally do not enter into long-termpurchase arrangements, and do not have any such commitments outstanding as ofDecember 31, 2006. Our only significant contractual obligationrelates to the leases of our corporate headquarters in Burlington, Massachusettsand our office in Madrid Spain. The following table sets forth our commitmentsto settle contractual obligations in cash after December 31, 2006:

| ** **                                     | ** ** | **2007**                | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|-----------|------------|
| ** **                                     | ** ** | **(in thousands)** | ** ** |
| Operating leases  as of December 31, 2006 |       | $                       | 1,218      |     | $          | 1,264    |       | $        | 1,327      |     | $          | 706       |       |   | $ | 38 |   |   | $ | 4,553 |   |
|                                                |            |                         |            |          |            |          |            |          |            |          |            |           |            |  |  |  |  |  |  |  |  |

 

***Off-Balance-Sheet Arrangements***

As of December 31,2006, we did not have any significant off-balance-sheet arrangements, asdefined in Item 303(a)(4)(ii) of Regulation S-K of the SEC.

***Recent Accounting Pronouncements***

In July 2006, the Financial Accounting StandardsBoard (“FASB”) issued Financial Accounting Standards Interpretation (FIN) No. 48,*Accounting for Uncertainty in Income Taxes*,which is an interpretation of SFAS No. 109. FIN 48 clarifies theaccounting for income taxes by prescribing the minimum recognition threshold atax position is required to meet before being recognized in the financialstatements. FIN 48 also provides guidance on derecognition, measurement, classification,interest and penalties, accounting in interim periods, disclosure andtransition. In addition, FIN 48 clearly scopes out income taxes from SFAS No. 5,*Accounting for Contingencies*. FIN 48 iseffective for fiscal years beginning after December 15, 2006. We willimplement this interpretation in the fiscal year starting January 1, 2007.We are currently analyzing the effect, if any, FIN 48 will have on ourconsolidated financial position and our results of operations.

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*, whichdefines fair value, establishes a framework for measuring fair value undergenerally accepted accounting principles, and expands disclosures about fairvalue measurements. SFAS No. 157 applies to other accountingpronouncements that require or permit fair value measurements. The new guidanceis effective for financial statements issued for fiscal years beginning after November 15,2007, and for interim periods within those fiscal years. We are currently analyzingthe effect, if any, SFAS No. 157 will have on our consolidated financialposition and results of operations.

In September 2006,the United States Securities and Exchange Commission issued Staff AccountingBulletin (SAB) No. 108, *Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements*. SAB 108 provides guidance on theconsideration of the effects of prior year misstatements in quantifying currentyear misstatements for the purpose of a materiality assessment. SAB 108establishes an approach that requires quantification of financial statementerrors based on the effects of each of the company’s balance sheet andstatement of operations financial statements and the related financial statementdisclosures. The SAB permits existing public companies to record the cumulativeeffect of initially applying this approach in the first year ending after November 15,2006 by recording the necessary correcting adjustments to the carrying valuesof assets and liabilities as of the beginning of that year with the offsettingadjustment recorded to the opening balance of retained 

57

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earnings.Additionally, the use of the cumulative effect transition method requiresdetailed disclosure of the nature and amount of each individual error beingcorrected through the cumulative adjustment and how and when it arose. Theadoption of SAB 108 did not have a material impact on our consolidatedfinancial position, results of operations or liquidity.

**Item7A.****                Quantitative andQualitative Disclosures About Market Risk**

Market risk represents therisk of loss that may impact our financial position due to adverse changes infinancial market prices and rates. Our market risk exposure is primarily aresult of fluctuations in foreign exchange rates and interest rates. We do nothold or issue financial instruments for trading purposes.

***Foreign Currency Exchange Risk***

To date, substantially allof our international customer agreements have been denominated inU.S. dollars. Accordingly, we have limited exposure to foreign currencyexchange rates and do not enter into foreign currency hedging transactions. Thefunctional currency of our foreign operations in Europe and Asia is theU.S. dollar. Accordingly, all assets and liabilities of these foreignsubsidiaries are remeasured into U.S. dollars using the exchange rates ineffect at the balance sheet date. Revenue and expenses of these foreignsubsidiaries are remeasured into U.S. dollars at the average rates in effectduring the year. Any differences resulting from the remeasurement of assets,liabilities and operations of the European and Asian subsidiaries are recordedwithin other income in the consolidated statements of operations. If theforeign currency exchange rates fluctuated by 10% as of December 31, 2006,our foreign exchange exposure would have fluctuated by less than $10,000.

***Interest Rate Risk***

At December 31, 2006, we had unrestricted cashand cash equivalents totaling $118.7 million. These amounts were investedprimarily in money market funds. The unrestricted cash and cash equivalentswere held for working capital purposes. We do not enter into investments fortrading or speculative purposes. Due to the short-term nature of theseinvestments, we believe that we do not have any material exposure to changes inthe fair value of our investment portfolio as a result of changes in interestrates. Declines in interest rates, however, would reduce future investmentincome.

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**Item 8**.   **Financial Statement and Supplementary Data**

**ACMEPACKET, INC.INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

|                                                                                                                 | ** ** | **Page No.** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|
| Report of Independent Registered Public Accounting  Firm                                                        |       |              | 60         |   |   |
| Consolidated  Balance Sheets as of December 31, 2006 and 2005                                              |       |              | 61         |   |   |
| Consolidated Statements of Operations for the Years  Ended December 31, 2006, 2005 and 2004                |       |              | 62         |   |   |
| Consolidated Statements of Stockholders’ Equity for  the Years Ended December 31, 2006, 2005 and 2004 |       |              | 63         |   |   |
| Consolidated Statements of Cash Flows for the Years Ended  December 31, 2006, 2005 and 2004                |       |              | 64         |   |   |
| Notes to Consolidated Financial Statements                                                                      |       |              | 65         |   |   |

 

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

**TheBoard of Directors and Stockholders ofAcme Packet, Inc.**

We have audited the accompanying consolidated balancesheets of Acme Packet, Inc. and subsidiaries (the “Company”) as of December 31,2006 and 2005, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the three years in the periodended December 31, 2006. These financial statements are the responsibilityof the Company’s management. Our responsibility is to express an opinion onthese financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. We were not engaged to perform an audit of the Company’s internalcontrol over financial reporting. Our audits included consideration of internalcontrol over financial reporting as a basis for designing auditprocedures  that are appropriate in the circumstances, but not for thepurpose of expressing an opinion on the effectiveness of the Company’s internalcontrol over financial reporting. Accordingly, we express no such opinion. Anaudit also includes examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements, assessing the accountingprinciples used and significant estimates made by management, and evaluatingthe overall financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Acme Packet, Inc. and subsidiaries at December 31, 2006and 2005, and the consolidated results of their operations and their cash flowsfor each of the three years in the period ended December 31, 2006, inconformity with U.S. generally accepted accounting principles.

As discussed in Note 2 tothe consolidated financial statements, on January 1, 2006, the Companyadopted the provisions of Statement of Financial Accounting Standards No. 123(R),*Share-Based Payment*.
|                                           | /s/ Ernst &  Young LLP |
|-------------------------------------------|----------------------------|
| Boston, Massachusetts  March 7, 2007 |                       |

 

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**ACME PACKET, INC.** CONSOLIDATED BALANCE SHEETS(in thousands, except share and per share data)

| ** **                                                                                                     | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                     |       |                  |       |   |   |
| Current assets:                                                                                                |       |                  |       |   |   |
| Cash and cash equivalents                                                                                      |       | $                     | 118,714    |   | $ | 15,369 |   |
| Accounts receivable, net of allowance of $695 and  $433, respectively                                          |       | 14,337                |       | 6,959 |   |
| Inventory                                                                                                      |       | 7,211                 |       | 3,281 |   |
| Restricted cash                                                                                                |       | 150                   |       | 132 |   |
| Deferred tax asset                                                                                             |       | 3,515                 |       | — |   |
| Other current assets                                                                                           |       | 1,531                 |       | 428 |   |
| Total current assets                                                                                           |       | 145,458               |       | 26,169 |   |
| Property and equipment, net                                                                                    |       | 6,857                 |       | 3,926 |   |
| Restricted cash                                                                                                |       | 329                   |       | 300 |   |
| Deferred tax asset                                                                                             |       | 1,265                 |       | — |   |
| Other assets                                                                                                   |       | 14                    |       | 4 |   |
| Total assets                                                                                                   |       | $                     | 153,923    |   | $ | 30,399 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                  |       |                  |       |   |   |
| Current liabilities:                                                                                           |       |                  |       |   |   |
| Accounts payable                                                                                               |       | $                     | 5,354      |   | $ | 2,623 |   |
| Accrued expenses and other current liabilities                                                                 |       | 7,859                 |       | 4,222 |   |
| Deferred revenue                                                                                               |       | 9,401                 |       | 5,541 |   |
| Total current liabilities                                                                                      |       | 22,614                |       | 12,386 |   |
| Deferred rent                                                                                                  |       | 372                   |       | 290 |   |
| Commitments and  contingencies (Note 7)                                                                        |       |                  |       |   |   |
| Stockholders’  equity:                                                                                    |       |                  |       |   |   |
| Series A  convertible preferred stock, $0.001 par value:                                                  |       |                  |       |   |   |
| Authorized—0  and 3,759,531 shares at December 31, 2006 and 2005, respectively                       |       |                  |       |   |   |
| Issued and outstanding—0 and 3,759,531 shares at  December 31, 2006 and 2005, respectively           |       | —                |       | 4 |   |
| Series B  convertible preferred stock, $0.001 par value:                                                  |       |                  |       |   |   |
| Authorized—0  and 21,467,931 shares at December 31, 2006 and 2005, respectively                      |       |                  |       |   |   |
| Issued and outstanding—0 and 20,676,816 shares at  December 31, 2006 and 2005, respectively          |       | —                |       | 21 |   |
| Series C  convertible preferred stock, $0.001 par value:                                                  |       |                  |       |   |   |
| Authorized—0  and 8,021,390 shares at December 31, 2006 and 2005, respectively                       |       |                  |       |   |   |
| Issued and outstanding—0 and 7,754,012 shares at  December 31, 2006 and 2005, respectively           |       | —                |       | 8 |   |
| Undesignated  preferred stock, $0.001 par value:                                                               |       |                  |       |   |   |
| Authorized—5,000,000  and 0 shares at December 31, 2006 and 2005, respectively                       |       |                  |       |   |   |
| Issued and outstanding—0 shares at December 31,  2006 and 2005                                       |       | —                |       | — |   |
| Common  stock, $0.001 par value:                                                                               |       |                  |       |   |   |
| Authorized—150,000,000  and 61,000,000 shares at December 31, 2006 and 2005, respectively            |       |                  |       |   |   |
| Issued and outstanding—58,565,985 and 15,853,171  shares at December 31, 2006 and 2005, respectively |       | 59                    |       | 16 |   |
| Additional paid-in capital                                                                                     |       | 130,306               |       | 45,966 |   |
| Retained earnings (deficit)                                                                                    |       | 572                   |       | (28,292 | ) |
| Total stockholders’ equity                                                                                |       | 130,937               |       | 17,723 |   |
| Total liabilities  and stockholders’ equity                                                               |       | $                     | 153,923    |   | $ | 30,399 |   |

 

See accompanying notes.

