**Table
          of Contents**





**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      10-Q/A**


(Mark
      One)





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




For
      the
      quarterly period ended September 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
xNo
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
oNo
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: 44,482,616 common shares as of January 31,
      2007.





**Table
        of Contents**


**Explanatory
      Note**





This
      amendment to our Quarterly Report on Form 10-Q/A is being filed for the purposes
      of reclassifying related party prepaid interest as a deduction from
      stockholders’ equity. Previously we had recorded the related party prepaid
      interest as an asset. The SEC staff has expressed the view that “only notes or
      receivables that are received by a grantor in exchange for the issuance of
      fully
      vested nonforfeitable equity instruments to a party unrelated to the grantor,
      and that are fully secured by specific assets other than the equity instruments
      granted can be classified in the grantor’s balance sheet as assets”. As the
      prepaid interest is not secured by specific assets, we are reclassifying
      $1,157,133 from current assets as of September 30, 2006 and December 31, 2005
      and $1,446,416 and $2,314,265 from long term assets as of September 30, 2006
      and
      December 31, 2005, respectively, totaling $2,603,549 and $3,471,398 as of
      September 30, 2006 and December 31, 2005, respectively, as a deduction from
      stockholders’ equity as of those dates.


**Table
            of Contents**




SPATIALIGHT,
      INC.


Quarterly
      Report on Form 10-Q/A


For
      the
      Quarter Ended September 30, 2006





Table
      of Contents





**PART
                I**
            **FINANCIAL
                INFORMATION**Item
                1.
            Condensed
                Consolidated Financial Statements
                (unaudited)Condensed
                Consolidated Balance Sheets as of September 30, 2006
                and December 31, 2005
            3Condensed
                Consolidated Statements of Operations for the Three
                and Nine Months Ended September 30, 2006 and 2005
            4Condensed
                Consolidated Statement of Stockholders’ Equity
                (Deficit) for the Nine Months Ended September 30, 2006
            5Condensed
                Consolidated Statements of Cash Flows for the Nine
                Months Ended September 30, 2006 and 2005
            6Notes
                to Condensed Consolidated Financial
                Statements
            7Item
                2.
            Management’s
                Discussion and Analysis of Financial Condition and
                Results of Operations
            31Item
                3.
            Quantitative
                and Qualitative Disclosures about Market
                Risks
            44Item
                4.
            Controls
                and Procedures
            45**PART
                II**
            **OTHER
                INFORMATION**Item
                1.
            Legal
                Proceedings.
            47Item
                1A.
            Business
                Risks and Uncertainties.
            47Item
                2.
            Unregistered
                Sales of Securities and Use of
                Proceeds
            60Item
                3.
            Defaults
                Upon Senior Securities.
            61Item
                4.
            Submission
                of Matters to a Vote of Security
                Holders
            61Item
                5.
            Other
                Information
            61Item
                6.
            Exhibits
                and Reports on Form 8-K
            62Signatures
            63


-2-
 **Table
          of Contents**




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




Item
      1.Condensed
      Consolidated Financial Statements




SPATIALIGHT,
                  INC.CONDENSED
                  CONSOLIDATED BALANCE SHEETSSeptember
                  30,
              
              December
                  31,2006
              
              2005(unaudited)
              
              (Note
                  2)ASSETSCurrent
                  assetsCash
                  and cash equivalents
              
              $
              280,844
              
              $
              42,565Accounts
                  receivable, net of $47,055 and $0 allowance for doubtfulaccounts
                  as of September 30, 2006 and December 31, 2005,
                  respectively
              
              
              270,612
              
              
              139,676Inventory,
                  net
              
              
              308,668
              
              
              756,723Prepaids
                  and other current assets
              
              
              307,065
              
              
              255,157Total
                  current assets
              
              
              1,167,189
              
              
              1,194,121Property,
                  plant and equipment, net
              
              
              6,744,732
              
              
              6,813,520Other
                  assets
              
              
              47,478
              
              
              73,437Total
                  assets
              
              $
              7,959,399
              
              $
              8,081,078LIABILITIES,
                  TEMPORARY EQUITY, AND STOCKHOLDERS' EQUITY (DEFICIT)Current
                  liabilitiesShort
                  term loans
              
