**United
      States**


**Securities
      and Exchange Commission**


**Washington,
      D.C. 20549**





**FORM
      10-Q**


(Mark
      One)





x
            Quarterly
                Report under Section 13 or 15(d) of the Securities and Exchange Act
                of
                1934





For
      the
      quarterly period ended June 30, 2006





o
            Transition
                report under Section 13 or 15(d) of the Exchange
                Act





For
      the
      transition period from ________________ to
      ________________





Commission
      File Number 000-19828





**SpatiaLight,
      Inc.**


(Exact
      name of registrant as specified in its charter)





New
                York
            16-1363082(State
                or other jurisdiction of
            (IRS
                Employer Identification No.)Incorporation
                or organization)





Five
      Hamilton Landing, Suite 100, Novato, California 94949


(Address
      of principal executive offices)





(415)
      883-1693


(Issuer’s
      telephone number)





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
      past 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
o





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 large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      one):


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





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


Yes
o   
No
x





APPLICABLE
      ONLY TO CORPORATE ISSUERS:





State
      the
      number of shares outstanding of each of the issuer’s classes of common equity,
      as of the latest practicable date: 40,797,740 common shares as of August 7,
      2006.





1




SPATIALIGHT,
      INC.


Quarterly
      Report on Form 10-Q


For
      the
      Quarter Ended June 30, 2006





Table
      of Contents





**PART
                I**
            **FINANCIAL
                INFORMATION**Item
                1.
            Condensed
                Consolidated Financial StatementsCondensed
                Consolidated Balance Sheets as ofJune
                30, 2006 and December 31, 2005
            3Condensed
                Consolidated Statements of Operationsfor
                the Three and Six Months Ended June 30, 2006 and 2005
            4Condensed
                Consolidated Statement of Stockholders’ Equity(Deficit)
                for the Six Months Ended June 30, 2006
            5Condensed
                Consolidated Statements of Cash Flowsfor
                the Six Months Ended June 30, 2006 and 2005
            6Notes
                to Condensed Consolidated Financial Statements
            7Item
                2.
            Management’s
                Discussion and Analysisof
                Financial Condition and Results of Operations
            27Item
                3.
            Quantitative
                and Qualitative Disclosures about Market Risks
            40Item
                4.
            Controls
                and Procedures
            40**PART
                II**
            **OTHER
                INFORMATION**Item
                1.
            Legal
                Proceedings.
            42Item
                1A.
            Business
                Risks and Uncertainties.
            42Item
                2.
            Unregistered
                Sales of Securities and Use of Proceeds
            46Item
                3.
            Defaults
                Upon Senior Securities.
            46Item
                4
            Submission
                of Matters to a Vote of Security Holders
            46Item
                5.
            Other
                Information
            48Item
                6.
            Exhibits
                and Reports on Form 8-K
            48Signatures
            49




2


**PART
              I.**
            **FINANCIAL
                INFORMATION**


Item
            1.  Condensed
                Consolidated Financial Statements




SPATIALIGHT,
        INC.


CONDENSED
        CONSOLIDATED BALANCE SHEETS


June
                  30,
              
              December
                  31,2006
              
              2005(unaudited)
              
              (Note
                  2)ASSETSCurrent
                  assetsCash
                  and cash equivalents
              
              $
              466,412
              
              $
              42,565Accounts
                  receivable, net of $11,270 and $0 allowance for doubtfulaccounts
                  as of June 30, 2006 and December 31, 2005, respectively
              
              
              60,645
              
              
              139,676Inventory,
                  net
              
              
              428,946
              
              
              756,723Prepaids
                  and other current assets
              
              
              399,012
              
              
              255,157Prepaid
                  current non-cash interest to related party
              
              
              1,157,133
              
              
              1,157,133Total
                  current assets
              
              
              2,512,148
              
              
              2,351,254Property,
                  plant and equipment, net
              
              
              6,757,900
              
              
              6,813,520Prepaid
                  non-cash interest to related party
              
              
              1,735,699
              
              
              2,314,265Other
                  assets
              
              
              48,234
              
              
              73,437Total
                  assets
              
              $
              11,053,981
              
              $
              11,552,476LIABILITIES,
                  TEMPORARY EQUITY, AND STOCKHOLDERS' EQUITY (DEFICIT)Current
                  liabilitiesShort
                  term loans
              
              $
              791,187
              
              $
              572,025Short
                  term loan from a related party
              
              
              -
              
              
              224,384Accounts
                  payable
              
              
              1,169,157
              
              
              1,665,711Fair
                  value of warrants to purchase common stock
              
              
              -
              
              
              778,270Accrued
                  expenses and other current liabilities
              
              
              1,232,489
              
              
              1,389,427Total
                  current liabilities
              
              
              3,192,833
              
              
              4,629,817Senior
                  secured and related party convertible notes
              
              
              10,562,100
              
              
              10,340,113Total
                  liabilities
              
              
              13,754,933
              
              
              14,969,930Commitments
                  and contingenciesTemporary
                  equity:Common
                  stock, subject to registration, $0.01 par value;571,431
                  shares issued and outstanding, net of original fair valueof
                  warrants of $958,625 and issuance costs of $15,000at
                  December 31, 2005
              
              
              -
              
              
              1,026,374Total
                  liabilities and temporary equity
              
              
              13,754,933
              
              
              15,996,304Stockholders'
                  equity (deficit):Common
                  stock, $.01 par value:50,000,000
                  shares authorized;40,797,740
                  and 36,777,069 shares issued and outstanding,at
                  June 30, 2006 and December 31, 2005, respectively
              
              
              407,977
              
              
              367,771Additional
                  paid-in capital
              
              
              89,212,044
              
              
              76,631,925Other
                  comprehensive income
              
              
              282,118
              
              
              222,317Accumulated
                  deficit
              
              
              (92,603,091
              )
              
              (81,665,841
              )Total
                  stockholders' equity (deficit)
              
              
              (2,700,952
              )
              
              (4,443,828
              )Total
                  liabilities, temporary equity, and stockholders' equity
                  (deficit)
              
              $
              11,053,981
              
              $
              11,552,476


See
        accompanying notes to condensed consolidated financial statements.
  3
 
  SPATIALIGHT,
            INC.
 CONDENSED
            CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
  Three
                      months ended June 30,
                  
                  Six
                      months ended June 30,2006
                  
                  2005
                  
                  2006
                  
                  2005Revenue
                  
                  $
                  59,148
                  
                  $
                  41,149
                  
                  $
                  144,842
                  
                  $
                  138,908Cost
                      of revenue
                  
                  
                  1,602,014
                  
                  
                  89,044
                  
                  
                  3,150,344
                  
                  
                  158,888Gross
                      margin
                  
                  
                  (1,542,866
                  )
                  
                  (47,895
                  )
                  
                  (3,005,502
                  )
                  
                  (19,980
                  )Selling,
                        general and administrative expenses (including stock-basedgeneral
                        and administrative expenses of $976,156 and $8,250for
                        the three month periods ended June 30, 2006 and 2005,respectively,
                        and $1,644,933 and $107,300 for the six monthperiods
                        ended June 30, 2006 and 2005, respectively).
                  
                  
                  2,894,372
                  
                  
                  1,780,477
                  
                  
                  5,534,466
                  
                  
                  3,589,092Research
                      and development expenses
                  
                  
                  411,175
                  
                  
                  1,165,634
                  
                  
                  653,246
                  
                  
                  1,659,130Total
                      operating expenses
                  
                  
                  3,305,547
                  
                  
                  2,946,111
                  
                  
                  6,187,712
                  
                  
                  5,248,222Operating
                      loss
                  
                  
                  (4,848,413
                  )
                  
                  (2,994,006
                  )
                  
                  (9,193,214
                  )
                  
                  (5,268,202
                  )Other
                      income (expense):Interest
                      expense:Interest
                      expense
                  
                  
                  (31,984
                  )
                  
                  (267,775
                  )
                  
                  (314,972
                  )
                  
                  (534,910
                  )Non-cash
                      interest expense
                  
                  
                  (473,729
                  )
                  
                  (277,592
                  )
                  
                  (1,486,500
                  )
                  
                  (555,184
                  )Total
                      interest expense
                  
                  
                  (505,713
                  )
                  
                  (545,367
                  )
                  
                  (1,801,472
                  )
                  
                  (1,090,094
                  )Gain
                      from revaluation of note purchase option and investment right
                      liabilities
                  
                  
                  -
                  
                  
                  6,537
                  
                  
                  -
                  
                  
                  657,772Gain
                      from revaluation of warrants
                  
                  
                  34,111
                  
                  
                  -
                  
                  
                  21,693
                  
                  
                  -Foreign
                      currency translation gain
                  
                  
                  7,780
                  
                  
                  -
                  
                  
                  12,353
                  
                  
                  -Interest
                      and other income
                  
                  
                  7,654
                  
                  
                  8,389
                  
                  
                  24,190
                  
                  
                  27,542Total
                      other income (expenses)
                  
                  
                  (456,168
                  )
                  
                  (530,441
                  )
                  
                  (1,743,236
                  )
                  
                  (404,780
                  )Loss
                      before income tax expense
                  
                  
                  (5,304,581
                  )
                  
                  (3,524,447
                  )
                  
                  (10,936,450
                  )
                  
                  (5,672,982
                  )Income
                      tax expense
                  
                  
                  -
                  
                  
                  -
                  
                  
                  800
                  
                  
                  -Net
                      loss
                  
                  $
                  (5,304,581
                  )
                  $
                  (3,524,447
                  )
                  $
                  (10,937,250
                  )
                  $
                  (5,672,982
                  )Net
                      loss per share - basic and diluted
                  
                  $
                  (0.13
                  )
                  $
                  (0.10
                  )
                  $
                  (0.28
                  )
                  $
                  (0.16
                  )Weighted
                      average shares used in computingnet
                      loss per share- basic and diluted
                  
                  
                  40,122,993
                  
                  
                  35,965,774
                  
                  
                  39,356,858
                  
                  
                  35,892,277
  See
            accompanying notes to condensed consolidated financial
            statements
  4
 
  SPATIALIGHT,
              INC.
 CONDENSED
            CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
            (unaudited)
 SIX
              MONTHS ENDED JUNE 30, 2006
  **ADDITIONAL**
                    
                    
                    
                    **OTHER**
                    
                    **TOTAL****COMMON
                        STOCK**
                    
                    **PAID-IN**
                    
                    **ACCUMULATED**
                    
                    **COMPREHEN-**
                    
                    **STOCKHOLDERS'****SHARES**
                    
                    **AMOUNT**
                    
                    **CAPITAL**
                    
                    **DEFICIT**
                    
                    **SIVE
                        INCOME**
                    
                    **EQUITY
                        (DEFICIT)**Balance,
                        January 1, 2006
                    
                    
                    36,777,069
                    
                    $
                    367,771
                    
                    $
                    76,631,925
                    
                    $
                    (81,665,841
                    )
                    $
                    222,317
                    
                    $
                    (4,443,828
                    )Exercise
                        of stock options and warrants
                    
                    
                    50,000
                    
                    
                    500
                    
                    
                    39,745
                    
                    
                    -
                    
                    
                    -
                    
                    
                    40,245Stock-based
                        compensation expense
                    
                    
                    -
                    
                    
                    -
                    
                    
                    1,644,993
                    
                    
                    -
                    
                    
                    -
                    
                    
                    1,644,993Issuance
                          of common shares, net of issuance costsof
                          $172,627
                    
                    
                    3,151,000
                    
                    
                    31,510
                    
                    
                    8,419,663
                    
                    
                    -
                    
                    
                    -
                    
                    
                    8,451,173Issuance
                        of common shares for interest andliquidated
                        damages charges
                    
                    
                    248,240
                    
                    
                    2,482
                    
                    
                    698,479
                    
                    
                    -
                    
                    
                    -
                    
                    
                    700,961Reclassification
                          from temporary equity of October2005
                          Financing shares upon effectiveness ofregistration
                          statement, including $756,579 marketvalue
                          of warrants issued
                    
                    
                    571,431
                    
                    
                    5,714
                    
                    
                    1,777,239
                    
                    
                    -
                    
                    
                    -
                    
                    
                    1,782,953Comprehensive
                        loss:Net
                        loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (10,937,250
                    )
                    
                    -
                    
                    
                    (10,937,250
                    )Foreign
                        currency translation adjustment
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    59,801
                    
                    
                    59,801Total
                        comprehensive loss
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (10,937,250
                    )
                    
                    59,801
                    
                    
                    (10,877,449
                    )Balance,
                        June 30, 2006
                    
                    
                    40,797,740
                    
                    $
                    407,977
                    
                    $
                    89,212,044
                    
                    $
                    (92,603,091
                    )
                    $
                    282,118
                    
                    $
                    (2,700,952
                    )
  See
              accompanying notes to condensed consolidated financial
              statements
  5




SPATIALIGHT,
        INC.


CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)


Six
                  months ended June 30,2006
              
              2005Cash
                  flows from operating activities:Net
                  loss
              
              $
              (10,937,250
              )
              $
              (5,672,982
              )Adjustments
                  to reconcile net loss to net cash used in operating
                  activities:Inventory
                  reserve adjustment
              
              
              386,329
              
              
              -Depreciation
                  and amortization
              
              
              441,448
              
              
              237,563Stock-based
                  general and administrative expenses
              
              
              1,644,993
              
              
              107,300Non-cash
                  interest expense
              
              
              1,486,500
              
              
              555,184Gain
                  from revaluation of note purchase option and investment right
                  liabilities
              
              
              -
              
              
              (657,772
              )Gain
                  from revaluation of warrants
              
              
              (21,693
              )
              
              -Non-cash
                  foreign currency translation gain
              
              
              (12,353
              )
              
              -Accrued
                  interest on notes receivable from stockholder
              
              
              -
              
              
              (7,034
              )Loss
                  on sale of fixed assets
              
              
              1,975
              
              
              -Changes
                  in operating assets and liabilities:Accounts
                  receivable
              
              
              79,031
              
              
              184,629Inventory
              
              
              (58,552
              )
              
              (17,034
              )Prepaids
                  and other current assets
              
              
              (139,930
              )
              
              96,930Other
                  assets
              
              
              25,203
              
              
              10,825Accounts
                  payable
              
              
              (481,970
              )
              
              850,990Accrued
                  expenses and other current liabilities
              
              
              (145,850
              )
              
              (1,149,412
              )Net
                  cash used in operating activities
              
              
              (7,732,119
              )
              
              (5,460,813
              )Cash
                  flows from investing activities:Purchase
                  of property, plant and equipment
              
              
              (320,947
              )
              
              (3,537,829
              )Proceeds
                  from sale of property, plant and equipment
              
              
              6,000
              
              
              -Net
                  cash used in investing activities
              
              
              (314,947
              )
              
              (3,537,829
              )Cash
                  flows from financing actitivies:Payments
                  received from notes receivable
              
              
              -
              
              
              200,000Proceeds
                  from issuance of short-term notes
              
              
              5,876,330
              
              
              -Payment
                  on short-term notes
              
              
              (5,897,573
              )
              
              -Proceeds
                  from the sale of common shares, net of fees
              
              
              8,451,175
              
              
              -Proceeds
                  from exercise of warrants and options
              
              
              40,245
              
              
              100,761Net
                  cash provided by financing activities
              
              
              8,470,177
              
              
              300,761Net
                  increase (decrease) in cash and cash equivalents
              
              
              423,111
              
              
              (8,697,881
              )Effect
                  of exchange rate changes on cash
              
              
              736
              
              
              1,255Cash
                  and cash equivalents at beginning of period
              
              
              42,565
              
              
              9,087,551Cash
                  and cash equivalents at end of period
              
              $
              466,412
              
              $
              390,925Non-cash
                  financing activities:Warrants
                  issued for fundraising services provided
              
              $
              -
              
              $
              72,387Shares
                  issued for interest and liquidated damages
              
              $
              700,960
              
              $
              -Supplemental
                  disclosure of cash flow information:Income
                  taxes paid during the period
              
              $
              800
              
              $
              2,300Interest
                  paid during the period
              
              $
              283,942
              
              $
              540,389




See
        accompanying notes to condensed consolidated financial
        statements.




6


**SPATIALIGHT,
        INC.**
 Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)




**Note
              1.**
            **Business
                Description**





We
      are in
      the business of manufacturing high-resolution liquid crystal on silicon (LCoS)
      microdisplays. We are currently focused on manufacturing one core product,
      our
      1080p T-3 LCoS Set, and selling that product to our customers and prospective
      customers, who are located in Asia. The T-3 LCoS model has a 1920 pixels by
      1080
      pixels configuration. Our current customers and current prospective customers
      are original equipment manufacturers (OEMs) engaged in the businesses of
      manufacturing high definition televisions, light engines for incorporation
      into
      high definition televisions and 3-dimensional near-to-eye display devices.
      Our
      products are also suitable for incorporation into other display applications
      including front projection systems, head mounted devices, rear projection
      computer monitors, wireless communication devices, portable games and digital
      assistants, although we are not currently working with OEMs of any of these
      products.





**Note
              2.**
            **Basis
                of Presentation**





The
      accompanying condensed consolidated financial statements incorporate the
      accounts of SpatiaLight, Inc. and its wholly-owned subsidiaries, SpatiaLight
      Technologies, Inc. and SpatiaLight Korea, Inc. All significant intercompany
      business and transactions have been eliminated in consolidation.





The
      accompanying condensed consolidated financial statements have been prepared
      in
      accordance with U. S. generally accepted accounting principles for interim
      financial information and with the instructions to Form 10-Q and Article 10
      of
      Regulation S-X. Accordingly, they do not include all of the information and
      footnotes necessary for a fair presentation of financial condition, results
      of
      operations and cash flows in conformity with U.S. generally accepted accounting
      principles. In our management’s opinion, the interim condensed consolidated
      financial statements included herewith contain all adjustments (consisting
      of
      normal recurring accruals and adjustments) necessary for their fair
      presentation. The unaudited interim condensed consolidated financial statements
      should be read in conjunction with our Annual Report on Form 10-K/A - Amendment
      No. 1, which contains the audited financial statements and notes thereto,
      together with the Management’s Discussion and Analysis, for the year ended
      December 31, 2005. The interim results for the six month period ended June
      30,
      2006 are not necessarily indicative of results for the full fiscal year. The
      accompanying consolidated balance sheet at December 31, 2005 has been derived
      from the audited financial statements at that date.