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**ACMEPACKET, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except share and per share data)**

| ** **                                                                                        | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                        | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                                                                          |       |                                        |       |   |   |   |   |
| Product                                                                                           |       | $                                           | 71,810     |   | $ | 31,080 |   | $ | 14,641 |   |
| Maintenance, support and service                                                                  |       | 12,260                                      |       | 5,040 |   | 1,352 |   |
| Total revenue                                                                                     |       | 84,070                                      |       | 36,120 |   | 15,993 |   |
| Cost of revenue(1):                                                                               |       |                                        |       |   |   |   |   |
| Product                                                                                           |       | 14,624                                      |       | 8,026 |   | 5,212 |   |
| Maintenance, support and service                                                                  |       | 2,951                                       |       | 1,201 |   | 583 |   |
| Total cost of revenue                                                                             |       | 17,575                                      |       | 9,227 |   | 5,795 |   |
| Gross profit                                                                                      |       | 66,495                                      |       | 26,893 |   | 10,198 |   |
| Operating expenses(1):                                                                            |       |                                        |       |   |   |   |   |
| Sales and marketing                                                                               |       | 23,759                                      |       | 14,969 |   | 8,558 |   |
| Research and development                                                                          |       | 12,988                                      |       | 8,705 |   | 5,552 |   |
| General and administrative                                                                        |       | 6,566                                       |       | 3,602 |   | 2,341 |   |
| Lease abandonment                                                                                 |       | —                                      |       | — |   | 848 |   |
| Total operating expenses                                                                          |       | 43,313                                      |       | 27,276 |   | 17,299 |   |
| Income (loss)  from operations                                                                    |       | 23,182                                      |       | (383 | ) | (7,101 | ) |
| Other income (expense):                                                                           |       |                                        |       |   |   |   |   |
| Interest income                                                                                   |       | 2,256                                       |       | 410 |   | 177 |   |
| Interest expense                                                                                  |       | —                                      |       | (6 | ) | (33 | ) |
| Other expense                                                                                     |       | (17                                         | )          | (56 | ) | — |   |
| Total other income, net                                                                           |       | 2,239                                       |       | 348 |   | 144 |   |
| Income (loss)  before benefit from income taxes                                                   |       | 25,421                                      |       | (35 | ) | (6,957 | ) |
| Benefit from  income taxes                                                                        |       | (3,443                                      | )          | — |   | — |   |
| Net income (loss)                                                                                 |       | $                                           | 28,864     |   | $ | (35 | ) | $ | (6,957 | ) |
| Net income (loss) per  share applicable to common stockholders (Note 2):                     |       |                                        |       |   |   |   |   |
| Basic                                                                                             |       | $                                           | 0.57       |   | $ | — |   | $ | (0.47 | ) |
| Diluted                                                                                           |       | $                                           | 0.50       |   | $ | — |   | $ | (0.47 | ) |
| Weighted average number  of common shares used in net income (loss) per common share calculation: |       |                                        |       |   |   |   |   |
| Basic                                                                                             |       | 50,437,801                                  |       | 15,240,890 |   | 14,732,597 |   |
| Diluted                                                                                           |       | 57,418,796                                  |       | 15,240,890 |   | 14,732,597 |   |
| (1)   Amounts include stock-based compensation expense  as follows:                |
| Cost of product revenue                                                                           |       | $                                           | 27         |   | $ | — |   | $ | — |   |
| Cost of maintenance, support and service revenue                                                  |       | 49                                          |       | — |   | — |   |
| Sales and marketing                                                                               |       | 337                                         |       | — |   | 2 |   |
| Research and development                                                                          |       | 296                                         |       | — |   | — |   |
| General and administrative                                                                        |       | 158                                         |       | — |   | — |   |

 

See accompanying notes.

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**ACMEPACKET, INC.CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(in thousands, except share data)**

| ** **                                                                                                               | ** ** | **Series A Convertible  Preferred Stock** | ** ** | **Series B Convertible  Preferred Stock** | ** ** | **Series C Convertible  Preferred Stock** | ** **  | **Common Stock**             | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **                       | ** ** | ** **             | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|-------------|------------------------------|------------|----------------------------------|------------|------------------------------|------------|----------------------------------|------------|------------------------|------------|
| ** **                                                                                                               | ** ** | **Number of   Shares**          | ** ** | **$0.001   Par   Value**        | ** ** | **Number of  Shares**                | ** **  | **$0.001  Par   Value** | ** ** | **Number of   Shares** | ** ** | **$0.001  Par   Value** | ** ** | **Number of   Shares** | ** ** | **$0.001  Par  Value** | ** ** | **Additional   Paid-in   Capital** | ** ** | **Notes  Receivable  From  Employees** | ** ** | **Retained  Earnings  (Deficit)** | ** ** | **Total  Stockholders’   Equity** | ** ** |
| Balance at December 31, 2003                                                                                        |       | 3,759,531                                 |       |                                      | $          | 4                                         |        | 20,676,816                   |       |                             | $          | 21                           |       | —                           |       |                   | $          | — |   | 15,088,636 |   |   | $ | 15 |   | $ | 31,317 |   |   | $ | (60 | ) | $ | (21,300 | ) |   | $ | 9,997 |   |
| Issuance of restricted common stock                                                                                      |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | 454,000    |   |   | 1 |   | 139 |   |   | — |   | — |   |   | 140 |   |
| Issuance of Series C convertible preferred  stock, net of offering costs of $67                                |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | 7,754,012                    |       |                             | 8          |                   | —     |   |   | — |   | 14,425 |   |   | — |   | — |   |   | 14,433 |   |
| Repurchase and retirement of common stock                                                                                |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | (7,813     | ) |   | — |   | (1 | ) |   | — |   | — |   |   | (1 | ) |
| Exercise of stock options                                                                                                |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | 100,008    |   |   | — |   | 20 |   |   | — |   | — |   |   | 20 |   |
| Issuance of common stock for professional services                                                                       |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | 8,237      |   |   | — |   | 2 |   |   | — |   | — |   |   | 2 |   |
| Net loss                                                                                                                 |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | —     |   |   | — |   | — |   |   | — |   | (6,957 | ) |   | (6,957 | ) |
| Balance at December 31, 2004                                                                                        |       | 3,759,531                                 |       |                                      | 4          |                                      | 20,676,816  |                         |       | 21                               |       | 7,754,012                    |       |                             | 8          |                   | 15,643,068 |   |   | 16 |   | 45,902 |   |   | (60 | ) | (28,257 | ) |   | 17,634 |   |
| Issuance of restricted common stock                                                                                      |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | 45,500     |   |   | — |   | 30 |   |   | — |   | — |   |   | 30 |   |
| Repurchase and retirement of common stock                                                                                |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | (1,021     | ) |   | — |   | — |   |   | — |   | — |   |   | — |   |
| Exercise of stock options                                                                                                |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | 165,624    |   |   | — |   | 34 |   |   | — |   | — |   |   | 34 |   |
| Proceeds from the repayment of employee notes  receivable                                                                |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | —     |   |   | — |   | — |   |   | 60 |   | — |   |   | 60 |   |
| Net loss                                                                                                                 |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | —     |   |   | — |   | — |   |   | — |   | (35 | ) |   | (35 | ) |
| Balance at December 31, 2005                                                                                        |       | 3,759,531                                 |       |                                      | 4          |                                      | 20,676,816  |                         |       | 21                               |       | 7,754,012                    |       |                             | 8          |                   | 15,853,171 |   |   | 16 |   | 45,966 |   |   | — |   | (28,292 | ) |   | 17,723 |   |
| Conversion of preferred stock in connection with the  Company’s initial public offering                             |       | (3,759,531                                | )          |                                      | (4         | )                                         | (20,676,816 | )                            |       | (21                              | )          | (7,754,012                   | )          |                             | (8         | )                      | 32,190,359 |   |   | 33 |   | — |   |   | — |   | — |   |   | — |   |
| Issuance of common stock in connection with the  Company’s initial public offering, net of issuance costs of $2,727 |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | 9,721,179  |   |   | 9 |   | 83,150 |   |   | — |   | — |   |   | 83,159 |   |
| Exercise of stock options                                                                                                |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | 801,276    |   |   | 1 |   | 212 |   |   | — |   | — |   |   | 213 |   |
| Stock-based compensation expense                                                                                         |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | —     |   |   | — |   | 867 |   |   | — |   | — |   |   | 867 |   |
| Tax benefit related to exercise of stock options                                                                         |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | —     |   |   | — |   | 111 |   |   | — |   | — |   |   | 111 |   |
| Net income                                                                                                               |       | —                                    |       |                                      | —     |                                      | —      |                         |       | —                           |       | —                       |       |                             | —     |                   | —     |   |   | — |   | — |   |   | — |   | 28,864 |   |   | 28,864 |   |
| Balance at  December  31, 2006                                                                                      |       | —                                    |       |                                      | $          | —                                    |        | —                       |       |                             | $          | —                       |       | —                           |       |                   | $          | — |   | 58,565,985 |   |   | $ | 59 |   | $ | 130,306 |   |   | $ | — |   | $ | 572 |   |   | $ | 130,937 |   |
|                                                                                                                          |            |                                           |            |                                           |            |                                           |             |                              |            |                                  |            |                              |            |                                  |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ACME PACKET, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)**

| ** **                                                                                                                | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Operating activities**                                                                                                  | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                                                         |       | $                                           | 28,864     |   | $ | (35 | ) | $ | (6,957 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities:                       |       |                                        |       |   |   |   |   |
| Depreciation and  amortization                                                                                            |       | 3,481                                       |       | 1,966 |   | 1,217 |   |
| Provision for bad debts                                                                                                   |       | 343                                         |       | 410 |   | 94 |   |
| Stock-based compensation  expense                                                                                         |       | 867                                         |       | — |   | 2 |   |
| Deferred income taxes                                                                                                     |       | (4,780                                      | )          | — |   | — |   |
| Tax benefit related to  the exercise of stock options                                                                     |       | (111                                        | )          | — |   | — |   |
| Loss on disposal of  property and equipment in connection with the restructuring                                          |       | —                                      |       | — |   | 88 |   |
| Change in operating assets and liabilities:                                                                               |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                                                       |       | (7,721                                      | )          | (3,216 | ) | (3,679 | ) |
| Inventory                                                                                                                 |       | (3,930                                      | )          | (1,302 | ) | (1,641 | ) |
| Other current assets                                                                                                      |       | (1,103                                      | )          | (116 | ) | (102 | ) |
| Accounts payable                                                                                                          |       | 2,731                                       |       | 1,046 |   | 1,136 |   |
| Accrued expenses, other  current liabilities and deferred rent                                                            |       | 3,830                                       |       | 1,404 |   | 2,316 |   |
| Deferred revenue                                                                                                          |       | 3,860                                       |       | 2,169 |   | 2,869 |   |
| Net cash provided by  (used in) operating activities                                                                      |       | 26,331                                      |       | 2,326 |   | (4,657 | ) |
| **Investing activities**                                                                                                  | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchases of property  and equipment                                                                                      |       | (6,412                                      | )          | (3,615 | ) | (2,125 | ) |
| Increase in other assets                                                                                                  |       | (57                                         | )          | (4 | ) | (136 | ) |
| Net cash used in  investing activities                                                                                    |       | (6,469                                      | )          | (3,619 | ) | (2,261 | ) |
| **Financing activities**                                                                                                  | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from sale of  preferred stock, net of issuance costs                                                             |       | —                                      |       | — |   | 14,433 |   |
| Proceeds from sale of  common stock in connection with the Company’s initial public offering, net of  issuance costs |       | 83,159                                      |       | — |   | — |   |
| Proceeds from sale of  common stock                                                                                       |       | —                                      |       | 30 |   | 140 |   |
| Payments made for  repurchase of common stock                                                                             |       | —                                      |       | — |   | (1 | ) |
| Proceeds from exercise  of stock options                                                                                  |       | 213                                         |       | 34 |   | 20 |   |
| Proceeds from repayment  of employee notes receivable                                                                     |       | —                                      |       | 60 |   | — |   |
| Tax benefit related to  the exercise of stock options                                                                     |       | 111                                         |       | — |   | — |   |
| Payments on long-term  debt                                                                                               |       | —                                      |       | (210 | ) | (486 | ) |
| Net cash provided by  (used in) financing activities                                                                      |       | 83,483                                      |       | (86 | ) | 14,106 |   |
| Net increase (decrease)  in cash and cash equivalents                                                                     |       | 103,345                                     |       | (1,379 | ) | 7,188 |   |
| Cash and cash  equivalents at beginning of year                                                                           |       | 15,369                                      |       | 16,748 |   | 9,560 |   |
| Cash and cash  equivalents at end of year                                                                                 |       | $                                           | 118,714    |   | $ | 15,369 |   | $ | 16,748 |   |
| **Supplemental disclosure of cash flow information**                                                                      | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid for interest                                                                                                    |       | $                                           | —     |   | $ | 7 |   | $ | 36 |   |
| Cash paid for income taxes                                                                                                |       | $                                           | 345        |   | $ | 2 |   | $ | 2 |   |

 

See accompanying notes.

