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U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON DC 20549



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FORM 10-Q



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(Mark One)

|x | QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------



For the quarterly period ended December 31, 2005



| ̈ | TRANSITION REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | -----------------------------------------------------------------------------------



For the transition period from  to
.



Commission File No. 0-28452



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VELOCITY EXPRESS CORPORATION

(Exact name of registrant as specified in its charter)



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|                                               |  |                                  
|---------------------------------------------- |  | ---------------------------------
|Delaware                                       |  | 87-0355929                       
|(State or other jurisdiction of incorporation) |  | (IRS Employer Identification No.)



One Morningside
Drive North, Bldg. B, Suite 300,

Westport, Connecticut 06880

(Address of Principal Executive Offices including Zip Code)



(203) 349-4160

(Registrants
telephone number, including area code)



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Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90
days.    YES  x    NO ̈



Indicate by check mark whether the registrant is a large accelerated filer, an accelerated
filer, or a non-accelerated filer. See definition of accelerated filer and larger accelerated filer in Rule 12b-2 of the Exchange Act. Large accelerated filer
() Accelerated filer () Non-accelerated filer  x



Indicate by check mark whether the registrant
is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).    YES ̈NO  x



As of February 6, 2006, there were 16,424,584 shares of common stock of the registrant issued and outstanding.



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##### Table of Contents

VELOCITY EXPRESS CORPORATION AND SUBSIDIARIES



INDEX TO FORM 10-Q



December 31, 2005



|           |  |                                                                                                     |  |     
|---------- |  | --------------------------------------------------------------------------------------------------- |  | ----
|           |  |                                                                                                     |  | Page
|PART I.    |  | FINANCIAL INFORMATION                                                                               |  | 3   
|           |  |                                                                                                    
|ITEM 1.    |  | Financial Statements                                                                                |  |     
|           |  |                                                                                                    
|           |  | Balance Sheets as of December 31, 2005 and July 2, 2005                                             |  | 3   
|           |  |                                                                                                    
|           |  | Statements of Operations for the Three and Six Months Ended December 31, 2005 and January 1, 2005   |  | 4   
|           |  |                                                                                                    
|           |  | Statement of Shareholders Equity and Comprehensive Loss for the Six Months Ended December 31, 2005 |  | 5   
|           |  |                                                                                                    
|           |  | Statements of Cash Flows for the Six Months Ended December 31, 2005 and January 1, 2005             |  | 6   
|           |  |                                                                                                    
|           |  | Notes to Consolidated Financial Statements                                                          |  | 7   
|           |  |                                                                                                    
|ITEM 2.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations               |  | 14  
|           |  |                                                                                                    
|ITEM 3.    |  | Quantitative and Qualitative Disclosures About Market Risk                                          |  | 21  
|           |  |                                                                                                    
|ITEM 4.    |  | Controls and Procedures                                                                             |  | 21  
|           |  |                                                                                                    
|PART II.   |  | OTHER INFORMATION                                                                                   |  | 22  
|           |  |                                                                                                    
|ITEM 1.    |  | Legal Proceedings                                                                                   |  | 22  
|           |  |                                                                                                    
|ITEM 2.    |  | Unregistered Sales of Equity Securities and Use of Proceeds                                         |  | 23  
|           |  |                                                                                                    
|ITEM 3.    |  | Defaults Upon Senior Securities                                                                     |  | 23  
|           |  |                                                                                                    
|ITEM 4.    |  | Submission of Matters to a Vote of Security Holders                                                 |  | 24  
|           |  |                                                                                                    
|ITEM 5.    |  | Other Information                                                                                   |  | 24  
|           |  |                                                                                                    
|ITEM 6.    |  | Exhibits                                                                                            |  | 24  
|           | 
|SIGNATURES |  | 25                                                                                                 



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##### Table of Contents

PART I.



ITEM 1. FINANCIAL STATEMENTS.



VELOCITY EXPRESS CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(Amounts in thousands, except
par value)



|                                                                                                                                                                |  |                  |          |   |              |   |          |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | -------- | - | ------------ | - | -------- | -
|                                                                                                                                                                |  | December 31,2005 |          |   | July 2, 2005 |  
|ASSETS                                                                                                                                                          |  |                  |          |   |              |   |          |  
|                                                                                                                                                                |  |                 
|Current assets:                                                                                                                                                 |  |                  |          |   |              |   |          |  
|Cash                                                                                                                                                            |  | $                | 1,775    |   |              | $ | 5,806    |  
|Accounts receivable, net of allowance of $6,290 and $9,879 at December 31, 2005 and July 2, 2005, respectively                                                  |  |                  | 17,097   |   |              |   | 19,736   |  
|Accounts receivable - other                                                                                                                                     |  |                  | 2,006    |   |              |   | 809      |  
|Prepaid workers compensation and auto liability insurance                                                                                                      |  |                  | 2,593    |   |              |   | 3,462    |  
|Other prepaid expenses                                                                                                                                          |  |                  | 1,071    |   |              |   | 1,983    |  
|Other current assets                                                                                                                                            |  |                  | 309      |   |              |   | 290      |  
|                                                                                                                                                                |  |                  |          |   |              |   |          |  
|Total current assets                                                                                                                                            |  |                  | 24,851   |   |              |   | 32,086   |  
|                                                                                                                                                                |  |                 
|Property and equipment, net                                                                                                                                     |  |                  | 8,040    |   |              |   | 9,486    |  
|Goodwill                                                                                                                                                        |  |                  | 42,830   |   |              |   | 42,830   |  
|Deferred financing costs, net                                                                                                                                   |  |                  | 1,144    |   |              |   | 1,821    |  
|Other assets                                                                                                                                                    |  |                  | 1,184    |   |              |   | 1,133    |  
|                                                                                                                                                                |  |                  |          |   |              |   |          |  
|Total assets                                                                                                                                                    |  | $                | 78,049   |   |              | $ | 87,356   |  
|                                                                                                                                                                |  |                  |          |   |              |   |          |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                                            |  |                  |          |   |              |   |          |  
|                                                                                                                                                                |  |                 
|Current liabilities:                                                                                                                                            |  |                  |          |   |              |   |          |  
|Trade accounts payable                                                                                                                                          |  | $                | 13,636   |   |              | $ | 18,962   |  
|Accrued insurance and claims                                                                                                                                    |  |                  | 2,403    |   |              |   | 3,206    |  
|Accrued wages and benefits                                                                                                                                      |  |                  | 2,198    |   |              |   | 2,623    |  
|Accrued legal and claims                                                                                                                                        |  |                  | 5,397    |   |              |   | 7,252    |  
|Related party liabilities                                                                                                                                       |  |                  | 124      |   |              |   | 2,446    |  
|Other accrued liabilities                                                                                                                                       |  |                  | 1,297    |   |              |   | 2,721    |  
|Current portion of long-term debt                                                                                                                               |  |                  | 25,520   |   |              |   | 31,326   |  
|                                                                                                                                                                |  |                  |          |   |              |   |          |  
|Total current liabilities                                                                                                                                       |  |                  | 50,575   |   |              |   | 68,536   |  
|                                                                                                                                                                |  |                 
|Long-term debt                                                                                                                                                  |  |                  | 71       |   |              |   | 2,829    |  
|Accrued insurance and claims                                                                                                                                    |  |                  | 3,029    |   |              |   | 4,775    |  
|Restructuring liabilities                                                                                                                                       |  |                  | 393      |   |              |   | 354      |  
|Other long-term liabilities                                                                                                                                     |  |                  | 389      |   |              |   | 433      |  
|                                                                                                                                                                |  |                 
|Commitments and contingencies                                                                                                                                   |  |                  |         |   |              |   |         |  
|                                                                                                                                                                |  |                 
|Shareholders equity:                                                                                                                                           |  |                  |          |   |              |   |          |  
|Preferred stock, $0.004 par value, 299,515 shares authorized 10,845 and 8,958 shares issued and outstanding at December 31, 2005 and
July 2, 2005, respectively |  |                  | 35,429   |   |              |   | 31,548   |  
|Common stock, $0.004 par value, 700,000 shares authorized 16,425 and 13,065 shares issued and outstanding at December 31, 2005 and
July 2, 2005, respectively   |  |                  | 66       |   |              |   | 52       |  
|Stock subscription receivable                                                                                                                                   |  |                  | (7,543   | ) |              |   | (7,543   | )
|Additional paid-in-capital                                                                                                                                      |  |                  | 309,940  |   |              |   | 286,896  |  
|Accumulated deficit                                                                                                                                             |  |                  | (314,316 | ) |              |   | (300,553 | )
|Accumulated other comprehensive income                                                                                                                          |  |                  | 16       |   |              |   | 29       |  
|                                                                                                                                                                |  |                  |          |   |              |   |          |  
|Total shareholders equity                                                                                                                                      |  |                  | 23,592   |   |              |   | 10,429   |  
|                                                                                                                                                                |  |                  |          |   |              |   |          |  
|Total liabilities and shareholders equity                                                                                                                      |  | $                | 78,049   |   |              | $ | 87,356   |  
|                                                                                                                                                                |  |                  |          |   |              |   |          |  



See notes to
consolidated financial statements.



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##### Table of Contents

VELOCITY EXPRESS CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(Amounts in thousands, except
per share data)



|                                           |  |                    |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|------------------------------------------ |  | ------------------ | ------ | - | ---------------- | - | ------- | ---------------- |  | - | -------------- | - |  | - | ------- | -
|                                           |  | Three Months Ended |        |   | Six Months Ended |  
|                                           |  | December 31,2005   |        |   | January 1,2005   |   |         | December 31,2005 |  |   | January 1,2005 |  
|Revenue                                    |  | $                  | 49,316 |   |                  | $ | 65,511  |                  |  | $ | 101,862        |   |  | $ | 133,424 |  
|Cost of services                           |  |                    | 35,136 |   |                  |   | 54,014  |                  |  |   | 73,348         |   |  |   | 109,066 |  
|                                           |  |                    |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Gross profit                               |  |                    | 14,180 |   |                  |   | 11,497  |                  |  |   | 28,514         |   |  |   | 24,358  |  
|Operating expenses:                        |  |                    |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Occupancy                                  |  |                    | 3,187  |   |                  |   | 3,629   |                  |  |   | 6,126          |   |  |   | 7,071   |  
|Selling, general and administrative        |  |                    | 13,662 |   |                  |   | 16,396  |                  |  |   | 27,971         |   |  |   | 31,377  |  
|                                           |  |                    |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Total operating expenses                   |  |                    | 16,849 |   |                  |   | 20,025  |                  |  |   | 34,097         |   |  |   | 38,448  |  
|                                           |  |                    |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Loss from operations                       |  |                    | (2,669 | ) |                  |   | (8,528  | )                |  |   | (5,583         | ) |  |   | (14,090 | )
|Other income (expense):                    |  |                    |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Interest expense                           |  |                    | (1,247 | ) |                  |   | (823    | )                |  |   | (2,343         | ) |  |   | (1,638  | )
|Other                                      |  |                    | 209    |   |                  |   | 140     |                  |  |   | 723            |   |  |   | 185     |  
|                                           |  |                    |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Net loss                                   |  | $                  | (3,707 | ) |                  | $ | (9,211  | )                |  | $ | (7,203         | ) |  | $ | (15,543 | )
|                                           |  |                    |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Net loss applicable to common shareholders |  | $                  | (5,777 | ) |                  | $ | (20,088 | )                |  | $ | (12,353        | ) |  | $ | (44,688 | )
|                                           |  |                    |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Basic and diluted net loss per share       |  | $                  | (0.36  | ) |                  | $ | (75.71  | )                |  | $ | (0.82          | ) |  | $ | (182.25 | )
|                                           |  |                    |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Weighted average shares outstanding        |  |                    |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Basic and diluted                          |  |                    | 15,907 |   |                  |   | 265     |                  |  |   | 15,023         |   |  |   | 245     |  
|                                           |  |                    |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  



See notes to
consolidated financial statements.