The
      accompanying condensed consolidated financial statements have been prepared
      assuming we will continue as a going concern. As reported in our 2005 Annual
      Report on Form 10K/A filed with the SEC on April 11, 2006, we have suffered
      recurring operating losses and negative cash flows from operations. We have
      continued to suffer operating losses during the first six months of 2006. While
      we plan on raising additional capital, no assurance can be given that we will
      be
      able to raise sufficient funds to continue our operations. If we do not receive
      additional funds, we will be required to scale back or terminate operations
      and/
      or seek protection under applicable bankruptcy laws. Additionally, as more
      fully
      described in Note 7, our Senior Secured Convertible Notes, maturing in November
      2007, are held by four noteholders. Two of the noteholders have alleged that
      certain events of default under the Senior Secured Convertible Notes have
      occurred. We strongly dispute that any events of default have occurred that
      would allow the noteholders to call the notes, and we plan to vigorously defend
      our position. We believe, after reviewing with outside counsel, with respect
      to
      each of the alleged events of default, that it is not probable that the
      noteholders would prevail in calling the loans based on any of the alleged
      events of default; therefore, we have continued classifying the notes as
      noncurrent liabilities in the accompanying condensed consolidated balance sheet
      and have not accrued for the alleged redemption premiums and liquidated damages.
      However, should the noteholders pursue their call for immediate redemption
      of
      the Senior Secured Convertible Notes, and prevail on their claim in a court
      of
      law, the Senior Secured Convertible Notes and related redemption premiums and
      liquidated damages would immediately become due and payable.





7
 
  **SPATIALIGHT,
          INC.**
 Notes
          to
          Condensed Consolidated Financial Statements (Unaudited)


These
      matters raise substantial doubt about our ability to continue as a going
      concern. The recoverability of a major portion of the recorded asset amounts
      shown in the accompanying condensed consolidated balance sheets is dependent
      upon our continuing operations. Our financial statements do not include any
      adjustments relating to the recoverability and classification of recorded asset
      amounts or amounts and classifications of liabilities that might be necessary
      should we be unable to continue as a going concern.





**Note
              3.**
            **Liquidity**





From
      inception through June 30, 2006, we have sustained recurring net losses from
      operations totaling approximately $92.6 million and at June 30, 2006, had total
      stockholders’ deficit of approximately $2.7 million and net negative working
      capital of approximately $0.7 million. During the six months ended June 30,
      2006, we experienced a net cash increase of approximately $0.4 million. In
      the
      first quarter of 2006, cash was primarily provided by the net proceeds of
      approximately $3.3 million that we received from the sale of 1,300,000 of our
      common shares on January 12, 2006 at a purchase price of $2.62 per share and
      approximately $1.1 million that we received from the sale of 500,000 of our
      common shares on March 17, 2006 at a purchase price of $2.18 per share.
      Additional contributions came from the exercise of employee stock options.
      Additionally, cash for the three months ended March 31, 2006 was provided by
      a
      Korean Won 1.5 billion (approximately $1.5 million) short-term loan obtained
      in
      March 2006 that was repaid in early April 2006. See Note 7 for further details
      of this loan. In the second quarter of 2006, cash was primarily provided by
      the
      net proceeds of approximately $2.4 million that we received from the sale of
      750,000 of our common shares on April 7, 2006 at a purchase price of $3.26
      per
      share and approximately $1.6 million that we received from the sale of 601,000
      of our common shares on June 6, 2006 at a purchase price of $2.80 per share.
      The
      funds from these financings were used to fund our operations for the second
      quarter of 2006. We recognized net losses for the six months ended June 30,
      2006, of approximately $10.9 million.





We
        expect
        to meet our immediate cash needs and fund our immediate working capital
        requirements with our existing cash balances, the proceeds of approximately
        $1.7
        million from the sale of 761,500 shares of our common shares expecting to
        close
        no later than August 16, 2006 from a private placement of our common shares,
        as
        more fully described in Note 14, and from additional sources. Those sources
        include **** cash
        payments from our customers; the exercises of stock options and warrants;
        and
        additional sales of our common shares. There can be no assurances with respect
        to these potential sources. We believe that our current cash and cash
        equivalents as of June 30, 2006, combined with the private placement detailed
        above, will be sufficient to meet our capital and liquidity requirements
        through
        September 2006. If we are unable to obtain additional funds on reasonable
        terms,
        we may be unable to continue our operations at current levels, or at
        all.





8


**SPATIALIGHT,
      INC.**


Notes
      to
      Condensed Consolidated Financial Statements (Unaudited)


**Note
              4.**
            **Stock-Based
                Compensation**





We
      have
      stock compensation plans for employees and directors which are described in
      Note
      6 to our consolidated financial statements in our 2005 Annual Report on Form
      10-K/ A as filed with the SEC on April 11, 2006. We adopted Statement of
      Financial Accounting Standards No. 123 (revised 2004), “ *Share-Based
      Payment* ,”
(“SFAS
      123R”) effective January 1, 2006. SFAS 123R requires the recognition of the fair
      value of stock compensation including stock options in net income (loss). We
      recognize the stock compensation expense over the requisite service period
      of
      the individual grantees, which generally equals the vesting period of the grant.
      All of our stock compensation is accounted for as an equity instrument. Prior
      to
      January 1, 2006, we followed Accounting Principles Board Opinion 25,
“ *Accounting
      for Stock Issued to Employees,* ”
(“APB
      25”) and related interpretations in accounting for our stock compensation. We
      adopted SFAS 123R using the modified prospective method. Under this method,
      the
      provisions of SFAS 123R apply to all awards granted or modified after the date
      of adoption. The unrecognized expense of awards not yet vested at the January
      1,
      2006 date of adoption is recognized in net income (loss) in the periods after
      the date of adoption using the same valuation method ( *i.e.* Black-Scholes) and assumptions determined under the original provisions of
      SFAS
      123, “ *Accounting
      for Stock-Based Compensation,”* as
      disclosed in our previous filings. Following the provisions of the modified
      prospective method, we have not restated our consolidated financial statements
      for periods prior to 2006 to reflect the adoption of SFAS 123R. Therefore,
      the
      results reported in the condensed consolidated statement of operations for
      the
      first two quarters of 2006 are not directly comparable to the results for the
      same period in the prior year.





Under
      the
      provisions of SFAS 123R, we recorded $976,156 and $1,644,993 of stock
      compensation, net of estimated forfeitures, in selling, general and
      administrative expenses, in our unaudited condensed consolidated statement
      of
      operations for the three and six months ended June 30, 2006, respectively.
      We
      utilized the Black-Scholes valuation model for estimating the fair value of
      the
      stock compensation granted after the adoption of SFAS 123R, with the following
      weighted-average assumptions:


Three
                  and six months ended June 30, 2006Dividend
                  yield
              
              
              -Expected
                  volatility
              
              
              92.8
              %Risk-free
                  interest rate
              
              
              4.6
              %Expected
                  lives (in years)
              
              
              5.21
                  to 5.46




The
      dividend yield of zero is based on the fact that we have never paid cash
      dividends and have no present intention to pay cash dividends. Expected
      volatility is based upon historical volatility of our common stock over the
      period commensurate with the expected life of the options. The risk-free
      interest rate is derived from the average U.S. Treasury Constant Maturity Rate
      during the period, which approximates the rate in effect at the time of the
      grant. The expected term is calculated using the simplified method prescribed
      by
      the SEC’s Staff Accounting Bulletin 107. Our currently unvested options vest
      over two years from the date of grant. Our options generally have a 10-year
      contractual term. Based on the above assumptions, the weighted-average fair
      values of the options granted under the stock option plans for the six months
      ended June 30, 2006 was $1.97. As required by SFAS No. 123R, we now
      estimate forfeitures of employee stock options and recognize compensation cost
      only for those awards expected to vest. Forfeiture rates are determined
      for four groups of employees - CEO, directors, senior management and all
      other employees - based on historical experience.  Estimated forfeitures
      are now adjusted to actual forfeiture experience as needed.




9
 
  **SPATIALIGHT,
          INC.**
 Notes
          to
          Condensed Consolidated Financial Statements (Unaudited)


SFAS
123R
      requires us to present pro forma information for the comparative period prior
      to
      the adoption as if we had accounted for all our employee stock options under
      the
      fair value method of the original SFAS 123. The following table illustrates
      the
      effect on net loss and loss per share if we had applied the fair value
      recognition provisions of SFAS 123 to stock-based employee compensation in
      the
      prior-year periods.




Three
                  months ended June 30, 2005
              
              Six
                  months ended June 30, 2005Net
                  loss as reported
              
              $
              (3,524,447
              )
              $
              (5,672,982
              )Add:
                  Stock-based employee/director compensationincluded
                  in reported net loss
              
              
              8,250
              
              
              16,500Deduct:
                  total stock-based employee compensationdetermined
                  under fair value method for all awards
              
              
              (1,270,330
              )
              
              (2,313,430
              )Proforma
                  net loss, as adjusted
              
              $
              (4,786,527
              )
              $
              (7,969,912
              )Loss
                  per share:Basic
                  and diluted, as reported
              
              $
              (0.10
              )
              $
              (0.16
              )Basic
                  and diluted, as adjusted
              
              $
              (0.13
              )
              $
              (0.22
              )





The
      assumptions used to determine the pro forma expenses under the Black-Scholes
      option model for the three and six months ended June 30, 2005 under SFAS 123
      were based on the following assumptions: expected dividend yield: 0 for both
      periods; expected volatility: 65% and 87%, respectively; expected lives, in
      years: 4 for both periods; and risk-free interest rate: 3% and 4.12%,
      respectively. In the pro forma information for periods prior to 2006, we
      accounted for forfeitures as they occurred.





10
 
  **SPATIALIGHT,
          INC.**
 Notes
          to
          Condensed Consolidated Financial Statements (Unaudited)


A
      summary
      of options under our stock option plans as of December 31, 2005 and changes
      during the six months ended June 30, 2006 are as follows:


Number
                  of Shares
              
              Weighted
                  Average Exercise Price
              
              Weighted
                  Average Remaining Contractual Term (in years)
              
              Aggregate
                  Intrinsic Value at June 30, 2006Outstanding
                  December 31, 2005
              
              
              5,882,394
              
              $
              4.06
              
              
              5.79Options
                  granted under the plans
              
              
              850,000
              
              $
              2.60Options
                  exercised
              
              
              (50,000
              )
              $
              0.80Options
                  forfeited or expired
              
              
              (562,500
              )
              $
              9.71Outstanding
                  June 30, 2006
              
              
              6,119,894
              
              $
              3.44
              
              
              6.05
              
              $
              1,251,310Options
                  vested and exercisableat
                  June 30, 2006
              
              
              5,944,894
              
              $
              3.45
              
              
              5.95
              
              $
              1,251,310


Aggregate
      intrinsic value is the sum of the amounts by which the quoted market price
      of
      our stock at June 30, 2006, $2.30 per share, exceeded the exercise price of
      the
      options, for those options for which the quoted market price was in excess
      of
      the exercise price (“in-the-money-options”). No options were exercised during
      the three months ended June 30, 2006. The aggregated intrinsic value of options
      exercised on the dates the options were exercised was $1,015,531 for the three
      month period ended June 30, 2005. The aggregated intrinsic value of options
      exercised on the dates the options were exercised was $112,865 and $1,055,956
      for the six month period ended June 30, 2006 and 2005,
      respectively.




As
      of
      June 30, 2006, total expected compensation cost of options outstanding but
      not
      yet vested is approximately $317,000. This cost is expected to be recognized
      through June 2007. We recorded no income tax benefits for stock-based
      compensation expense arrangements for the six months ended June 30, 2006, as
      we
      have cumulative operating losses, for which a full valuation allowance has
      been
      established.





11
 
  **SPATIALIGHT,
          INC.**
 Notes
          to
          Condensed Consolidated Financial Statements (Unaudited)


**Note
                5.**
            **Per
                Share Information**





Basic
      net
      loss per common share excludes dilution and is computed by dividing net loss
      by
      the weighted average number of common shares outstanding for the period. Diluted
      net loss per common share reflects the potential dilution that could occur
      if
      securities or other contracts to issue common shares were exercised or converted
      into common shares. The table below reflects potentially dilutive securities
      which were excluded from the computation of diluted net loss per share for
      the
      six months ended June 30, 2006 and 2005 because the effect of their assumed
      exercise would be antidilutive.


As
                  of June 30,2006
              
              2005Number
                  of Potentially Dilutive Shares
              
              Weighted
                  Average Exercise/Conversion Price
              
              Number
                  of Potentially Dilutive Shares
              
              Weighted
                  Average Exercise/Conversion PriceStock
                  options and warrants
              
              
              6,795,231
              
              $
              3.45
              
              
              6,646,211
              
              $
              4.00Convertible
                  notes
              
              
              3,404,807
              
              $
              3.29
              
              
              3,404,807
              
              $
              3.29Total
              
              
              10,200,038
              
              
              
              
              
              10,051,018




**Note
              6.**
            **Property,
                Plant and Equipment**





Property,
      plant and equipment include:


As
                  ofJune
                  30, 2006
              
              December
                  31, 2005Building
              
              $
              4,572,538
              
              $
              4,360,663Other
                  equipment and instruments
              
              
              2,344,770
              
              
              2,659,653Machinery
                  and manufacturing equipment
              
              
              1,573,310
              
              
              1,141,726Office
                  furniture and fixtures
              
              
              455,705
              
              
              590,696Tooling
              
              
              371,700
              
              
              371,700Leasehold
                  improvements
              
              
              175,654
              
              
              175,654Computer
                  hardware and software
              
              
              344,582
              
              
              215,109Total
                  property, plant and equipment
              
              
              9,838,259
              
              
              9,515,201Accumulated
                  depreciation
              
              
              (3,080,359
              )
              
              (2,701,681
              )Property,
                  plant and equipment, net
              
              $
              6,757,900
              
              $
              6,813,520




**Note
              7.**
            **S****hort-Term
                Loans and Notes Payable**





Short-Term
      Loans





*Short-Term
      Loan From a Related Party*





During
      March 2006, our wholly-owned subsidiary, SpatiaLight Korea, Inc. borrowed KRW
      85,000,000 (approximately US $86,250) from JeWon Yeun, SpatiaLight Korea’s
      former President. This non-interest bearing, unsecured loan was repaid in early
      April 2006.





12


**SPATIALIGHT,
      INC.**


Notes
      to
      Condensed Consolidated Financial Statements (Unaudited)


*Short-Term
      Loans*





Our
      wholly-owned subsidiary SpatiaLight Korea has revolving credit facilities with
      five separate South Korean banks as detailed below (amounts in thousands, Korean
      Won, unless otherwise stated):


Bank
              
              Shinhan
                  Bank
              
              Kyongnam
                  Bank
              
              Korea
                  Exchange Bank
              
              Pusan
                  Bank
              
              Industrial
                  Bank of Korea (4)
              
              TotalInterest
                  rate type
              
              
              Variable
                  (1)
              
              
              Variable
                  (2)
              
              
              Fixed
              
              
              Variable
                  (3)
              
              
              FixedInterest
                  rate at 6/30/06
              
              
              7.01
              %
              
              8.95
              %
              
              10.51
              %
              
              10.58
              %
              
              7.25
              %Maturity
                  date
              
              
              9/22/2006
              
              
              10/27/2006
              
              
              10/10/2006
              
              
              1/10/2007
              
              
              3/23/2007Maximum
                  amount of line
              
              
              200,000
              
              
              200,000
              
              
              300,000
              
              
              100,000
              
              
              -
              
              
              800,000Amount
                  outstanding at 6/30/06
              
              
              198,310
              
              
              197,699
              
              
              272,814
              
              
              99,171
              
              
              -
              
              
              767,994Remaining
                  available
              
              
              1,690
              
              
              2,301
              
              
              27,186
              
              
              829
              
              
              -
              
              
              32,006Approximate
                  US dollar equivalent
              
              $
              204,299
              
              $
              203,669
              
              $
              281,053
              
              $
              102,166
              
              $
              0
              
              $
              791,187




(1)
              Yield
                  ratio of annual bank debenture plus
                  1.857%
 (2)
                Yield
                    ratio of annual industrial financial debenture plus
                    3.0%
 (3)
                Pusan
                    Bank's internal market related base rate plus
                    5.56%
 (4)
                The
                    IBK facility was terminated in April 2006. See details
                    below.





Interest
      under each of the credit facilities is payable monthly. We are required to
      repay
      funds on the credit facilities by the maturity dates of each of the respective
      credit facilities as noted in the table above. On April 10, 2006, the Korean
      Exchange Bank extended the expiration date on the line of credit from April
      10,
      2006 to October 10, 2006.





On
      March
      24, 2006, the Industrial Bank of Korea (IBK) committed itself to extend a
      secured line of credit (the “March Facility”) of up to 1.5 billion Korean Won
      (or approximately $1.5 million in U.S. dollars) to SpatiaLight Korea. As of
      March 31, 2006, SpatiaLight Korea had drawn down approximately $1.5 million
      on
      the March Facility for working capital purposes and to repay certain of its
      outstanding indebtedness. On April 6, 2006, the March Facility was terminated
      by
      repaying all monies borrowed as well as certain prepayment and finance charges.
      IBK has released its lien on SpatiaLight Korea’s assets securing the March
      Facility and related personal guarantees made by certain officers. We terminated
      this line of credit as some of the terms of the line might have been precluded
      by our other contractual obligations.