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**ACME PACKET, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSYears Ended December 31, 2006, 2005 and 2004(in thousands, except share and per share data)**

**1.**                 Organizationand Operations

Acme Packet, Inc.(the Company) was incorporated in the State of Delaware on August 3, 2000.The Company provides session border controllers that enable service providersto deliver secure and high quality interactive communications—voice, video andother real-time multimedia sessions—across Internet Protocol network borders.The Company is headquartered in Burlington, Massachusetts and has sales officesthere, as well as in Europe and Asia.

**2.**                 Summaryof Significant Accounting Policies

The accompanyingconsolidated financial statements reflect the application of certain significantaccounting policies as described below and elsewhere in these notes to theconsolidated financial statements.

***Principles of Consolidation***

The accompanyingconsolidated financial statements include the accounts of the Company and itswholly owned subsidiaries. All significant intercompany accounts andtransactions have been eliminated in consolidation.

***Management’s Estimates and Uncertainties***

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and the disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenue and expenses during the reporting period.

Significant estimates and judgments relied upon bymanagement in preparing these financial statements include revenue recognition,allowances for doubtful accounts, inventory allowances, expensing andcapitalization of research and development costs for software, thedetermination of the fair value of stock awards issued, warranty allowances,and the recoverability of the Company’s net deferred tax assets and relatedvaluation allowance.

Although the Company regularly assesses theseestimates, actual results could differ materially from these estimates. Changesin estimates are recorded in the period in which they become known. The Companybases its estimates on historical experience and various other assumptions thatit believes to be reasonable under the circumstances. Actual results may differfrom management’s estimates if these results differ from historical experienceor other assumptions prove not to be substantially accurate, even if suchassumptions are reasonable when made.

The Company is subject toa number of risks similar to those of other companies of similar size in itsindustry, including, but not limited to, rapid technological changes,competition from substitute products and services from larger companies,limited number of suppliers, customer concentration, government regulations,management of international activities, protection of proprietary rights,patent litigation, and dependence on key individuals.

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***Cash and Cash Equivalents and Restricted Cash***

Cash equivalents consistof highly liquid investments with original maturities of 90 days or less.Cash equivalents are carried at cost, which approximate their fair marketvalue. Cash and cash equivalents consisted of the following:

| ** **                       | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Cash                             |       | $                     | 4,378      |   | $ | 1,111 |   |
| Money market  funds              |       | 114,336               |       | 14,258 |   |
| Total cash and cash  equivalents |       | $                     | 118,714    |   | $ | 15,369 |   |

 

As of December 31, 2005, the Company hadrestricted cash in the amount of $432 as collateral related to its facilityleases. On May 31, 2006, the restriction on cash in the amount of $132expired in connection with the expiration of the Company’s operating lease forthe Woburn, Massachusetts facility. The remaining $300 of restricted cash as ofDecember 31, 2005 is used to collateralize a standby letter of creditrelated to the lease of the Company’s facility in Burlington, Massachusetts.The Company’s restriction with respect to $150 of this amount expires in June 2007,while the remaining amount expires in June 2010.

In July 2006, theCompany entered into two operating leases for office facilities in Burlington,Massachusetts and Madrid, Spain. As of December 31, 2006, $479 ofrestricted cash is used to collateralize standby letters of credit related tothe Burlington, Massachusetts leases and the Madrid, Spain lease.  The Company’s restrictions with respect to therestricted cash amounts expire in June 2010 for the Burlington,Massachusetts leases and July 2011 for the Madrid, Spain lease,respectively.

***Revenue Recognition***

The Company recognizes revenue in accordance with theAmerican Institute of Certified Public Accountants (AICPA) Statement ofPosition (SOP) 97-2,*Software RevenueRecognition* , SOP 98-9,*Software Revenue Recognition With Respect to Certain Transactions*,and the Emerging Issues Task Force (EITF) Issue No. 03-5,*Applicability of AICPA Statement of Position 97-2to Nonsoftware Deliverables in an Arrangement Containing More-Than-IncidentalSoftware*. The Company has determined that the software element ofits product is “more than incidental” to its products as a whole. As a result,in accordance with EITF Issue No. 03-5, the Company is required torecognize revenue under SOP 97-2 and SOP 98-9.

In accordance withthese standards, revenue is recognized when persuasive evidence of anarrangement exists, delivery has occurred, the fee is fixed or determinable,and collection of the related accounts receivable is deemed probable. In makingthese judgments, management evaluates these criteria as follows:

·       *Persuasive evidence of an arrangement*. The Company considersa noncancelable agreement signed by the Company and the customer to berepresentative of pervasive evidence of an arrangement.

·       *Delivery has occurred*. The Company considers delivery tohave occurred when the product has been delivered to the customer and nopostdelivery obligations exist. In instances where customer acceptance isrequired, delivery is deemed to have occurred when customer acceptance has beenachieved. Certain of the Company’s agreements contain products that might notconform to published specifications or contain a requirement to deliveradditional elements which are essential to the functionality of the deliveredelements. Revenue associated with these agreements is recognized when the customerspecifications have been met or delivery of the additional elements hasoccurred.

·       *Fees are fixed or determinable*. The Company considers thefee to be fixed or determinable unless the fee is subject to refund oradjustment or is not payable within normal payment terms. If the fee is 

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subject to refund oradjustment, the Company recognizes revenue when the refund or adjustment rightlapses. If offered payment terms exceed the Company’s normal terms, the Companyrecognizes revenue as the amounts become due and payable or upon the receipt ofcash.

·       *Collection is deemed probable*. The Company conducts a creditreview for all transactions at the inception of an arrangement to determine thecreditworthiness of the customer. Collection is deemed probable if, based uponthe Company’s evaluation, the Company expects that the customer will be able topay amounts under the arrangement as payments become due. If the Companydetermines that collection is not probable, revenue is deferred and recognizedupon the receipt of cash.

A substantial amount of the Company’s sales involvemultiple element arrangements, such as products, maintenance, professionalservices, and training. When arrangements include multiple elements, theCompany allocates the total fee among the various elements using the residualmethod. Under the residual method, revenue is recognized when vendor specificobjective evidence (VSOE) of fair value exists for all of the undeliveredelements of the arrangement, but does not exist for one or more of the deliveredelements of the arrangement. Each arrangement requires the Company to analyzethe individual elements in the transaction and to estimate the fair value ofeach undelivered element, which typically represents maintenance and services.Revenue is allocated to each of the undelivered elements based on itsrespective fair value, with the fair value determined by the price charged whenthat element is sold separately.

Maintenance, support, and service revenue includesales of maintenance and other services, including professional services,training, and reimbursable travel.

Maintenance and support services include telephonesupport, return and repair services, and unspecified rights to product upgradesand enhancements, and are recognized ratably over the term of the serviceperiod, which is generally 12 months. Maintenance and support revenue isgenerally deferred until the related product has been accepted and all otherrevenue recognition criteria have been met.

Professional services and training revenue isrecognized as the related service has been performed.

The Company’s products and services are distributedindirectly through distribution partners and directly through the Company’ssales force. Revenue arrangements with distribution partners are recognizedwhen the above criteria are met and only when the Company receives evidencethat the distribution partner has an order from an end-user customer. TheCompany typically does not offer contractual rights of return, stock balancingor price protection to its distribution partners, and actual product returnsfrom them have been insignificant to date. As a result, the Company does notmaintain reserves for product returns and related allowances.

In accordance with EITF Issue No. 00-10, *Accounting for Shipping and Handling Fees*,the Company has classified the reimbursement by customers of shipping andhandling costs as revenue and the associated cost as cost of revenue.Reimbursed shipping and handling costs, included in service revenue and costsof service revenue totaled approximately $82, $32 and $29 for the years ended December 31,2006, 2005 and 2004, respectively.

In accordance with EITFIssue No. 01-14, *Income StatementCharacterization of Reimbursements Received for “Out-of-Pocket” Expenses Incurred*,the Company included approximately $516, $165 and $44 of out-of-pocket expensesin service revenue and cost of service revenue in the years ended December 31,2006, 2005 and 2004, respectively.

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***Allowance for Doubtful Accounts***

The Company reduces gross trade accounts receivable byan allowance for doubtful accounts. The allowance for doubtful accounts is theCompany’s best estimate of the amount of probable credit losses in the Company’sexisting accounts receivable. The Company reviews its allowance for doubtfulaccounts on a regular basis and all past due balances are reviewed individuallyfor collectibility. Account balances are charged off against the allowanceafter all means of collection have been exhausted and the potential forrecovery is considered remote. Provisions for allowance for doubtful accountsare recorded in general and administrative expenses.

Below is a summary of thechanges in the Company’s allowance for doubtful accounts for the years ended December 31,2006, 2005 and 2004.

| ** **                         | ** ** | **Balance at  Beginning of  Period** | ** ** | **Provision** | ** ** | **Write-offs** | ** ** | **Balance at  End of  Period** | ** ** |
|------------------------------------|------------|------------------------------------------------|------------|---------------|------------|----------------|------------|------------------------------------------|------------|
| Year Ended  December 31, 2006 |       |                                           | $          | 433           |       |           |       | $                                        | 343        |   |   |   | $ | (81 | ) |   |   | $ | 695 |   |   |
| Year Ended  December 31, 2005 |       |                                           | 131        |          |       |           | 410        |                                     |       |   | (108 | ) |   |   | 433 |   |   |
| Year Ended  December 31, 2004 |       |                                           | 51         |          |       |           | 94         |                                     |       |   | (14 | ) |   |   | 131 |   |   |

 

***Inventory***

Inventory is stated at the lower of cost, determinedon a first-in, first-out basis, or market, and consists primarily of finishedproducts.

The Company provides for inventory losses based onobsolescence and levels in excess of forecasted demand. In these cases,inventory is reduced to estimated realizable value based on historical usageand expected demand. Inherent in the Company’s estimates of market value indetermining inventory valuation are estimates related to economic trends,future demand for the Company’s products, and technical obsolescence ofproducts.

When products have beendelivered, but the product revenue associated with the arrangement has beendeferred as a result of not meeting the revenue recognition criteria requiredby SOP 97-2, the Company includes the costs for the delivered items ininventory until recognition of the related revenue occurs.

***Property and Equipment***

Property and equipment isstated at cost. Depreciation and amortization is expensed using the straight-linemethod over the estimated useful lives of the assets as follows:

| **Assets  Classification**        | ** ** | **Estimated Useful Life**                                           |
|-----------------------------------|------------|---------------------------------------------------------------------|
| Computer hardware  and software   |       | 3 years                                                             |
| Furniture and  fixtures           |       | 3  years                                                            |
| Office and  engineering equipment |       | 3  years                                                            |
| Evaluation systems                |       | 2  years                                                            |
| Leasehold  improvements           |       | Shorter  of asset’s useful life or remaining life of the lease |

 

Evaluation systems are carried at the lower of theirdepreciated value or their net realizable value.