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##### Table of Contents

VELOCITY EXPRESS CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS EQUITY AND
COMPREHENSIVE LOSS

(Unaudited)

(Amounts in thousands)



|                                                   |  |                          |   |  |                          |        |   |                          |       |   |                          |   |        |              |  |                             |        |  |                          |        |   |                    |       |  |                                            |       |        |       |        |  |   |    |  |   |        |   |  |   |         |   |  |   |          |   |  |   |     |   |  |   |        |  
|-------------------------------------------------- |  | ------------------------ | - |  | ------------------------ | ------ | - | ------------------------ | ----- | - | ------------------------ | - | ------ | ------------ |  | --------------------------- | ------ |  | ------------------------ | ------ | - | ------------------ | ----- |  | ------------------------------------------ | ----- | ------ | ----- | ------ |  | - | -- |  | - | ------ | - |  | - | ------- | - |  | - | -------- | - |  | - | --- | - |  | - | ------ | -
|                                                   |  | Series M Preferred Stock |   |  | Series N Preferred Stock |        |   | Series O Preferred Stock |       |   | Series P Preferred Stock |   |        | Common Stock |  | StockSubscriptionReceivable |        |  | AdditionalPaid-inCapital |        |   | AccumulatedDeficit |       |  | AccumulatedOtherComprehensiveIncome (loss) |       |        | Total |       
|                                                   |  | Shares                   |   |  | Amount                   |        |   | Shares                   |       |   | Amount                   |   |        | Shares       |  |                             | Amount |  |                          | Shares |   | Amount             |       |  | Shares                                     |       | Amount |       |        |  |   |   
|Balance at July 2, 2005                            |  | 6,414                    |   |  | $                        | 22,591 |   |                          | 2,544 |   |                          | $ | 8,957  |              |  |                            |        |  | $                        |       |   |                    |      |  | $                                          |      |        |       | 13,065 |  | $ | 52 |  | $ | (7,543 | ) |  | $ | 286,896 |   |  | $ | (300,553 | ) |  | $ | 29  |   |  | $ | 10,429 |  
|                                                   |  |                          |   |  |                          |        |   |                          |       |   |                          |   |        |              | 
|Stock option and warrant expense                   |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  |                            |        |  |                          |       |   |                    |      |  |                                            |      |        |       |       |  |   |   |  |   |       |   |  |   | 352     |   |  |   |         |   |  |   |    |   |  |   | 352    |  
|Warrants conversion                                |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  |                            |        |  |                          |       |   |                    |      |  |                                            |      |        |       | 19     |  |   |   |  |   |       |   |  |   | 4       |   |  |   |         |   |  |   |    |   |  |   | 4      |  
|Warrants issued                                    |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  |                            |        |  |                          |       |   |                    |      |  |                                            |      |        |       |       |  |   |   |  |   |       |   |  |   | 4,890   |   |  |   |         |   |  |   |    |   |  |   | 4,890  |  
|Preferred Stock PIK Dividends Declared             |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  |                            |        |  |                          |       |   |                    |      |  |                                            |      |        |       |       |  |   |   |  |   |       |   |  |   | 1,512   |   |  |   | (1,410   | ) |  |   |    |   |  |   | 102    |  
|Offering costs                                     |  |                         |   |  |                          |       |   |                          |      |   |                          |   | (19    | )            |  |                            |        |  |                          | (209   | ) |                    |      |  |                                            | (743  | )      |       |       |  |   |   |  |   |       |   |  |   |        |   |  |   |         |   |  |   |    |   |  |   | (971   | )
|Issuance of Common Stock                           |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  |                            |        |  |                          |       |   |                    |      |  |                                            |      |        |       | 500    |  |   | 2  |  |   |       |   |  |   | 1,228   |   |  |   |         |   |  |   |    |   |  |   | 1,230  |  
|Issuance of Series M Preferred Stock PIK Dividends |  | 228                      |   |  |                          | 841    |   |                          |      |   |                          |   |       |              |  |                            |        |  |                          |       |   |                    |      |  |                                            |      |        |       |       |  |   |   |  |   |       |   |  |   | (841    | ) |  |   |         |   |  |   |    |   |  |   |       |  
|Issuance of Series O Preferred Stock               |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  | 1,400                       |        |  |                          | 5,600  |   |                    |      |  |                                            |      |        |       |       |  |   |   |  |   |       |   |  |   |        |   |  |   |         |   |  |   |    |   |  |   | 5,600  |  
|Issuance of Series P Preferred Stock               |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  |                             |        |  |                          |        |   |                    | 3,094 |  |                                            | 9,152 |        |       |       |  |   |   |  |   |       |   |  |   |        |   |  |   |         |   |  |   |    |   |  |   | 9,152  |  
|Issuance of Series P Preferred Stock for services  |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  |                             |        |  |                          |        |   |                    | 6     |  |                                            | 20    |        |       |       |  |   |   |  |   |       |   |  |   |        |   |  |   |         |   |  |   |    |   |  |   | 20     |  
|Conversion of Series M Preferred to Common Stock   |  | (1,200                   | ) |  |                          | (4,422 | ) |                          |      |   |                          |   |       |              |  |                            |        |  |                          |       |   |                    |      |  |                                            |      |        |       | 1,200  |  |   | 5  |  |   |       |   |  |   | 4,417   |   |  |   |         |   |  |   |    |   |  |   |       |  
|Conversion of Series N Preferred to Common Stock   |  |                         |   |  |                          |       |   |                          | (715  | ) |                          |   | (2,634 | )            |  |                            |        |  |                          |       |   |                    |      |  |                                            |      |        |       | 715    |  |   | 3  |  |   |       |   |  |   | 2,631   |   |  |   |         |   |  |   |    |   |  |   |       |  
|Conversion of Series O Preferred to Common Stock   |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  | (926                        | )      |  |                          | (3,705 | ) |                    |      |  |                                            |      |        |       | 926    |  |   | 4  |  |   |       |   |  |   | 3,701   |   |  |   |         |   |  |   |    |   |  |   |       |  
|Beneficial conversion of Series N Preferred Stock  |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  |                            |        |  |                          |       |   |                    |      |  |                                            |      |        |       |       |  |   |   |  |   |       |   |  |   | 648     |   |  |   | (648     | ) |  |   |    |   |  |   |       |  
|Beneficial conversion of Series O Preferred Stock  |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  |                            |        |  |                          |       |   |                    |      |  |                                            |      |        |       |       |  |   |   |  |   |       |   |  |   | 3,270   |   |  |   | (3,270   | ) |  |   |    |   |  |   |       |  
|Beneficial conversion of Series P Preferred Stock  |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  |                            |        |  |                          |       |   |                    |      |  |                                            |      |        |       |       |  |   |   |  |   |       |   |  |   | 1,232   |   |  |   | (1,232   | ) |  |   |    |   |  |   |       |  
|Net loss                                           |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  |                            |        |  |                          |       |   |                    |      |  |                                            |      |        |       |       |  |   |   |  |   |       |   |  |   |        |   |  |   | (7,203   | ) |  |   |    |   |  |   | (7,203 | )
|Foreign currency translation                       |  |                         |   |  |                          |       |   |                          |      |   |                          |   |       |              |  |                            |        |  |                          |       |   |                    |      |  |                                            |      |        |       |       |  |   |   |  |   |       |   |  |   |        |   |  |   |         |   |  |   | (13 | ) |  |   | (13    | )
|                                                   |  |                          |   |  |                          |        |   |                          |       |   |                          |   |        |              |  |                             |        |  |                          |        |   |                    |       |  |                                            |       |        |       |        |  |   |    |  |   |        |   |  |   |         |   |  |   |          |   |  |   |     |   |  |   |        |  
|Comprehensive loss                                 |  |                          |   |  |                          |        |   |                          |       |   |                          |   |        |              |  |                             |        |  |                          |        |   |                    |       |  |                                            |       |        |       |        |  |   |    |  |   |        |   |  |   |         |   |  |   |          |   |  |   |     |   |  | $ | (7,216 | )
|                                                   |  |                          |   |  |                          |        |   |                          |       |   |                          |   |        |              |  |                             |        |  |                          |        |   |                    |       |  |                                            |       |        |       |        |  |   |    |  |   |        |   |  |   |         |   |  |   |          |   |  |   |     |   |  |   |        |  
|Balance at December 31, 2005                       |  | 5,442                    |   |  | $                        | 19,010 |   |                          | 1,829 |   |                          | $ | 6,304  |              |  | 474                         |        |  | $                        | 1,686  |   |                    | 3,100 |  | $                                          | 8,429 |        |       | 16,425 |  | $ | 66 |  | $ | (7,543 | ) |  | $ | 309,940 |   |  | $ | (314,316 | ) |  | $ | 16  |   |  | $ | 23,592 |  
|                                                   |  |                          |   |  |                          |        |   |                          |       |   |                          |   |        |              |  |                             |        |  |                          |        |   |                    |       |  |                                            |       |        |       |        |  |   |    |  |   |        |   |  |   |         |   |  |   |          |   |  |   |     |   |  |   |        |  



See notes to
consolidated financial statements.



5



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##### Table of Contents

VELOCITY EXPRESS CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Amounts in thousands)



|                                                                                  |  |                  |        |   |                |   |         |  
|--------------------------------------------------------------------------------- |  | ---------------- | ------ | - | -------------- | - | ------- | -
|                                                                                  |  | Six Months Ended |       
|                                                                                  |  | December 31,2005 |        |   | January 1,2005 |  
|OPERATING ACTIVITIES                                                              |  |                  |        |   |                |   |         |  
|Net loss                                                                          |  | $                | (7,203 | ) |                | $ | (15,543 | )
|Adjustments to reconcile net loss to net cash flows used in operating activities: |  |                  |        |   |                |   |         |  
|Depreciation                                                                      |  |                  | 2,213  |   |                |   | 2,125   |  
|Amortization                                                                      |  |                  | 682    |   |                |   | 280     |  
|Gain on the sale of assets                                                        |  |                  | (74    | ) |                |   |        |  
|Equity instruments issued in lieu of payment for services received                |  |                  |       |   |                |   | 757     |  
|Change in fair value of settlement liability                                      |  |                  | 175    |   |                |   |        |  
|Stock option expense                                                              |  |                  | 352    |   |                |   | 92      |  
|Non-cash interest expense                                                         |  |                  | 80     |   |                |   | 29      |  
|Provision for doubtful accounts                                                   |  |                  | 1,010  |   |                |   | 830     |  
|Change in operating assets and liabilities:                                       |  |                  |        |   |                |   |         |  
|Accounts receivable                                                               |  |                  | 1,628  |   |                |   | 1,370   |  
|Other current assets                                                              |  |                  | 561    |   |                |   | (2,773  | )
|Other assets                                                                      |  |                  | (51    | ) |                |   | (275    | )
|Accounts payable                                                                  |  |                  | (5,327 | ) |                |   | (4,746  | )
|Accrued liabilities                                                               |  |                  | (3,934 | ) |                |   | (3,743  | )
|                                                                                  |  |                  |        |   |                |   |         |  
|Cash used in operating activities                                                 |  |                  | (9,888 | ) |                |   | (21,597 | )
|INVESTING ACTIVITIES                                                              |  |                  |        |   |                |   |         |  
|Proceeds from sale of assets                                                      |  |                  | 90     |   |                |   | 6       |  
|Capital expenditures                                                              |  |                  | (778   | ) |                |   | (2,563  | )
|Other                                                                             |  |                  |       |   |                |   | 157     |  
|                                                                                  |  |                  |        |   |                |   |         |  
|Cash used in investing activities                                                 |  |                  | (688   | ) |                |   | (2,400  | )
|FINANCING ACTIVITIES                                                              |  |                  |        |   |                |   |         |  
|Repayments of revolving credit agreement, net                                     |  |                  | (8,343 | ) |                |   | (1,256  | )
|(Payments of) proceeds from notes payable and long-term debt                      |  |                  | (301   | ) |                |   | 20,945  |  
|Proceeds from issuance of preferred stock, net                                    |  |                  | 15,189 |   |                |   | 21,645  |  
|Proceeds from issuance of common stock, net                                       |  |                  |       |   |                |   | 11      |  
|Stock subscription receivable, net activity                                       |  |                  |       |   |                |   | 54      |  
|                                                                                  |  |                  |        |   |                |   |         |  
|Cash provided by financing activities                                             |  |                  | 6,545  |   |                |   | 41,399  |  
|                                                                                  |  |                  |        |   |                |   |         |  
|Net change in cash                                                                |  |                  | (4,031 | ) |                |   | 17,402  |  
|                                                                                  |  |                  |        |   |                |   |         |  
|Cash, beginning of period                                                         |  |                  | 5,806  |   |                |   | 1,220   |  
|                                                                                  |  |                  |        |   |                |   |         |  
|Cash, end of period                                                               |  | $                | 1,775  |   |                | $ | 18,622  |  
|                                                                                  |  |                  |        |   |                |   |         |  