Related
      Party and Senior Secured Convertible notes outstanding at June 30, 2006 consist
      of the following:





13


**SPATIALIGHT,
      INC.**


Notes
      to
      Condensed Consolidated Financial Statements (Unaudited)


*Argyle
      Notes:*





In
      1998,
      we received $1,188,000 in cash in exchange for notes payable in that amount
      to
      Argyle Capital Management Corporation (Argyle), a company owned and controlled
      by Robert A. Olins, our Chief Executive Officer, Secretary, Treasurer, and
      a
      Director. The notes accrue interest at a contractual rate of 6% per annum,
      and
      are secured by substantially all of our assets, although these notes are
      subordinated to the November 2004 Financing Senior Secured Convertible Notes
      described below. Both principal and interest are convertible into our common
      shares at $0.50 per share. On May 23, 2001, the due date of the notes was
      extended until December 31, 2002. On the extension date, the beneficial
      conversion effect representing the excess aggregate value of the common shares
      receivable upon conversion of the notes based on the then current market price
      of $1.90 per share, over the aggregate conversion price for such common shares
      (limited to the original proceeds of $1,188,000), was recorded as additional
      paid-in capital. The resulting $1,188,000 discount to the debt arising from
      the
      beneficial conversion feature was originally
      being amortized through December 31, 2002. The effective interest rate for
      financial statement purposes due to this discount differs from the actual
      contractual interest received or receivable in cash or shares by Argyle. This
      discount, along with the contractual 6% interest rate, resulted in a new
      effective interest rate of 72% per annum as of the May 23, 2001 extension date
      when compared to the outstanding principal balances. The effective rate prior
      to
      extension had been the 6% per annum contractual rate.





On
      September 20, 2002, the due date was further extended until March 31, 2004.
      Accordingly, the remaining unamortized discount at the extension date of
      $198,000 was being amortized through March 31, 2004, resulting in a new
      effective interest rate of 17% per annum when compared to the outstanding
      principal balances. On December 31, 2003, the due date was extended until June
      30, 2005. Accordingly, the remaining unamortized discount of $33,000 at the
      extension date was being amortized through June 30, 2005, resulting in a new
      effective interest rate of 8% per annum when compared to the outstanding
      principal balances. On November 30, 2004, the due date was extended until
      December 31, 2008. The remaining unamortized discount of $11,000 at the
      extension date was amortized through June 30, 2005.





We
      paid
      interest payable on the Argyle notes by issuing 142,360 common shares with
      a
      market value of $354,476 in 2003, and 142,360 common shares with a market value
      of $800,063 in 2004. The market value of the shares was based on the closing
      price of the shares on the day before issuance, and was recorded as interest
      expense. On March 4, 2004, we issued 71,676 common shares with a market value
      of
      $338,311 as a prepayment of interest payable on the Argyle notes of $35,640
      for
      the period January 1, 2005 to June 30, 2005. Prepaid interest was computed
      using
      the closing price of the shares of $4.72 on March 3, 2004. In December 2004,
      we
      issued 50,000 common shares, and in January 2005, we issued 448,768 common
      shares, as a prepayment of interest payable on the Argyle notes of $249,480
      for
      the period July 1, 2005 through December 31, 2008. These shares had a market
      value of $4,049,964, based on the closing price of the shares of $8.12 on
      December 21, 2004. As of June 30, 2006, total prepaid interest on the Argyle
      notes for the period July 1, 2006 to December 31, 2008 is $2,892,832 with
      $1,157,133 classified as a current asset, and $1,735,699 classified as a
      non-current asset in the accompanying condensed consolidated balance sheets.





14


**SPATIALIGHT,
      INC.**


Notes
      to
      Condensed Consolidated Financial Statements (Unaudited)


Non-cash
        interest expense includes $542,926 and $302,670 for the six months ended
        June
        30, 2006 and 2005 resulting from the beneficial conversion price of interest
        payable, which is convertible into common
        shares at $0.50 per share. This non-cash interest was computed as the excess
        of
        the market price of the shares issued for the interest over accrued interest
        payable.




At
      June
      30, 2006, the carrying value of the Argyle notes totaled $1,188,000 representing
      the unpaid principal balance *.*





*November
      2004 Financing:*





On
      November 30, 2004, we completed a non-brokered private placement of $10 million
      of senior secured notes (the Senior Secured Convertible Notes). The Senior
      Secured Convertible Notes accrue interest at 10% per annum, payable quarterly
      in
      cash or our common shares at our option, if certain conditions are met, such
      as
      the availability of an effective registration statement pursuant to which
      resales may be made or the availability of Rule 144(k) for resale of the common
      shares underlying our Senior Secured Convertible Notes. The value of the shares
      for the purposes of calculating interest payments shall be equal to the 20-day
      trailing average of the volume weighted average prices of our common shares
      at
      the end of each quarterly interest period. The Senior Secured Convertible Notes
      are due November 30, 2007.





The
      Senior Secured Convertible Notes are convertible, at the option of their
      holders, into our common shares at the conversion price of $9.72 per share.
      The
      Senior Secured Convertible Notes are senior to notes that we issued to Argyle,
      which, as noted above, is wholly owned by Robert A. Olins, our Chief Executive
      Officer, Secretary, Treasurer and a Director. The holders of our Senior Secured
      Convertible Notes have a senior security interest in substantially all of our
      assets, except those located in South Korea. However, the holders of our Senior
      Secured Convertible Notes have a pledge on SpatiaLight Korea’s shares. In
      addition, under the terms of the November 2004 Financing, we are prohibited
      from
      paying cash dividends.





In
      a
      letter that we received on December 12, 2005, one of the holders of our Senior
      Secured Convertible Notes, Portside Growth & Opportunity Fund (“Portside”),
      an affiliate of Ramius Capital Group, LLC, notified us of two alleged events
      of
      default under their note, set forth below. In a letter that we received on
      December 13, 2005, another holder of our Senior Secured Convertible Notes,
      Smithfield Fiduciary LLC (“Smithfield”), an affiliate of Highbridge Capital
      Management, LLC, notified us only with respect to the second of Portside’s two
      alleged events of default, set forth below. In a letter that we received on
      February 9, 2006, Portside notified us of a third alleged event of default
      under
      its note, as set forth below. Each of these notices call for us to redeem the
      entire $4.5 million principal amount of the Portside and Smithfield Senior
      Secured Convertible Notes, or $9.0 million in the aggregate, plus a redemption
      premium of $675,000 plus liquidated damages to each of these holders of the
      2004
      notes pursuant to relevant provisions of their notes.





The
      following are the alleged defaults: (i) Registration Statement Failure pursuant
      to Section 4(a)(i) of their Senior Secured Convertible Notes - Based upon our
      filing of a Post-Effective Amendment to the registration statement on Form
      S-3
      relating to the underlying common shares of the Senior Secured Convertible
      Notes
      (Reg. No. 333-122391); (ii) Failure to Make Interest Payment pursuant to Section
      4(a)(v) of their Senior Secured Convertible Notes - Based upon a claim that
      we
      did not make a November 2005 interest payment; and (iii) Entering into
      unpermitted debt financing transactions prohibited pursuant to Section 4(a)
      (xi)
      of their Senior Secured Convertible Notes - Based upon a claim that certain
      debt
      financing transactions that we have entered into are not permitted under the
      Senior Secured Convertible Notes. We believe, after review with outside legal
      counsel, that these allegations lack merit and would not entitle the holders
      of
      the Senior Secured Convertible Notes to call their notes or to any of the other
      remedies that they are seeking. With respect to the first alleged event of
      default concerning the alleged registration maintenance failure, we contend
      that
      the filing of our post-effective amendments to the registration statements
      registering the underlying common shares did not and does not constitute an
      event of default under Section 4(a)(i) of Portside’s Senior Secured Convertible
      Note. We contend that the second allegation of default is incorrect because
      on
      November 30, 2005 (the interest due date), we tendered payment by forwarding
      checks payable to Portside, Smithfield and the other holders of our Senior
      Secured Convertible Notes by overnight courier to an attorney representing
      the
      holders for the full amounts of the relevant quarterly interest payments. That
      attorney did not distribute the checks to the four holders (although all were
      located in the same city), but instead returned the checks to us in California.
      We have since tendered payment of that full interest installment amount owing
      to
      all of the holders via federal funds wire into designated accounts for each
      of
      these parties. We contend that the third allegation of default lacks
      merit because we believe that the debt financing transactions that we have
      entered into are permitted under the Senior Secured Convertible Notes and,
      even
      if deemed not permitted, do not constitute a breach or failure in any
      material respect under the Senior Secured Convertible Notes.





15


We
      believe that Portside has undertaken to make allegations of events of default
      that lack merit in an attempt to achieve its objective of amending the terms
      of
      its Senior Secured Convertible Note to its advantage, including a reduction
      in
      the conversion price of the notes or an acceleration in repayment of principal
      on its Senior Secured Convertible Note, although that principal is not due
      and
      payable until the note's maturity date, which is November 30, 2007. We have
      rejected its offers in this regard. We will continue to take appropriate actions
      that we believe are in the best interests of our Company and our
      shareholders.





If
      the
      holders of the Senior Secured Convertible Notes were entitled to call their
      notes (a) the entire $10 million debt obligation can become due and payable
      immediately, including the redemption premiums and liquidated damages, and
      (b)
      we would, in accordance with FAS 78, “Classification of Obligations That are
      Callable by the Creditor”, classify them as a current liability. We believe,
      however, that the alleged events of default of which Portside and Smithfield
      have given notice lack merit and would not entitle the noteholders to the
      remedies that they are seeking. Therefore, we believe it is not probable the
      noteholders would prevail in calling the Senior Secured Convertible Notes.
      As a
      result, in accordance with, FAS 5, “ *Accounting
      for Contingencies,”* we have
      continued to classify the Senior Secured Convertible Notes as long-term
      obligations in our balance sheet at June 30, 2006. The redemption premium and
      liquidated damages of $1.5 million and approximately $0.6 million, respectively,
      have not been accrued in our consolidated financial statements as of December
      31, 2005 included in our Annual Report on Form 10-K/A for our fiscal year then
      ended or in the condensed consolidated financial statements as of June 30,
      2006
      included in this Form 10-Q. We refer you to Note 1 of our Notes to consolidated
      financial statements contained in that Form 10-K/A report for additional
      information regarding the accounting treatment of the Senior Secured Convertible
      Notes.





16


**SPATIALIGHT,
      INC.**


Notes
      to
      Condensed Consolidated Financial Statements (Unaudited)


Activity
      in notes payable for the six months ended June 30, 2006 is as
      follows:


**Debt
                  Principal:**
              
              **Balance
                  at December 31, 2005**
              
              **Addition
                  or New Discount**
              
              **(Payment)
                  or Discount Amortization**
              
              **Conversion
                  to Equity**
              
              **Balance
                  at June 30, 2006**Argyle
                  note
              
              $
              1,188,000
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              1,188,000Senior
                  Secured Convertible Notes
              
              
              10,000,000
              
              
              -
              
              
              -
              
              
              -
              
              
              10,000,000Senior
                  Secured Convertible Notesbeneficial
                  conversion feature
              
              
              (100,060
              )
              
              -
              
              
              26,100
              
              
              -
              
              
              (73,960
              )Reimbursement
                  of investor's legal fees
              
              
              (63,889
              )
              
              -
              
              
              16,667
              
              
              -
              
              
              (47,222
              )Senior
                  Secured Convertible NotesAIR
                  discount
              
              
              (683,938
              )
              
              -
              
              
              179,220
              
              
              -
              
              
              (504,718
              )Total
              
              $
              10,340,113
              
              $
              -
              
              $
              221,987
              
              $
              -
              
              $
              10,562,100**Interest:**Accrued
                  Argyle note 6%
              
              $
              -
              
              $
              35,640
              
              $
              -
              
              $
              (35,640
              )
              $
              -Argyle
                  note beneficial interest
              
              
              -
              
              
              542,926
              
              
              -
              
              
              (542,926
              )
              
              -Senior
                  Secured Convertible Notes 10%
              
              
              84,932
              
              
              497,239
              
              
              (499,978
              )
              
              -
              
              
              82,193Total
              
              $
              84,932
              
              $
              1,075,805
              
              $
              (499,978
              )
              $
              (578,566
              )
              $
              82,193





Non-cash
      interest expense is as follows:


Six
                  months ended June 30,2006
              
              2005Amortization
                  of Senior Secured Convertible Notes
              
              $
              221,987
              
              $
              221,987Senior
                  Secured Convertible Notes 10% paid in stock
              
              
              252,055
              
              
              -Amortization
                  of Argyle note discount
              
              
              -
              
              
              11,000Liquidated
                  damages on the October 2005 andJanuary
                  2006 financings
              
              
              437,817
              
              
              -Beneficial
                  conversion privileges of intereston
                  Argyle note
              
              
              542,926
              
              
              302,670Amortization
                  of prepaid financing costs
              
              
              31,715
              
              
              19,527Total
                  non-cash interest expense
              
              $
              1,486,500
              
              $
              555,184




17




**SPATIALIGHT,
        INC.**
 Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)





Activity
      in notes payable for the three months ended June 30, 2006 is as
      follows:


**Debt
                  Principal:**
              
              **Balance
                  at March 31, 2006**
              
              **Addition
                  or New Discount**
              
              **(Payment)
                  or Discount Amortization**
              
              **Conversion
                  to Equity**
              
              **Balance
                  at June 30, 2006**Argyle
                  note
              
              $
              1,188,000
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              1,188,000Senior
                  Secured Convertible Notes
              
              
              10,000,000
              
              
              -
              
              
              -
              
              
              -
              
              
              10,000,000Senior
                  Secured Convertible Notesbeneficial
                  conversion feature
              
              
              (87,010
              )
              
              -
              
              
              13,050
              
              
              -
              
              
              (73,960
              )Reimbursement
                  of investor's legal fees
              
              
              (55,556
              )
              
              -
              
              
              8,334
              
              
              -
              
              
              (47,222
              )Senior
                  Secured Convertible NotesAIR
                  discount
              
              
              (594,328
              )
              
              -
              
              
              89,610
              
              
              -
              
              
              (504,718
              )Total
              
              $
              10,451,106
              
              $
              -
              
              $
              110,994
              
              $
              -
              
              $
              10,562,100**Interest:**Accrued
                  Argyle note 6%
              
              $
              -
              
              $
              17,820
              
              $
              -
              
              $
              (17,820
              )
              $
              -Argyle
                  note beneficial interest
              
              
              -
              
              
              271,463
              
              
              -
              
              
              (271,463
              )
              
              -Senior
                  Secured Convertible Notes 10%
              
              
              84,932
              
              
              249,316
              
              
              (252,055
              )
              
              -
              
              
              82,193Total
              
              $
              84,932
              
              $
              538,599
              
              $
              (252,055
              )
              $
              (289,283
              )
              $
              82,193




Non-cash
      interest expense is as follows:


Three
                  months ended June 30,2006
              
              2005Amortization
                  of Senior Secured Convertible Notes
              
              $
              110,994
              
              $
              110,993Senior
                  Secured Convertible Notes 10% paid in stock
              
              
              252,055
              
              
              -Amortization
                  of Argyle note discount
              
              
              -
              
              
              5,500Liquidated
                  damages on the October 2005 andJanuary
                  2006 financings
              
              
              (176,640
              )
              
              -Beneficial
                  conversion privileges of intereston
                  Argyle note
              
              
              271,463
              
              
              151,335Amortization
                  of prepaid financing costs
              
              
              15,857
              
              
              9,764Total
                  non-cash interest expense
              
              $
              473,729
              
              $
              277,592





**Note
              8.**
            **Issuance
                of Securities**





Exercise
      of Stock Options and Warrants in the Three and Six Months Ended June 30,
      2006





During
      the first six months of 2006, 50,000 common shares were issued upon the exercise
      of employee/director stock options. No warrants were exercised during the first
      six months of 2006. Total cash received from option exercises for the six months
      ended June 30, 2006 was $40,245.





Issuance
      of Shares, Stock Options and Warrants During the Six Months ended June 30,
      2006





In
      June
      2006, we sold to certain institutional buyers, each of which is managed by
      Wellington Management Company, LLP, an aggregate of 601,000 of our common shares
      at a price per share of $2.80, for an aggregate purchase price of approximately
      $1,682,800. We made the sale pursuant to a post-effective amendment to a “shelf”
registration statement on Form S-3 (File No. 333-122392), which was declared
      effective by the SEC before this transaction, and which was amended by a
      registration statement on Form S-3 MEF (File No. 333-134626) filed by us on
      May
      31, 2006. As
      of the
      date of this filing, 5,150 of our common shares registered under these “shelf”
registration statements remain. These funds were used for working capital and
      other general corporate purposes.





18
 
  **SPATIALIGHT,
          INC.**
 Notes
          to
          Condensed Consolidated Financial Statements (Unaudited)


On
      May
      31, 2006, when the price of our stock was $3.06, we issued 81,665 of our common
      shares in lieu of cash to the Senior Secured Notes for the payment of one
      quarter’s interest incurred from these notes. The holders of our notes provide
      that we can issue our common shares instead of making cash payments for interest
      at our option, as long as certain specified conditions are met. All of the
      specified conditions were met as of May 31, 2006.





On
      April
      7, 2006, we sold 750,000 of our common shares at a purchase price of $3.26
      per
      share to three institutional purchasers. Those shares were registered in our
      Post-Effective Amendment No. 6 to a Form S-3 “shelf” registration statement
      (File Number 333-122392), as post-effectively amended through February 14,
      2006.
      The purchase price for those common shares was $2,445,000 in the aggregate.
      The
      purchase price was based upon the five-day volume weighted average price of
      our
      common shares through April 6, 2006, discounted by five percent. We paid
      aggregate fees equal to $89,650 to persons who introduced us to the investors.
      These funds were used for working capital and other general corporate
      purposes.





On
      March
      17, 2006, we sold 500,000 of our common shares at a purchase price of $2.18
      per
      share to certain institutional investors. Those shares were included in our
      Post-Effective Amendment No. 6 to Form S-3 "shelf" registration statement (File
      No. 333-122392), as post-effectively amended through February 14, 2006. The
      purchase price was based upon the five-day volume weighted average price of
      our
      common shares through March 16, 2006, discounted by five percent. We received
      net proceeds of approximately $1.1 million, intended for working capital and
      other general corporate purposes.