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Propertyand equipment consists of the following:

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Computer hardware  and software                 |       | $                     | 3,240      |   | $ | 2,023 |   |
| Furniture and  fixtures                         |       | 1,282                 |       | 782 |   |
| Office and  engineering equipment               |       | 3,771                 |       | 2,223 |   |
| Evaluation  systems                             |       | 6,018                 |       | 3,515 |   |
| Leasehold  improvements                         |       | 1,056                 |       | 412 |   |
|                                            |       | 15,367                |       | 8,955 |   |
| Less accumulated  depreciation and amortization |       | (8,510                | )          | (5,029 | ) |
| Property and equipment,  net                    |       | $                     | 6,857      |   | $ | 3,926 |   |

 

Depreciation expense was $3,481, $1,966 and $1,217 forthe years ended December 31, 2006, 2005 and 2004, respectively.

In connection with the abandonment of a facility leaseduring 2004, the Company recorded an impairment charge of $88 for certainproperty and equipment (Note 8).

Expenditures formaintenance and repairs are charged to expense as incurred, whereas majorbetterments are capitalized as additions to property and equipment. The Companyreviews its property and equipment whenever events or changes in circumstancesindicate that the carrying value of certain assets might not be recoverable. Inthese instances, the Company recognizes an impairment loss when it is probablethat the estimated cash flows are less than the carrying value of the asset. Todate, no such impairment losses have been recorded.

***Financial Instruments***

Financial instrumentsconsist of cash and cash equivalents, restricted cash, accounts receivable, andaccounts payable. The estimated fair value of these financial instrumentsapproximates their carrying value.

***Concentrations of Credit Risk and Off-Balance SheetRisk***

The Company has no significant off-balance sheet risksuch as foreign exchange contracts, option contracts, or other foreign hedgingarrangements. Financial instruments that potentially expose the Company toconcentrations of credit risk consist mainly of cash and cash equivalents andaccounts receivable. The Company maintains its cash and cash equivalentsprincipally in accredited financial institutions of high credit standing. TheCompany routinely assesses the credit worthiness of its customers. The Companygenerally has not experienced any material losses related to receivables fromindividual customers or groups of customers. The Company does not requirecollateral. Due to these factors, no additional credit risk beyond amountsprovided for collection losses is believed by management to be probable in theCompany’s amounts receivable.

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TheCompany had certain customers whose revenue individually represented 10% ormore of the Company’s total revenue, as follows:

| ** ** | ** ** | **Years Ended  December 31,** | ** ** |
|------------|------------|-----------------------------------------|------------|
| ** ** | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Customer A |       |                                    | 16         | % |   |   | 14 | % |   |   | * |   |   |
| Customer B |       |                                    | 11         |   |   |   | * |   |   |   | * |   |   |
| Customer C |       |                                    | *          |   |   |   | 14 |   |   |   | * |   |   |
| Customer D |       |                                    | *          |   |   |   | 12 |   |   |   | * |   |   |
| Customer E |       |                                    | *          |   |   |   | 11 |   |   |   | 13 | % |   |
| Customer F |       |                                    | *          |   |   |   | * |   |   |   | 15 |   |   |
| Customer G |       |                                    | *          |   |   |   | * |   |   |   | 11 |   |   |

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****                   *Less than 10% of total revenue.

The Company had certaincustomers whose accounts receivable balances individually represented 10% ormore of the Company’s total accounts receivable, as follows:

| ** ** | ** ** | **December 31,** | ** ** |
|------------|------------|-----------------------|------------|
| ** ** | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Customer C |       |                  | 12         | % |   |   | 21 | % |   |
| Customer D |       |                  | 10         |   |   |   | * |   |   |
| Customer E |       |                  | *          |   |   |   | 12 |   |   |
| Customer F |       |                  | 10         |   |   |   | 10 |   |   |
| Customer H |       |                  | 11         |   |   |   | * |   |   |
| Customer I |       |                  | *          |   |   |   | 15 |   |   |

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****                   *Less than 10% of total accountsreceivable.

***Product Warranties***

Substantially all of theCompany’s products are covered by a standard warranty of 90 days forsoftware and one year for hardware. In the event of a failure of product orsoftware covered by this warranty, the Company must repair or replace thesoftware or product or, if those remedies are insufficient, and at thediscretion of the Company, provide a refund. The Company’s customers typicallypurchase maintenance and support contracts, which encompass its warrantyobligations. The Company’s warranty reserve reflects estimated material andlabor costs for potential or actual product issues in its installed base thatare not covered under maintenance contracts but for which the Company expectsto incur an obligation. The Company’s estimates of anticipated rates ofwarranty claims and costs are primarily based on historical information andfuture forecasts. The Company periodically assesses the adequacy of thewarranty allowance and adjusts the amount as necessary. (See Note 9)

***Stock-Based Compensation***

At December 31, 2006, the Company had twostock-based employee compensation plans, which are more fully described inNote 6.

Through December 31, 2005, the Company accountedfor its stock-based awards to employees using the intrinsic value methodprescribed in Accounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*, and relatedinterpretations. Under the intrinsic value method, compensation expense ismeasured on the date of grant as the difference between the deemed fair valueof the Company’s common stock and the stock option exercise price or restrictedstock award purchase price multiplied by the number of stock options orrestricted stock awards granted. Generally, the Company 

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grants stock-based awardswith exercise prices equal to the estimated fair value of its common stock;however, to the extent that the deemed fair value of the common stock exceedsthe exercise or purchase price of stock-based awards granted to employees onthe date of grant, the Company amortizes the expense over the vesting scheduleof the awards, generally four years. The fair value of the Company’s commonstock is determined by the Company’s Board of Directors (the Board).

Given the absence of a public market for the Company’scommon stock prior to the completion of the Company’s initial public offering (IPO),the fair value for the Company’s common stock was estimated by the Board, withinput from management. The Board exercised judgment in determining theestimated fair value of the Company’s common stock on the date of grant basedon several factors, including the liquidation preferences, dividend rights andvoting control attributable to the Company’s then-outstanding convertiblepreferred stock and, primarily, the likelihood of achieving a liquidity eventsuch as an initial public offering or sale of the Company. In the absence of apublic trading market for the Company’s common stock, the Board consideredobjective and subjective factors in determining the fair value of the Company’scommon stock. The Company believes this to have been a reasonable methodologybased upon the Company’s internal peer company analyses and based on severalarm’s-length transactions involving the Company’s common stock supportive ofthe results produced by this valuation methodology.

On December 16, 2004 the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standards(SFAS) No. 123(R), *Share-Based Payment*,which is a revision of SFAS No. 123,*Accounting for Stock-Based Compensation.*SFASNo. 123(R) supersedes APB Opinion No. 25,** and amends SFAS No. 95,*Statement of Cash Flows*. Generally, theapproach under SFAS No. 123(R) is similar to the approach described inSFAS No. 123. However, SFAS No. 123(R) requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the income statement based on their fair values. Pro formadisclosure is no longer an alternative.

SFAS No. 123(R) must be adopted for fiscal yearsstarting after June 15, 2005. As a result, the Company adopted SFASNo. 123(R) starting in its fiscal first quarter of 2006, which began onJanuary 1, 2006.

SFAS No. 123(R) requires nonpublic companies thatused the minimum value method under SFAS No. 123 for either recognition orpro forma disclosures to apply SFAS No. 123(R) using theprospective-transition method. As such, the Company will continue to apply APBOpinion No. 25 in future periods to equity awards outstanding at the dateof SFAS No. 123(R)’s adoption that were measured using the minimum valuemethod. In accordance with the requirements of SFAS No. 123(R), theCompany will not present pro forma disclosures for periods prior to the adoptionof SFAS No. 123(R) as the estimated fair value of the Company’s stockoptions granted through December 31, 2005 was determined using the minimumvalue method.

Effective with the adoption of SFAS No. 123(R),the Company has elected to use the Black-Scholes option pricing model todetermine the weighted average fair value of stock options granted. Inaccordance with SFAS No. 123(R), the Company will recognize thecompensation cost of stock-based awards on a straight-line basis over thevesting period of the award.

As there was no publicmarket for its common stock prior to October 13, 2006, the effective dateof the Company’s IPO, the Company determined the volatility for options grantedin 2006 based on an analysis of reported data for a peer group of companiesthat issued options with substantially similar terms. The expected volatilityof options granted has been determined using an average of the historicalvolatility measures of this peer group of companies. The expected life of optionshas been determined utilizing the “simplified” method as prescribed by the SEC’sStaff Accounting Bulletin No. 107,*Share-Based Payment*. The risk-free interest rate is based on atreasury instrument whose term is consistent with the expected life of thestock options. The Company has not paid and does not anticipate paying cashdividends on its common stock; therefore, the expected dividend yield isassumed to be zero. In addition, SFAS 

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No. 123(R) requirescompanies to utilize an estimated forfeiture rate when calculating the expensefor the period, whereas, SFAS No. 123 permitted companies to recordforfeitures based on actual forfeitures, which was the Company’s historicalpolicy under SFAS No. 123. As a result, the Company applied an estimatedforfeiture rate of 11.25% for the year ended December 31, 2006 indetermining the expense recorded in the accompanying consolidated statement ofoperations.  The weighted-averageassumptions utilized to determine such values are presented in the followingtable:

| ** **               | ** ** | **Year Ended  December 31, 2006** | ** ** |
|--------------------------|------------|--------------------------------------------------|------------|
| Risk-free  interest rate | ** ** |                                             | 4.79%      |   |   |
| Expected  volatility     | ** ** |                                             | 81.44%     |   |   |
| Expected life            | ** ** |                                             | 6.25 years |   |   |
| Dividend yield           | ** ** |                                             | —     |   |   |

 

The weighted-average fair value of options grantedduring the year ended December 31, 2006 was $5.43.

In connection with the preparation for the Company’s IPO,the Company reassessed the valuations of its common stock during 2006 and 2005,in light of the AICPA’s Practice Aid,*Valuation of Privately-Held-Company Equity Securities Issued as Compensation*.As a result, the Company reassessed the fair value of its common stock as of December 14,2005, December 23, 2005, February 7, 2006 and March 15, 2006.

Based on these reassessments, the Company is requiredto recognize compensation expense of $821 to reflect the difference between thereassessed fair value of the Company’s common stock and the grant price for thestock-based awards granted on December 14, 2005 and December 23, 2005and an amount equal to the difference between the value calculated using theBlack-Scholes option pricing model with the initial assessment of fair value ofcommon stock and the value calculated using the Black-Scholes option pricingmodel with the reassessed fair value of common stock for the stock-based awardsgranted on February 7, 2006 and March 22, 2006. The compensationexpense is being recognized over the vesting schedule of the awards commencingin the three month period ended September 30, 2006. As a result of thesereassessments, the Company recognized compensation expense of $202 during theyear ended December 31, 2006.

Including stock-based compensation expense related tothe reassessment of the fair value of the Company’s common stock, for the yearended December 31, 2006, the Company recorded stock-based compensationexpense of approximately $867 in connection with stock-based payment awards. Asof December 31 2006, there was $6.9 million of unrecognized compensationexpense related to non-vested stock option awards that is expected to berecognized over a weighted-average period of 3.45 years.