See notes to
consolidated financial statements.



6



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##### Table of Contents

1. DESCRIPTION OF BUSINESS



Velocity Express Corporation and its subsidiaries (collectively, the Company) are engaged in the business of providing same-day transportation and distribution/logistics services to individual consumers and businesses. The
Company operates primarily in the United States with limited operations in Canada. The Company currently operates in a single-business segment and thus additional disclosures under Statement of Financial Accounting Standards (SFAS)
No. 131, Disclosures About Segments of an Enterprise and Related Information, are not required.



2. SIGNIFICANT ACCOUNTING POLICIES



Basis of PresentationThe accompanying condensed consolidated financial statements included herein have been prepared by the Company, pursuant to the rules and regulations of the Securities
and Exchange Commission. Certain information in footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles has been condensed or omitted pursuant to such rules and regulations.
However, the Company believes that the disclosures are adequate to make the information presented not misleading. In the opinion of the Company, all adjustments, consisting of normal recurring adjustments, necessary to present fairly the financial
position of the Company, the results of its operations, and its cash flows have been included. The results of operations for interim periods are not necessarily indicative of the results that may be expected for the fiscal year ending July 1,
2006.



These consolidated financial statements should be read
in conjunction with the financial statements for the year ended July 2, 2005, and the footnotes thereto, included in the Companys Report on Form 10-K, as amended, filed with the Securities and Exchange Commission for such fiscal year. In
connection with the preparation of such consolidated financial statements for the year ended July 2, 2005 certain material weaknesses became evident to management including the inability to fully reconcile cash applications on a timely basis,
and due to resource constraints, the inability to close the Companys books in a timely manner on a month to month basis. A material weakness is a significant deficiency in one or more of the internal control components that alone or in the
aggregate precludes the Companys internal controls from reducing to an appropriately low level the risk that material misstatements in its financial statements will not be prevented or detected on a timely basis. If the Company is unable to
correct these weaknesses in a timely manner it will represent a risk.



Principles of ConsolidationThe consolidated financial statements include the accounts of Velocity Express Corporation and its wholly-owned subsidiaries. All inter-company balances and transactions have been
eliminated in the consolidation. The consolidated financial statements for the six month period ended January 1, 2005 also include Peritas as required by FASB Interpretation No. 46, Consolidation of Variable Interest Entities[FIN No. 46]. In November 2004 the Company no longer had a variable interest in Peritas that was at risk of disproportionate loss pursuant to its voting rights. Accordingly, Peritas was deconsolidated from the Companys
financial statements as of January 2, 2005.



ReclassificationsCertain reclassifications have been made to the prior period consolidated financial statements to conform to the current period presentation.



Comprehensive LossComprehensive loss were $3.7
million and $7.2 million for the three and six months ended December 31, 2005, respectively, and $9.1 million and $15.4 million for the three and six months ended January 1, 2005, respectively. The difference between net loss and total
comprehensive loss in the respective periods related to foreign currency translation adjustments.



Reverse stock SplitShareholder approval was granted for a 1:50 reverse stock split at the shareholders meeting held on
February 14, 2005. Such reverse stock split became effective at open of trading on February 16, 2005. All such share amounts are restated herein to reflect such reverse stock split.



Loss Per ShareBasic and diluted loss per share
are computed based on the weighted average number of common shares outstanding by dividing net loss applicable to common shareholders by the weighted average number of



7



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##### Table of Contents

common shares outstanding for the period. Securities or other obligations to issue common stock such as options, warrants
or convertible preferred stock, were excluded since their effect was anti-dilutive.



The following table sets forth a reconciliation of the numerators and denominators of basic and diluted net loss per common share



|                                                     |  |                                               |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|---------------------------------------------------- |  | --------------------------------------------- | ------ | - | ---------------- | - | ------- | ---------------- |  | - | -------------- | - |  | - | ------- | -
|                                                     |  | Three Months Ended                            |        |   | Six Months Ended |  
|                                                     |  | December 31,2005                              |        |   | January 1,2005   |   |         | December 31,2005 |  |   | January 1,2005 |  
|                                                     |  | (Amounts in thousands, except per share data) |       
|Numerator                                            |  |                                               |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Net loss                                             |  | $                                             | (3,707 | ) |                  | $ | (9,211  | )                |  | $ | (7,203         | ) |  | $ | (15,543 | )
|Beneficial conversion feature for Series J Preferred |  |                                               |       |   |                  |   |        |                  |  |   |               |   |  |   | (7,368  | )
|Beneficial conversion feature for Series K Preferred |  |                                               |       |   |                  |   | (3,877  | )                |  |   |               |   |  |   | (14,777 | )
|Beneficial conversion feature for Series L Preferred |  |                                               |       |   |                  |   | (7,000  | )                |  |   |               |   |  |   | (7,000  | )
|Beneficial conversion feature for Series N Preferred |  |                                               | (648   | ) |                  |   |         |                  |  |   | (648           | ) |  |   |         |  
|Beneficial conversion feature for Series O Preferred |  |                                               | (190   | ) |                  |   |        |                  |  |   | (3,270         | ) |  |   |        |  
|Beneficial conversion feature for Series P Preferred |  |                                               | (1,232 | ) |                  |   |        |                  |  |   | (1,232         | ) |  |   |        |  
|                                                     |  |                                               |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Net loss applicable to common shareholders           |  | $                                             | (5,777 | ) |                  | $ | (20,088 | )                |  | $ | (12,353        | ) |  | $ | (44,688 | )
|                                                     |  |                                               |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Denominator for basic and diluted loss per share     |  |                                               |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Weighted average common stock shares                 |  |                                               | 15,907 |   |                  |   | 265     |                  |  |   | 15,023         |   |  |   | 245     |  
|                                                     |  |                                               |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  
|Basic and Diluted Loss Per Share                     |  | $                                             | (0.36  | ) |                  | $ | (75.71  | )                |  | $ | (0.82          | ) |  | $ | (182.25 | )
|                                                     |  |                                               |        |   |                  |   |         |                  |  |   |                |   |  |   |         |  

The following table presents securities that could be converted into common shares and potentially
dilute basic loss per share in the future. In the quarters and six months ended December 31, 2005 and January 1, 2005, the potentially dilutive securities were not included in the computation of diluted loss per share because to do so
would have been antidilutive:



|                               |  |                        |  |                  |  |                  |  |               
|------------------------------ |  | ---------------------- |  | ---------------- |  | ---------------- |  | --------------
|                               |  | Three Months Ended     |  | Six Months Ended
|                               |  | December 31,2005       |  | January 1,2005   |  | December 31,2005 |  | January 1,2005
|                               |  | (Amounts in thousands)
|Common stock warrants          |  | 2,055                  |  | 225              |  | 1,319            |  | 219           
|Preferred stock warrants:      |  |                        |  |                  |  |                  |  |               
|Series C Convertible Preferred |  |                       |  | 98               |  |                 |  | 99            
|Series D Convertible Preferred |  |                       |  | 63               |  |                 |  | 63            
|Convertible preferred stock:   |  |                        |  |                  |  |                  |  |               
|Series B Convertible Preferred |  |                       |  | 483              |  |                 |  | 482           
|Series C Convertible Preferred |  |                       |  | 239              |  |                 |  | 239           
|Series D Convertible Preferred |  |                       |  | 447              |  |                 |  | 447           
|Series F Convertible Preferred |  |                       |  | 426              |  |                 |  | 430           
|Series G Convertible Preferred |  |                       |  | 132              |  |                 |  | 134           
|Series H Convertible Preferred |  |                       |  | 457              |  |                 |  | 464           
|Series I Convertible Preferred |  |                       |  | 4,983            |  |                 |  | 4,983         
|Series J Convertible Preferred |  |                       |  | 1,951            |  |                 |  | 1,821         
|Series K Convertible Preferred |  |                       |  | 1,637            |  |                  |  | 1,171         
|Series L Convertible Preferred |  |                        |  | 185              |  |                  |  | 92            
|Series M Convertible Preferred |  | 5,363                  |  |                 |  | 5,214            |  |              
|Series N Convertible Preferred |  | 1,829                  |  |                 |  | 1,829            |  |              
|Series O Convertible Preferred |  | 474                    |  |                 |  | 429              |  |              
|Series P Convertible Preferred |  | 2,691                  |  |                 |  | 1,168            |  |              
|                               |  |                        |  |                  |  |                  |  |               
|                               |  | 12,412                 |  | 11,326           |  | 9,959            |  | 10,644        
|                               |  |                        |  |                  |  |                  |  |               



All of the
Companys outstanding options were not included in the computation of diluted EPS because the effect would have been antidilutive. These options were antidilutive because their exercise prices were greater than the average market value of a
share of common stock during the period.



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##### Table of Contents

Share-Based Payments



In December 2004, the FASB issued SFAS No. 123 (revised 2004), Shared-Based Payment(SFAS 123(R)),which is a
revision of SFAS No. 123, Accounting for Stock-Based Compensation.SFAS 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees(APB 25),and amends SFAS No. 95, Statement of Cash Flows.Generally the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement
based on their fair values.



On July 3, 2005, the Company adopted SFAS
123(R) using a modified prospective method resulting in the recognition of share-based compensation expense of $290,000 and $352,000 for the three and six month periods ended December 31, 2005, respectively. Prior period amounts have not been
restated. Under this modified prospective method, the Company is required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date
of adoption. Prior to the adoption of SFAS 123(R), the Company accounted for share-based compensation using APB 25 and related interpretations.