In
      mid-January 2006, we issued and sold 1,300,000 of our common shares in a private
      placement to three institutional investors. The purchase price of the common
      shares was $2.62 per share. We received approximately $3.3 million in net
      proceeds from the sale of these shares, which were used for working capital
      and
      other general corporate purposes, including the repayment of certain short-term
      debt obligations. We are required under a registration rights agreement, to
      file
      a registration statement for the resale of the shares within 30 calendar days
      after January 12, 2006 and have the registration statement declared effective
      no
      later than 90 calendar days after January 12, 2006. The latter may be extended
      to no later than 120 calendar days if the registration statement is subject
      to
      review, comments or other actions by the SEC. As the registration statement
      was
      not filed by February 11, 2006 or declared effective prior to April 12, 2006,
      the registration rights agreement required us to pay an amount equal to 5%
      of
      the aggregate purchase price or $170,300 as partial liquidated damages when
      each
      of these dates occur and an additional $170,300 for every 30 days thereafter
      up
      to six months. After six months, the percentage increases to 10% or $340,600
      for
      each additional 30 days. We have included $329,602 as liquidated damages in
      non-cash interest expense from inception through June 30, 2006. The registration
      statement related to these shares was filed with the SEC on May 5, 2006 and
      was
      declared effective on May 12, 2006. Concurrent with the effectiveness of the
      registration statement, the investors of the January financing received an
      aggregate of 122,725 restricted shares in settlement of any and all liquidated
      damages. The shares were issued as follows: 57,725 restricted shares of our
      common stock were issued on May 18, 2006, when the market value of our shares
      was $3.12, resulting in an intrinsic value of $180,102; 65,000 restricted shares
      of our common stock were issued on June 30, 2006, when the market price of
      our
      shares was $2.30, resulting in an intrinsic value of $149,500.





19
 
  **SPATIALIGHT,
          INC.**
 Notes
          to
          Condensed Consolidated Financial Statements (Unaudited)


The
      emerging issues task force (“EITF”) is currently reviewing the accounting for
      securities with liquidated damages clauses as stated in EITF 05-04, “The Effect
      of a Liquidated Damages Clause on a Freestanding Financial Instrument Subject
      to
      EITF 00-19”. There are currently several views as to how to account for this
      type of transaction and the EITF has not yet reached a consensus. In accordance
      with EITF 00-19, “Accounting for Derivative Financial Instruments Indexed To,
      and Potentially Settled in the Company’s Own Stock,” and EITF 05-04, because the
      maximum potential liquidated damages as described above may be greater than
      the
      difference in fair values between registered and unregistered shares, the value
      of the common stock subject to registration should be classified as temporary
      equity until the registration statement becomes effective. Based on the above
      determination, the Company had classified the $3,333,950 value of common stock
      subject to registration as temporary equity as of March 31, 2006 related to
      the
      January 2006 Financing. Additionally, $1,026,374 related to our October 2005
      equity financing continued to be classified as temporary equity at March 31,
      2006. As the registration statements for both of these financings were filed
      and
      declared effective by the SEC during the second quarter of 2006, these amounts
      have been reclassified to and are included in equity at June 30,
      2006.





On
      February 27, 2006, we filed a registration statement (File No. 333-132048)
      registering shares issued in our October 2005 financing. Because this
      registration statement was not filed by November 12, 2005, we may be required
      to
      pay $30,000 as liquidated damages to the investors as of November 12, 2005
      and
      every thirty days thereafter through February 27, 2006. Additionally, since
      the
      registration statement was not declared effective by the SEC prior to January
      12, 2006, we may be required to pay $30,000 as liquidated damages to the
      investors on January 12, 2006 and for every thirty days thereafter until April
      18, 2006, the date of effectiveness for this registration statement. We have
      included $187,215 as liquidated damages in non-cash interest expense through
      June 30, 2006. Subsequent to March 31, 2006 and concurrent with the
      effectiveness of the registration statement, investors accounting for 25% of
      the
      invested amount in this transaction have waived their rights to any liquidated
      damages. In addition, in settlement of any and all liquidated damages, investors
      accounting for 50% of the invested amount in this transaction received an
      aggregate of 43,850 shares of our common stock on June 5, 2006, when the market
      price of our stock was $2.77, resulting in an intrinsic value of $121,465.
      These
      shares were included in our amended registration statement on Form S-3 MEP
      (File
      No. 333-134626) filed by us on June 1, 2006.





Stock-based
      compensation, included in selling, general and administrative expenses, is
      as
      follows:


Three
                  months ended June 30,
              
              Six
                  months ended June 30,2006
              
              2005
              
              2006
              
              2005Options
                  granted to employees and directors
              
              $
              976,156
              
              $
              8,250
              
              $
              1,644,993
              
              $
              16,500Warrants
                  issued for services
              
              
              -
              
              
              -
              
              
              -
              
              
              90,800$
              976,156
              
              $
              8,250
              
              $
              1,644,993
              
              $
              107,300





20


**SPATIALIGHT,
      INC.**


Notes
      to
      Condensed Consolidated Financial Statements (Unaudited)


**Note
              9.**
            **Segment
                Information and Significant Customer Information**





Our
      chief
      operating decision-maker is our Chief Executive Officer. The chief operating
      decision-maker reviews only financial information prepared on a basis
      substantially consistent with the accompanying condensed consolidated financial
      statements of operations. Therefore, we have determined that we operate in
      a
      single business segment. All of our assets are located at our facilities in
      the
      United States at June 30, 2006, except for the following:




Korea
              
              Hong
                  Kong
              
              Japan
              
              TotalCash
              
              $
              100,447
              
              $
              -
              
              $
              -
              
              $
              100,447Accounts
                  receivable
              
              
              57,683
              
              
              -
              
              
              -
              
              
              57,683Prepaid
                  expenses
              
              
              135,668
              
              
              -
              
              
              -
              
              
              135,668Deposits
              
              
              13,753
              
              
              -
              
              
              -
              
              
              13,753Building,
                  net
              
              
              4,392,126
              
              
              -
              
              
              -
              
              
              4,392,126Machinery
                  and manufacturing equipment, net
              
              
              728,264
              
              
              -
              
              
              -
              
              
              728,264Office
                  furniture and fixtures, net
              
              
              105,814
              
              
              -
              
              
              -
              
              
              105,814Other
                  equipment and instruments, net
              
              
              853,487
              
              
              -
              
              
              -
              
              
              853,487Inventory,
                  net
              
              
              251,903
              
              
              109,164
              
              
              4,228
              
              
              365,295$
              6,639,145
              
              $
              109,164
              
              $
              4,228
              
              $
              6,752,537





The
      following table summarizes our product revenue percentages for the six months
      ended June 30, 2006 and 2005.


Six
                  months ended June 30,2006
              
              2005LCoS
                  (T-3) sets
              
              
              88
              %
              
              77
              %LCoS
                  (T-1) sets
              
              
              -
              
              
              7
              %Light
                  engine display units
              
              
              -
              
              
              1
              %Other
                  (primarily supporting electronics)
              
              
              12
              %
              
              15
              %Total
              
              
              100
              %
              
              100
              %





Of
      our
      total revenue in 2006, 89% was derived from the sales of our LCoS Sets to LG
      Electronics, a customer located in South Korea. The remaining 11% was derived
      from the sales of our LCoS Sets to ThinTek Optronics, our customer in Taiwan.
      LG
      Electronics made up 100% of our accounts receivable balance at June 30, 2006.





21


**SPATIALIGHT,
      INC.**


Notes
      to
      Condensed Consolidated Financial Statements (Unaudited)


**Note
              10.**
            **Inventory**





Inventory
      consisted of the following as of June 30, 2006 and December 31,
      2005:


June
                  30,
              
              December
                  31,2006
              
              2005Raw
                  materials
              
              $
              965,844
              
              $
              796,770Work-in-progress
              
              
              85,393
              
              
              17,043Finished
                  goods
              
              
              115,415
              
              
              294,2871,166,652
              
              
              1,108,100Inventory
                  reserve
              
              
              (737,706
              )
              
              (351,377
              )Total
                  inventory, net
              
              $
              428,946
              
              $
              756,723


**Note
                11.**
            **Management
                Changes**





On
      June
      13, 2006, Theodore H. Banzhaf resigned as our Executive Vice President of
      Strategic Planning and as President and Chief Executive Officer of SpatiaLight
      Technologies, Inc., a non-active wholly owned subsidiary, effective immediately.
      Mr. Banzhaf may exercise his 265,000 vested options awarded pursuant to his
      Time
      Accelerated Restricted Stock Award Plan by no later than September 13, 2006.
      Pursuant to a General Release contract between Mr. Banzhaf and us, Mr. Banzhaf
      will receive his current salary through September 9, 2006.





JeWon
      Yeun resigned as our President of SpatiaLight Korea, effective May 31,
      2006.




**Note
              12.**
            **Recent
                Accounting Pronouncements**





In
      June
      2006, the Financial Accounting Standards Board (FASB) issued Interpretation
      No.
      48, *Accounting
      for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109* (“FIN
      48”). This Interpretation clarifies the accounting for uncertainty in income
      taxes recognized in a company’s financial statements in accordance with FASB
      Statement No. 109, *Accounting
      for Income Taxes.* FIN 48
      prescribes a recognition threshold and measurement attribute for the financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return. This Interpretation also provides guidance on
      derecognition, classification, interest and penalties, accounting in interim
      periods, disclosure, and transition. The evaluation of a tax position in
      accordance with FIN 48 is a two-step process. The first step is recognition:
      The
      company determines whether it is “more-likely-than-not” that a tax position will
      be sustained upon examination, including resolution of any related appeals
      or
      litigation processes, based on the technical merits of the position. In
      evaluating whether a tax position has met the “more-likely-than-not” recognition
      threshold, the company presumes that the position will be examined by the
      appropriate taxing authority that would have full knowledge of all relevant
      information. The second step is measurement: A tax position that meets the
      “more-likely-than-not” recognition threshold is measured to determine the amount
      of benefit to recognize in the financial statements. The tax position is
      measured at the largest amount of benefit that is greater than 50 percent likely
      to be realized upon ultimate settlement. FIN 48 is effective for fiscal years
      beginning after December 15, 2006. We do not believe that the adoption of FIN
      48
      will have a material impact on our results of operations or financial condition.





22
 
  **SPATIALIGHT,
          INC.**
 Notes
          to
          Condensed Consolidated Financial Statements (Unaudited)


In
      February 2006, the Financial Accounting Standards Board (FASB) issued
      SFAS No. 155,*“Accounting
      for Certain Hybrid Financial Instruments — an amendment of FASB Statements
      No. 133 and 140*”
      (SFAS 155).
      SFAS 155amends
      SFAS No. 133,*“Accounting
      for Derivative Instruments and Hedging Activities”*(SFAS 133),
      and SFAS No. 140,*“Accounting
      for Transfers and Servicing of Financial Assets and Extinguishments of
      Liabilities”*(SFAS 140).
      This statement also resolves issues addressed in Statement No. 133
      Implementation Issue No. D1,*“Application
      of Statement 133 to Beneficial Interests in Securitized Financial Assets.”*SFAS 155permits
      fair value remeasurement for any hybrid financial instrument that contains
      an
      embedded derivative that otherwise would require bifurcation and clarifies
      which
      interest-only strips and principal-only strips are not subject to the
      requirements of SFAS 133. SFAS 140 is amended to eliminate the
      prohibition on a qualifying special-purpose entity from holding a derivative
      financial instrument that pertains to a beneficial interest other than another
      derivative financial instrument. SFAS 155is
      effective for all financial instruments acquired or issued during fiscal years
      beginning after September 15, 2006 (January 1, 2007 for the Company).
      Wedo not
      expect this statement to have a material impact on its consolidated financial
      statements.




In
      June
      2005, the FASB issued Statement No. 154, "Accounting Changes and Error
      Corrections" (SFAS 154), a replacement of APB No. 20, "Accounting Changes"
      and
      FASB Statement No. 3, "Reporting Accounting Changes in Interim Financial
      Statements". FAS 154 applies to all voluntary changes in accounting principle
      and changes the requirements for accounting for and reporting of a change in
      accounting principle. This statement establishes that unless impracticable,
      retrospective application is the required method for reporting a change in
      accounting principle in the absence of explicit transition requirements specific
      to the newly adopted accounting principle. It also requires the reporting of
      an
      error correction which involves adjustments to previously-issued financial
      statements similar to those generally applicable to reporting an accounting
      change retrospectively. FAS 154 became effective for accounting changes and
      corrections of errors made in our fiscal year beginning on January 1, 2006.
      The
      adoption of FAS 154 has not had a material impact on our results of operations
      or financial condition.





In
      December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment” to revise
      SFAS No. 123, “Accounting for Stock-Based Compensation” and supersede APB
      Opinion No. 25, “Accounting for Stock Issued to Employees” and its related
      implementation guidance. It requires companies to recognize their compensation
      costs related to share-based payment transactions in financial statements.
      These
      costs are to be measured based on the fair value of the equity or liability
      instruments issued and are recognized over the period during which an employee
      is required to provide services in exchange for the award - the requisite
      service period (usually the vesting period). We have applied
      SFAS No. 123R beginning January 1, 2006 .
      See
      Note 4 - Stock-Based Compensation for further information.





In
      November 2004, the FASB issued SFAS No. 151, Inventory Costs, An Amendment
      Of
      ARB No. 43, Chapter 4 ("SFAS 151"). SFAS 151 amends ARB 43, Chapter 4, to
      clarify that abnormal amounts of idle facility expense, freight, handling costs
      and wasted materials (spoilage) be recognized as current period charges. It
      also
      requires that allocation of fixed production overheads to the costs of
      conversion be based on the normal capacity of the production facilities. SFAS
      151 became effective for the Company beginning with its 2006 fiscal year. The
      adoption of SFAS 151 has not had a material impact on our results of operations
      or financial position.





23




**SPATIALIGHT,
        INC.**
 Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)




**Note
              13.**
            **Commitments
                and Contingencies**





*Alleged
      Events of Default on Senior Secured Convertible Notes*





Certain
      allegations of events of default related to the November 30, 2004 Financing
      have
      been communicated to us as more fully described in Note 7.





*Legal
      Proceedings*





We
      are
      not currently involved in any material legal proceedings. We are a party to
      routine claims and lawsuits from time to time in the ordinary course of
      business. While the outcome of such ordinary course proceedings cannot be
      predicted with certainty, we believe that the resolution of any future ordinary
      course matters individually or in the aggregate will not have a material adverse
      effect on our business, financial condition or results of
      operations.




*U.S.
      Securities and Exchange Commission Investigation*





As
      previously reported in our post-effective amendments to the Form S-3
      Registration Statement registering the common shares underlying the Senior
      Secured Convertible Notes (the “Financing Registration Statement”) (File No.
      333-122391) and the Form S-3 Registration Statement registering common shares
      on
      a “shelf” (the “Shelf Registration Statement”) (File No. 333-122392), we filed
      an unauthorized consent of BDO Siedman to Amendment Nos. 5 and 6 to the
      Financing Registration Statement and to Amendment Nos. 3 and 4 to the Shelf
      Registration Statement in order to incorporate by reference their report on
      our
      consolidated financial statements for the fiscal years ended December 31, 2002
      and 2003, respectively. Although we received the requisite authorized consents
      from BDO Seidman to incorporate by reference their report on the consolidated
      financial statements into the Financing Registration Statement and the Shelf
      Registration Statement when initially filed and in subsequent amendments thereto
      (and BDO Seidman has not withdrawn these subsequent consents), we did not
      receive the requisite authorization from BDO Seidman to file its consent as
      an
      exhibit to the penultimate and final pre-effective amendments to either the
      Financing Registration Statement or the Shelf Registration Statement (i.e.
      Amendment Nos. 5 and 6 and Amendment Nos. 3 and 4 to the respective registration
      statements). The penultimate and final pre-effective amendments to both the
      Financing Registration Statement and the Shelf Registration Statement were
      filed
      with the SEC on July 27, 2005.





The
      Audit
      Committee of our Board of Directors conducted an investigation and review of
      the
      developments pertaining to the BDO Seidman consent issue with the assistance
      of
      independent counsel.





The
      Audit
      Committee delivered its report, dated October 31, 2005, to our Chief Executive
      Officer, Robert A. Olins. The Report concluded that the evidence does not
      support a finding that any of our employees included the unauthorized BDO
      consents in the amendments to the Registration Statements referred to above
      with
      fraudulent intent or with specific knowledge that BDO Seidman had not authorized
      the filing of these consents. It concluded that the evidence was consistent
      with
      our inclusion of the consents due to lack of communication, a series of
      misunderstandings and/or a failure of inquiry. As to Mr. Olins, the Report
      concluded that the Audit Committee found no evidence that Mr. Olins was informed
      that BDO Seidman had not authorized the filing of these consents. However,
      it
      also found no evidence that Mr. Olins inquired or determined whether BDO Seidman
      had in fact authorized inclusion of the consents in these filings. The Audit
      Committee Report determined that Mr. Olins, as our Chief Executive Officer,
      did
      not exercise sufficient diligence in supervising the filing of the amendments
      to
      the Registration Statements, that this was a particularly serious failing in
      light of the SEC having highlighted the need for consents from BDO Seidman,
      and
      that as CEO he bears responsibility for the filings. The Audit Committee also
      stated its belief that, throughout the process of preparing and filing the
      amendments to the Registration Statements, Mr. Olins acted with our best
      interests and the best interests of our shareholders in mind, and that his
      lack
      of diligence was not motivated by self-interest and that nothing related to
      this
      incident personally benefited him financially.