The Company accounts for transactions in whichservices are received from nonemployees in exchange for equity instrumentsbased on the fair value of such services received or of the equity instrumentsissued, whichever is more reliably measured, in accordance with SFAS No. 123(R),**and EITF Issue No. 96-18,*Accounting for Equity Instruments That Are Issued toOther Than Employees for Acquiring, or in Conjunction With Selling, Goods orServices*. During 2004, the Company granted 8,237 shares ofrestricted common stock to nonemployees which, using the Black-Scholesvaluation model, resulted in charges of $2 for the year ended December 31,2004. There were no stock-based awards made to non-employees in the years endedDecember 31, 2006 or 2005.

See Note 6 for asummary of the stock option activity under the Company’s stock-based employeecompensation plans for the years ended December 31, 2006, 2005 and 2004.

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***Research and Development***

Research and developmentexpense includes costs incurred to develop intellectual property and arecharged to expense as incurred. The costs for the development of new softwareand substantial enhancements to existing software are expensed as incurreduntil technological feasibility has been established, at which time anyadditional costs would be capitalized. The Company has determined thattechnological feasibility is established at the time a working model ofsoftware is completed. Because the Company believes its current process fordeveloping software will be essentially completed concurrently with theestablishment of technological feasibility, no costs have been capitalized todate.

***Comprehensive Income (Loss)***

SFAS No. 130, *Reporting Comprehensive Income,*establishes standards for reporting and displaying comprehensive income (loss)and its components in financial statements. Comprehensive income (loss) isdefined as the change in stockholders’ equity of a business enterprise during aperiod from transactions and other events and circumstances from nonownersources. The comprehensive income (loss) for all periods presented does notdiffer from the net reported income (loss).

***Net Income (Loss) Per Share***

The Company calculates net income (loss) per share inaccordance with SFAS No. 128, *EarningsPer Share*, as clarified by EITF Issue No. 03-6,*Participating Securities and the Two-Class MethodUnder FASB Statement No. 128, Earnings Per Share*. EITF Issue No. 03-6clarifies the use of the “two-class” method of calculating earnings per shareas originally prescribed in SFAS No. 128. Effective for periods beginningafter March 31, 2004, EITF Issue No. 03-6 provides guidance onhow to determine whether a security should be considered a “participatingsecurity” for purposes of computing earnings per share and how earnings shouldbe allocated to a participating security when using the two-class method forcomputing basic earnings per share. The Company has determined that itsconvertible preferred stock represents a participating security and thereforehas adopted the provisions of EITF Issue No. 03-6 retroactively forall periods presented.

Under the two-class method, basic net income (loss)per share is computed by dividing the net income (loss) applicable to commonstockholders by the weighted-average number of common shares outstanding forthe fiscal period. Diluted net income (loss) per share is computed using themore dilutive of (a) the two-class method or (b) the if-convertedmethod. The Company allocates net income first to preferred stockholders basedon dividend rights under the Company’s charter and then to common stockholdersbased on ownership interests. Net losses are not allocated to preferredstockholders. Diluted net income (loss) per share gives effect to all potentiallydilutive securities, including stock options using the treasury stock method.For the years ended December 31, 2005 and 2004, the Company incurred netlosses. As such, the two-class method was not applicable. For the year ended December 31,2006, the Company has used the if-converted method to compute net income pershare as the effect was more dilutive than the two-class method. Accordingly,the Company has not allocated net income to the preferred stockholders forpurposes of the net income per share calculation for the year ended December 31,2006.

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Areconciliation of the denominator used in the calculation of basic and dilutednet income (loss) per share is as follows:

| ** **                                                                                                                    | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                    | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Numerator:**                                                                                                                |       |                                        |       |   |   |   |   |
| Net income (loss)                                                                                                             |       | $                                           | 28,864     |   | $ | (35 | ) | $ | (6,957 | ) |
| **Denominator:**                                                                                                              |       |                                        |       |   |   |   |   |
| Weighted-average shares of common stock outstanding                                                                           |       | 50,734,071                                  |       | 15,751,142 |   | 15,331,381 |   |
| Less: Weighted-average number of unvested restricted  common shares outstanding                                               |       | (296,270                                    | )          | (510,252 | ) | (598,784 | ) |
| Weighted-average number of common shares used in  calculating basic net income (loss) per common share                        |       | 50,437,801                                  |       | 15,240,890 |   | 14,732,597 |   |
| Weighted-average number of common shares issuable  upon exercise of outstanding stock options, based on treasury stock method |       | 6,559,725                                   |       | — |   | — |   |
| Weighted-average number of unvested restricted  common shares outstanding                                                     |       | 296,270                                     |       | — |   | — |   |
| Weighted-average number of common shares issuable  upon exercise of common stock warrant                                      |       | 125,000                                     |       | — |   | — |   |
| Weighted-average number of  common shares used in computing diluted net income (loss) per common share                        |       | 57,418,796                                  |       | 15,240,890 |   | 14,732,597 |   |
| **Net income (loss) per common  share:**                                                                                      |       |                                        |       |   |   |   |   |
| Basic                                                                                                                         |       | $                                           | 0.57       |   | (0.00 | ) | (0.47 | ) |
| Diluted:                                                                                                                      |       | $                                           | 0.50       |   | (0.00 | ) | (0.47 | ) |
|                                                                                                                               |            |                                             |            |  |  |  |  |  |  |  |

 

The followingweighted-average common share equivalents have been excluded from thecomputation of diluted weighted-average shares outstanding as ofDecember 31, 2006, 2005 and 2004, respectively, as their effect would havebeen be antidilutive:

| ** **                                           | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                           | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Participating  convertible preferred stock           |       | —                                |       | 32,190,359 |   | 28,663,877 |   |
| Options  outstanding, based on treasury stock method |       | 260,753                               |       | 1,775,672 |   | 511,472 |   |
| Warrants                                             |       | —                                |       | 125,000 |   | 125,000 |   |

 

***Impairment of Long-Lived Assets***

The Company accounts forits long-lived assets in accordance with SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*. This statement requires that long-lived assetsand certain identifiable intangible assets be reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amount of theasset may not be recoverable. Any write-downs are treated as permanentreductions in the carrying amount of the assets. Based on this evaluation, theCompany believes that, as of each of the balance sheet dates presented, none ofthe Company’s long-lived assets were impaired.

***Capitalized Internal-Use Software***

The Company capitalizescertain costs incurred to purchase or create internal-use software inaccordance with SOP 98-1, *Accountingfor the Costs of Computer Software Developed or Obtained for*

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*Internal Use*. To date, such costs haveincluded external direct costs of materials and services consumed in obtaininginternal-use software and are included within computer hardware and software.Once the capitalization criteria of SOP 98-1 have been met, such costsare classified as software and are amortized on a straight-line basis overthree years once the software has been put into use. Subsequent additions,modifications, or upgrades to internal-use software are capitalized only to theextent that they allow the software to perform a task it previously did notperform. Software maintenance and training costs are expensed in the period inwhich they are incurred.

***Foreign Currency Translation***

The financial statementsof the Company’s foreign subsidiaries are translated in accordance with SFASNo. 52, *Foreign Currency Translation*.The functional currency of the Company’s foreign subsidiaries in the UnitedKingdom, Japan, and Hong Kong is the U.S. dollar. Accordingly, all assets andliabilities of these foreign subsidiaries are remeasured into U.S. dollarsusing the exchange rates in effect at the balance sheet date. Revenue andexpenses of these foreign subsidiaries are remeasured into U.S. dollars at theaverage rates in effect during the year. Any differences resulting from theremeasurement of assets, liabilities, and operations of the United Kingdom,Japan, and Hong Kong subsidiaries are recorded within other income (expense) inthe consolidated statements of operations. During the years ended December 31,2006 and 2005 the Company recorded foreign currency losses of $17, and $36,respectively, in other income (expense). During the year endedDecember 31, 2004, foreign currency gains (losses) were not material.

***Income Taxes***

The Company accounts forincome taxes in accordance with SFAS No. 109, *Accounting for Income Taxes,* which is the asset andliability method for accounting and reporting for income taxes. Under SFASNo. 109, deferred tax assets and liabilities are recognized based ontemporary differences between the financial reporting and income tax bases ofassets and liabilities using statutory rates. In addition, SFAS No. 109requires a valuation allowance against net deferred tax assets if, based uponthe available evidence, it is more likely than not that some or all of thedeferred tax assets will not be realized.

***Advertising Expense***

Advertising expenseprimarily includes promotional expenditures and is expensed as incurred, assuch efforts have not met the direct-response criteria required forcapitalization. Amounts incurred for advertising expense were not material forthe years ended December 31, 2006, 2005, and 2004.

***Recent Accounting Pronouncements***

In July 2006, the FASB issued FinancialAccounting Standards Interpretation (FIN) No. 48, *Accountingfor Uncertainty in Income Taxes*, which is an interpretation of SFASNo. 109. FIN 48 clarifies the accounting for income taxes by prescribingthe minimum recognition threshold a tax position is required to meet beforebeing recognized in the financial statements. FIN 48 also provides guidance onderecognition, measurement, classification, interest and penalties, accountingin interim periods, disclosure and transition. In addition, FIN 48 clearlyscopes out income taxes from SFAS No. 5, *Accountingfor Contingencies*. FIN 48 is effective for fiscal years beginningafter December 15, 2006. The Company will implement this interpretation inthe fiscal year starting January 1, 2007. The Company is currently analyzing the effect, if any, FIN 48 will haveon its consolidated financial position and our results of operations

In September 2006, FASB issued SFAS No. 157,*Fair Value Measurements*, whichdefines fair value, establishes a framework for measuring fair value under generallyaccepted accounting principles, and 

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expands disclosures aboutfair value measurements. SFAS No. 157 applies to other accountingpronouncements that require or permit fair value measurements. The new guidanceis effective for financial statements issued for fiscal years beginning afterNovember 15, 2007, and for interim periods within those fiscal years. TheCompany is currently analyzing the effect, if any, SFAS No. 157 will haveon its consolidated financial position and results of operations.

In September 2006,the United States Securities and Exchange Commission issued Staff AccountingBulletin (SAB) No. 108, *Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements*. SAB 108 provides guidance on theconsideration of the effects of prior year misstatements in quantifying currentyear misstatements for the purpose of a materiality assessment. SAB 108establishes an approach that requires quantification of financial statement errorsbased on the effects of each of the company’s balance sheet and statement ofoperations financial statements and the related financial statementdisclosures. The SAB permits existing public companies to record the cumulativeeffect of initially applying this approach in the first year ending afterNovember 15, 2006 by recording the necessary correcting adjustments to thecarrying values of assets and liabilities as of the beginning of that year withthe offsetting adjustment recorded to the opening balance of retained earnings.Additionally, the use of the cumulative effect transition method requiresdetailed disclosure of the nature and amount of each individual error beingcorrected through the cumulative adjustment and how and when it arose. Theadoption of SAB 108 did not have a material impact on the Company’sconsolidated financial position, results of operations or liquidity.

**3. Debt**

On June 22, 2001, theCompany entered into a $1,000 capital expenditure line of credit (the CapitalEquipment Line). The Capital Equipment Line was modified in August 2002,to increase the amount available to $1,750. Outstanding amounts under theCapital Equipment Line accrued interest at the bank’s prime rate plus 3.25% -3.50% at the funding date of each advance. Any advances from the CapitalEquipment Line were payable in equal payments over 36-consecutive monthscommencing on the funding day. The Capital Equipment Line was collateralized byall business assets of the Company and expired on March 31, 2003, at whichtime the amounts outstanding converted into a term loan payable. During theyear ended December 31, 2005, the Company paid all amounts owed under theCapital Equipment Line. There were no amounts outstanding as of December 31,2006 or 2005.