The following table details the effect on net loss applicable to common shareholders and basic and diluted loss per share had compensation expense for the employee
share-based awards been recorded in the three and six months ended January 1, 2005 based on the fair value method under SFAS 123:



|                                                                                                               |  |                                                 |         |   |                                 |   |         |  
|-------------------------------------------------------------------------------------------------------------- |  | ----------------------------------------------- | ------- | - | ------------------------------- | - | ------- | -
|                                                                                                               |  | Three Months EndedJanuary 1, 2005               |         |   | Six Months EndedJanuary 1, 2005 |  
|                                                                                                               |  | (Amounts in thousands,except per share amounts) |        
|Net loss applicable to common shareholders, as reported                                                        |  | $                                               | (20,088 | ) |                                 | $ | (44,688 | )
|Add: Stock-based employee compensation expense included in reported net loss applicable to common shareholders |  |                                                 | 32      |   |                                 |   | 64      |  
|Deduct: Stock-based compensation expense determined under fair value method for all awards                     |  |                                                 | (72     | ) |                                 |   | (60     | )
|                                                                                                               |  |                                                 |         |   |                                 |   |         |  
|Pro forma                                                                                                      |  | $                                               | (20,128 | ) |                                 | $ | (44,684 | )
|                                                                                                               |  |                                                 |         |   |                                 |   |         |  
|Basic and diluted loss per common share:                                                                       |  |                                                 |         |   |                                 |   |         |  
|As reported                                                                                                    |  | $                                               | (75.71  | ) |                                 | $ | (182.25 | )
|                                                                                                               |  |                                                 |         |   |                                 |   |         |  
|Pro forma                                                                                                      |  | $                                               | (75.86  | ) |                                 | $ | (182.23 | )
|                                                                                                               |  |                                                 |         |   |                                 |   |         |  



The Company currently sponsors the
1995 Stock Option Plan, the 2000 Stock Option Plan, the 1996 Director Stock Option Plan, and the 2004 Stock Option Plan. These plans provide for the issuance of up to 7,670,996 shares of common stock. Options may be granted to employees, directors
and consultants. With the exception of the 2000 Stock Option Plan, option exercise prices are not less than the fair market value of the Companys common stock on the date of grant. In the case of the 2000 Stock Option Plan, non-statutory
options may be granted at not less than 85% of the fair market value of the Companys common stock on the date of grant. The majority of the options vest annually in equal amounts over a two-year period. The 2000 Stock Option Plan also allows
for the issuance of performance shares or restricted stock. As of December 31, 2005, there were 850 shares of restricted stock outstanding. All outstanding restricted stock was vested as of July 2, 2005. The Company has 3,363,952 shares of
common stock available for grants under the option plans at December 31, 2005.



9



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##### Table of Contents

The Company uses the Black-Scholes option-pricing model to calculate the fair value of share based awards. The key
assumptions for this valuation method include the expected term of the option, stock price volatility, risk-free interest rate, dividend yield, exercise price, and forfeiture rate. Many of these assumptions are judgmental and highly sensitive in the
determination of compensation expense.



Under the assumptions indicated below,
the weighted-average fair value of stock option grants to employees for the three and six months ended December 31, 2005 were $1.92 and $1.92, respectively. For the three and six month period ended December 31, 2005 the fair value of the
warrants granted to employees was $2,005,200 and $2,139,783, respectively. Also, in the six month period ended December 31, 2005, the Company issued 142,333 common stock warrants to a broker in connection with costs of a prior period issue of
preferred stock. The Company recorded the warrants at $895,000 which was the fair value of the services received. The table below indicates the key assumptions used in the option and warrant valuation calculations for share based awards granted to
employees in the three and six months ended December 31, 2005 and a discussion of our methodology for developing each of the assumptions used in the valuation model:



|                        |  |                             |   |                           |       |  |        |   |  |      
|----------------------- |  | --------------------------- | - | ------------------------- | ----- |  | ------ | - |  | -----
|                        |  | Three Months Ended31-Dec-05 |   | Six Months Ended31-Dec-05
|Term                    |  | 1.58                        |   |                           | Years |  | 1.62   |   |  | Years
|Volatility              |  | 171.00                      | % |                           |       |  | 170.60 | % |  |      
|Dividend Yield          |  | 0.00                        | % |                           |       |  | 0.00   | % |  |      
|Risk-free interest rate |  | 4.34                        | % |                           |       |  | 4.33   | % |  |      
|Forfeiture rate         |  | 2.84                        | % |                           |       |  | 2.89   | % |  |      



There were no options grants during
fiscal 2005 or during the first quarter of fiscal 2006.



Term - This is
the period of time over which the awards granted are expected to remain outstanding. The warrants and options issued in the six month period ended December 31, 2005 have a maximum contractual term of either five or seven years. An increase in
the expected term will increase compensation expense.



Volatility - This
is a measure of the amount by which a price has fluctuated or is expected to fluctuate. Volatility is based on historical volatility of the Companys common stock value and other factors, such as expected changes in volatility arising from
planned changes in the Companys business operations. An increase in the expected volatility will increase compensation expense.



Risk-Free Interest Rate - This is the U.S. Treasury rate for the week of the grant having a term equal to the expected term of the awards. An increase in the
risk-free interest rate will increase compensation expense.



Dividend Yield The Company has not made any dividend payments during the last five fiscal years and has no plans to pay dividends in the foreseeable future. An increase in the dividend yield will decrease compensation expense.



Forfeiture Rate - This is the estimated percentage of awards granted that are expected
to be forfeited or canceled before becoming fully vested. An increase in the forfeiture rate will decrease compensation expense.



A summary of the status of outstanding stock options and activity is presented below:



|                                       |  |                  |   |  |                                |          |                                           |      |       |                                        |   |  
|-------------------------------------- |  | ---------------- | - |  | ------------------------------ | -------- | ----------------------------------------- | ---- | ----- | -------------------------------------- | - | -
|                                       |  | Number ofOptions |   |  | Weighted AverageExercise Price |          | Weighted AverageRemainingContractual Life |      |       | AggregateIntrinsic Value(in thousands)
|Options outstanding, July 3, 2005      |  | 18,163           |   |  | $                              | 678.45   |                                           |      |       |                                        |   |  
|Granted                                |  | 1,665,931        |   |  | $                              | 2.56     |                                           |      |       |                                        |   |  
|Expired                                |  | (60              | ) |  | $                              | 1,718.75 |                                           |      |       |                                        |   |  
|                                       |  |                  |   |  |                                |          |                                           |      |       |                                        |   |  
|Options outstanding, December 31, 2005 |  | 1,684,034        |   |  | $                              | 9.79     |                                           | 9.90 | years |                                        | $ | 
|                                       |  |                  |   |  |                                |          |                                           |      |       |                                        |   |  
|Options exercisable, December 31, 2005 |  | 18,103           |   |  | $                              | 675.00   |                                           | 4.92 | years |                                        | $ | 
|                                       |  |                  |   |  |                                |          |                                           |      |       |                                        |   |  



As of December 31, 2005 there was
$4.8 million of total unrecognized compensation expense related to stock options.



There have been no exercises of stock options during the six months ended December 31, 2005.



In the six month period ended December 31, 2005, the Company granted 2,715,022 common stock warrants to certain employees for services provided. The Company calculated the fair value of the common stock warrants
using the Black-Scholes option-pricing model using the parameters detailed above.



10



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##### Table of Contents



A summary of the status of the
Companys common stock warrants outstanding as of December 31, 2005 and activity during the six month period then ended is presented below:



|                                        |  |                   |   |  |                                |        |                                           |      |       |                                        |   |        
|--------------------------------------- |  | ----------------- | - |  | ------------------------------ | ------ | ----------------------------------------- | ---- | ----- | -------------------------------------- | - | -------
|                                        |  | Number ofWarrants |   |  | Weighted AverageExercise Price |        | Weighted AverageRemainingContractual Life |      |       | AggregateIntrinsic Value(in thousands)
|Warrants outstanding, July 3, 2005      |  | 426,202           |   |  | $                              | 9.34   |                                           |      |       |                                        |   |        
|Granted                                 |  | 2,715,022         |   |  | $                              | 3.30   |                                           |      |       |                                        |   |        
|Exercised                               |  | (7,000            | ) |  | $                              | 0.50   |                                           |      |       |                                        |   |        
|Forfeited                               |  | (6,141            | ) |  | $                              | 110.33 |                                           |      |       |                                        |   |        
|                                        |  |                   |   |  |                                |        |                                           |      |       |                                        |   |        
|Warrants outstanding, December 31, 2005 |  | 3,128,083         |   |  | $                              | 3.92   |                                           | 3.04 | years |                                        | $ | 620,691
|                                        |  |                   |   |  |                                |        |                                           |      |       |                                        |   |        
|Warrants exercisable, December 31, 2005 |  | 597,788           |   |  | $                              | 0.72   |                                           | 3.34 | years |                                        | $ | 620,691
|                                        |  |                   |   |  |                                |        |                                           |      |       |                                        |   |        



3. RESTRUCTURING



At the end of the third quarter of fiscal 2005, the Companys
management moved to redefine the business model to take advantage of the Companys strengths in service delivery to its local markets. Approximately 40 operating centers were designated for closure and employee headcount was reduced by about
200. At that time, the Company recorded a charge of $602,000 related to the restructuring, mostly for severance costs. During the fourth quarter of fiscal 2005, the Company ceased use of most of the named facilities and recorded a charge of $950,000
including an additional $550,000 in net lease contract termination costs and fixed asset impairments, $100,000 in severance, and an estimated $300,000 to recognize the cost of spare cell phone service contracts that have no future economic benefit
to the Company. Approximately $0.8 million of the liability remained accrued at December 31, 2005, of which $0.7 million is included with current accrued liabilities.



Changes in the restructure liabilities follow:



|                              |  |                                      |       |          |   |      |                                    |  |   |                                           |   |  |   |    
|----------------------------- |  | ------------------------------------ | ----- | -------- | - | ---- | ---------------------------------- |  | - | ----------------------------------------- | - |  | - | ---
|                              |  | RestructuringLiabilitiesJuly 2, 2005 |       | Payments |   |      | Adjustmentsand Changesin Estimates |  |   | RestructuringLiabilitiesDecember 31, 2005
|Employee termination benefits |  | $                                    | 520   |          | $ | (219 | )                                  |  | $ | (59                                       | ) |  | $ | 242
|Lease termination costs       |  |                                      | 559   |          |   | (153 | )                                  |  |   |                                           |   |  |   | 406
|Other                         |  |                                      | 311   |          |   | (120 | )                                  |  |   | (41                                       | ) |  |   | 150
|                              |  |                                      |       |          |   |      |                                    |  |   |                                           |   |  |   |    
|                              |  | $                                    | 1,390 |          | $ | (492 | )                                  |  | $ | (100                                      | ) |  | $ | 798
|                              |  |                                      |       |          |   |      |                                    |  |   |                                           |   |  |   |    



During fiscal 2004,
the Company relocated its headquarters and financial functions to Westport, Connecticut from Minneapolis, Minnesota. The costs of relocation, employee acquisition, training and severance were recognized as period costs.