24
 
  **SPATIALIGHT,
          INC.**
 Notes
          to
          Condensed Consolidated Financial Statements (Unaudited)


The
      Audit
      Committee recommended three remedial actions. It concluded that the membership
      of the Board of Directors should be supplemented with a financial expert within
      the meaning of SEC rules. It also concluded that we must improve our corporate
      governance and disclosure controls, including hiring a full-time Chief Financial
      Officer and a Controller (who can be the same person). It further concluded
      that
      by reason of Mr. Olins' responsibility as CEO for supervision of corporate
      filings, he should reimburse us for the sum of $50,000, a portion of the costs
      incurred by us by reason of the unauthorized BDO Seidman consents and the
      resulting inquiries. In compliance with the Audit Committee Report, in December
      2005, Mr. Olins made the $50,000 payment to reimburse the Company. To date,
      our
      Board of Directors has not been supplemented with a financial expert and we
      have
      not hired a fulltime CFO or Controller. As of April 28, 2006, we have hired
      a
      part-time Director of Accounting and Finance. We have been advised by the Staff
      of the SEC that the Staff is conducting an investigation into matters and events
      pertaining to the filing of the unauthorized BDO consent. We have been
      cooperating with the Staff with respect to this matter.





*Other
      matters*





Following
      the filing in July 2005 of amendment number 6 to the Financing Registration
      Statement and amendment number 4 to the “shelf” registration statement, which
      contained the unauthorized consents referred to above, the Staff of the SEC
      declared both of the registration statements effective. In August 2005, we
      filed
      post-effective amendments number 1 to both of these registration statements
      (those post-effective amendments were subsequently withdrawn and replaced by
      additional post-effective amendments), which disclosed the filing of the
      unauthorized consents.





Because
      both registration statements were used to sell common shares after the SEC
      declared the registration statements effective, it is conceivable that there
      may
      be litigation against us or our officers or directors under Section 11 of the
      Securities Act. Although we do not believe that the filing of an invalid consent
      constitutes a materially misleading statement or an omission to disclose a
      material fact within the meaning of Section 11 of the Securities Act, a contrary
      determination could result in a liability for us.





At
      present, we are unable to ascertain the exact amount of damages, if any, to
      which we could potentially be subject under a Section 11 claim instituted by
      any
      persons who directly purchased shares pursuant to those registration statements.
      Furthermore, at this date, we cannot ascertain the amount of damages, if any,
      for which we could be liable for claims instituted by any subsequent purchasers
      who could trace the shares purchased by them to those registration statements.
      In August 2005, we sold 500,000 common shares to three institutional purchasers
      for $5.40 per share pursuant to the “shelf” registration statement referenced
      herein. Each of those investors has since represented to us in writing, in
      connection with a separate transaction, that they have disposed of all of those
      shares. One of those institutional investors has represented to us that it
      sold
      those shares at a sale price at or higher than its purchase price from us.
      We
      believe, based upon discussions with the other two investors, that they sold
      their shares at a sale price of not lower than $4.25 per share. Therefore,
      we
      believe that our maximum damages pursuant to Section 11 claims from direct
      purchasers, which we would fully contest, would be $385,250, or the difference
      between the two investor’s purchase price and lowest believed resale price,
      multiplied by the 335,000 shares that they purchased and then
      resold.





25
 
  **SPATIALIGHT,
          INC.**
 Notes
          to
          Condensed Consolidated Financial Statements (Unaudited)


In
      addition to any damage claims, which may be material to our financial condition,
      any lawsuit alleging securities law violations could require us to expend
      significant financial and managerial resources.





**Note
              14.**
            **Subsequent
                Events**





*Increase
      in Authorized Shares*


On
      July
      6, 2006, we filed an Amendment to our Amended and Restated Certificate of
      Incorporation with the Secretary of State of New York that increased the number
      of shares of authorized common stock from 50 million to 100 million. Our
      shareholders approved the Amendment to the Certificate of Incorporation at
      our
      2006 Annual Meeting held on June 28, 2006. A principle purpose for authorizing
      the additional shares was for issuance pursuant to arrangements to finance
      our
      continuing operations.





*Short-Swing
      Profits*


Our
        Audit
        Committee determined that Robert A. Olins, our Chief Executive Officer,
        Secretary, Treasurer and a Director failed to report the sale of an aggregate
        of
        70,556 of our common shares in August 2005 and February 2006 at sales prices
        ranging from $5.30 to $3.00. Pursuant to Section 16 of the Exchange Act,
        in July
        2006, Mr. Olins has filed all delinquent reports and disgorged $22,273 in
        “short-swing profits” that he realized from the sales. These funds will be
        recorded as an increase in additional paid in capital during the third quarter
        2006.
  *August
          Financing*
 On
            August
            9, 2006, we entered into an agreement to sell 761,500 of our common shares
            in a
            private placement to an institutional investor. The purchase price of
            the common
            shares is $2.25 per share. We expect to receive approximately $1.7 million
            in
            gross proceeds, before issuance costs, from the sale of these shares,
            which will
            be used for working capital and other general corporate purposes. We
            will be
            required under a registration rights agreement to file a registration
            statement
            for the resale of the shares within 30 calendar days once the deal closes
            and
            have the registration statement declared effective no later than 90 calendar
            days after the closing date. The sale of these shares is expected to
            be
            completed no later than August 16, 2006. The registration rights agreement
            provides that if we do not meet the above deadlines, we may be required
            to pay
            an amount equal to 1.5% of the aggregate purchase price or $25,700 as
            partial
            liquidated damages when each of these dates occur and an additional $25,700
            for
            every 30 days thereafter up to six month. After six months, the percentage
            increases to 2.5% or $42,800 for each additional 30
            days.







26


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





*This
      Form 10-Q contains certain forward-looking statements within the meaning of
      Section 21E of the Securities and Exchange Act of 1934, as amended, which
      statements are subject to the Safe Harbor provisions created by that statute.
      In
      this report, the words “anticipates,” “believes,” “expects,” “future,”
“intends,” and similar expressions identify forward-looking statements. Such
      statements are subject to certain risks and uncertainties, including, but not
      limited to, those discussed herein, those contained in this Part II Item 1A
      and
      those discussed in the Company’s Annual Report on Form 10-K/A - Amendment No. 1
      as filed with the U.S. Securities and Exchange Commission on April 11, 2006
      and
      the Company’s Quarterly Report on Form 10-Q, as filed with the SEC on May 10,
      2006. Readers are cautioned not to place undue reliance on these forward-looking
      statements, which speak only as of the date hereof. The Company undertakes
      no
      obligation to publicly release the results of any revisions to these
      forward-looking statements that may be needed to reflect events or circumstances
      after the date hereof or to reflect the occurrence of unanticipated
      events.*





The
      following is a discussion and analysis of our condensed consolidated financial
      condition as of June 30, 2006, and our results of operations for the three
      and
      six months ended June 30, 2006 and 2005. The following should be read in
      conjunction with our unaudited condensed consolidated financial statements
      and
      related notes appearing elsewhere herein.





OVERVIEW





We
      are in
      the business of manufacturing high-resolution LCoS microdisplays. Our current
      customers and prospective customers are original equipment manufacturers (OEMs)
      engaged in the businesses of manufacturing high definition televisions or
      manufacturing light engines for incorporation into high definition televisions
      and 3-dimensional near-to-eye display devices. Currently we are working with
      OEMs of high definition televisions, light engines for incorporation into high
      definition televisions and near-to-eye display devices.





***Status
      of Business with LG Electronics, Inc.***





In
      July
      2004, we entered into an agreement with LG Electronics (filed as Exhibit 10.3
      to
      this quarterly report on Form 10-Q), providing for us to sell our T-3 LCoS
      Sets
      to LG Electronics. There have been a number of subsequent modifications to
      our
      arrangements with LG Electronics, most significantly with respect to a number
      of
      product specifications, as well as in timing of deliveries and quantities.
      The
      changes in the timing of deliveries and quantities to be delivered were, in
      part, a result of our attempts to respond to these product specification change
      requests and agreements.





In
      August
      2005, we received a firm purchase order from LG Electronics for its purchase
      from us of an aggregate minimum quantity of 9,300 LCoS Sets for the period
      July
      through December 2005, thereby reducing the initial purchase commitment set
      forth in our July 2004 agreement. We subsequently agreed with LG Electronics,
      through a series of communications, that the initial purchase order for 9,300
      LCoS Sets could be filled over a period of time that would extend beyond April
      2006. We currently expect that we will be able to fulfill the initial order
      for
      9,300 LCoS Sets during the fourth quarter of 2006, although there can be no
      assurance that deliveries will be fulfilled if we encounter further
      manufacturing difficulties or if product specifications change
      further.





27


We
      have
      been delivering a limited quantity of production LCoS Sets to LG Electronics
      since July 2005, but our delivery ramp up has been slower and more inconsistent
      than expected due to LG Electronics’ product specification changes, problems
      that we have experienced with increasing our manufacturing volumes, and 100%
      product testing. See “Manufacturing of LCoS Sets” in this section for a more
      detailed discussion of our manufacturing difficulties and our attempts to
      resolve these matters.





LG
      Electronics commenced an initial consumer market rollout in Australia of a
      limited quantity of 71-inch LCoS televisions incorporating our LCoS Sets during
      the first quarter of 2006. The LG Electronics 71” LCoS television has received
      very positive feedback in Australia. LG Electronics communicated to its U.S.
      distributors in the first quarter of 2006 that it had postponed its plans to
      introduce its 71” and 62” LCoS televisions into the U.S. marketplace. LG
      Electronics has attributed this postponement to uncertainty regarding the
      timetable for the availability of sufficiently large supplies of our LCoS Sets
      to enable a significant product launch. We believe that delays in LG
      Electronics’ initial product rollouts have been based upon revisions to our
      delivery schedule caused by LG Electronics’ product specification changes and
      our problems in ramping up production that have occurred over time. However,
      our
      recent production deliveries to LG Electronics have been of acceptable quantity
      and quality. Based on these and other factors, LG Electronics has informed
      us
      that if our deliveries of LCoS Sets in August are of similar quality and
      quantity as we have delivered in June and July, LG Electronics will be able
      to
      make a U.S. launch through the Custom Electronic Design and Installation
      Association (CEDIA) distribution channel early in the fourth quarter of 2006.
      LG
      Electronics has also advised us that it intends LCoS product rollouts into
      the
      South Korean consumer market thereafter. In our manufacturing process we have
      recently made a transition from 100% testing of certain characteristics to
      sample testing. This removes a bottleneck that will facilitate the production
      ramp up.





In
      2005
      and the first half of 2006, a substantial percentage of our product deliveries,
      which were in small quantities, were made to LG Electronics. Based upon our
      arrangements with LG Electronics and our current expectations, it is likely
      that
      a substantial percentage of our anticipated future product deliveries in 2006
      will be made to LG Electronics as well. The loss of LG Electronics as a customer
      or further significant delays in our delivery schedule to LG Electronics could
      materially harm our future sales and results of operations; and our substantial
      dependence on one customer is subject to risks set forth under the heading
      “Business Risks and Uncertainties” in
      Part
      II Item 1A.





***Status
      of Business in Taiwan***





To
      date,
      we have delivered limited quantities of our T-3 LCoS Sets to our Taiwanese
      customer, ThinTek Optronics Corporation. A substantial portion of these product
      deliveries took place in 2005 and the first quarter of 2006. ThinTek has ordered
      quantities sufficient for pilot programs and sample products, but not enough
      to
      enable them to launch mass production of LCoS high definition televisions.
      On
      July 19, 2006, one of the parent organizations to ThinTek, United Microdisplay
      Optronics (UMO), announced that it was acquiring ThinTek. The acquisition will
      be effective October 1, 2006. We understand that as part of this acquisition,
      ThinTek’s and UMO’s business models are under evaluation. Although we have
      continuing business relationships with customers and prospective customers
      in
      Taiwan, including ThinTek,we cannot provide assurance concerning the quantities
      of our products that we will sell to ThinTek and other prospective Taiwanese
      customers in the future.





28





***Status
      of Business in China***





To
      date,
      we have delivered limited quantities of our microdisplay products to our Chinese
      customers. A substantial portion of these product deliveries occurred in 2004,
      with a smaller quantity delivered in 2005. The quantities of our products
      delivered to our Chinese customers are sufficient only for engineering testing
      and pilot program purposes. To date, our Chinese customers have not ordered
      quantities of our products that would enable them to launch commercial sales
      of
      LCoS high definition televisions.





We
      have
      continuing business relationships with customers and prospective customers
      in
      China. Current Chinese prospective customers are at different stages in the
      development and product introduction processes, and their efforts are
      progressing at a slower rate than we originally anticipated. One of our original
      Chinese customers, Skyworth Display Limited, is selling televisions utilizing
      our display units incorporating our T-1 LCoS Sets into the Chinese educational
      market. However, we do not intend to sell any additional display units
      incorporating our T-1 LCoS Sets beyond those we currently have in inventory
      to
      Skyworth. They may, although we have no assurance that they will, elect to
      transition to products incorporating our T-3 LCoS Sets. We cannot provide
      assurance concerning the quantities of our products that we will sell to our
      Chinese customers and prospective customers in the future.





We
      are
      currently providing sample product to Jiangxi Greatsource Display Tech Co.,
      Ltd.
      (KHD), a Chinese manufacturer of LCoS light engines and televisions that has
      received significant financing from the Chinese government. We are currently
      supporting KHD pilot evaluation runs with our personnel at their plant in China.
      Assuming that KHD’s plans and projections come to fruition, we believe that KHD
      could develop into a significant customer for us within the next year. However,
      our development efforts with KHD have not yet resulted in a purchase order
      for
      production volumes.





***Market
      Strategy for Taiwan and China***


Although
      our Chinese and Taiwanese customers’ progression from product prototyping to
      mass production has been far slower than we had anticipated, we remain positive
      about our business prospects in China and Taiwan and the potential for China
      and
      Taiwan to become large markets for us. We believe that Chinese and Taiwanese
      television manufacturers tend to apply a market strategy of following the
      successful business models of global television manufacturing leaders, rather
      than acting as leaders themselves in terms of introducing new technologies
      to
      the marketplace. We therefore believe that if the LCoS technology gains greater
      acceptance in the high definition television marketplace, and if industry
      leaders, such as Sony, JVC and LG Electronics, present their LCoS based
      televisions to the worldwide consumer markets in a prominent fashion, it will
      then be more likely that the Chinese and Taiwanese television manufacturers
      will
      follow these business models and ramp up their own lines of LCoS high definition
      televisions. We believe that our present course of continuing to transact
      business with major Chinese and Taiwanese television manufacturers is
      positioning us to be a leading LCoS supplier in China and Taiwan in the
      future.





***Other
      Business Development***





We
      are
      currently continuing to develop working relationships with prospective
      customers, located primarily in Japan and other parts of the Pacific Rim region.
      These prospective customers fall into two general categories: 1) television
      manufacturers and 2) light engine suppliers. We have provided samples of our
      LCoS Sets to certain of these prospective customers, but we do not have any
      formal agreements with these parties. While we have made significant progress
      with respect to product integration and negotiating purchase orders with certain
      of these prospective customers, we cannot assure that we will receive any
      purchase orders that will be binding on any of these companies for their
      purchase of our products in the near future. Even assuming that we receive
      purchase orders that are binding on the prospective customers, these orders
      and
      our sales to these customers and to our existing customers are subject to
      certain contingencies described under "Business Risks and Uncertainties" in
      Part
      II Item 1A and in the “Risk Factors” described in our Annual report on Form
      10-K/A filed with the SEC on April 11, 2006.





29


***3-D
      Near-To-Eye Display Market***




We
      have
      commenced working with a South Korean-based designer and manufacturer of 3-D
      eyeglass-type display devices. These eyeglasses, which are being designed to
      be
      powered by our existing 1080p microdisplays, will provide users with a visual
      experience comparable to that of a large screen high definition television.
      Although we have agreed not to disclose the name of the developer at this time,
      the parties have not entered into any written agreements. The product line
      under
      development is a 3-D eyeglass-type display device for use with wireless phones,
      personal digital assistants (PDA) and personal media players, which will enable
      the viewing of broadband content, cable and satellite television, music videos
      as well as the playing of video games, all with the experience of high
      definition large screen television. The device will be designed to minimize
      the
      weight and maximize the comfort of the eyeglasses by locating the LCoS
      microdisplays and control functions in the wireless phone, PDA or personal
      media
      player, with the video signal transmitted to the eyeglass through optical fiber.
      We are in the process of developing a new dual imager solution for this display
      application. We believe that 3-D near-to-eye display products represent a
      growing segment of the consumer electronics sector and we intend to actively
      pursue business opportunities in this market, although there can be no
      assurances that we will be able to derive meaningful sales from this
      market.




***Manufacturing
      of LCoS Sets***





We
      completed construction of our South Korean manufacturing facility in January
      2005. This facility serves as our central commercial manufacturing base. The
      facility began producing products for commercial sale in limited quantities
      in
      the second quarter of 2005. The facility is designed with the capacity, on
      full
      employment, to produce up to 28,000 LCoS Sets per month. The facility has been
      specially designed for expansion to a capacity of 120,000 LCoS Sets per month
      in
      several expansion phases. We believe that the facility can be expanded in an
      efficient manner in the event that such expansion becomes necessary based upon
      increased or perceived increased demand for our products from our
      customers.





We
      completed the process of relocation of all of our manufacturing operations
      to
      South Korea in February of 2006. As part of the transition to full-scale
      manufacturing, we experienced a variety of manufacturing problems, most of
      which
      were due to environmental factors such as dust particles, temperature and
      humidity. We addressed these issues by relocating the final portions of our
      manufacturing process from California to our production facility in South Korea,
      where the combination of a new facility designed to our specifications and
      qualified manufacturing personnel provides us with more exacting controls over
      the external variables that can impact our manufacturing process. At our
      manufacturing facility in South Korea, it appears that we are no longer
      experiencing the production problems attributable to the environmental issues
      specified above.