              $
              830,009
              
              $
              572,025Short
                  term loan from related parties
              
              
              244,000
              
              
              224,384Accounts
                  payable
              
              
              1,580,121
              
              
              1,665,711Fair
                  value of warrants to purchase common stock
              
              
              129,279
              
              
              778,270Accrued
                  expenses and other current liabilities
              
              
              1,573,442
              
              
              1,389,427Total
                  current liabilities
              
              
              4,356,851
              
              
              4,629,817Senior
                  secured and related party convertible notes
              
              
              10,673,093
              
              
              10,340,113Total
                  liabilities
              
              
              15,029,944
              
              
              14,969,930Commitments
                  and contingenciesTemporary
                  equity:Common
                  stock, subject to registration, $0.01 par value;1,031,770
                  and 571,431 shares issued and outstanding, net oforiginal
                  fair value of warrants of $137,966 and $958,625 andissuance
                  costs of $127,500 and $15,000 at September 30, 2006and
                  December 31, 2005, respectively
              
              
              1,947,909
              
              
              1,026,374Total
                  liabilities and temporary equity
              
              
              16,977,853
              
              
              15,996,304Stockholders'
                  equity (deficit):Common
                  stock, $.01 par value:100,000,000
                  and 50,000,000 shares authorized as of September 30, 2006
                  andDecember
                  31, 2005, respectively; 40,906,883 and 36,777,069 shares issuedand
                  outstanding at September 30, 2006 and December 31, 2005,
                  respectively
              
              
              409,069
              
              
              367,771Additional
                  paid-in capital
              
              
              89,652,518
              
              
              76,631,925Related
                  party prepaid interest
              
              
              (2,603,549
              )
              
              (3,471,398
              )Other
                  comprehensive income
              
              
              300,585
              
              
              222,317Accumulated
                  deficit
              
              
              (96,777,077
              )
              
              (81,665,841
              )Total
                  stockholders' equity (deficit)
              
              
              (9,018,454
              )
              
              (7,915,226
              )Total
                  liabilities, temporary equity, and stockholders' equity
                  (deficit)
              
              $
              7,959,399
              
              $
              8,081,078See
                  accompanying notes to condensed consolidated financial
                  statements.


-3-
 **Table
          of Contents**




SPATIALIGHT,
                  INC.CONDENSED
                  CONSOLIDATED STATEMENTS OF OPERATIONS
                  (unaudited)Three
                  months ended September 30,
              
              Nine
                  months ended September 30,2006
              
              2005
              
              2006
              
              2005Revenue
              
              $
              298,046
              
              $
              58,457
              
              $
              442,888
              
              $
              197,365Cost
                  of revenue
              
              
              1,665,324
              
              
              57,492
              
              
              4,815,668
              
              
              216,380Gross
                  margin
              
              
              (1,367,278
              )
              
              965
              
              
              (4,372,780
              )
              
              (19,015
              )Selling,
                  general and administrative expenses (including stock-basedgeneral
                  and administrative expenses of $184,797 and $78,887for
                  the three month periods ended September 30, 2006 and 2005,respectively,
                  and $1,829,790 and $186,187 for the nine monthperiods
                  ended September 30, 2006 and 2005, respectively).
              