**4. Income Taxes**

Incomebefore the benefit from income taxes consists of the following:

| ** ** | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Domestic   |       | $                                           | 25,185     |   | $ | (60) |   | $ | (6,957) |   |
| Foreign    |       | 236                                         |       | 25 |   | — |   |
| Total      |       | $                                           | 25,421     |   | $ | (35) |   | $ | (6,957) |   |

 

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Thebenefit from income taxes in the accompanying consolidated financial statementsconsists of the following:

| ** **         | ** ** | **Years Ended December 31,** | ** ** |
|--------------------|------------|---------------------------------------------|------------|
| ** **         | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current provision: |       |                                        |       |   |   |   |   |   |   |   |   |
| Federal            |       | $                                           | 1,115      |   |   | $ | — |   |   |   | $ | — |   |   |
| State              |       | 159                                         |       |   | — |   |   |   | — |   |   |
| Foreign            |       | 63                                          |       |   | — |   |   |   | — |   |   |
| Total              |       | $                                           | 1,337      |   |   | $ | — |   |   |   | $ | — |   |   |
| Deferred benefit:  |       |                                        |       |   |   |   |   |   |   |   |   |
| Federal            |       | $                                           | (3,361     | ) |   | $ | — |   |   |   | $ | — |   |   |
| State              |       | (1,419                                      | )          |   | — |   |   |   | — |   |   |
| Foreign            |       | —                                      |       |   | — |   |   |   | — |   |   |
| Total              |       | $                                           | (4,780     | ) |   | $ | — |   |   |   | $ | — |   |   |
| Total benefit:     |       | $                                           | (3,443     | ) |   | $ | — |   |   |   | $ | — |   |   |

 

Areconciliation of the U.S. federal statutory rate to the Company’s effectivetax rate is as follows:

| ** **                            | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| U.S. federal  statutory rate          |       | 35.0                                        | %          | (34.0 | )% | (34.0 | )% |
| State taxes, net                      |       | 0.4                                         |       | (6.3 | ) | (6.3 | ) |
| Permanent  differences                |       | 1.4                                         |       | — |   | 0.5 |   |
| Research and development  tax credits |       | (2.8                                        | )          | — |   | — |   |
| Change in  valuation allowance        |       | (47.5                                       | )          | 40.3 |   | 39.8 |   |
| Effective tax rate                    |       | (13.5                                       | )%         | 0.0 | % | 0.0 | % |

 

Significantcomponents of the Company’s deferred tax assets and liabilities for incometaxes consisted of the following at December 31, 2006 and 2005:

| ** **                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Net operating  loss and credit carryforwards |       | $                     | 1,543      |   | $ | 9,410 |   |
| Start-up costs,  net of amortization         |       | 654                   |       | 1,339 |   |
| Other temporary  differences                 |       | 1,258                 |       | 756 |   |
| Sales tax accrual                            |       | 587                   |       | 426 |   |
| Inventory and  warranty allowances           |       | 738                   |       | 491 |   |
| Restructuring  loss provisions               |       | —                |       | 84 |   |
| Valuation  allowance                         |       | —                |       | (12,506 | ) |
| Net deferred tax asset                       |       | $                     | 4,780      |   | $ | — |   |

 

The Company is required to compute income tax expensein each jurisdiction in which it operates. This process requires the Company toproject its current tax liability and estimate its deferred tax assets andliabilities, including net operating loss (NOL) and tax credit carryforwards. Inassessing the need for a valuation allowance, the Company considered its recentoperating results, future taxable income projections and feasible tax planningstrategies. In the year ended December 31, 2005, due to uncertaintysurrounding the Company’s ability to utilize its remaining NOL and creditcarryforwards and other deferred tax assets, the Company provided a fullvaluation allowance against its otherwise remaining recognizable deferred taxassets. In the year ended December 31, 2006, the Company utilized asubstantial 

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portion of its NOLcarryforwards to reduce income taxes currently payable and determined that itwas more likely than not that the Company would realize all of its remainingdeferred tax assets. Therefore, the Company reduced the valuation allowance relatedto these deferred tax assets of $4,780 in December 2006. The benefit ofthe release of the valuation allowance was realized through a reduction ofincome tax expense.

As of December 31, 2006, the Company had U.S.federal research and development tax credits of $979 that expire beginning in2023, and state research and development tax credits of $868 that expirebeginning in 2019, and are both subject to review and possible adjustment bythe taxing authorities. The Internal Revenue Code contains provisions thatlimit the net operating losses and tax credit carryforwards available to beused in any given year in the event of certain circumstances, includingsignificant changes in ownership interests, as defined.

The Company’s currentintention is to reinvest the total amount of its unremitted earnings in thelocal jurisdiction or to repatriate the earnings only when tax-effective. Assuch, the Company has not provided for U.S. taxes on the unremitted earnings ofits foreign subsidiaries.

**5. Stockholders’Equity**

As of December 31, 2005, the authorized capitalstock of the Company was 61,000,000 shares of common stock, $0.001 parvalue per share, and 33,248,852 shares of convertible preferred stock,$0.001 par value per share, of which 3,759,531 shares are designated Series Aconvertible preferred stock (Series A Preferred Stock),21,467,931 shares are designated Series B convertible preferred stock(Series B Preferred Stock), and 8,021,390 shares are designated Series Cconvertible preferred stock (Series C Preferred Stock).

In September 2006, the Board of Directorsapproved an amendment and restatement of the Company’s Certificate ofIncorporation to increase the authorized number of shares of common stock from61,000,000 to 150,000,000, to authorize 5,000,000 shares of undesignatedpreferred stock, par value $0.001 per share, and to eliminate all reference tothe designated Series Preferred Stock.

On October 13, 2006,the Company completed its IPO of common stock in which the Company sold andissued 9,721,179 shares of the Company’s common stock, including 1,721,179shares sold by the Company pursuant to the underwriters’ full exercise of theirover-allotment option, at an issue price of $9.50 per share. The Company raiseda total of $92.4 million in gross proceeds from the IPO, or $83.2 million innet proceeds after deducting underwriting discounts and commissions of $6.5million and other estimated offering costs of approximately $2.7 million. Uponthe closing of the IPO, all shares of convertible preferred stock outstandingautomatically converted into 32,190,359 shares of common stock.

***Restricted Stock***

During 2001, the Boardestablished a Stock Restriction and Repurchase Agreement for key employees andconsultants to the Company. Under the terms of the agreement, shares of commonstock issued or sold to an employee or consultant are subject to a vestingschedule commencing on the date shares are distributed to the employee. Vestingoccurs periodically at specified time intervals and specified percentages. Allshares of common stock become fully vested within four years of the date ofdistribution. As of December 31, 2006, the Company had issued andoutstanding 1,800,151 shares of common stock under the Stock Restrictionand Repurchase Agreement. As of December 31, 2006, 1,582,886 of theseshares were vested.

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***Warrants***

In connection with theCapital Equipment Line, the Company issued a warrant to the lender to purchaseup to 125,000 shares of Series B Preferred Stock at an exercise priceof $1.39 per share. Upon completion of the Company’s IPO in October 2006,these warrants automatically converted into warrants to purchase shares of theCompany’s common stock. Upon their issuance, the Company valued the warrantusing the Black-Scholes option-pricing model and recorded the value of thewarrant of $14 as interest expense for the year ended December 31, 2003.At December 31, 2006, there were 125,000 shares of the Company’scommon stock reserved for the exercise of the warrant. The warrant expires on June 22,2011.

**6. Stock OptionPlans**

In August 2000, the Company adopted the AcmePacket, Inc. 2000 Equity Incentive Plan (the 2000 Plan) under which it maygrant incentive stock options (ISOs), nonqualified stock options (NSOs),restricted stock, and stock grants to purchase up to 3,000,000 shares ofcommon stock. Under the 2000 Plan, ISOs may not be granted at less thanfair market value on the date of the grant and all options generally vest overa four-year period and certain options are subject to accelerated vesting basedon certain future events. These options expire ten years after the grant date.Employees are allowed to exercise their unvested options in exchange forrestricted stock subject to repurchase by the Company. The repurchase rightslapse on the same vesting schedule as the original options. In 2006, 2005, 2004and 2003, the Company increased the number of shares available under the 2000Plan by an additional 1,200,000, 4,000,000, 2,000,000 and 2,000,000 shares,respectively, to a total of 12,200,000 shares. In September 2006, theBoard approved the amended and restated 2000 Equity Incentive Plan, which wasapproved by the stockholders on September 19, 2006 and became effective uponthe consummation of the IPO. Effective upon the consummation of the IPO, nofurther awards will be made pursuant to the 2000 Plan, but any outstandingawards under the 2000 Plan will remain in effect and will continue to besubject to the terms of the 2000 Plan.

In September 2006, the Company’s Board ofDirectors (the Board) approved the 2006 Equity Incentive Plan, which wasapproved by the stockholders on September 19, 2006 and became effectiveupon the consummation of the Company’s IPO. The 2006 Equity Incentive Planallows the Company to grant ISOs, NSOs, restricted stock, and stock grants toemployees, consultants, and directors of the Company. Under the 2006 EquityIncentive Plan, stock options may not be granted at less than fair market valueon the date of grant, and all options generally vest over a four-year period. Theseoptions expire ten years after the grant date. The Company has reserved forissuance an aggregate of 3,000,000 shares of common stock under the 2006 EquityIncentive Plan plus an additional annual increase to be added automatically on January 1of each year, from 2006 and until 2016, equal to the lesser of (i) 3,000,000shares of common stock or (ii) five percent of the Company’s outstandingequity on a fully diluted basis as of the end of the immediately precedingfiscal year. As of December 31, 2006, 2,672,500 shares were available forfuture issuance under the 2006 Equity Incentive Plan.

In September 2006, the Board approved the 2006Director Option Plan, which was approved by the stockholders on September 19,2006 and became effective upon the consummation of the Company’s IPO. Under the2006 Director Plan, no options may be granted to eligible directors at lessthan fair market value on the date of grant, and all options will vest over aone year period from the grant date. These options expire ten years after thegrant date. The Company has reserved for issuance an aggregate of 300,000shares of common stock under the 2006 Director Plan plus an additional annualincrease to be added automatically on January 1 of each year of 75,000shares of common stock. The Board may waive the annual increases, in whole orin part. As of December 31, 2006, 300,000 shares were available for futureissuance under the 2006 Director Option Plan.