30


However,
      early in the second quarter of 2006, we experienced certain other production
      problems, some of which we believe were principally attributable to flaws in
      the
      silicon wafers used for our backplane that we obtained from our supplier. Our
      supplier has transferred our wafer fabrication production line to a newer
      facility and processes have been slightly modified. Initial indications are
      that
      improvement has occurred, but our supplier must produce a greater volume of
      wafers to confirm the positive results.





In
      addition, we had been testing all of our microdisplays for certain
      characteristics. We have now obtained solid statistics on a reasonable volume
      of
      product and have now moved, as of July 31, 2006 to a sampling test mode for
      these characteristics. The testing of all of our microdisplays for certain
      characteristics had been providing a bottleneck to our LCoS Set delivery to
      LG
      Electronics, which is now removed. Current and potential additional difficulties
      in the manufacturing process of our LCoS Sets could have a material negative
      impact upon our results of operations as set forth under Business Risks and
      Uncertainties in Part II. Item 1A.





See
      “Status of Business with LG Electronics, Inc.” for a discussion of the effects
      of manufacturing problems upon our business.





***Business
      Strategy***





We
      are
      currently offering one core product, our T-3 LCoS Set, to our customers and
      prospective customers who are located primarily in Asia. Our T-3 LCoS Set is
      comprised of three of our proprietary SpatiaLight imagEngine(TM) LCoS
      microdisplays, which we sometimes refer to as “imagers.” Another former product
      that we no longer offer to our customers, except out of current inventory,
      is
      the T-1 based display unit, which is comprised of a T-1 LCoS Set fitted onto
      a
      light engine.





We
      currently are focused on manufacturing the T-3 LCoS Set model, which has a
      1920
      pixels by 1080 pixels configuration. We are exclusively focusing on
      manufacturing the T-3 model of our LCoS Sets because we believe that the market
      demand for this higher resolution product will be significantly greater than
      our
      earlier T-1 LCoS Set model, which only had a 1280 by 960 pixels
      configuration.





Since
      we
      commenced delivering our products to our customers in the third quarter of
      2003,
      there has been a significant shift in the type of product that we have delivered
      to our customers based upon their demand. The shift in deliveries has been
      heavily in the direction of more LCoS Sets as opposed to display units, which
      is
      an LCoS Set combined with a light engine. We believe that this shift is
      significant because we anticipate that LCoS Sets will be, in the long run,
      a
      higher margin product line and require less working capital than display units.
      LCoS Sets yield less revenue than display units per unit sold. In the beginning
      of 2005, we made it our short-term strategic objective to operate primarily
      as a
      seller of LCoS Sets and decrease our supply of display units to our customers,
      and our longer-term strategic goal to exclusively sell LCoS Sets to our
      customers. Since the beginning of 2006, we are actively offering only LCoS
      Sets
      to our customers and prospective customers.





Our
      supply agreement with LG Electronics is exclusively for LCoS Sets, as LG
      Electronics has developed its own light engine designed to incorporate our
      LCoS
      Sets. Our prospective Chinese customers have indicated an interest in one of
      our
      historical products - our display unit. Although we have sold a small amount
      of
      these display units, we expect that there will be a shift in products demanded
      by our prospective Chinese customers, over time, from display units to LCoS
      Sets. These trends are consistent with our overall product
      strategy.





31


We
      believe that the T-3 model will become the standard for the next generation
      of
      rear projection display devices and will provide the most cost effective,
      high-resolution microdisplays in the industry and will position us to be a
      potential market leader. We believe that the T-3’s ability to deliver 2
      megapixel resolution in a high performance, reliable, and cost effective manner
      was a key factor in our obtaining the supply agreement with LG Electronics.
      The
      T-3 model is the central component of our ongoing customer acquisition strategy
      described above.





***U.S.
      Securities and Exchange Commission Investigation and Related
      Matters***





As
      previously reported in our post-effective amendments to the Form S-3
      Registration Statement registering the common shares underlying the Senior
      Secured Convertible Notes (the “Financing Registration Statement”) (File No.
      333-122391) and the Form S-3 Registration Statement registering common shares
      on
      a “shelf” (the “Shelf Registration Statement”) (File No. 333-122392), we filed
      an unauthorized consent of BDO Seidman LLP to Amendment Nos. 5 and 6 to the
      Financing Registration Statement and to Amendment Nos. 3 and 4 to the Shelf
      Registration Statement in order to incorporate by reference their report on
      our
      consolidated financial statements for the fiscal years ended December 31, 2002
      and 2003, respectively. Although we received the requisite authorized consents
      from BDO Seidman to the incorporation by reference of their report on the
      consolidated financing statements into the Financing Registration Statement
      and
      the Shelf Registration Statement when initially filed and in subsequent
      amendments thereto (and BDO Seidman has not withdrawn these subsequent
      consents), we did not receive the requisite authorization from BDO Seidman
      to
      file its consent as an exhibit to the penultimate and final pre-effective
      amendments to either the Financing Registration Statement or the Shelf
      Registration Statement (i.e. Amendment Nos. 5 and 6 and Amendment Nos. 3 and
      4
      to the respective registration statements). The penultimate and final
      pre-effective amendments to both the Financing Registration Statement and the
      Shelf Registration Statement were filed with the SEC on July 27,
      2005.





The
      Audit
      Committee of our Board of Directors conducted an investigation and review of
      the
      developments pertaining to the BDO Seidman consent issue with the assistance
      of
      independent counsel.





The
      Audit
      Committee delivered its report, dated October 31, 2005, to our Chief Executive
      Officer, Robert A. Olins. The Report concluded that the evidence does not
      support a finding that any of our employees included the unauthorized BDO
      consents in the amendments to the registration statements referred to above
      with
      fraudulent intent or with specific knowledge that BDO Seidman had not authorized
      the filing of these consents. It concluded that the evidence was consistent
      with
      our inclusion of the consents due to lack of communication, a series of
      misunderstandings and/or a failure of inquiry. As to Mr. Olins, the Report
      concluded that the Audit Committee found no evidence that Mr. Olins was informed
      that BDO Seidman had not authorized the filing of these consents. However,
      it
      also found no evidence that Mr. Olins inquired or determined whether BDO Seidman
      had in fact authorized inclusion of the consents in these filings. The Audit
      Committee Report determined that Mr. Olins, as our Chief Executive Officer,
      did
      not exercise sufficient diligence in supervising the filing of the amendments
      to
      the registration statements, that this was a particularly serious failing in
      light of the SEC having highlighted the need for consents from BDO Seidman,
      and
      that as CEO he bears responsibility for the filings. The Audit Committee also
      stated its belief that, throughout the process of preparing and filing the
      amendments to the registration statements, Mr. Olins acted with our best
      interests and the best interests of our shareholders in mind, and that his
      lack
      of diligence was not motivated by self-interest and that nothing related to
      this
      incident personally benefited him financially.





32


The
      Audit
      Committee recommended three remedial actions. It concluded that the membership
      of the Board of Directors should be supplemented with a financial expert within
      the meaning of SEC rules. It also concluded that we must improve our corporate
      governance and disclosure controls, including hiring a full-time chief financial
      officer and a controller (who can be the same person). It further concluded
      that, by reason of Mr. Olins’ responsibility as CEO for supervision of corporate
      filings, he should reimburse us for the sum of $50,000, a portion of the costs
      incurred by us by reason of the unauthorized BDO Seidman consents and the
      resulting inquiries. In compliance with the Audit Committee Report, in December
      2005, Mr. Olins made the $50,000 payment to reimburse the Company. To date,
      our
      Board of Directors has not been supplemented with a financial expert and we
      have
      not hired a fulltime chief financial officer or controller, although we have
      hired a part-time Director of Accounting and Finance.





The
      SEC
      is conducting an investigation into matters and events pertaining to the filing
      of the unauthorized BDO Seidman consent. We have been cooperating with the
      Staff
      with respect to this matter.





On
      December 6, 2005, we filed Post-Effective Amendment No. 2 to the Financing
      Registration Statement and the Shelf Registration Statement for the purpose
      of
      filing an amended Exhibit 23.2, which included the consent of the independent
      registered public accounting firm, Odenberg, Ullakko, Muranishi & Co.,
      LLP (OUM). That consent allows us to incorporate by reference into that
      registration statement OUM’s report on the consolidated financial statements
      appearing in our Annual Report on Form 10-K/A for the fiscal year ending
      December 31, 2004 and filed on December 29, 2005, as of and for each of the
      three years ended December 31, 2004.





In
      February 2006, we were advised by the Staff of the SEC that Post-Effective
      Amendments No. 6 to both the Financing Registration Statement and the Shelf
      Registration Statement were declared effective by the SEC.





LIQUIDITY
      AND CAPITAL RESOURCES





As
      of
      June 30, 2006, we had approximately $0.5 million in cash and cash equivalents,
      an increase of approximately $0.4 million from the December 31, 2005 balance
      of
      approximately $43,000. Our net working capital deficiency at June 30, 2006
      was
      approximately $0.7 million compared to approximately $2.3 million at December
      31, 2005.





Net
      cash
      used in operating activities totaled approximately $3.5 million and $3.8 million
      for the three months ended June 30, 2006 and 2005, respectively and
      approximately $7.7 million and $5.5 million for the six months ended June 30,
      2006 and 2005, respectively. Cash used in operating activities increased
      primarily due to increased operations in our South Korean manufacturing
      facility. This facility became fully operational in late 2005.





Net
      cash
      used in investing activities totaled approximately $0.1 million and $0.2 million
      for the three months ended June 30, 2006 and 2005, and approximately $0.3
      million and $3.5 million for the six months ended June 30, 2006 and 2005,
      respectively. Cash used in investing activities during 2005 were related to
      building our South Korean manufacturing facility. These building activities
      were
      completed during 2005.





33


Net
      cash
      provided by financing activities in the three months ended June 30, 2006 and
      2005 were approximately $2.7 million and $0.3 million, respectively, and
      approximately $8.5 million and $0.3 million for the six months ended June 30,
      2006 and 2005, respectively. In the first quarter of 2006, cash was primarily
      provided by the net proceeds of approximately $3.3 million that we received
      from
      the sale of 1,300,000 of our common shares on January 12, 2006, at a purchase
      price of $2.62 per share, and approximately $1.1 million that we received from
      the sale of 500,000 shares sold on March 17, 2006, at a purchase price of $2.18
      per share. We borrowed an additional approximately $1.4 million on our lines
      of
      credit with South Korean banks during the first quarter of 2006. In the second
      quarter of 2006, cash was primarily provided by the net proceeds of
      approximately $2.4 million that we received from the sale of 750,000 of our
      common shares on April 7, 2006 at a purchase price of $3.26 per share and
      approximately $1.7 million that we received from the sale of 601,000 of our
      common shares on June 6, 2006 at a purchase price of $2.80 per share.





We
        expect
        to meet our immediate cash needs and fund our immediate working capital
        requirements with our existing cash balances, the proceeds of approximately
        $1.7
        million from the sale of 761,500 shares of our common shares expecting to
        close
        no later than August 16, 2006 from a private placement of our common shares,
        as
        more fully described in Note 14, and from additional sources. Those sources
        include **** cash
        payments from our customers; the exercises of stock options and warrants;
        and
        additional sales of our common shares. There can be no assurances with respect
        to these potential sources. We believe that our current cash and cash
        equivalents as of June 30, 2006, combined with the private placement detailed
        above, will be sufficient to meet our capital and liquidity requirements
        through
        September 2006. If we are unable to obtain additional funds on reasonable
        terms,
        we may be unable to continue our operations at current levels, or at
        all.





RESULTS
      OF OPERATIONS





*Three
      months ended June 30, 2006 and 2005*





*Revenue* . ** We
      recognized revenue of approximately $59,000 and $41,000 during the quarters
      ended June 30, 2006 and 2005, respectively. Revenue in both periods was derived
      primarily from sales of LCoS Sets to LG Electronics.





The
      following table summarizes our sales revenue by product for the second quarter
      2006 and 2005.


Three
                  months ended June 30,2006
              
              2005LCoS
                  (T-3) sets
              
              
              94
              %
              
              96
              %Other
                  (primarily supporting electronics)
              
              
              6
              %
              
              4
              %Total
              
              
              100
              %
              
              100
              %





Revenue
      from one customer, LG Electronics, accounted for 100% and 98% of our total
      revenue for the three months ended June 30, 2006 and 2005, respectively. The
      loss of this customer and our inability to obtain additional purchase orders
      from our current or prospective customers to replace the lost expected revenue
      in a timely manner could harm our sales or results of operations.




34


*Gross
      Margin* .
      Negative gross margin increased from approximately $48,000 during the second
      quarter of 2005 to negative gross margin of approximately $1,543,000 during
      the
      second quarter 2006. The second quarter of 2006 includes the costs to operate
      our South Korean manufacturing facility. We were in the process of building
      this
      facility during the second quarter of 2005 but had no operational expenses
      related to it. Until the plant output and associated sales reach the
      manufacturing break-even volume, which we cannot assure, we will continue to
      experience negative gross margins.





*Selling,
      general and administrative costs.* Cash-based selling, general and administrative costs were approximately
      $1,918,000 and $1,772,000 during the three months ended June 30, 2006 and 2005,
      respectively, an increase of $146,000 or 8%. Significantly contributing to
      the
      increase were increased legal fees of approximately $392,000 primarily related
      to the routine review of our registration statements on Forms S-3 and our Annual
      Report on Form 10-K for the year ended December 31, 2005 as well as involvement
      with the ongoing SEC investigation. $90,000 of the increase relates to a
      severance agreement pursuant to the resignation of Mr. Banzhaf, our former
      Executive Vice President of Strategic Planning. Offsetting these increases
      were
      reductions of approximately $87,000 in consulting expenses, primarily related
      to
      our 2005 implementation of Navision in our California office as well as timing
      differences associated with our testing of internal controls in accordance
      with
      the Sarbanes-Oxley act; a reduction of approximately $80,000 in travel expenses
      as fewer trips were required to visit our South Korean facility as compared
      to
      the same period in 2005; $136,000 decrease in freight expense due to a
      significant reduction in the amount of supplies and equipment being shipped
      from
      our California facility to our South Korean facility, and decreases in general
      office expenses of approximately $33,000 due to a reduction of staff and
      activities in our California offices as well as timing differences.





*Stock-based
      compensation included in selling, general and administrative
      costs.* Stock-based compensation was approximately $976,000 and $8,000 in the three
      months ended June 30, 2006 and 2005, respectively. We
      adopted Statement of Financial Accounting Standards No. 123 (revised 2004),
“ *Share-Based
      Payment* ,”
(“SFAS
      123R”) effective January 1, 2006. SFAS 123R requires the recognition of the fair
      value of stock compensation in net income (loss). We recognize the stock
      compensation expense over the requisite service period of the individual
      grantees, which generally equals the vesting period. All of our stock
      compensation is accounted for as an equity instrument. Prior to January 1,
      2006, we followed Accounting Principles Board (“APB”) Opinion 25, “ *Accounting
      for Stock Issued to Employees,* ”
and
      related interpretations in accounting for our stock compensation. Expenses
      in
      the second quarter of 2005 included the value of a warrant issued for sales
      services as well as expense related to stock options issued to an employee
      in
      2003 at an exercise price lower than the fair market value of the stock on
      the
      date of grant expensed over the vesting period.





*Research
      and development costs* .
      Research and development costs were approximately $411,000 and $1,166,000 in
      the
      three months ended June 30, 2006 and 2005, respectively, a decrease of $755,000
      or 65%. During the second quarter of 2005, significant effort was expended
      on
      developing the LCoS Sets to meet LG Electronics’ new specifications as well as
      ramping up the South Korean plant to prepare for commercial scale production.
      These efforts neared completion towards the end of 2005, resulting in reduced
      expenses during the second quarter of 2006.





*Interest
      expense.* Interest
      expense for the three months ended June 30, 2006 decreased approximately
      $236,000 from $268,000 during second quarter 2005 to $32,000 for the second
      quarter 2006. Approximately $252,000 of the decrease is due to issuing our
      common shares in lieu of cash to the Senior Secured Noteholders for the payment
      of one quarter’s interest. The decrease is partially offset by interest incurred
      on the short-term South Korean debt facilities. No comparable facilities existed
      during the second quarter of 2005.





35


*Non-cash
      interest expense.*  ** Non-cash
      interest expense was approximately $474,000 and $278,000 for the three months
      ended June 30, 2006 and 2005, respectively. Non-cash interest expense includes
      expense associated with the amortization of the beneficial conversion price
      of
      shares issued to prepay interest on the notes payable to Argyle Capital
      Management Corporation, a company wholly owned by Robert A. Olins, our Chief
      Executive Officer, Secretary, Treasurer, Principal Financial and Accounting
      Officer and a Director. The beneficial conversion interest represents the excess
      value of the shares received or receivable at current market prices over the
      $0.50 per share conversion price. Also included in non-cash interest expense
      is
      the amortization of note discounts and note financing costs of the Senior
      Secured Convertible Notes.  Approximately
      $252,000 of increase in the three months ended June 30, 2006 as compared to
      the
      same period in 2005 primarily relates to the issuance of our common shares
      in
      lieu of cash to the Senior Secured Noteholders for the payment of one quarter’s
      interest. This increase is partially offset by the reversal of an accrual of
      approximately $177,000 relating to potential liquidated damages in connection
      with the registration rights agreement entered into as part of the October
      2005
      Financing and the January 2006 Financing. The above mentioned reversal of the
      liquidated damages accrual was due to settlement of these charges with the
      investors.





*Six
      months ended June 30, 2006 and 2005*





*Revenue* . ** We
      recognized revenue of approximately $145,000 and $139,000 during the six months
      ended June 30, 2006 and 2005, respectively. Revenue in both periods was derived
      primarily from sales of LCoS Sets to LG Electronics.





The
      following table summarizes our sales revenue by product for the six months
      ended
      June 30, 2006 and 2005.