              
              1,918,043
              
              
              1,735,892
              
              
              7,452,509
              
              
              5,322,259Research
                  and development expenses
              
              
              269,582
              
              
              1,081,020
              
              
              922,828
              
              
              2,740,150Total
                  operating expenses
              
              
              2,187,625
              
              
              2,816,912
              
              
              8,375,337
              
              
              8,062,409Operating
                  loss
              
              
              (3,554,903
              )
              
              (2,815,947
              )
              
              (12,748,117
              )
              
              (8,081,424
              )Other
                  income (expense):Interest
                  expense:Interest
                  expense
              
              
              (40,206
              )
              
              (270,631
              )
              
              (355,178
              )
              
              (805,541
              )Non-cash
                  interest expense
              
              
              (643,907
              )
              
              (631,393
              )
              
              (2,130,407
              )
              
              (1,186,577
              )Total
                  interest expense
              
              
              (684,113
              )
              
              (902,024
              )
              
              (2,485,585
              )
              
              (1,992,118
              )Gain
                  from revaluation of note purchase option and investmentright
                  liabilities
              
              
              -
              
              
              96,602
              
              
              -
              
              
              754,374Gain
                  from revaluation of warrants
              
              
              21,945
              
              
              -
              
              
              43,638
              
              
              -Foreign
                  currency translation gain
              
              
              27,283
              
              
              -
              
              
              39,635
              
              
              -Interest
                  and other income
              
              
              15,803
              
              
              618
              
              
              39,993
              
              
              28,160Total
                  other income (expenses)
              
              
              (619,082
              )
              
              (804,804
              )
              
              (2,362,319
              )
              
              (1,209,584
              )Loss
                  before income tax expense
              
              
              (4,173,985
              )
              
              (3,620,751
              )
              
              (15,110,436
              )
              
              (9,291,008
              )Income
                  tax expense
              
              
              -
              
              
              -
              
              
              800
              
              
              2,725Net
                  loss
              
              $
              (4,173,985
              )
              $
              (3,620,751
              )
              $
              (15,111,236
              )
              $
              (9,293,733
              )Net
                  loss per share - basic and diluted
              
              $
              (0.10
              )
              $
              (0.10
              )
              $
              (0.38
              )
              $
              (0.26
              )Weighted
                  average shares used in computingnet
                  loss per share- basic and diluted
              
              
              41,266,681
              
              
              36,490,446
              
              
              40,002,827
              
              
              36,093,858See
                  accompanying notes to condensed consolidated financial
                  statements




-4-
 **Table
          of Contents**


SPATIALIGHT,
                  INC.CONDENSED
                  CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
                  (DEFICIT) (unaudited)NINE
                  MONTHS ENDED SEPTEMBER 30, 2006**ADDITIONAL**
              
              **RELATED
                  PARTY**
              
              
              
              **OTHER**
              
              **TOTAL****COMMON
                  STOCK**
              
              **PAID-IN**
              
              **PREPAID**
              
              **ACCUMULATED**
              
              **COMPREHEN-**
              
              **STOCKHOLDERS'****SHARES**
              
              **AMOUNT**
              
              **CAPITAL**
              
              **INTEREST**
              
              **DEFICIT**
              
              **SIVE
                  INCOME**
              
              **EQUITY
                  (DEFICIT)**Balance,
                  January 1, 2006(as restated - see Note 2)
              
              
              36,777,069
              
              $
              367,771
              
              $
              76,631,925
              
              $
              (3,471,398
              )
              $
              (81,665,841
              )
              $
              222,317
              
              $
              (7,915,226
              )Exercise
                  of stock options
              
              
              50,000
              
              
              500
              
              
              39,745
              
              
              -
              
              
              -
              
              
              -
              
              
              40,245Stock-based
                  compensation expense
              
              
              -
              
              
              -
              
              
              1,829,790
              
              
              -
              
              
              -
              
              
              -
              
              
              1,829,790Issuance
                  of common shares, net of issuance costsof
                  $172,625
              
              
              3,151,000
              
              
              31,510
              
              
              8,419,666
              
              
              -
              
              
              -
              
              
              -
              
              
              8,451,176Issuance
                  of common shares for interest andliquidated
                  damages charges
              