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4. LONG-TERM DEBT



Long-term debt consisted of the following:



|                         |  |                        |         |   |             |   |         |  
|------------------------ |  | ---------------------- | ------- | - | ----------- | - | ------- | -
|                         |  | December 31,2005       |         |   | July 2,2005 |  
|                         |  | (Amounts in thousands) |        
|Revolving note           |  | $                      | 19,486  |   |             | $ | 27,829  |  
|Senior subordinated note |  |                        | 5,607   |   |             |   | 5,627   |  
|Other                    |  |                        | 498     |   |             |   | 699     |  
|                         |  |                        |         |   |             |   |         |  
|                         |  |                        | 25,591  |   |             |   | 34,155  |  
|Less current maturities  |  |                        | (25,520 | ) |             |   | (31,326 | )
|                         |  |                        |         |   |             |   |         |  
|Total Long Term Debt     |  | $                      | 71      |   |             | $ | 2,829   |  
|                         |  |                        |         |   |             |   |         |  



The Company maintains
a revolving credit facility with Bank of America/Fleet Capital Corporation (the Senior Lender) that allows for borrowings up to the lesser of $42.5 million or an amount based on a defined portion of eligible accounts receivable. As of
December 31, 2005 the balance borrowed under the facility equals $19.5 million. Interest is payable monthly at a rate, which is adjusted annually by an amount not exceeding 25 basis points depending upon the Companys achieving certain
conditions as defined in the agreement, of prime plus 1.25% (8.75% at December 31, 2005), or, at the Companys election, at LIBOR plus 3.25%. As of December 31, 2005, the Company had 51% of the facility usage under LIBOR contracts at
an interest rate of 7.625%.In addition, the Company is required to pay a commitment fee of 0.375% on unused amounts of the total commitment, as defined in the agreement. The facility terminates on December 31, 2006. While the Company is
in negotiations to extend or replace the revolving credit facility failure to do so may require the Company to obtain financing through alternative means to sustain continuing operations.



Substantially all of the Companys assets have been pledged to secure borrowings under the revolving credit facility
and senior subordinated note. The Company is subject to certain restrictive covenants under the agreements. The more significant covenants include limitations on capital asset expenditures, dividends, acquisitions, new indebtedness in excess of $0.5
million and changes in capital structure. The Company is also required to maintain financial covenants related to capital expenditures and to maintain definitive levels of minimum availability. Unused availability was $2.7 million at December 31,
2005. Due to the characteristics of the revolving credit facility, the Company has classified the amount outstanding under the revolving credit facility as a current liability.



On March 31, 2004, July 1, 2004, and December 21, 2004, the Company entered into the third, fourth, and
fifth amendments, respectively, to the amended and restated revolving credit facility with Bank of America/Fleet. The purpose of these amendments was to reset certain of the financial covenants provided for in the agreement discussed above.



On December 7, 2005 the Company entered into the sixth
amendment to the amended and restated revolving credit facility with Bank of America/Fleet. The purpose of the amendment was to approve, and allow payments under, the terms of the negotiated settlement to resolve litigation arising from a contract
entered into in 1997 between Corporate Express Delivery Systems, Inc. and Mobile Information Systems, Inc. (MIS). [See Note 5, Litigation Settlement]. This amendment also approved the restructure of the senior subordinated debt allowing
for quarterly principal repayments of $100,000.



At December
31, 2005, the Company was not in compliance with certain non-financial affirmative covenants under the revolving credit facility and its senior subordinated debt facility with respect to furnishing financial statements on a timely basis to the
respective lenders. [See Note 7, Liquidity]. The Company will pursue waivers pertaining to these matters of compliance.



On February 16, 2006, the Companys Senior Lender released $2.0 million of previously restricted availability after receiving a limited guarantee in
the amount of $2.0 million from one of the Companys investors, TH Lee Putnam Ventures (THLPV). THLPV received no compensation, consideration or promises from the Company in exchange for providing the guarantee.



The Company also maintains a $6.0 million senior subordinated note with
interest payable quarterly at 15% per annum (to be reduced to 12% upon the occurrence of certain events). The initial carrying value of the senior subordinated note was $6.0 million and was reduced by $0.6 million for the fair value of Series I
Preferred Stock issued to the senior subordinated lender. The unamortized discount was $0.3 million at December 31, 2005, and is being amortized over the remaining term of the note. The Company also incurred fees of $0.2 million, $0.1 million of
which were satisfied through the issuance of Series I Preferred Stock. These fees were recorded as deferred financing costs and are also being amortized over the life of the loan. The senior subordinated note included a requirement of quarterly
principal repayments of $0.5 million beginning January 31, 2005 if agreed to by the primary lender. No principal payments have been made to the senior subordinated note holder under this schedule as such payments have not been approved by the
primary lender.



On December 7,
2005 the senior subordinated note was amended and restated to adjust the entire payment schedule to $100,000 per quarter with a lump sum final payment at the October 31, 2007 maturity date. The senior debt holder has approved and authorized such
schedule of payments. In accordance with the new amended and restated agreement the Company is now required to pay a service fee of $10,000 per month related to the acquisition and management of the indebtedness; it had previously been $5,000 per
month under the prior agreement structure. The senior subordinated note is due October 31, 2007. The note remains subordinate to the revolving credit facility.



At December 31, 2005, the Company had in place waivers of its financial debt covenants relating to its revolving credit facility and its senior
subordinated debt facility. These waivers are in effect through January 1, 2007.



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5.LITIGATION SETTLEMENT



On August 1, 2005, the Company received notice from the Superior Court for the State of California, County of Santa Clara,
that the Court had entered an order granting certain motions for summary judgment against the Company in the matter styled Velocity Express, Inc. v. Banc of America Commercial Finance Corporation, Banc of America Leasing and Capital, LLC, John
Hancock Life Insurance Company and John Hancock Mezzanine Lenders, LP, Charles F. Short III, Sidewinder Holdings Ltd. and Sidewinder N. A. Ltd. Corp., (the Plaintiffs). The motions sought to resolve the substantive liability issues in
the case and to recover in excess of $10 million for breach of contract, fees, interest and other charges arising from a contract entered into in 1997 between Corporate Express Delivery Systems, Inc., a predecessor company, and Mobile Information
Systems, Inc. (MIS). By granting the motions, the court did resolve the liability issues and hold that Bank of America/Hancock is entitled to recover the amounts sued for.



On December 7, 2005 the parties executed a negotiated settlement outside of the court; with the Company making scheduled
payments totaling $2.9 million after initial good faith payments of $0.3 million. In addition, on December 9, 2005, the Plaintiffs were issued 500,000 shares of the Companys common stock, guaranteed at a $6.00 per share minimum value subject
to future conditions (the Guarantee). The Plaintiffs also received an accelerated payment of $0.5 million of the $2.9 million settlement pursuant to conditions of the agreement related to the Companys raise of any equity funding.
As part of the final settlement, the Company received waivers of financial covenants of the Companys Amended and Restated Loan and Security Agreement, with Fleet Capital Corporation and Merrill Lynch Capital (the Senior Lender),
and with BET Associates, LP relative to waiver of certain financial covenants of its Subordinated Debt. At issuance of the Common Stock, the Guarantee had an estimated initial fair value of $1.8 million, which was recorded as a liability on the
consolidated balance sheet. The estimated fair value of the Guarantee was determined using the December 9, 2005 closing price of the Companys Common Stock trading on the NASDAQ-SCM stock market. For the three months ended December 31, 2005,
the Company recorded other expense on the consolidated statements of operations for the change in fair value of the Guarantee of approximately $0.2 million. The Guarantee will be adjusted to its fair value on a quarterly basis, with the
corresponding charge or credit to other expense or income. At December 31, 2005, the estimated fair value of the Guarantee was $1.9 million.



6. SHAREHOLDERS EQUITY



Series O Convertible Preferred Stock - On July 20, 2005, the Company executed Stock Purchase Agreements with seven institutional
and accredited investors to provide for the private placement of 1,400,000 shares of a newly authorized series of the Companys preferred stock (the Series O Preferred) in exchange for aggregate gross proceeds of $5,600,000. Based
on the pricing of the Series O Preferred, the sale of Series O Preferred contained a beneficial conversion amounting to $3.1 million which was recognized as a deemed dividend to preferred shareholders at the time of the sale and a charge against net
loss available to common shareholders.



The Series O Preferred
is entitled to receive in preference to holders of all other classes of stock, other than holders of the Series M Preferred and N Preferred, a dividend at the rate of 6% per annum of the Series O Preferred stated value. Upon any liquidation,
dissolution or winding up of the Company the holders of the shares of Series O Preferred shall rank senior to the holders of the Common Stock, but junior to the holders of the Series M Preferred and N Preferred, as to such distributions, and shall
be entitled to be paid an amount per share equal to the Series O Preferred stated value plus any accrued and unpaid dividends (the Liquidation Preference). In addition to being junior the Series M Preferred and N Preferred from the
standpoint of liquidation, the Series O Preferred also has reduced voting rights. For example, the approval of at least 62.5% of the outstanding shares of Series O Preferred is not required in order for the Company to merge, dispose of substantial
assets, engage in affiliate transactions, pay dividends, authorize new stock options plans, license or sell its intellectual property or change the number of board of directors.



Each of the investors has the right, at its option at any time, to convert any such shares of Series O Preferred into such
number of fully paid and no assessable whole shares of Common Stock as is obtained by multiplying the number of shares of Series O Preferred so to be converted by the Liquidation Preference per share and dividing the result by the conversion price
of $4.00 per share subject to certain adjustments.



Series P Convertible Preferred StockOn October 14, 2005, the Company entered into Stock Purchase Agreements (the Purchase Agreements) with one group of institutional investment funds and one
accredited investor (the Investors). The Purchase Agreements provide for the private placement of 3,099,513 shares of a newly authorized series of the Companys preferred stock (the Series P Preferred) in exchange for
aggregate gross proceeds of $10,352,370. The Series P Preferred has a term of three years (the Term) and is entitled to receive a dividend at the rate of 8% per annum of the Series P Preferred stated value, payable quarterly, in
cash or PIK shares of Series P Preferred at the option of the Company. Under certain events of default, the dividend rate will convert to 18%. To the extent that the issuance of such PIK shares would result in the Company issuing in excess of 20% of
its outstanding Common Stock, the issuance will require the prior approval of the Companys shareholders. Upon any liquidation, dissolution or winding up of the Company, the Investors of the shares of Series P Preferred shall rank on parity
with the holders of the Companys Series M Preferred Stock. Each of the Investors has the right, at its option at any time, to convert any shares of Series P Preferred into shares of Common Stock at the conversion price of $3.34 per share
subject to certain adjustments. At any time after the effective date of the Registration Statement and (i) prior to the Term, or (ii) upon a Change of Control, the Company shall have the right, but not the obligation, to redeem all or a
portion of the shares of Series P Preferred by tendering to the Holder 130% of the stated value of the outstanding Series P Preferred together with all accrued dividends. At the Term, the Company shall have the right, but not the obligation, to
redeem all or a portion of the shares of Series P Preferred by tendering to the Holder 100% of the Conversion Price together with all accrued but unpaid dividends. In the event that the Company elects to redeem the Series P Preferred prior to the
Registration Statement becoming effective, the Company may redeem the Series P Preferred by paying to the Investor the greater of: (1) 130% of the



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outstanding stated value of the Series P Preferred plus accrued dividends, and (2) 100% of the stated value of the
Series P Preferred plus all accrued dividends, plus 50% of the difference between the conversion price then in effect and the average closing price of the Companys Common Stock for the 30 calendar days preceding such redemption. Each Investor
also received an A Warrant and B Warrant, each to purchase up to 20% of the amount of Series P Preferred purchased. The exercise of the A Warrant and B Warrant are subject to the prior approval of the Companys shareholders. The exercise price
for both warrants is $4.00, subject to adjustments. Additionally, the B Warrant is only exercisable in the event that a registration statement, allowing for the sale of the Series P Preferred, is not declared effective within 270 days of closing.
The Company has the option to redeem both warrants in the event that the Companys common stock maintains a closing price of at least $7.00 for twenty consecutive trading days. The Investors are also parties to a Registration Rights Agreement
(the Rights Agreement). The Rights Agreement requires the filing of a registration statement no later than 90 days after the closing date, and that it be effective within 180 days. Due to the value of the A warrant, the sale of Series P
Preferred contained a beneficial conversion amounting to $1.2 million which was recognized as a deemed dividend to preferred shareholders at the time of sale and as a charge against net loss available to common shareholders.