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TheCompany’s stock option activity for the three years ended December 31,2006 is as follows:

| ** **                                               | ** ** | **Number  of Shares** | ** ** | **Exercise Price  Per Share** | ** **   | **Weighted-Average  Exercise Price  Per Share** | ** ** | **Weighted-Average  Remaining  Contractural  Life (Years)** | ** ** | **Aggregate  Intrinsic  Value(2)** | ** ** |
|----------------------------------------------------------|------------|----------------------------|------------|-----------------------------------------|--------------|-----------------------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------|------------|
| Outstanding at  December 31, 2003                   |       | 1,501,747                  |       |                                    | $            | 0.20                                                      |       |                                                             |       | $                                  | 0.20       |   |   |   |   |   |   |   |   |   |   |
| Granted                                                  |       | 1,757,500                  |       |                                    | 0.20 - 0.50  |                                                      |       |                                                             | 0.32       |                               |       |   |   |   |   |   |   |   |   |
| Canceled                                                 |       | (37,813                    | )          |                                    | 0.20         |                                                      |       |                                                             | 0.20       |                               |       |   |   |   |   |   |   |   |   |
| Exercised                                                |       | (100,008                   | )          |                                    | 0.20         |                                                      |       |                                                             | 0.20       |                               |       |   |   |   |   |   |   |   |   |
| Outstanding at  December 31, 2004                   |       | 3,121,426                  |       |                                    | 0.20 - 0.50  |                                                      |       |                                                             | 0.27       |                               |       |   |   |   |   |   |   |   |   |
| Granted                                                  |       | 4,786,000                  |       |                                    | 0.55 - 1.10  |                                                      |       |                                                             | 0.87       |                               |       |   |   |   |   |   |   |   |   |
| Canceled                                                 |       | (210,417                   | )          |                                    | 0.30 - 0.65  |                                                      |       |                                                             | 0.43       |                               |       |   |   |   |   |   |   |   |   |
| Exercised                                                |       | (165,624                   | )          |                                    | 0.20 - 0.30  |                                                      |       |                                                             | 0.21       |                               |       |   |   |   |   |   |   |   |   |
| Outstanding at  December 31, 2005                   |       | 7,531,385                  |       |                                    | 0.20 - 1.10  |                                                      |       |                                                             | 0.65       |                               |       |   |   |   |   |   |   |   |   |
| Granted                                                  |       | 2,263,000                  |       |                                    | 1.10 - 18.36 |                                                      |       |                                                             | 5.43       |                               |       |   |   |   |   |   |   |   |   |
| Canceled                                                 |       | (170,415                   | )          |                                    | 0.50 - 4.50  |                                                      |       |                                                             | 1.50       |                               |       |   |   |   |   |   |   |   |   |
| Exercised                                                |       | (801,276                   | )          |                                    | 0.20 - 0.65  |                                                      |       |                                                             | 0.26       |                               |       |   |   |   |   |   | $ | 3,209 |   |   |
| Outstanding at  December 31, 2006                   |       | 8,822,694                  |       |                                    | $            | 0.20  - 18.36                                             |       |                                                             |       | $                                  | 1.89       |   |   |   | 8.51 |   |   |   | $ | 165,403 |   |   |
| Exercisable at December 31,  2004                   |       | 981,006                    |       |                                    | $            | 0.20                                                      |       |                                                             |       | $                                  | 0.20       |   |   |   |   |   |   |   |   |   |   |
| Exercisable at December 31,  2005                   |       | 1,588,644                  |       |                                    | $            | 0.20  - $0.55                                             |       |                                                             |       | $                                  | 0.24       |   |   |   |   |   |   |   |   |   |   |
| Exercisable at December 31,  2006                   |       | 2,768,587                  |       |                                    | $            | 0.20  - 1.10                                              |       |                                                             |       | $                                  | 0.55       |   |   |   | 7.64 |   |   |   | $ | 55,621 |   |   |
| Vested or expected to  vest at December 31, 2006(1) |       | 7,436,164                  |       |                                    | $            | 0.20  - 18.36                                             |       |                                                             |       | $                                  | 1.81       |   |   |   | 8.43 |   |   |   | $ | 140,045 |   |   |

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(1)          This represents thenumber of vested options as of December 31, 2006 plus the number ofunvested options expected to vest as of December 31, 2006 based on theunvested options outstanding at December 31, 2006, adjusted for theestimated forfeiture rate of 11.25%.

(2)          The aggregate intrinsicvalue was calculated based on the positive difference between the fair value ofthe Company’s common stock on December 31, 2006 or the date of exercise,as appropriate and the exercise price of the underlying options.

The ranges of exerciseprices for options outstanding and options exercisable at December 31,2006 were as follows:

| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Number of  Shares**   | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Life (Years)** | ** ** | **Number of  Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| $0.20 to 0.30                               |       | 1,649,756                    |       |                         | $          | 0.24 |   |   |   | 6.68 |   |   | 1,178,103 |   |   | $ | 0.23 |   |   |
|  0.33 to  0.65                         |       | 1,749,438                    |       |                         | 0.57       |   |   |   | 8.19 |   |   | 732,125 |   |   | 0.56 |   |   |
|  0.85 to  0.85                         |       | 753,000                      |       |                         | 0.85       |   |   |   | 8.90 |   |   | 205,858 |   |   | 0.85 |   |   |
|  1.00 to  1.00                         |       | 1,937,500                    |       |                         | 1.00       |   |   |   | 8.98 |   |   | 490,001 |   |   | 1.00 |   |   |
|  1.10 to  3.40                         |       | 1,758,000                    |       |                         | 2.01       |   |   |   | 9.18 |   |   | 162,500 |   |   | 1.10 |   |   |
|  4.50 to  14.45                        |       | 797,500                      |       |                         | 7.42       |   |   |   | 9.69 |   |   | — |   |   | — |   |   |
| 18.36 to 18.36                              |       | 177,500                      |       |                         | 18.36      |   |   |   | 9.97 |   |   | — |   |   | — |   |   |
| Total                                       |       | 8,822,694                    |       |                         | $          | 1.89 |   |   |   | 8.51 |   |   | 2,768,587 |   |   | $ | 0.55 |   |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

80

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***Note Receivable Issued to Employees***

The Company issued sharesof common stock to employees in exchange for promissory notes. These notes werefull recourse to the employees and were collateralized by the underlying sharesof common stock. The note receivable accrued interest at 7% per annum, whichwas the prevailing market interest rate on the date of issuance. As ofDecember 31, 2005, the outstanding balance of the promissory notes and allaccrued interest had been repaid in full.

**7. Commitments andContingencies**

***Operating Leases***

TheCompany conducts its operations in leased office facilities under variousoperating leases that expire through fiscal 2011. Certain of the Company’soperating leases include escalating payment amounts. In accordance with SFAS No. 13,*Accounting for Leases*, the Company isrecognizing the related rent expense on a straight-line basis over the term ofthe lease. As of December 31, 2006 and 2005, the Company has deferred rentof approximately $372 and $290, respectively. Total rent expense under theseoperating leases was approximately $1,052, $746 and $599, for the years endedDecember 31, 2006, 2005 and 2004, respectively. Future minimum leasepayments under noncancelable operating leases at December 31, 2006 were asfollows:

| Years Ending  December 31: |   |   |   |
|---------------------------------|--------|--------|--------|
| 2007                            |   | $      | 1,218  |   |
| 2008                            |   | 1,264  |   |
| 2009                            |   | 1,327  |   |
| 2010                            |   | 706    |   |
| 2011                            |   | 38     |   |
| Total minimum lease  payments   |   | $      | 4,553  |   |

 

***Litigation***

From time to time and inthe ordinary course of business, the Company may be subject to various claims,charges, and litigation. At December 31, 2006, 2005 and 2004, the Companydid not have any pending claims, charges, or litigation that it expects wouldhave a material adverse effect on its consolidated financial position, resultsof operations, or cash flows.

***Other***

Certain of the Company’s arrangements with customersinclude clauses whereby the Company may be subject to penalties for failure tomeet certain performance obligations. The Company has not incurred any suchpenalties to date.

**8. LeaseAbandonment**

During the year ended December 31, 2004, theCompany recorded expense of $848 related to the relocation of the Company’scorporate headquarters which occurred in January 2005. Of this charge,$760 represents the loss on the prior facilities lease and $88 related to theabandonment of related fixed assets and leasehold improvements. The facilitylease loss represents 16.5 months of rent remaining under an existinglease obligation at the time the use of the facility was ceased and relatedoperating expenses. The Company does not anticipate any sublease income overthe remaining term of the lease agreement.

81

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Thefollowing table summarizes the lease abandonment reserve balance and activityduring the years ended December 31, 2006, 2005 and 2004:

| ** **                            | ** ** | **Long-Lived  Asset  Impairment** | ** ** | **Existing Lease  Obligations** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|-----------------------------------|------------|--------------------------------------|------------|-----------|------------|
| Balance as of  December 31, 2003 |       |                              | $          | —                               |       |      |       | $ | — |   |   | $ | — |   |
| Lease loss provision                  |       |                              | 88         |                                 |       |      | 760        |   |   | 848 |   |
| Asset write-downs                     |       |                              | (88        | )                                    |       |      | —     |   |   | (88 | ) |
| Balance as of December 31, 2004  |       |                              | —     |                                 |       |      | 760        |   |   | 760 |   |
| Cash payments                         |       |                              | —     |                                 |       |      | (551       | ) |   | (551 | ) |
| Balance as of December 31, 2005  |       |                              | —     |                                 |       |      | 209        |   |   | 209 |   |
| Cash payments                         |       |                              | —     |                                 |       |      | (209       | ) |   | (209 | ) |
| Balance as of  December 31, 2006 |       |                              | $          | —                               |       |      |       | $ | — |   |   | $ | — |   |

 

As of December 31,2005, the remaining lease loss reserve balance is classified as current and isincluded in accrued expenses in the accompanying consolidated balance sheet.

**9. Accrued Expensesand Other Current Liabilities**

Accruedexpenses and other current liabilities consist of the following:

| ** **                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Accrued compensation  and related benefits |       |                  | 3,339      |   |   | $ | 2,297 |   |
| Accrued sales and  use taxes               |       |                  | 2,293      |   |   | 1,057 |   |
| Accrued income  taxes                      |       |                  | 925        |   |   | — |   |
| Lease  abandonment, current portion        |       |                  | —     |   |   | 209 |   |
| Accrued warranty                           |       |                  | 461        |   |   | 392 |   |
| Other accrued  liabilities                 |       |                  | 841        |   |   | 267 |   |
| Total                                      |       |                  | $          | 7,859 |   |   | $ | 4,222 |   |
|                                            |            |                       |            |  |  |  |  |  |  |

 

**10. SegmentInformation**

SFAS No. 131, *DisclosuresAbout Segments of an Enterprise and Related Information*, establishesstandards for reporting information about operating segments in annualfinancial statements and requires selected information of these segments bepresented in interim financial reports issued to stockholders. Operatingsegments are defined as components of an enterprise about which separatefinancial information is available that is evaluated regularly by the chiefoperating decision maker, or decision making group, in making decisions on howto allocate resources and assess performance. The Company’s chief decisionmaker, as defined under SFAS No. 131, is the chief executive officer. TheCompany views its operations and manages its business as one operating segment.

For the years ended December 31,2006, 2005 and 2004, operations related to the Company’s foreign subsidiariesare not material to the accompanying consolidated financial statements taken asa whole.

82

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**Geographic Data**

Netsales to unaffiliated customers by geographic area were as follows:

| ** **                | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------|------------|----------------------------------------|------------|
| ** **                | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States and  Canada |       | $                                      | 47,965     |   | $ | 21,357 |   | $ | 8,045 |   |
| International             |       | 36,105                                 |       | 14,763 |   | 7,948 |   |
|                      |       | $                                      | 84,070     |   | $ | 36,120 |   | $ | 15,993 |   |

 

**11. 401(k) Plan**

The Company maintains theAcme Packet, Inc. 401(k) Pension and Profit Sharing Plan (the 401(k) Plan)under Section 401(k) of the Internal Revenue Code covering alleligible employees. Employees of the Company may participate in the 401(k) Planafter reaching the age of 21. The Company may make discretionary matchingcontributions and profit sharing contributions, as determined annually by theBoard. Employee contributions vest immediately, while Company matchingcontributions vest ratably over four years. To date, the Company has not madeany discretionary contributions to the 401(k) Plan.