              
              357,383
              
              
              3,574
              
              
              945,140
              
              
              -
              
              
              -
              
              
              -
              
              
              948,714Reclassification
                  from temporary equity of October2005
                  Financing shares upon effectiveness ofregistration
                  statement, including $743,319 marketvalue
                  of warrants issued
              
              
              571,431
              
              
              5,714
              
              
              1,763,979
              
              
              -
              
              
              -
              
              
              -
              
              
              1,769,693Short
                  swing profit
              
              
              -
              
              
              -
              
              
              22,273
              
              
              -
              
              
              -
              
              
              -
              
              
              22,273Amortization
                  of pre-paid interest
              
              
              -
              
              
              -
              
              
              -
              
              
              867,849
              
              
              -
              
              
              -
              
              
              867,849Comprehensive
                  loss:Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (15,111,236
              )
              
              -
              
              
              (15,111,236
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              78,268
              
              
              78,268Total
                  comprehensive loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (15,111,236
              )
              
              78,268
              
              
              (15,032,968
              )Balance,
                  September 30, 2006
              
              
              40,906,883
              
              $
              409,069
              
              $
              89,652,518
              
              $
              (2,603,549
              )
              $
              (96,777,077
              )
              $
              300,585
              
              $
              (9,018,454
              )See
                  accompanying notes to condensed consolidated financial
                  statements






-5-
 **Table
          of Contents**


SPATIALIGHT,
                      INC.CONDENSED
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                      (unaudited)Nine
                      months ended September 30,2006
                  
                  2005Cash
                      flows from operating activities:Net
                      loss
                  
                  $
                  (15,111,236
                  )
                  $
                  (9,293,733
                  )Adjustments
                      to reconcile net loss to net cash used in operating
                      activities:Inventory
                      reserve adjustment
                  
                  
                  442,433
                  
                  
                  -Depreciation
                      and amortization
                  
                  
                  669,055
                  
                  
                  449,631Stock-based
                      general and administrative expenses
                  
                  
                  1,829,790
                  
                  
                  186,187Non-cash
                      interest expense
                  
                  
                  2,130,407
                  
                  
                  1,186,577Gain
                      from revaluation of note purchase option and investment right
                      liabilities
                  
                  
                  -
                  
                  
                  (754,374
                  )Gain
                      from revaluation of warrants
                  
                  
                  (43,638
                  )
                  
                  -Non-cash
                      foreign currency translation gain
                  
                  
                  (39,635
                  )
                  
                  -Accrued
                      interest on notes receivable from stockholder
                  
                  
                  -
                  
                  
                  (7,643
                  )Gain
                      on sale of fixed assets
                  
                  
                  (3,376
                  )
                  
                  -Changes
                      in operating assets and liabilities:Accounts
                      receivable
                  
                  
                  (130,936
                  )
                  
                  121,252Inventory
                  
                  
                  5,623
                  
                  
                  (38,526
                  )Prepaids
                      and other current assets
                  
                  
                  (46,021
                  )
                  
                  196,489Other
                      assets
                  
                  
                  25,959
                  
                  
                  50,332Accounts
                      payable
                  
                  
                  (43,723
                  )
                  
                  588,285Accrued
                      expenses and other current liabilities
                  
                  
                  197,262
                  
                  
                  (438,987
                  )Net
                      cash used in operating activities
                  
                  
                  (10,118,036
                  )
                  
                  (7,754,510
                  )Cash
                      flows from investing activities:Purchase
                      of property, plant and equipment
                  
                  
                  (580,220
                  )
                  
                  (3,901,566
                  )Proceeds
                      from sale of property, plant and equipment
                  
                  
                  84,166
                  
                  
                  -Net
                      cash used in investing activities
                  
                  
                  (496,054
                  )
                  
                  (3,901,566
                  )Cash
                      flows from financing actitivies:Payments
                      received from notes receivable
                  
                  
                  -
                  
                  
                  249,105Proceeds
                      from issuance of short-term notes
                  
                  
                  6,811,150
                  
                  
                  -Payment
                      on short-term notes
                  
                  
                  (6,559,226
                  )
                  