7. LIQUIDITY



The Company is managing to a plan to achieve positive cash flow over the next year. Key components of the plan include
increased profitable revenue growth with numerous existing and potential customers in targeted markets, improved gross margins through continued utilization of the Companys route optimization software, and reduced expenses through attrition
and centralization of many key operational functions. As with any operating plan, there is an element of risk associated with the Companys ability to execute against this plan. If the Company is unable to execute against the plan, it may need
additional capital as a means to meet its ongoing operations.



As of December 31, 2005, the Company had $1.8 million in cash and $2.7 million of available borrowing under its revolving credit facility. Borrowings under the revolving credit facility are classified as current liabilities because the
Company is required to maintain a lockbox account with the lender. In turn, the lender may apply funds received against outstanding borrowings. However, as such funds are applied to outstanding borrowings then additional borrowing capacity becomes
available to the Company. Until its maturity the Company does not expect to pay down, on a net basis, any of the $19.5 million outstanding at December 31, 2005 and included in current liabilities. The facility terminates on December 31, 2006. While
the Company is in negotiations to extend or replace the revolving credit facility failure to do so will require the Company to obtain funds through equity means in order to sustain continuing operations.



On February 16, 2006, the Companys Senior Lender released $2.0 million
of previously restricted availability after receiving a limited guarantee in the amount of $2.0 million from one of the Companys investors, TH Lee Putnam Ventures (THLPV). THLPV received no compensation, consideration or promises
from the Company in exchange for providing the guarantee.



8.SUBSEQUENT EVENTS



On February 3, 2005 the Company
agreed to resolve litigation pending with Nextel of Texas, Inc. in which the Company claimed that Nextels invoices contained significant overcharges. Nextel claimed that the Company owed in excess of $1.3 million for phone services. Under the
settlement, the parties are to dismiss all claims against the other and the Company will pay Nextel $700,000, payable in fourteen equal monthly payments, with the first payment due April 1, 2006. Such amounts have been present valued and accrued on
the Companys financial statements. A formal settlement to document the terms agreement is being drafted. Once this settlement has been formalized the Company will pursue the required bank waiver to allow for assumption of the debt, as the
level of debt assumed would otherwise result in a debt covenant violation.



On February 16, 2006, the Companys Senior Lender released $2.0 million of previously restricted availability after receiving a limited guarantee in the amount of $2.0 million from one of the Companys
investors, TH Lee Putnam Ventures (THLPV). THLPV received no compensation, consideration or promises from the Company in exchange for providing the guarantee.



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



VELOCITY EXPRESS CORPORATION AND SUBSIDIARIES



In accordance with the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995, the Company notes that certain
statements in this Form 10-Q and elsewhere that are forward-looking and that provide other than historical information, involve risks and uncertainties that may impact the Companys results of operations. These forward-looking statements
include, among others, statements concerning the Companys general business strategies, financing decisions, and expectations for funding capital expenditures and operations in the future. When used herein, the words believe,
plan, continue, hope, estimate, project, intend, expect, and similar expressions are intended to identify such forward-looking statements. Although the Company
believes that the expectations reflected in such forward-looking statements are based on reasonable assumptions, no statements contained in this Form 10-Q should be relied upon as predictions of future events. Such statements are necessarily
dependent on assumptions, data or methods that may be incorrect or imprecise and may be incapable of being realized. The risks and uncertainties inherent in these forward-looking statements could cause results to differ materially from those
expressed in or implied by these statements.



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Readers are cautioned not to attribute undue certainty to the forward-looking statements contained
herein, which speak only as of the date hereof. The information contained in this Form 10-Q is believed by the Company to be accurate as of the date hereof. Changes may occur after that date, and the Company will not update that information except
as required by law in the normal course of its public disclosure practices.



Overview



The Company provides same-day
time-critical logistics solutions to individual consumers and businesses, primarily in the United States with limited operations in Canada.



The Company has one of the largest nationwide networks of time-critical logistics solutions in the United States and is a leading provider of scheduled,
distribution and expedited logistics services.



The
Companys service offerings are categorized as:



| |  |  | Scheduled logistics consisting of the daily pickup and delivery of parcels with narrowly defined time schedules predetermined by the customer.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Distribution logistics consisting of the receipt of customer bulk shipments that are divided and sorted at major metropolitan locations and delivered into multiple routes with
defined endpoints and more broadly defined time schedules.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Expedited logistics consisting of unique and expedited point-to-point service for customers with extremely time sensitive delivery requirements.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------



The Companys customers represent a variety of industries and utilize
the Companys services across multiple service offerings. Revenue categories by percentages were as follows:



|                               |  |                  |   |  |                |  
|------------------------------ |  | ---------------- | - |  | -------------- | -
|                               |  | Six Months Ended |  
|                               |  | December 31,2005 |   |  | January 1,2005 |  
|Commercial and office products |  | 48.6             | % |  | 40.3           | %
|Healthcare                     |  | 21.8             | % |  | 19.1           | %
|Financial services             |  | 17.3             | % |  | 27.2           | %
|Transportation and logistics   |  | 5.8              | % |  | 7.4            | %
|Energy                         |  | 4.9              | % |  | 4.6            | %
|Technology                     |  | 1.6              | % |  | 1.4            | %



For the three months
ended December 31, 2005, two customers within the Commercial and Office Products service offerings accounted for 13.1% and 10.4% of the Companys net revenues. For the six months ended December 31, 2005, these two customers accounted for 12.4%
and 10.4% of net revenues.



With the enactment of the Federal
Law known as Check 21, on October 28, 2004, the Company anticipates a continued decline of financial services revenue as financial institutions will now electronically scan and process checks, without the required need to move the physical
documents to the clearing institution. More than off-setting this decline of revenue in the financial services industry, the Company believes that in addition to a greater product mix towards commercial and office products, it will also continue to
benefit from the growth in healthcare and healthcare related services industries within the United States, and be able to effectively leverage their broad coverage footprint to capitalize on this national growth industry.



During fiscal 2006, the Company plans to continue to invest in automated
technologies that will increase its competitive advantage in the market by providing more economical delivery routing, enhance and automated package tracking, and increased productivity from both a frontline delivery and back office perspective.
During fiscal years 2004 and 2005, the Company spent over $5 million, in the development and implementation of route management software solutions that are anticipated to have a significant impact on reducing overall delivery cost, and increasing
the Companys ability to better manage its variable operating cost.



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Historical Results of Operations



Revenue for the quarter ended December 31, 2005 decreased $16.2 million or 24.7% to $49.3 million from $65.5 million
for the quarter ended January 1, 2005. The decrease in revenue for the quarter ended December 31, 2005 compared to the same period last year was primarily the result of restructure that was done in the March through June 2005 timeframe.
Over 40 locations were closed and a number of unprofitable accounts were resigned.



Revenue for the six months ended December 31, 2005 decreased $31.6 million or 23.7% to $101.9 million from $133.4 million for the six months ended January 1, 2005. The decrease in revenue for the six months
ended December 31, 2005 compared to the same period last year was primarily the result of the restructure of the business done in the March through June 2005 timeframe. Approximately 25% of the revenue was eliminated through the closure of over
40 locations and resigning a number of unprofitable accounts.



Cost of services for the quarter ended December 31, 2005 was $35.1 million, a decrease of $18.9 million or 35.0% from $54.0 million for the quarter ended January 1, 2005. Of the reduction in cost, $13.3 million resulted from
reduced revenue. The remaining reduction in cost was the result of completing the restructure of the Companys delivery model. Driver pay was reduced by $1.7 million, vehicle cost was reduced by $1.7 million, and insurance was reduced by $2.0
million. As a result, gross margin increased from 17.5% in the prior year quarter to 28.8% for the quarter ended December 31, 2005.



Cost of services for the six months ended December 31, 2005 was $73.3 million, a decrease of $35.7 million or 32.7% from $109.1 million for the six
months ended January 1, 2005. Of the reduction in cost, $26.5 million resulted from reduced revenue. The remaining reduction in cost, and improvement in gross margin were the result of completing the restructure of the Companys delivery
model. Driver pay was reduced by $2.9 million, vehicle cost was reduced by $3.7 million, and insurance was reduced by $3.9 million. As a result, gross margin increased from 18.3% in the prior year six months period to 28.0% for the six months ended
December 31, 2005.



Selling, general and administrative
expenses for the quarter ended December 31, 2005 were $13.7 million or 27.7% of revenue, a decrease of $2.7 million or 16.7% as compared with $16.4 million or 25.0% of revenue for the quarter ended January 1, 2005. The decrease in SG&A
for the quarter period resulted primarily from the Companys third fiscal quarter 2005 restructure and continuing focused efforts on cost control. Salary and benefits were reduced $2.4 million, telecommunications were reduced $0.5 million,
travel was reduced $0.3 million and other items were reduced $0.5 million, partially offset by additional legal costs.



Selling, general and administrative expenses for the six months ended December 31, 2005 were $28.0 million or 27.5% of revenue, a decrease of $3.4
million or 10.9% as compared with $31.4 million or 23.5% of revenue for the six months ended January 1, 2005. The decrease in SG&A for the six months period resulted primarily from the Companys third fiscal quarter 2005 restructure
and continuing focused efforts on cost control. Salary and benefits were reduced by $3.8 million and telecommunications were reduced by $0.8 million, partially offset by additional legal costs.



Occupancy charges for the quarter ended December 31, 2005 were $3.2
million, a decrease of $0.4 million or 12.2% from $3.6 million for the quarter ended January 1, 2005. This decrease is also a result of Companys third fiscal quarter 2005 restructure and the closure of over 40 locations.



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Occupancy charges for the six months ended December 31, 2005 were $6.1 million, a decrease of $0.9
million or 13.4% from $7.1 million for the six months ended January 1, 2005. This decrease is also a result of Companys third fiscal quarter 2005 restructure and the closure of over 40 locations.



Interest expense for the quarter ended December 31, 2005 increased $0.4
million to $1.2 million from $0.8 million for the quarter ended January 1, 2005. The increase is a result comprised of $0.1 million of amortized financing costs associated with Series M and a $0.3 million present value adjustment of legal
settlements and restructuring costs.



Interest expense for the
six months ended December 31, 2005 increased $0.7 million to $2.3 million from $1.6 million for the six months ended January 1, 2005. The increase is a result comprised of $0.4 million of amortized financing costs associated with Series M
and a $0.3 million present value adjustment of legal settlements and restructuring costs.



New Accounting Pronouncements



In December 2004, the FASB issued SFAS No. 123 (revised 2004), Shared-Based Payment(SFAS 123(R)),which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation.SFAS 123(R)
supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees(APB 25),and amends SFAS No. 95, Statement of Cash Flows.Generally the approach in SFAS 123(R) is similar to the approach described in SFAS 123.
However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values.



On July 3, 2005, the Company adopted SFAS 123(R) using a modified prospective method resulting in the recognition of
share-based compensation expense of $290,000 and $352,000 for the three and six month periods ended December 31, 2005, respectively. Prior period amounts have not been restated. Under this modified prospective method, the Company is required to
record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Prior to the adoption of SFAS 123(R), we accounted for
share-based compensation using APB 25 and related interpretations in accounting for our plans.



Liquidity and Capital Resources



Cash used in operations was $9.9 million for the first six months of fiscal 2006. Of the $9.9 million of negative cash flow, $7.1 used was as a result of working capital changes. Cash provided as a result of the decrease in accounts
receivable was approximately $1.6 million. Accounts payable used approximately $5.3 million as a result of changes in vendor payment arrangements. The remaining use of working capital of $3.4 million was due to funding of insurance, legal and other
miscellaneous claims.