**12. Quarterly Financial Data (unaudited)**

| ** **                                                        | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                        | ** ** | **March 31,  2005**         | ** ** | **June 30,  2005** | ** ** | **Sept. 30,  2005** | ** ** | **Dec. 31,  2005** | ** ** |
| Total revenue                                                     | ** ** |                             | $          | 8,407 |   |   |   | $ | 8,270 | ** ** |   | $ | 6,768 | ** ** | $ | 12,675 |   |
| Gross profit                                                      | ** ** |                             | 6,092      |   |   |   | 6,025 | ** ** |   | 4,539 | ** ** | 10,237 |   |
| Income (loss)  from operations                                    | ** ** |                             | 267        |   |   |   | (365 | ) |   | (2,586 | ) | 2,301 |   |
| Net income (loss)                                                 | ** ** |                             | 357        |   |   |   | (274 | ) |   | (2,501 | ) | 2,383 |   |
| Net income (loss) per share applicable to common stockholders(1): | ** ** |                             |       |   |   |   |   |   |   |   |   |   |   |
| Basic                                                             | ** ** |                             | $          | — |   |   |   | $ | (0.02 | ) |   | $ | (0.16 | ) | $ | — |   |
| Diluted                                                           | ** ** |                             | $          | — |   |   |   | $ | (0.02 | ) |   | $ | (0.16 | ) | $ | — |   |

 

| ** **                                                  | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                  | ** ** | **March 31,  2006**         | ** ** | **June 30,  2006** | ** ** | **Sept. 30,  2006** | ** ** | **Dec. 31,  2006** | ** ** |
| Total revenue                                               |       |                             | $          | 18,925 |   |   | $ | 19,154 |   | $ | 22,295 |   | $ | 23,696 |   |
| Gross profit                                                |       |                             | 14,634     |   |   | 15,353 |   | 17,745 |   | 18,763 |   |
| Income from  operations                                     |       |                             | 6,016      |   |   | 5,053 |   | 6,712 |   | 5,401 |   |
| Net income                                                  |       |                             | 6,021      |   |   | 5,229 |   | 6,813 |   | 10,801 |   |
| Net income per  share applicable to common stockholders(1): |       |                             |       |   |   |   |   |   |   |   |   |
| Basic                                                       |       |                             | $          | 0.12 |   |   | $ | 0.11 |   | $ | 0.14 |   | $ | 0.20 |   |
| Diluted                                                     |       |                             | $          | 0.11 |   |   | $ | 0.09 |   | $ | 0.12 |   | $ | 0.18 |   |

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(1)          Netincome (loss) per share for all periods presented has been calculated inaccordance with SFAS No. 128, as clarified by EITF Issue No. 03-6.See Note 2 for further detail.

**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosure

None.

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**Item 9A.**                Controlsand Procedures

Our management, with the participation of our chiefexecutive officer and chief financial officer, evaluated the effectiveness ofour disclosure controls and procedures as of December 31, 2006. The term “disclosurecontrols and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act, means controls and other procedures of a company that aredesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under the Exchange Act is recorded,processed, summarized and reported, within the time periods specified in theSEC’s rules and forms. Disclosure controls and procedures include, withoutlimitation, controls and procedures designed to ensure that informationrequired to be disclosed by a company in the reports that it files or submitsunder the Exchange Act is accumulated and communicated to the company’s management,including its principal executive and principal financial officers, asappropriate to allow timely decisions regarding required disclosure. Managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving their objectivesand management necessarily applies its judgment in evaluating the cost-benefitrelationship of possible controls and procedures. Based on the evaluation ofour disclosure controls and procedures as of December 31, 2006, our chiefexecutive officer and chief financial officer concluded that, as of such date,our disclosure controls and procedures were effective at the reasonableassurance level.

No change in our internalcontrol over financial reporting occurred during the fiscal quarter ended December 31,2006 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

**Item 9B.**               OtherInformation

None.

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**PART III**

**Item 10.      Directors and Executive Officers of theRegistrant**

Incorporated by referencefrom the information in our proxy statement for the 2007 Annual Meeting ofStockholders, which we will file with the Securities and Exchange Commissionwithin 120 days of the end of the fiscal year to which this reportrelates.

**Item11.      Executive Compensation**

Incorporated by referencefrom the information in our proxy statement for the 2007 Annual Meeting ofStockholders, which we will file with the Securities and Exchange Commissionwithin 120 days of the end of the fiscal year to which this reportrelates.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

Incorporated by referencefrom the information in our proxy statement for the 2007 Annual Meeting ofStockholders, which we will file with the Securities and Exchange Commissionwithin 120 days of the end of the fiscal year to which this reportrelates.

**Item 13.**                 CertainRelationships and Related Transactions and Director Independence

Incorporated by referencefrom the information in our proxy statement for the 2007 Annual Meeting of Stockholders,which we will file with the Securities and Exchange Commission within120 days of the end of the fiscal year to which this report relates.

**Item 14.**                 PrincipalAccounting Fees and Services

Incorporated by reference from the information in ourproxy statement for the 2007 Annual Meeting of Stockholders, which we will filewith the Securities and Exchange Commission within 120 days of the end ofthe fiscal year to which this report relates.

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**PART IV**

**Item 15.**          Exhibits,Financial Statement Schedules

(a)(1)                    FinancialStatements.

The response tothis portion of Item 15 is set forth under Item 8 above.

(a)(2)                    FinancialStatement Schedules.

All schedules havebeen omitted because they are not required or because the required informationis given in the Consolidated Financial Statements or Notes thereto.

(a)(3)                    Exhibits

**EXHIBIT INDEX**

| **Exhibit No.** | ** ** | **Description**                                                                                                                                 | ** ** |
|----------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|   3.1*     |       | Eighth Amended  and Restated Certificate of Incorporation of the Registrant                                                                     |       |
|   3.2*     |       | Bylaws of the  Registrant                                                                                                                       |       |
|   3.3*     |       | Amended and  Restated Certificate of Incorporation of the Registrant                                                                            |       |
|   3.4*     |       | Amended and  Restated Bylaws of the Registrant                                                                                                  |       |
|   4.1*     |       | Specimen  certificate evidencing shares of common stock                                                                                         |       |
| 10.1*                |       | Northwest Park  Lease, dated August 9, 2004, by and between Seventy One Limited  Liability Company and the Registrant                      |       |
| 10.2*                |       | Northwest Park  Lease, dated July 10, 2006, by and between the Registrant and MTP  Limited Partnership                                     |       |
| 10.3*                |       | Amended and  Restated 2000 Equity Incentive Plan                                                                                                |       |
| 10.4*                |       | Amended and  Restated Registration Rights Agreement, dated June 8, 2004, by and  between the Registrant and the shareholders named therein |       |
| 10.5*                |       | Incentive Stock  Option Agreement, dated December 23, 2005, by and between the Registrant  and Patrick MeLampy                             |       |
| 10.6*                |       | Incentive Stock  Option Agreement, dated May 19, 2004, by and between the Registrant and  Patrick MeLampy                                  |       |
| 10.7*                |       | Incentive Stock  Option Agreement, dated December 23, 2005, by and between the Registrant  and Dino DiPalma                                |       |
| 10.8*                |       | Incentive Stock  Option Agreement, dated November 23, 2005, by and between the Registrant  and Dino DiPalma                                |       |
| 10.9*                |       | Incentive Stock  Option Agreement, dated January 19, 2005, by and between the Registrant  and Dino DiPalma                                 |       |
| 10.10*               |       | Incentive Stock  Option Agreement, dated August 16, 2004, by and between the Registrant  and Dino DiPalma                                  |       |
| 10.11*               |       | Incentive Stock  Option Agreement, dated January 14, 2004, by and between the Registrant  and Dino DiPalma                                 |       |
| 10.12*               |       | Incentive Stock  Option Agreement, dated September 17, 2002, by and between the  Registrant and Dino DiPalma                               |       |

86

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| 10.13* |   | Employee Stock  Purchase Agreement, dated September 15, 2004, by and among the  Registrant, Seamus Hourihan and Robert G. Ory, in his capacity as escrow  holder |   |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| 10.14* |   | Employee Stock  Purchase Agreement, dated January 29, 2004, by and among the Registrant,  Seamus Hourihan and Robert G. Ory, in his capacity as escrow holder         |   |
| 10.15* |   | Incentive Stock  Option Agreement, dated September 17, 2002, between the Registrant and  Seamus Hourihan                                                              |   |
| 10.16* |   | Incentive Stock  Option Agreement, dated December 23, 2005, by and between the Registrant  and Andrew Ory                                                             |   |
| 10.17* |   | Incentive Stock  Option Agreement, dated May 19, 2004, by and between the Registrant and  Andrew Ory                                                                  |   |
| 10.18* |   | Incentive Stock  Option Agreement, dated December 23, 2005, by and between the Registrant  and Keith Seidman                                                          |   |
| 10.19* |   | Incentive Stock  Option Agreement, dated November 23, 2005, by and between the Registrant  and Keith Seidman                                                          |   |
| 10.20* |   | Incentive Stock  Option Agreement, dated August 16, 2004, by and between the Registrant  and Keith Seidman                                                            |   |
| 10.21* |   | Incentive Stock  Option Agreement, dated September 18, 2003, by and between the  Registrant and Keith Seidman                                                         |   |
| 10.22* |   | 2006 Equity  Incentive Plan                                                                                                                                                |   |
| 10.23* |   | 2006 Director  Stock Option Plan                                                                                                                                           |   |
| 14.1   |   | Code of Ethics                                                                                                                                                             |   |
| 21.1*  |   | Subsidiaries of  the Registrant                                                                                                                                            |   |
| 23.1   |   | Consent of  Enst & Young LLP, Independent Registered Public Accounting Firm                                                                                       |   |
| 31.1   |   | Certification of  the Chief Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act                                                                      |   |
| 31.2   |   | Certification of  the Chief Financial Officer pursuant to Section 302 of the  Sarbanes-Oxley Act                                                                      |   |
| 32.1   |   | Certification of  the Chief Executive Officer and Chief Financial Officer pursuant to  Section 906 of the Sarbanes-Oxley Act                                          |   |

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*                    Incorporatedby reference to Registrant’s Form S-1 Registration No. 333-134683

87

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**SIGNATURES**

Pursuant to therequirements of the Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

|                            | aCME  pACKET, iNC.  (Registrant) |
|----------------------------|----------------------------------|
| Date: March 15,  2007 | By:                              | /s/  ANDREW D. ORY |
|                       |                             | Andrew D. Ory

*President  and Chief Executive Officer* |
| Date: March 15,  2007 | By:                              | /s/  KEITH SEIDMAN |
|                       |                             | Keith Seidman

*Chief  Financial Officer and Treasurer* |

 

Pursuantto the requirements of the Securities Act of 1934, this report has been signedbelow by the following persons in the capacities and dates indicated.

|                                    | **Signature** | ** **                                       | ** ** | ** **           | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|------------------------------------|---------------|--------------------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
| /s/  ANDREW  D. ORY      |          | President and  Chief Executive Officer; Director |       | March 15,  2007 |
| Andrew  D. Ory                     |          | (Principal Executive  Officer)                   |       |                 |
| /s/ KEITH  SEIDMAN            |          | Chief Financial  Officer                         |       | March 15,  2007 |
| Keith  Seidman                     |          | (Principal Accounting  and Financial Officer)    |       |                 |
| /s/ GARY  J. BOWEN            |          | Director                                         |       | March 15,  2007 |
| Gary  J. Bowen                     |          |                                             |       |                 |
| /s/ DAVID  ELSBREE                 |          | Director                                         |       | March 15,  2007 |
| David  Elsbree                     |          |                                             |       |                 |
| /s/ ROBERT  HOWER             |          | Director                                         |       | March 15,  2007 |
| Robert  Hower                      |          |                                             |       |                 |
| /s/  PATRICK  J. MElAMPY |          | Director                                         |       | March 15,  2007 |
| Patrick  J. MeLampy                |          |                                             |       |                 |
| /s/  ROBERT  G. ORY      |          | Director                                         |       | March 15,  2007 |
| Robert  G. Ory                     |          |                                             |       |                 |
| /s/ SONJA HOEL  PERKINS            |          | Director                                         |       | March 15,  2007 |
| Sonja Hoel  Perkins                |          |                                             |       |                 |

 

88

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