                  -Proceeds
                      from the sale of common shares and warrants, net of issuance
                      costs
                  
                  
                  10,559,324
                  
                  
                  2,641,395Proceeds
                      from exercise of warrants and options
                  
                  
                  40,245
                  
                  
                  395,987Net
                      cash provided by financing activities
                  
                  
                  10,851,493
                  
                  
                  3,286,487Net
                      increase (decrease) in cash and cash equivalents
                  
                  
                  237,403
                  
                  
                  (8,369,589
                  )Effect
                      of exchange rate changes on cash
                  
                  
                  876
                  
                  
                  1,740Cash
                      and cash equivalents at beginning of period
                  
                  
                  42,565
                  
                  
                  9,087,551Cash
                      and cash equivalents at end of period
                  
                  $
                  280,844
                  
                  $
                  719,702Non-cash
                      financing activities:Warrants
                      issued for fundraising services provided
                  
                  $
                  -
                  
                  $
                  73,387Shares
                      issued for interest and liquidated damages
                  
                  $
                  948,714
                  
                  $
                  -Supplemental
                      disclosure of cash flow information:Income
                      taxes paid during the period
                  
                  $
                  1,800
                  
                  $
                  2,725Interest
                      paid during the period
                  
                  $
                  302,758
                  
                  $
                  754,821See
                      accompanying notes to condensed consolidated financial
                      statements.
   -6-
 **Table
              of Contents**
  **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.





**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 nine month period ended September
      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 (see “Reclassifications”
below regarding certain reclassifications made to the December 31, 2005 balance
      sheet to conform to the September 30, 2006 presentation).





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 nine 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  -7-
 **Table
            of Contents**
  **SPATIALIGHT,
        INC.**
 Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


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.





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.





Reclassification
      - Certain prior year amounts have been reclassified in order to conform to
      current period presentation. In our Annual Report on Form 10-K for the year
      ended December 31, 2005, we reported prepaid non-cash interest to related party
      totaling $3,471,398 as an asset. As of September 30, 2006, we began reporting
      prepaid non-cash interest to related party as a deduction from stockholders’
equity in accordance with the SEC staff’s view that “only notes or receivables
      that are received by a grantor in exchange for the issuance of fully vested
      nonforfeitable equity instruments to a party unrelated to the grantor, and
      that
      are fully secured by specific assets other than the equity instruments granted
      can be classified in the grantor’s balance sheet as assets”.





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





From
      inception through September 30, 2006, we have sustained recurring net losses
      from operations totaling approximately $97 million and at September 30, 2006,
      had total stockholders’ deficit of approximately $9.0 million and working
      capital deficiency of approximately $3.2 million. During the nine months ended
      September 30, 2006, we experienced a net cash increase of approximately $0.2
      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 in mid-January 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. In the third quarter of 2006, cash was primarily
      provided by the net proceeds of approximately $1.6 million that we received
      from
      the sale of 761,500 of our common shares on August 9, 2006 at a purchase price
      of $2.25 per share and $0.5 million that we received from the sale of 270,270
      of
      our common shares on September 26, 2006 at a purchase price of $1.85 per share.
      The funds from these financings were used to fund our operations for the third
      quarter of 2006. We recognized net losses for the nine months ended September
      30, 2006, of approximately $15.1 million.  -8-
 **Table
            of Contents**
  **SPATIALIGHT,
        INC.**
 Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


We
      expect
      to meet our immediate cash needs and fund our immediate working capital
      requirements with the following sources: 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.
      If
      we are unable to obtain additional funds on reasonable terms, we may be unable
      to continue our operations at current levels beyond November 2006, or at
      all.