Cash used as a result of investing
activities was $0.7 million for the first six months of fiscal 2006 and consisted primarily of capital expenditures for the Companys continued efforts to leverage technology to provide customer-driven technology solutions



Cash provided as a result of financing activities amounted to $6.5 million
during first six months of fiscal 2006. The primary source of cash was from issuance of preferred stock, which provided $15.2 million. Net reductions of long term debt and on borrowings on the revolving credit facility used $8.6 million.



As of December 31, 2005, the Company had no outstanding purchase
commitments for capital improvements.



The Company reported a
loss from operations of approximately $5.6 million for the first six months of fiscal 2006 and has negative working capital of approximately $25.7 million at December 31, 2005.



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The Company is managing to a plan to achieve positive cash flow over the next year. Key components of the
plan include increased profitable revenue growth with numerous existing and potential customers in targeted markets, improved gross margins through continued utilization of the Companys route optimization software, and reduced expenses through
attrition and centralization of many key operational functions. As with any operating plan, there is an element of risk associated with the Companys ability to execute against this plan. If the Company is unable to execute against the plan, it
may need additional capital as a means to meet its ongoing operations.



On February 16, 2006, the Companys Senior Lender released $2.0 million of previously restricted availability after receiving a limited guarantee in the amount of $2.0 million from one of the Companys investors, TH Lee Putnam
Ventures (THLPV). THLPV received no compensation, consideration or promises from the Company in exchange for providing the guarantee.



As of December 31, 2005, the Company had $1.8 million in cash and $2.7 million of available borrowing under its revolving credit facility. Borrowings
under the revolving credit facility are classified as current liabilities because the Company is required to maintain a lockbox account with the lender. In turn, the lender may apply funds received against outstanding borrowings. However, as such
funds are applied to outstanding borrowings then additional borrowing capacity becomes available to the Company. Through maturity of the debt, the Company does not expect to repay, on a net basis, any of the $19.5 million outstanding at
December 31, 2005 and included in current liabilities. The revolving credit agreement expires on December 31, 2006. While the Company is in negotiations to extend or replace the revolving credit facility failure to do so will require the
Company to obtain funds through equity means to sustain continuing operations.



On March 31, 2004, July 1, 2004, and December 21, 2004, the Company entered into the third, fourth, and fifth amendments, respectively, to the amended and restated revolving credit facility with
Bank of America/Fleet. The purpose of these amendments was to reset certain of the financial covenants provided for in the agreement discussed above.



On December 7, 2005 the Company entered into the sixth amendment to the amended and restated revolving credit facility with Fleet. The purpose of the
amendment was to approve, and allow payments under, the terms of the negotiated settlement to resolve litigation arising from a contract entered into in 1997 between Corporate Express Delivery Systems, Inc. and Mobile Information Systems, Inc.
(MIS). [See footnote 5, Litigation Settlement].



At
December 31, 2005, the Company was not in compliance with certain non-financial affirmative covenants under the revolving credit facility and its senior subordinated debt facility with respect to furnishing financial statements on a timely basis to
the respective lenders. [See footnote 7, Liquidity]. The Company will pursue waivers pertaining to these matters of compliance.



We are continuing to pursue operational efficiencies through conversion of employee drivers to independent contractors, reducing back office workforce,
and pursuing savings in other areas.



Risk Factors



History of Losses



Our net losses applicable to common shareholders for the six months ended December 31, 2005 and January 1, 2005
were $12.4 million and $44.7 million, respectively. Such losses include $5.2 million and $29.1 million, respectfully, resulting from beneficial conversion charges, increased such respective period losses to the aforementioned levels of net losses
applicable to common shareholders.



Material Weakness



In connection with the preparation of the Companys consolidated
financial statements for the year ended July 2, 2005 certain material weaknesses became evident to management including the inability to fully reconcile cash applications on a timely basis and due to resource constraints, the inability to close
the Companys books in a timely manner on a month to month basis. A material weakness is a significant deficiency in one or more of the internal control components that alone or in the aggregate precludes the Companys internal controls
from reducing to an appropriately low level the risk that material misstatements in its financial statements will not be prevented or detected on a timely basis.



At the direction of the Audit Committee, management has continued to review how the material weaknesses and deficiencies in
internal control occurred and is proceeding expeditiously with its existing plan to enhance internal controls and procedures. The Company has accelerated efforts to improve its reconciliations process and has aggressively added to and upgraded its
financial staff to address issues of timeliness in financial reporting.



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Customer Contractual Commitments



The Companys contracts with its commercial customers typically have a term of one to three years, but are terminable
upon 30 or 60 days notice. Early termination of these contracts could have a material adverse effect on the Companys business, financial condition and results of operations.



Customer Concentration



The Company has two customers that each account for more than 10% of net revenues for the three and six months ended December 31, 2005. If these customers
modify these service levels or transition to another service provider, it could have a negative impact on the Companys financial position, results of operations, and cash flows.



Highly Competitive Industry



The market for same-day delivery and logistics services has been and is expected to remain highly competitive. Competition is often intense, particularly
for basic delivery services. High fragmentation and low barriers to entry characterize the industry. Other companies in the industry compete with the Company not only for provision of services but also for qualified drivers. Some of these companies
have longer operating histories and greater financial and other resources than the Company. Additionally, companies that do not currently operate delivery and logistics businesses may enter the industry in the future.



Claims Exposure



As of December 31, 2005, the Company utilized the services of approximately 2,751 independent drivers and messengers.
From time to time such persons are involved in accidents or other activities that may give rise to liability claims. The Company currently carries liability insurance with a per-occurrence and an aggregate limit of $5 million. Owner-operators
are required to maintain liability insurance of at least the minimum amounts required by applicable state or provincial law. The Company also has insurance policies covering property and fiduciary trust liability, which coverage includes all drivers
and messengers. There can be no assurance that claims against the Company, whether under the liability insurance or the surety bonds, will not exceed the applicable amount of coverage, that the Companys insurer will be solvent at the time of
settlement of an insured claim, or that the Company will be able to obtain insurance at acceptable levels and costs in the future. If the Company were to experience a material increase in the frequency or severity of accidents, liability claims,
workers compensation claims or unfavorable resolutions of claims, the Companys business, financial condition and results of operations could be materially adversely affected. In addition, significant increases in insurance costs could
reduce the Companys profitability.



Certain Tax Matters Related to
Drivers



A significant number of the Companys
drivers are currently independent contractors (meaning that they are not Company employees). From time to time, federal and state taxing authorities have sought to assert that independent contractor drivers in the same-day transportation and
transportation industries are employees. The Company does not pay or withhold federal or state employment taxes with respect to drivers who are independent contractors. Although the Company believes that the independent contractors the Company
utilizes are not employees under existing interpretations of federal and state laws, the Company cannot guarantee that federal and state authorities will not challenge this position or that other laws or regulations, including tax laws and laws
relating to employment and workers compensation, will not change. If the IRS were to successfully assert that the Companys independent contractors are in fact its employees, the Company would be required to pay withholding taxes, extend
additional employee benefits to these persons and could be required to pay penalties or be subject to other liabilities as a result of incorrectly classifying employees. If drivers are deemed to be employees rather than independent contractors, the
Company could be required to increase their compensation since they may no longer be receiving commission-based compensation. Any of the foregoing possibilities could increase the Companys operating costs and have a material adverse effect on
its business, financial condition and results of operations.



Local Delivery
Industry; General Economic Conditions



The Companys
sales and earnings are especially sensitive to events that affect the delivery services industry including extreme weather conditions, economic factors affecting the Companys significant customers and shortages of or disputes with labor, any
of which could result in the Companys inability to service its clients effectively or the inability of the Company to profitably manage its operations. In addition, downturns in the level of general economic activity and employment in the U.S.
or Canada may negatively impact demand for the Companys services.



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Permits and Licensing



Although certain aspects of the transportation industry have been significantly deregulated, the Companys delivery operations are still subject to
various federal (U.S. and Canadian), state, provincial and local laws, ordinances and regulations that in many instances require certificates, permits and licenses. Failure by the Company to maintain required certificates, permits or licenses, or to
comply with applicable laws, ordinances or regulations could result in substantial fines or possible revocation of the Companys authority to conduct certain of its operations.



Dependence on Key Personnel



The Companys success is largely dependent on the skills, experience and performance of certain key members of its management. The loss of the
services of any of these key employees could have a material adverse effect on the Companys business, financial condition and results of operations. The Companys future success and plans for growth also depend on its ability to attract
and retain skilled personnel in all areas of its business. There is strong competition for skilled personnel in the same-day delivery and logistics businesses.



Dependence on Availability of Qualified Delivery Personnel



The Company is dependent upon its ability to attract and retain, as employees or through independent contractor or other arrangements, qualified delivery
personnel who possess the skills and experience necessary to meet the needs of its operations. The Company competes in markets in which unemployment is generally relatively low and the competition for owner-operators and other employees is intense.
The Company must continually evaluate and upgrade its pool of available owner-operators to keep pace with demands for delivery services. There can be no assurance that qualified delivery personnel will continue to be available in sufficient numbers
and on terms acceptable to the Company. The inability to attract and retain qualified delivery personnel could have a material adverse impact on the Companys business, financial condition and results of operations.



Volatility of Stock Price



Prices for the Companys Common Stock will be determined in the
marketplace and may be influenced by many factors, including the depth and liquidity of the market for the Common Stock, investor perception of the Company and general economic and market conditions. Variations in the Companys operating
results, general trends in the industry and other factors could cause the market price of the Common Stock to fluctuate significantly. In addition, general trends and developments in the industry, government regulation and other factors could have a
significant impact on the price of the Common Stock. The stock market has, on occasion, experienced extreme price and volume fluctuations that have often particularly affected market prices for smaller companies and that often have been unrelated or
disproportionate to the operating performance of the affected companies, and the price of the Common Stock could be affected by such fluctuations.



Fuel Costs



The owner-operators utilized by the Company are responsible for all vehicle expense including maintenance, insurance, fuel and all other operating costs.
The Company makes every reasonable effort to include fuel cost adjustments in customer billings that are paid to owner-operators to offset the impact of fuel price increases. If future fuel cost adjustments are insufficient to offset
owner-operators costs, the Company may be unable to attract a sufficient number of owner-operators that may negatively impact the Companys business, financial condition and results of operations.



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Capital Funding Requirements



Achieving the Companys financial goals involves maximizing the effectiveness of the variable cost model, the
implementation of customer-driven technology solutions and continued leverage of the consolidated back office SG&A platform. To date, the Company has primarily relied upon debt and equity investments to fund these activities.



Additionally, at December 31, 2005, the Company was in violation of
certain non-financial affirmative covenants under the revolving credit facility and its senior subordinated debt facility with respect to furnishing financial statements on a timely basis to the respective lenders. The Companys ability to fund
operations is dependent on its ability to maintain the financing under the revolving credit agreement and its subordinated debt facility. The Company will pursue waivers with respect to the aforementioned debt covenants.



Uncertainty of Future Profitability



The Company has continued to experience net losses of $7.2 million for the
six months ended December 31, 2005. In fiscal 2005, the declines in operating income had significantly exceeded the cost saving resulting from improved systems. To achieve profitability, the Company must successfully pursue new revenue
opportunities, effectively limit the impact of competitive pressures on pricing and freight volumes, and fully implement its technology initiatives and other cost-saving measures.