Six
                  months ended June 30,2006
              
              2005LCoS
                  (T-3) sets
              
              
              88
              %
              
              77
              %LCoS
                  (T-1) sets
              
              
              -
              
              
              7
              %Light
                  engine display units
              
              
              -
              
              
              1
              %Other
                  (primarily supporting electronics)
              
              
              12
              %
              
              15
              %Total
              
              
              100
              %
              
              100
              %





Revenue
      from one customer, LG Electronics, accounted for 89% and 78% of our total
      revenue for the six months ended June 30, 2006 and 2005, respectively. The
      loss
      of this customer and our inability to obtain additional purchase orders from
      our
      current or prospective customers to replace the lost expected revenue in a
      timely manner could harm our sales or results of operations.




*Gross
      Margin* .
      Negative gross margin increased from approximately $20,000 during the first
      half
      of 2005 to negative gross margin of approximately $3,006,000 during the first
      half 2006. The first half of 2006 includes the costs to operate our South Korean
      manufacturing facility. We were in the process of building this facility during
      the first half of 2005 but had no operational expenses related to it. Until
      the
      plant output and associated sales reach the manufacturing break-even volume,
      which we cannot assure, we will continue to experience negative gross margins.
      Additionally, cost of revenue during the first half of 2006 includes a reserve
      of approximately $386,000, which was recorded to reserve the remaining value
      of
      our T-1 LCoS Set inventory as well as a percentage of our light engine
      inventory. We believe there are still opportunities to sell both products,
      but
      we have shifted our focus to the manufacture and sale of our T-3 LCoS Set
      products. We are not currently manufacturing either the T-1 LCoS Set or the
      light engine products and their sales were minimal during 2005.





36


*Selling,
      general and administrative costs.* Cash-based selling, general and administrative costs were approximately
      $3,890,000 and $3,482,000 during the six months ended June 30, 2006 and 2005,
      respectively, an increase of $408,000 or 12%. Significantly contributing to
      the
      increase were increased legal fees of approximately $576,000 primarily related
      to the routine review of our registration statements on Forms S-3 and our Annual
      Report on Form 10-K for the year ended December 31, 2005 as well as involvement
      with the ongoing SEC investigation. $90,000 of the increase relates to a
      severance agreement pursuant to the resignation of Mr. Banzhaf, our former
      Executive Vice President of Strategic Planning. Finally, approximately $80,000
      of the increase represents wages, office supplies and other general and
      administrative expenses related to our new South Korean facility. Offsetting
      these increases were reductions of approximately $246,000 in consulting
      expenses, primarily related to our 2005 implementation of Navision software
      in
      our California office as well as timing differences associated with our testing
      of internal controls in accordance with the Sarbanes-Oxley act and a reduction
      of approximately $91,000 in travel expenses as fewer trips were required to
      visit our South Korean facility as compared to the same period in 2005.





*Stock-based
      compensation included in selling, general and administrative
      costs.* Stock-based compensation was approximately $1,645,000 and $107,000 in the six
      months ended June 30, 2006 and 2005, respectively. We
      adopted Statement of Financial Accounting Standards No. 123 (revised 2004),
“ *Share-Based
      Payment* ,”
(“SFAS
      123R”) effective January 1, 2006. SFAS 123R requires the recognition of the fair
      value of stock compensation in net income (loss). We recognize the stock
      compensation expense over the requisite service period of the individual
      grantees, which generally equals the vesting period. All of our stock
      compensation is accounted for as an equity instrument. Prior to January 1,
      2006, we followed Accounting Principles Board (“APB”) Opinion 25, “ *Accounting
      for Stock Issued to Employees,* ”
and
      related interpretations in accounting for our stock compensation. Expenses
      in
      the first half of 2005 included the value of a warrant issued for sales services
      as well as expense related to stock options issued to an employee in 2003 at
      an
      exercise price lower than the fair market value of the stock on the date of
      grant expensed over the vesting period.





*Research
      and development costs* .
      Research and development costs were approximately $653,000 and $1,659,000 in
      the
      six months ended June 30, 2006 and 2005, respectively, a decrease of $1,006,000
      or 61%. During the second quarter of 2005, significant effort was expended
      on
      developing the LCoS Sets to meet LG Electronics’ new specifications as well as
      ramping up the South Korean plant to prepare for commercial scale production.
      These efforts neared completion towards the end of 2005, resulting in reduced
      expenses during the first half of 2006.





*Interest
      expense.* Interest
      expense for the six months ended June 30, 2006 decreased approximately $220,000
      from $535,000 during the first half of 2005 to $315,000 for the first half
      of
      2006. Approximately $252,000 of the decrease is due to issuing our common shares
      in lieu of cash to the Senior Secured Noteholders for the payment of one
      quarter’s interest. The decrease is partially offset by interest incurred on the
      short-term South Korean debt facilities. No comparable facilities existed during
      the first half of 2005.





37


*Non-cash
      interest expense.*  ** Non-cash
      interest expense was approximately $1,487,000 and $555,000 for the six months
      ended June 30, 2006 and 2005, respectively. Non-cash interest expense includes
      expense associated with the amortization of the beneficial conversion price
      of
      shares issued to prepay interest on the notes payable to Argyle Capital
      Management Corporation, a company wholly owned by Robert A. Olins, our Chief
      Executive Officer, Secretary, Treasurer, Principal Financial and Accounting
      Officer and a Director. The beneficial conversion interest represents the excess
      value of the shares received or receivable at current market prices over the
      $0.50 per share conversion price. Also included in non-cash interest expense
      is
      the amortization of note discounts and note financing costs of the Senior
      Secured Convertible Notes.  Approximately
      $252,000 of increase in the six months ended June 30, 2006 as compared to the
      same period in 2005 primarily relates to the issuance of our common shares
      in
      lieu of cash to the Senior Secured Noteholders for the payment of one quarter’s
      interest. Additionally, approximately $438,000 of the increase relates to
      liquidated damages in connection with the registration rights agreement entered
      into as part of the October 2005 Financing and the January 2006
      Financing.





Critical
      Accounting Policies





*Revenue
      Recognition* - We
      evaluate revenue recognition for transactions using the following criteria
      (collectively called the Revenue Recognition Criteria):





·
            Evidence
                of an arrangement: Before revenue is recognized, we must have evidence
                of
                an agreement with the customer reflecting the terms and conditions
                to
                deliver our products.


·
            Delivery:
                For products, delivery is considered to occur when title and risk
                of loss
                have been transferred, which generally occurs upon shipment.


·
            Fixed
                or determinable fee: We consider a fee to be fixed or determinable
                if the
                fee is not subject to refund or adjustment. If a portion of the
                arrangement fee is not fixed or determinable, we recognize that amount
                as
                revenue when the amount becomes fixed or determinable. We do not
                consider
                a fee to be fixed and determinable if any amount is due more than
                180 days
                from the delivery date. Payment terms of less than 180 days are evaluated
                based upon the laws or trade practices of the country in which the
                arrangement is entered into to assess whether the fee is fixed and
                determinable.


·
            Collection
                is deemed reasonably assured: Collection is deemed reasonably assured
                if
                we expect the customer to be able to pay amounts under the arrangement
                as
                those amounts become due. We reduce product revenue for customer
                returns
                and sales allowances and record an allowance for doubtful accounts
                should
                collectibility become questionable. If it is determined that an account
                is
                uncollectible, the account is written off against the allowance.





*Inventory
      valuation* - We
      value inventories at the lower of cost (based on the first-in, first-out method)
      or market value. We include raw materials, labor and manufacturing overhead
      in
      the cost of inventories. In determining inventory market values, we give
      substantial consideration to the expected selling price of the product based
      on
      historical recovery rates. If we assess the market value of our inventory to
      be
      less than costs we write it down to its replacement cost or its net realizable
      value. Our estimates may differ from actual results due to the quantity, quality
      and mix of products in inventory, consumer and retailer preferences and economic
      conditions.




38


*Stock-based
      Payments -* Effective January 1, 2006 we adopted SFAS 123R using the modified
      prospective method and therefore have not restated prior periods’ results for
      the adoption of SFAS 123R.  Under the fair value recognition provisions of
      SFAS 123R, we recognize stock-based compensation net of an estimated forfeiture
      rate and therefore only recognize compensation cost for those shares expected
      to
      vest over the service period of the award.  Prior to SFAS 123R adoption, we
      accounted for share-based payments under APB 25 and accordingly, generally
      recognized compensation expense related to stock options with intrinsic value
      and accounted for forfeitures as they occurred.




We
      estimated the fair value of options granted using the Black-Scholes option
      pricing model and the assumptions shown in Note 4, Stock-Based Compensation,
      to
      our condensed consolidated financial statements. Calculating stock-based
      compensation expense under the provisions of SFAS 123R requires the input of
      highly subjective assumptions, including the expected term of the stock-based
      awards, stock price volatility, and pre-vesting option forfeitures.  We
      estimate the expected life of options granted based on the simplified method
      provided in Staff Accounting Bulletin No. 107 for "plain vanilla" options. 
We estimate the volatility of our common stock at the date of grant based on
      the
      historical volatility of our common stock.  In addition, we are required to
      estimate the expected forfeiture rate and only recognize expense for those
      shares expected to vest.  We estimate the forfeiture rate based on
      historical experience of our stock-based awards that are granted, exercised
      and
      cancelled.  If our actual forfeiture rate is materially different from our
      estimate, the stock-based compensation expense could be significantly different
      from what we have recorded in the current period.  The assumptions used in
      calculating the fair value of stock-based awards represent our best estimates,
      but these estimates involve inherent uncertainties and the application of
      management judgment.  As a result, if factors change and we use different
      assumptions, our stock-based compensation expense could be materially different
      in the future.  As required under SFAS 123R, we will review our valuation
      assumptions at each grant date and, as a result, are likely to periodically
      change the valuation assumptions used to value employee stock-based awards
      granted in future periods. The guidance in SFAS 123R is relatively new and
      best
      practices are not well established. The application of the various valuation
      assumptions may be subject to further interpretation and refinement over time.
      There are significant differences among valuation models and there is a
      possibility that we will adopt different valuation models and assumptions in
      the
      future. This may result in a lack of comparability with other companies that
      use
      different models, methods and assumptions and in a lack of consistency in future
      periods. See Note 4—“Stock-Based Compensation” in the condensed
      consolidated financial statements for additional information.





*Research
      and Development* -
      Research and development costs, including the costs of prototype and
      pre-production LCoS Sets, pre-production display units, and other pre-production
      activities at our South Korean manufacturing facility are charged to expense
      when incurred.





*Income
      tax assets and liabilities -* In
      establishing our deferred income tax assets and liabilities, we make judgments
      and interpretations based on the enacted tax laws and published tax guidance
      that are applicable to our operations. We record deferred tax assets and
      liabilities and evaluate the need for valuation allowances to reduce the
      deferred tax assets to realizable amounts. The likelihood of a material change
      in our expected realization of these assets is dependent on future taxable
      income, our ability to use foreign tax credit carryforwards and carrybacks,
      final U.S. and foreign tax settlements, and the effectiveness of our tax
      planning strategies in the various relevant jurisdictions. Due to our lack
      of
      profitable operating history, potential limitations on usage of operating losses
      and general uncertainty, we provided for a 100% valuation allowance against
      our
      deferred tax assets. We are also subject to examination of our income tax
      returns for multiple years by the Internal Revenue Service and other tax
      authorities. We periodically assess the likelihood of adverse outcomes resulting
      from these examinations to determine the adequacy of our provision for income
      taxes. Changes to our income tax provision or the valuation of the deferred
      tax
      assets and liabilities may affect our annual effective income tax
      rate.





39




**Item
              3.**
            **Quantitative
                and Qualitative Disclosures About Market
                Risks.**





We
      are
      exposed to the impact of interest rate changes and foreign currency
      fluctuations.





*Interest
      Rate Risk* .
      Our
      exposure to market rate risk for changes in interest rates relates primarily
      to
      our cash accounts and our lines of credit in South Korea. We invest excess
      cash
      and cash equivalents in a checking account or money market account with
      reputable banks both in the United States and South Korea. Our cash accounts
      in
      the United States are not FDIC or otherwise insured, to the extent that the
      accounts exceed $100,000; and our cash accounts in South Korea are not insured.
      As of June 30, 2006, our cash and cash equivalents totaled approximately $0.5
      million. Short term debt under our South Korean lines of credit totaled
      approximately $0.8 million at June 30, 2006.





*Foreign
      Currency Risk.* We
      are
      exposed to foreign exchange rates fluctuations as we convert the financial
      statements of our foreign subsidiary into U.S. dollars in consolidation. If
      there is a change in foreign currency exchange rates, the conversion of the
      foreign subsidiary's financial statements into U.S. dollars will lead to a
      translation gain or loss which is recorded as a component of other comprehensive
      income or loss. Changes in the functional currency value of these assets and
      liabilities create fluctuations that will lead to a transaction gain or loss.
      When appropriate, we may enter into hedging transactions in order to mitigate
      our risk from foreign currency fluctuations. We may use hedging programs in
      the
      future and may use currency forward contracts, currency options and/ or other
      derivative financial instruments commonly utilized to reduce financial market
      risks if it is determined that such hedging activities are appropriate to reduce
      risk. We do not hold or purchase any foreign currency contracts for trading
      purposes. As of June 30, 2006, we had no hedging contracts. During the first
      and
      second quarter of 2006, the foreign currency transaction gains, realized and
      unrealized, were not material.





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




**Disclosure
      Controls and Procedures.** As
      of
      June 30, 2006, management of our Company, under the supervision of our principal
      executive and financial officer (CEO), evaluated (the Controls Evaluation)
      the
      effectiveness of the design and operation of our "disclosure controls and
      procedures", as such term is defined under Rule 13a-15(e) promulgated under
      the
      Securities Exchange Act of 1934, as amended (Disclosure Controls), and our
      "internal controls and procedures for financial reporting" (Internal Controls).





40


*Limitations
      on the Effectiveness of Controls.* Our CEO
      does not expect that our Disclosure Controls or our internal control over
      financial reporting will prevent all error and all fraud. A control system,
      no
      matter how well conceived and operated, can provide only reasonable, not
      absolute, assurance that the control system’s objectives will be met. Further,
      the design of a control system must reflect the fact that there are resource
      constraints, and the benefits of controls must be considered relative to their
      costs. We have only had limited revenue derived from the sale of our
      microdisplay products in the current reporting period and since we commenced
      operations. While the Controls Evaluation has accounted for such limited sales
      and revenue, new or additional controls may or may not be required once we
      begin
      selling our microdisplay products in increased volume in the ordinary course
      of
      business. Because of the inherent limitations in all control systems, no
      evaluation of controls can provide absolute assurance that all control issues
      and instances of fraud, if any, within the Company have been detected. These
      inherent limitations include the realities that judgments in decision-making
      can
      be faulty, and that breakdowns can occur because of simple error or honest
      mistake. Additionally, controls can be circumvented by the individual acts
      of
      some persons, by collusion of two or more persons, or by management override
      of
      the controls. The design of any system of controls also is based in part upon
      certain assumptions about the likelihood of future events, and there can be
      no
      assurance that any design will succeed in achieving its stated goals under
      all
      potential future conditions. Over time, specific controls may or may not become
      inadequate (e.g., when we commence to sell our products in increased volume
      in
      the ordinary course of business) because of changes in conditions or
      deterioration in the degree of compliance with policies or procedures. Because
      of the inherent limitations in a cost-effective control system, misstatements
      due to error or fraud may occur and not be detected.





*Conclusion
      regarding the Effectiveness of Disclosure Controls and
      Procedures.* **** As
      of
      June 30, 2006, our CEO conducted evaluations of our disclosure controls and
      procedures. As defined under Sections 13a-15(e) and 15d-15(e) of the Exchange
      Act, the term “disclosure controls and procedures” means controls and other
      procedures of an issuer that are designed to ensure that information required
      to
      be disclosed by the issuer in the reports that it files or submits under the
      Exchange Act is recorded, processed, summarized and reported, within the time
      periods specified in the SEC’s rules and forms. Disclosure controls and
      procedures include, without limitation, controls and procedures designed to
      ensure that information required to be disclosed by an issuer in the reports
      that it files or submits under the Exchange Act is accumulated and communicated
      to the issuer’s management, including the issuer’s CEO, to allow timely
      decisions regarding required disclosure. Based on his evaluation, as described
      in Item 9A “Controls and Procedures” in our Annual report on Form 10-K/A filed
      with the SEC on April 11, 2006, the CEO has concluded that our disclosure
      controls and procedures were not effective to ensure that material information
      is recorded, processed, summarized and reported by management on a timely basis
      in order to comply with our disclosure obligations under the Exchange Act,
      and
      the rules and regulations promulgated thereunder. Among
      other weaknesses identified in our disclosure controls and procedures, our
      policy for monitoring sales of common shares by our employees, officers and
      directors does not provide a means for independent review and approval of sales
      of common shares by our CEO and our process of determining the securities
      beneficially owned by our officers and directors does not provide adequate
      assurance that all shares beneficially owned by our officers and directors
      are
      accurately reported to us.





**Changes
      in Internal Controls**





Except
      as
      noted below, there have been no significant changes in the Company’s internal
      control over financial reporting that occurred during the quarter covered by
      this report that have materially affected, or are reasonably likely to
      materially affect, the Company’s internal control over financial
      reporting.





On
      June
      29, 2006, the Board of Directors adopted Corporate Governance Guidelines and
      established a Corporate Governance and Nominating Committee.





On
      April
      28, 2006, we hired a part-time Director of Accounting and Finance. This
      individual had been working with us in the same capacity on a consulting basis
      since October 2005. Part of her responsibilities include overseeing and
      monitoring complex and significant transactions in order to provide reasonable
      assurance that such transactions are reflected accurately and fairly in the
      financial statements.





41


Our
      Chief
      Operating Officer and our Director of Accounting and Finance have been closely
      reviewing the financial statements of Spatialight Korea, which are prepared
      by a
      third party. This partially mitigates the previously disclosed lack of
      sufficient control over the existence, completeness and accuracy over account
      balances in the close process of our facility in South Korea.