**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 nine months 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 $184,797 and $1,829,790 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 nine months ended September 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
                  months ended September 30, 2006
              
              Nine
                  months ended September 30, 2006Dividend
                  yield
              
              
              -
              
              
              -Expected
                  volatility
              
              
              97.9
              %
              
              92.8
                  % - 99.02
              %Risk-free
                  interest rate
              
              
              5.2
              %
              
              4.6%
                  - 5.2
              %Expected
                  lives (in years)
              
              
              5.8
              
              
              5.2
                  - 5.8


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


-9-
 **Table
            of Contents**





**SPATIALIGHT,
      INC.**


Notes
      to
      Condensed Consolidated Financial Statements (Unaudited)






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 nine months ended September 30, 2006 was $1.95.
      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.




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 September 30, 2005
              
              Nine
                  months ended September 30, 2005Net
                  loss as reported
              
              $
              (3,620,751
              )
              $
              (9,293,733
              )Add:
                  Stock-based employee/director compensationincluded
                  in reported net loss
              
              
              5,500
              
              
              22,000Deduct:
                  total stock-based employee compensationdetermined
                  under fair value method for all awards
              
              
              (277,645
              )
              
              (2,591,075
              )Proforma
                  net loss, as adjusted
              
              $
              (3,892,896
              )
              $
              (11,862,808
              )Loss
                  per share:Basic
                  and diluted, as reported
              
              $
              (0.10
              )
              $
              (0.26
              )Basic
                  and diluted, as adjusted
              
              $
              (0.11
              )
              $
              (0.33
              )


The
      assumptions used to determine the pro forma expenses under the Black-Scholes
      option model for the three and nine months ended September 30, 2005 under SFAS
      123 were based on the following assumptions: expected dividend yield: 0 for
      both
      periods; expected volatility: 93% and 90%, respectively; expected lives, in
      years: 2 and 4, respectively; and risk-free interest rate: 4.0% and 4.07%,
      respectively. In the pro forma information for periods prior to 2006, we
      accounted for forfeitures as they occurred.


-10-
 **Table
            of Contents**




**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 nine months ended September 30, 2006 are as follows:




Number
                  of Shares
              
              Weighted
                  Average Exercise Price
              
              Weighted
                  Average Remaining Contractual Term
                (in
                  years)
              
              Aggregate
                  Intrinsic Value at
                September
                  30, 2006Outstanding
                  December 31, 2005
              
              
              5,882,394
              
              $
              4.06
              
              
              5.79Options
                  granted under the plans
              
              
              900,000
              
              $
              2.57Options
                  exercised
              
              
              (50,000
              )
              $
              0.80Options
                  forfeited or expired
              
              
              (662,500
              )
              $
              9.00Outstanding
                  September 30, 2006
              
              
              6,069,894
              
              $
              3.41
              
              
              5.82
              
              $
              885,078Options
                  vested and exercisableat
                  September 30, 2006
              
              
              5,907,394
              
              $
              3.42
              
              
              5.72
              
              $
              885,078


Aggregate
      intrinsic value is the sum of the amounts by which the quoted market price
      of
      our stock at September 30, 2006, $2.09 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 September 30, 2006. The aggregated intrinsic value of
      options exercised on the dates the options were exercised was $394,300 for
      the
      three month period ended September 30, 2005. The aggregated intrinsic value
      of
      options exercised on the dates the options were exercised was $112,865 and
      $1,450,256 for the nine month period ended September 30, 2006 and 2005,
      respectively.




As
      of
      September 30, 2006, total expected compensation cost of options outstanding
      but
      not yet vested is approximately $209,480. This cost is expected to be recognized
      through June 2008. We recorded no income tax benefits for stock-based
      compensation expense arrangements for the nine months ended September 30, 2006,
      as we have cumulative operating losses, for which a full valuation allowance
      has
      been established.


-11-
 **Table
            of Contents**




**SPATIALIGHT,
      INC.**


Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


Note5.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
      nine months ended September 30, 2006 and 2005 because the effect of their
      assumed exercise would be antidilutive.