Dependence on Additional Financing



The Company has depended, and is likely to continue to depend, on its ability to obtain additional financing to fund its liquidity requirements. The
Company may not be able to continue to obtain additional capital when the Company wants it or need it, and capital may not be available on satisfactory terms. If the Company issues additional equity securities or convertible debt to raise capital,
the issuance may be dilutive to the holders of the Companys common or preferred stock. In addition, any additional capital may have terms and conditions that adversely affect the Companys business, such as financial or operating
covenants.



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.



The Companys operations are not currently subject to material market risks for interest rates, foreign currency rates, or other market price risks.
However, the Company has revolving debt of $19.5 million at December 31, 2005. If the entire revolving credit facility were subject to a one percentage point change in the borrowing rate, the corresponding annualized effect on interest expense
would be $195,000.



ITEM 4. CONTROLS AND PROCEDURES



(a)
Evaluation of Disclosure Controls and Procedures



As
of the end of the period covered by this report, under the supervision and with the participation of the Companys management, including the companys Chief Executive Officer (CEO) and Chief Financial Officer (CFO) (the Certifying
Officers), the Company carried out an evaluation of the effectiveness of its disclosure controls and procedures (as the term is defined in the Securities Exchange Act of 1934, as amended (the Act) Rules 13a-15(e) and
15d-15(e) to mean controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports it files or submits under the Act is recorded, processed, summarized and reported, within
the time periods specified in the Commissions rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the
reports that it files or submits under the Act is accumulated and communicated to the issuers management, including the Certifying Officers, to allow timely decisions regarding required disclosure).



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As we reported in our Form 10-K for the fiscal year ended July 1, 2005 (filed October 19,
2005), as amended on October 26, 2005, in connection with the audit of our financial statements for that year, certain material weaknesses became evident to management including the inability to fully reconcile cash applications on a timely
basis and, due to resource constraints, the inability to close the Companys books in a timely manner on a month to month basis. A material weakness is a significant deficiency in one or more of the internal control components that alone or in
the aggregate precludes the Companys internal controls from reducing to an appropriately low level the risk that material misstatements in its financial statements will not be prevented or detected on a timely basis. Based on this evaluation,
the Certifying Officers concluded that the Companys disclosure controls and procedures were not effective to ensure that material information was recorded, processed, summarized and reported by management of the Company on a timely basis in
order to comply with the Companys disclosure obligations under the Act, and the rules and regulations promulgated thereunder. Such material weakness and associated ineffectiveness, as reported in Form 10-K under ITEM 9A. Controls and
Procedures have been evaluated, and at December 31, 2005, the Company has action plans in place to address and eliminate them.



|(b) | Changes in internal controls over financial reporting
|--- | -----------------------------------------------------



As described in section (a) above, on October 19, 2005 we reported a material weakness as of July 1, 2005 which still existed at December
31, 2005. The Company has taken steps to attempt to improve its internal controls and its control environment. The Company has established, and is implementing, a cash applications initiative to ensure timely and accurate posting of cash receipts
and has aggressively recruited experienced professionals to augment and upgrade its financial staff to address issues of timeliness in financial reporting. The Company believes that the corrective steps described herein will enable management to
conclude that the internal controls over its financial reporting are effective when they are fully implemented. The Company will continue its efforts to identify, assess and correct any additional weaknesses in internal control.



PART II



ITEM 1. LEGAL PROCEEDINGS.



The Company is a party to litigation and has claims asserted against it incidental to its business. Most of such claims are routine litigation that involve workers compensation claims, claims arising out of vehicle accidents and other
claims arising out of the performance of same-day transportation services. The Company carries workers compensation insurance and auto liability coverage for its employees.The Company and its subsidiaries are also named as defendants
in various employment-related lawsuits arising in the ordinary course of the business of the Company. The Company vigorously defends against all of the foregoing claims.



The Company has established reserves for litigation, which it believes are adequate. The Company reviews its litigation
matters on a regular basis to evaluate the demands and likelihood of settlements and litigation related expenses. Based on this review, the Company does not believe that the pending active lawsuits, if resolved or settled unfavorably to the Company,
would have a material adverse effect upon the Companys balance sheet or results of operations. The Company has managed to fund settlements and litigation expenses through cash flow and believes that it will be able to do so going forward.
Settlements and litigation expenses have not had a material impact on cash flow and the Company believes they will not have a material impact going forward.



Cautionary Statements Regarding Pending Litigation and Claims



The Companys statements above concerning pending litigation constitute forward-looking statements. Investors should
consider that there are many important factors that could adversely affect the Companys assumptions and the outcome of claims, and cause actual results to differ materially from those projected in the forward-looking statements. These factors
include:



| |  |  | The Company has made estimates of its exposure in connection with the lawsuits and claims that have been made. As a result of litigation or settlement of cases, the actual amount of
exposure in a given
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | case could differ materially from that projected. In addition, in some instances, the Companys liability for claims may increase or decrease depending upon the ultimate
development of those claims.
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In estimating the Companys exposure to claims, the Company is relying upon its assessment of insurance coverages and the availability of insurance. In some instances insurers
could contest their obligation to indemnify the Company for certain claims, based upon insurance policy exclusions or limitations. In addition, from time to time, in connection with routine litigation incidental to the Companys business,
plaintiffs may bring claims against the Company that may include undetermined amounts of punitive damages. The Company is currently not aware of any such punitive damages claim or claims in the aggregate which would exceed 10% of its current assets.
Such punitive damages are not normally covered by insurance.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.



Series P Convertible Preferred StockOn October 14, 2005, the Company entered into Stock Purchase Agreements (the
Purchase Agreements) with one group of institutional investment funds and one accredited investor (the Investors). The Purchase Agreements provide for the private placement of 3,099,513 shares of a newly authorized series of
the Companys preferred stock (the Series P Preferred) in exchange for aggregate gross proceeds of $10,352,370. The Series P Preferred has a term of three years (the Term) and is entitled to receive a dividend at the
rate of 8% per annum of the Series P Preferred stated value, payable quarterly, in cash or PIK shares of Series P Preferred at the option of the Company. Under certain events of default, the dividend rate will convert to 18%. To the extent that
the issuance of such PIK shares would result in the Company issuing in excess of 20% of its outstanding Common Stock, the issuance will require the prior approval of the Companys shareholders. Upon any liquidation, dissolution or winding up of
the Company, the Investors of the shares of Series P Preferred shall rank on parity with the holders of the Companys Series M Preferred Stock. Each of the Investors has the right, at its option at any time, to convert any shares of Series P
Preferred into shares of Common Stock at the conversion price of $3.34 per share subject to certain adjustments. At any time after the effective date of the Registration Statement and (i) prior to the Term, or (ii) upon a Change of
Control, the Company shall have the right, but not the obligation, to redeem all or a portion of the shares of Series P Preferred by tendering to the Holder 130% of the stated value of the outstanding Series P Preferred together with all accrued
dividends. At the Term, the Company shall have the right, but not the obligation, to redeem all or a portion of the shares of Series P Preferred by tendering to the Holder 100% of the Conversion Price together with all accrued but unpaid dividends.
In the event that the Company elects to redeem the Series P Preferred prior to the Registration Statement becoming effective, the Company may redeem the Series P Preferred by paying to the Investor the greater of: (1) 130% of the outstanding
stated value of the Series P Preferred plus accrued dividends, and (2) 100% of the stated value of the Series P Preferred plus all accrued dividends, plus 50% of the difference between the conversion price then in effect and the average closing
price of the Companys Common Stock for the 30 calendar days preceding such redemption. Each Investor also received an A Warrant and B Warrant, each to purchase up to 20% of the amount of Series P Preferred purchased. The exercise of the A
Warrant and B Warrant are subject to the prior approval of the Companys shareholders. The exercise price for both warrants is $4.00, subject to adjustments. Additionally, the B Warrant is only exercisable in the event that a registration
statement, allowing for the sale of the Series P Preferred, is not declared effective within 270 days of closing. The Company has the option to redeem both warrants in the event that the Companys common stock maintains a closing price of at
least $7.00 for twenty consecutive trading days. The Investors are also parties to a Registration Rights Agreement (the Rights Agreement). The Rights Agreement requires the filing of a registration statement no later than 90 days after
the closing date, and that it be effective within 180 days.



|ITEM 3. | DEFAULTS UPON SENIOR SECURITIES.
|------- | --------------------------------



As of July 3, 2004, the Company was not in compliance with the minimum availability or interest coverage ratio covenants in the revolving credit
facility and the interest coverage ratio covenant in the senior subordinated debt facility. However, the Company had in place waivers of its financial debt covenants related



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to its revolving credit facility and its senior subordinated debt facility. These waivers were in effect through
January 1, 2005; and, pursuant to the Companys receipt of $21.0 million of investment capital on December 21, 2004 the Company obtained additional waivers and consents from its lenders. The lenders waived all existing defaults and
delayed the start date for the financial covenants for both minimum EBITDA and interest coverage ratio until the earlier of January 1, 2007 or the date upon which the (a) Companys EBITDA for each of two consecutive months equals or
exceeds the Companys fixed charges (interest expense and scheduled principal payments due with respect to money borrowed) for the applicable month and (b) availability under the credit facility for each day of the immediately preceding
thirty days is greater than or equal to $1,000,000.



As of
December 31, 2005, the Company was not in compliance with certain non-financial covenants relative to the timely remittance of monthly financial statements. The Company is working to secure waivers to cure this situation.



ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.



On January 27, 2006 at a special meeting of shareholders, the Company submitted to its shareholders three matters, all of which were approved. The matters and voting thereon were as follows:



| | 1. | To approve certain terms of Series P Convertible Preferred Stock (Series P) to permit the Company to (a) issue additional Series P as payment-in-kind dividends,
(b) issue additional conversion shares pursuant to anti-dilution provisions of the Series P, and (c) exercise of the A Warrant and B Warrant issuable in connection with the Series P.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                 |  |        
|---------------- |  | -------
|For              |  | 587,874
|Against          |  | 99,917 
|Abstain          |  | 9,120  
|Broker non-votes |  | 0      



| | 2. | To approve certain terms of Series N Convertible Preferred Stock (Series N) to permit the Company to issue additional Series N as payment-in-kind dividends, and the
issuance of additional conversion shares pursuant to anti-dilution provisions thereof; and
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                 |  |        
|---------------- |  | -------
|For              |  | 587,172
|Against          |  | 100,618
|Abstain          |  | 9,121  
|Broker non-votes |  | 0      



| | 3. | To approve certain terms of Series O Convertible Preferred Stock (Series O) to permit the Company to issue additional Series O as payment-in-kind dividends, and the
issuance of additional conversion shares pursuant to anti-dilution provisions thereof.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                 |  |        
|---------------- |  | -------
|For              |  | 587,088
|Against          |  | 100,702
|Abstain          |  | 9,121  
|Broker non-votes |  | 0      



ITEM 5. OTHER INFORMATION.



Not Applicable.



ITEM 6. EXHIBITS.



Exhibits required by Item 601 of Regulation S-K:



| | 31.1 | Section 302 Certification of CEO.
| | ---- | ---------------------------------



| | 31.2 | Section 302 Certification of CFO.
| | ---- | ---------------------------------



| | 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
| | ---- | -----------------------------------------------------------------------------------------------------------------------------------



| | 32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
| | ---- | -----------------------------------------------------------------------------------------------------------------------------------



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SIGNATURES



In accordance with the
requirements of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the Town of Westport, State of Connecticut on February 17, 2006.



VELOCITY EXPRESS CORPORATION.By

/s/ Vincent A. WasikVINCENT A. WASIKChief Executive OfficerBy

/s/ Daniel R. DeFazioDANIEL R. DEFAZIOChief Financial Officer




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