**PART
              II.**
            **OTHER
                INFORMATION**





**ITEM
              1**
            **Legal
                Proceedings**





None.
      See
      our discussion of the SEC investigation being conducted, which is described
      under “Item 3, Management’s Discussion and Analysis of Financial Condition and
      results of Operations - Overview Certain Development.”





**ITEM
              1A**
            **Business
                Risks and Uncertainties**





Other
      than with respect to the risk factors below, there have been no material changes
      from the risk factors disclosed in the “Risk Factors” section of the Company’s
      Annual Report on Form 10-K/A for the year ended December 31, 2005. The risk
      factors below were disclosed on the Form 10-K/A and have been updated.





**We
      have experienced significant manufacturing difficulties during the past year
      that have resulted in our manufacturing and shipping our LCoS Sets in only
      limited commercial quantities. If we encounter further difficulties in
      manufacturing our products in larger quantities then we may have difficulty
      meeting customer demands and our operating results could be significantly harmed
      by such difficulties.**





We
      have
      experienced difficulties in manufacturing our LCoS Sets during the past year
      principally due to various problems that we have experienced in certain specific
      portions of our manufacturing process. See “Manufacturing of LCoS Sets” set
      forth under Part I. Item 2. Management’s Discussion and Analysis of Financial
      Condition and Results of Operations for a more detailed discussion of
      manufacturing difficulties that we have experienced. Although we believe that
      we
      have developed solutions to the past problems that will allow us to achieve
      higher production and shipment volumes, because the manufacture of our LCoS
      Sets
      involves highly complex processes, technical problems may continue to arise
      as
      we manufacture our LCoS Sets and we cannot assure satisfactory manufacturing
      yields on a continuing basis or that we will be able to adequately ramp up
      volume production of our LCoS Sets.





Current
      purchase orders, including our agreement with LG Electronics, and anticipated
      future purchase orders, which we cannot assure, will require us to produce
      greater quantities of our LCoS Sets than we have produced in the past. If future
      manufacturing yields cannot be improved further or if we incur unanticipated
      problems in production of our LCoS Sets, it will significantly harm our business
      and operating results because we will have already incurred the costs for the
      materials used in the LCoS Set manufacturing processes as well as the costs
      of
      operating our South Korean manufacturing facility. Unanticipated further
      problems in manufacturing our LCoS Sets could also cause production delays
      that
      might lead our current and prospective customers to seek other sources, which
      would negatively affect our operating results.





42


In
      addition, the complexity of our manufacturing processes will increase as the
      sophistication of our LCoS Sets increases, and such complexities may cause
      similar difficulties that could harm our business and operating results.
      Although we believe that we will be able to mass produce our LCoS Sets, other
      companies, including some with substantially greater resources than us, have
      found great difficulty manufacturing LCoS products. We do not have reliable
      information about why other companies have failed to be able to manufacture
      similar liquid crystal microdisplays and can therefore make no assurances that
      we will not encounter similar problems.





We
      currently obtain silicon backplanes, a vital component in our microdisplays,
      from a company in Taiwan, which is subject to potential instability because
      of
      Taiwan’s troubled relations with China. Unless we obtain an alternative source,
      any disruption or termination of our silicon backplane manufacturing source’s
      operation in Taiwan could significantly harm our operations. Early in the second
      quarter of 2006, the silicon wafers that we received from our supplier contained
      flaws that have materially harmed our manufacturing yields. We refer you to
      “Manufacturing of LCoS Sets” contained in Part I, Item 2. Management’s
      Discussion and Analysis of Financial Condition and Results of Operations for
      a
      more detailed discussion of our problems with the silicon wafers.





The
      design and manufacture of LCoS Sets are highly complex processes that are
      sensitive to a wide variety of factors, including the level of contaminants
      in
      the manufacturing environment, variations in temperature and humidity,
      impurities in the materials used, and the performance of personnel and
      equipment. We have built and equipped a manufacturing plant in South Korea
      where
      we currently manufacture our LCoS Sets in limited quantities. We believe that
      these arrangements provide us with strong quality controls and effectively
      protect our proprietary technology in our products, but the risks discussed
      above associated with the highly complex processes of manufacturing these liquid
      crystal microdisplays remain applicable.





**Although
      we have commenced producing LCoS Sets in our manufacturing facility in South
      Korea, which serves as our principal facility for manufacturing our LCoS
      imagers,, we may encounter difficulties in conducting our manufacturing
      operations and difficulties in maintaining our quality controls over the
      manufacturing and production processes in a foreign country, any of which would
      be likely to cause significant harm to our business.**





Our
      manufacturing operations were recently relocated from California to South Korea
      and the relocation of our manufacturing operations in South Korea may cause
      us
      to encounter one or more potential problems in our operations that could harm
      our business. Because of cultural or language differences, problems may arise
      in
      the training of, or communications with, our employees or the general operation
      of our manufacturing facility. These cultural or language differences may also
      create misunderstandings or the creation of inefficiencies in our operations.
      Furthermore, the geographic separation between our corporate offices in the
      United States and our principal manufacturing operation in South Korea could
      result in managerial or supervisory problems, which could lead to decreased
      quality controls and consequently materially harm our business.





**We
      are largely dependent on one customer, LG Electronics, for our future revenues,
      and failure to expand our customer base or receive additional orders from our
      existing customer base will make us vulnerable to substantial loss of potential
      revenues.**





In
      2005
      and the first half of 2006, almost all of our revenue has been derived from
      LG
      Electronics, Inc. Based upon our arrangements with LG Electronics, it is likely
      that a substantial percentage of our anticipated future revenues will be derived
      from LG Electronics as well. If we cannot diversify our customer base or derive
      increased revenues through additional purchase orders and product deliveries
      from customers other than LG Electronics, and remain primarily reliant on only
      one customer for a substantial percentage of our revenues, we will be vulnerable
      to a substantial decline in anticipated revenues if we lose LG Electronics
      as a
      customer for any reason or if LG Electronics were to otherwise reduce, delay
      or
      cancel its orders. Any such events could have a material adverse effect on
      our
      business, operations and financial condition and the value of our common shares
      could decline substantially.





43


Our
      ability to retain and receive additional purchase orders from our current
      customers and to attract and receive purchase orders from prospective customers
      may depend upon the acceptance of LG Electronics’ products in the consumer
      marketplace. If LG Electronics’ television products incorporating our LCoS
      technology are not commercially successful, demand for our products from our
      current and prospective customers may not materialize, which could negatively
      impact our results of operations and our financial condition. ****





**The
      obligations arising from our Senior Secured Convertible Notes restrict our
      future financing alternatives and may result in financial difficulties for
      us in
      the future.**





The
      Senior Secured Convertible Notes issued in November 2004 bear a 10% rate of
      interest per annum and are not prepayable, in whole or in part, prior to their
      maturity on November 30, 2007. Therefore, we do not have the ability to
      refinance the 2004 Senior Secured Convertible Notes with debt obligations
      bearing more favorable terms to us or out of the proceeds of an equity financing
      until their maturity date. We do have the right to force the conversion of
      the
      Senior Secured Convertible Notes into our common shares in the event that our
      common shares trade at or above $14.58 (150% of the $9.72 conversion price
      of
      the Senior Secured Convertible Notes) for twenty consecutive trading days.
      The
      last sale price of our common shares on August 7, 2006, was $2.50 per
      share.





Furthermore,
      the Senior Secured Convertible Notes are secured by virtually all of our assets,
      other than those located in South Korea, and it may therefore be difficult
      for
      us to obtain future debt financing. However, the terms of the Senior Secured
      Convertible Notes allow us to subordinate the liens on accounts receivable,
      certain contract rights and inventory (the “Subject Property”) securing the
      Senior Secured Convertible Notes, to liens on the Subject Property securing
      certain other debt permitted, subject to certain conditions, by the Senior
      Secured Convertible Notes.





In
      addition, the issuance of any additional debt securities, except certain types
      of bank debt permitted under the Senior Secured Convertible Notes, will require
      the consent of the holders of a majority in interest of our Senior Secured
      Convertible Notes, to the extent that such notes remain issued and outstanding
      at the time of issuance of any additional debt securities. The prohibition
      against incurring debt may negatively affect our ability to engage in capital
      expenditures and to maintain and expend our manufacturing
      operations.





If
      we
      default in meeting our obligations under the Senior Secured Convertible Notes,
      the indebtedness which they evidence may become immediately due and payable,
      and
      the holders of the Senior Secured Convertible Notes may be entitled to foreclose
      on any of our assets securing the notes. As noted earlier, certain of the
      holders of our Senior Secured Convertible Notes have alleged that we have
      defaulted in meeting our obligations under the Senior Secured Convertible Notes
      and have demanded the immediate repayment of principal and liquidated damages.
      In the event these holders pursue their claims, and a court determines that
      we
      have defaulted in our obligations, we will have to seek financing from third
      parties to satisfy the holder’s claims. The Senior Secured Convertible Notes are
      convertible into our common shares and the issuance of such shares (including
      any shares issued in payment of interest on such notes) may have a dilutive
      effect on the value of our outstanding common shares.





44


**Geopolitical
      conditions or potential military conflicts between allies, the United States
      and
      South Korea, and North Korea may negatively impact our business.**





We
      commenced producing products in our principal manufacturing operations in South
      Korea during the second quarter of 2005, and our largest customer, LG
      Electronics, resides in South Korea. South Korea and North Korea are technically
      at war with each other, despite the mutually agreed upon existence of the
      Demilitarized Zone and the relative absence of physical conflict for several
      decades. Any escalation in the existing conflict between these countries or
      any
      commencement, or perceived commencement, of a military conflict between the
      United States and North Korea, may limit our ability to effectively operate
      our
      manufacturing facility in South Korea and may also substantially limit our
      ability to sell products into South Korea because of the negative economic,
      physical or other destructive impact that such a conflict could have on our
      most
      important customer. Any such disruptions to our manufacturing operations and/or
      ability to consummate sales to a substantial customer could adversely affect
      the
      development of our business and our financial condition. The recent escalation
      in tension between the United States and North Korea, as a result of North
      Korea’s attempts to test certain of their missiles, has not impacted our
      operations in South Korea, but we can provide no assurances that continued
      tension will not negatively affect our operations.





**The
      material weaknesses identified by our management and our independent registered
      public accounting firm with respect to our internal controls over financial
      reporting may have a materially negative impact on our
      business.**





In
      accordance with the rules prescribed by the SEC and the Sarbanes-Oxley Act
      of
      2002, we must periodically review and test our internal controls over financial
      reporting to ensure compliance. During our preparation of our Annual Report
      on
      Form 10-K for the fiscal year ended December 31, 2005, our management and our
      independent registered public accounting firm identified several material
      weaknesses in our internal controls over financial reporting. Although these
      material weaknesses did not result in a misstatement of our financial results,
      they relate closely to assuring the fulfillment of critical components of the
      financial reporting functions of our business. As of this date, the material
      weaknesses identified include the fact that our Company does not have a
      full-time chief financial officer to work with the chief executive officer
      and
      chief operating officer in overseeing and monitoring complex and significant
      transactions in order to provide reasonable assurance that such transactions
      are
      reflected accurately and fairly in the financial statements. Furthermore, our
      audit committee does not have a member who is deemed a “financial expert” as
      defined by the rules promulgated by the SEC, although a member of our audit
      committee has the level of financial sophistication that the Nasdaq’s rules
      require. Additionally, we lack adequate controls and procedures over inventory,
      we lack information technology controls and procedures that would likely prevent
      unauthorized access to accounting and financial systems, we do not have
      effective internal controls over financial reporting at our wholly owned
      subsidiary in South Korea, we do not maintain formal accounting policies and
      procedures to allow the accounting function to adequately analyze transactions
      and determine correct accounting under United States Generally Accepted
      Accounting Principles (GAAP), and we do not have formal procedures to prevent
      the filing of registration statements with the SEC without the required
      accountant’s consent. We may therefore need to incur significant additional
      expenses to achieve compliance and we may incur other costs in connection with
      regulatory enforcement actions, any of which could negatively impact our
      business.





45




**ITEM
              2.**
            **Unregistered
                Sales of Equity Securities and Use of Proceeds**





Following
      the effectiveness of the registration statement for our January financing,
      the
      investors of the January financing received an aggregate of 122,725 restricted
      shares in settlement of any and all liquidated damages. The shares were issued
      as follows: 57,725 restricted shares of our common stock were issued on May
      18,
      2006, when the market value of our shares was $3.12, resulting in an intrinsic
      value of $180,102; 65,000 restricted shares of our common stock were issued
      on
      June 30, 2006, when the market price of our shares was $2.30, resulting in
      an
      intrinsic value of $149,500. All of these shares were issued pursuant to an
      exemption from registration under Section 4(2) of the Securities Act of 1933,
      as
      amended.





**ITEM
              3**
            **Defaults
                Upon Senior Securities**




None.





**ITEM
              4**
            **Submission
                of Matters to a vote of Security
                Holders**




At
      the
      Annual Meeting of Shareholders held on June 28, 2006 the shareholders approved
      the following:





PROPOSAL
      NO. 1





1.
            The
                election of Lawrence J. Matteson as a director of the Corporation
                to serve
                for the ensuing year and until his successor is duly elected and
                qualified.





For:
                35,960,744
            Against:
                0
            Withheld:
                313,530





2.
            The
                election of Robert C. Munro as a director of the Corporation to serve
                for
                the ensuing year and until his successor is duly elected and qualified.





For:
                36,040,640
            Against:
                0
            Withheld:
                233,634





3.
            The
                election of Robert A. Olins as a director of the Corporation to serve
                for
                the ensuing year and until his successor is duly elected and qualified.





For:
                35,964,965
            Against:
                0
            Withheld:
                309,309





4.
            The
                election of Claude Piaget as a director of the Corporation to serve
                for
                the ensuing year and until his successor is duly elected and qualified.





For:
                35,964,340
            Against:
                0
            Withheld:
                309,934





5.
            The
                election of David F. Hakala as a director of the Corporation to serve
                for
                the ensuing year and until his successor is duly elected and qualified.





For:
                36,043,551
            Against:
                0
            Withheld:
                230,723





46


6.
            The
                election of Herbert Ehrenthal as a director of the Corporation to
                serve
                for the ensuing year and until his successor is duly elected and
                qualified.





For:
                36,045,563
            Against:
                0
            Withheld:
                228,711





7.
            The
                election of Jerilyn Kessel as a director of the Corporation to serve
                for
                the ensuing year and until his successor is duly elected and qualified.





For:
                36,035,763
            Against:
                0
            Withheld:
                238,511








PROPOSAL
      NO. 2





8.
            To
                approve an amendment to the Corporation's Restated Certificate of
                Incorporation, as amended, to increase the number of authorized Common
                Shares, $.01 par value, from 50,000,000 to 100,000,000.





For:
                35,270,697
            Against:
                838,157
            Abstain:
                181,275





47


PROPOSAL
      NO. 3





9.
            To
                approve the Corporation’s 2006 Incentive Plan. As described in our
                Supplemental Notice sent to shareholders on or around June 22, 2006,
                the
                polls were kept open solely with respect to Proposal Number Three
                through
                the close of business on Wednesday, July 5, 2006, a period of seven
                days
                after the date of the Meeting, whereupon the polls were closed and
                the
                Inspector of Elections was given the opportunity to compute the final
                Shareholders’ vote with respect to Proposal No.
                Three.





For:
                6,710,311
            Against:
                2,414,768
            Abstain:
                201,815Broker
                Non Votes: 26,954,266





PROPOSAL
      NO. 4





10.
            The
                ratification of the appointment of Odenberg, Ullakko, Muranishi & Co.
                LLP (OUM) as the Corporation’s independent public accountants for the
                fiscal year ending December 31, 2006.





For:
                35,995,178
            Against:
                193,612
            Abstain:
                101,339





**ITEM
              5**
            **Other
                Information**  Our
                Audit Committee determined that Robert A. Olins, our Chief Executive
                Officer, Secretary, Treasurer and a Director failed to report the
                sale of
                an aggregate of 70,556 of our common shares in August 2005 and February
                2006 at sales prices ranging from $5.30 to $3.00. Pursuant to Section 16
                of the Exchange Act, Mr. Olins has filed all delinquent reports and
                disgorged $22,273 in “short-swing profits” that he realized from the
                sales.







**ITEM
              6**
            **Exhibits
                and Reports on Form 8-K**





(a)
            Exhibits





4.1
            Restated
                Certificate of Incorporation*


4.2
            Certificate
                of Amendment of Certificate of Incorporation of SpatiaLight,
                Inc.


4.3
            Bylaws*


10.1
            Letter
                Agreement between SpatiaLight, Inc. and certain investors dated May
                26,
                2006


10.2
            General
                Release agreement between SpatiaLight, Inc. and Theodore H. Banzhaf
                signed
                June 13, 2006


10.3
            LCoS
                Supply Agreement between SpatiaLight, Inc. and LG Electronics, Inc.
                dated
                July 1, 2004†


10.4
            SpatiaLight
                2006 Incentive Plan 10.5
            Securities
              Purchase Agreement among Spatialight, Inc. and Certain Purchasers dated
              as
              of August 9, 2006 10.6
            Registration Rights Agreement among
              Spatialight, Inc. and Certain Purchasers dated as of August 9,
              2006


31.1
            Rule
                13a-14(a)/15d-14(a) Certification of Robert A.
                Olins


32.1
            Certification
                of Robert A. Olins Pursuant to 18 U.S.C. Section 1350, As Adopted
                Pursuant
                to Section 906 of the Sarbanes-Oxley Act of
                2002.





*Previously
      filed.


† Confidential
      Treatment has been requested with respect to certain portions of this exhibit.
      Omitted portions have been filed separately with the Securities and Exchange
      Commission.





48





**SIGNATURES**





In
      accordance with the requirements of the Securities Exchange Act of 1934, as
      amended, the Registrant has duly caused the report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized.






Date:August
                9,
                2006
              
              SpatiaLight,
                Inc.
              
              
              By:/s/
                Robert A.
                Olins
              Robert
                A. Olins
              Chief
                Executive Officer, Principal Financial
              and
                Accounting Officer





49