As
                of September 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
            
            
            6,834,420
            
            $
            3.41
            
            
            6,473,711
            
            $
            4.01Convertible
                notes
            
            
            3,404,807
            
            $
            3.29
            
            
            3,404,807
            
            $
            3.29Total
            
            
            10,239,227
            
            
            
            
            
            9,878,518




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





Property,
      plant and equipment include:




As
                ofSeptember
                30, 2006
            
            December
                31, 2005Building
            
            $
            4,635,683
            
            $
            4,360,663Other
                equipment and instruments
            
            
            2,380,236
            
            
            2,659,653Machinery
                and manufacturing equipment
            
            
            1,684,192
            
            
            1,141,726Office
                furniture and fixtures
            
            
            429,599
            
            
            590,696Tooling
            
            
            371,700
            
            
            371,700Leasehold
                improvements
            
            
            165,937
            
            
            175,654Computer
                hardware and software
            
            
            347,825
            
            
            215,109Total
                property, plant and equipment
            
            
            10,015,172
            
            
            9,515,201Accumulated
                depreciation
            
            
            (3,270,440
            )
            
            (2,701,681
            )Property,
                plant and equipment, net
            
            $
            6,744,732
            
            $
            6,813,520




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





Short-Term
      Loans





*Short-Term
      Loan From Related Parties*





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. During the third quarter of 2006, we


-12-
 **Table
            of Contents**




**SPATIALIGHT,
      INC.**


Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


had
      net
      short term borrowings of $100,000 from Herbert Ehrenthal, one of our Directors,
      and $144,000 from Robert A. Olins, our former Chief Executive Officer,
      Secretary, Treasurer, and a Director. These short term borrowings have a term
      of
      less than three months and bear interest at 8% per annum.





*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 9/30/06
              
              
              6.72
              %
              
              9.20
              %
              
              10.51
              %
              
              10.53
              %
              
              0.00
              %Maturity
                  date
              
              
              9/22/2007
              
              
              4/28/2007
              
              
              1/10/2007
              
              
              1/10/2007
              
              
              3/23/2007Maximum
                  amount of line
              
              
              200,000
              
              
              200,000
              
              
              300,000
              
              
              100,000
              
              
              -
              
              
              800,000Amount
                  outstanding at 9/30/06
              
              
              199,124
              
              
              199,752
              
              
              298,228
              
              
              98,763
              
              
              -
              
              
              795,868Remaining
                  available
              
              
              876
              
              
              248
              
              
              1,772
              
              
              1,237
              
              
              -
              
              
              4,132Approximate
                  US dollar equivalent
              
              $
              207,666
              
              $
              208,321
              
              $
              311,022
              
              $
              103,000
              
              $
              -
              
              $
              830,009
 
 (1)
              Yield
                  ratio of annual bank debenture plus
                  1.85%
 (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. In early October 2006, the Korean Exchange Bank
      changed the terms of the line of credit to a loan at the same interest rate
      to
      be repaid in three monthly installments with the final payment due January
      10,
      2007. In late October 2006, the Kyongnam Bank extended the expiration date
      of
      the line of credit from October 28, 2006 to April 28, 2007 in exchange for
      an
      increase in the interest rate by 1%.





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.


-13-
 **Table
            of Contents**




**SPATIALIGHT,
      INC.**


Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


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





*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 former 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 September 30, 2006, total prepaid interest on the
      Argyle notes for the period October 1, 2006 to December 31, 2008 is $2,603,549,
      and is classified as a deduction from stockholders’ equity in the
      accompanying condensed consolidated balance sheets.


-14-
 **Table
            of Contents**




**SPATIALIGHT,
      INC.**


Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


Non-cash
      interest expense includes $814,389 and $574,134 for the nine months ended
      September 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
      September 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 10-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 former 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  -15-
 **Table
            of Contents**
  **SPATIALIGHT,
        INC.**
 Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


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.





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 September 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
      September 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-
 **Table
            of Contents**
  **SPATIALIGHT,
        INC.**
 Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


Activity
      in notes payable for the nine months ended September 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 September 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
              )
              
              -
              
              
              39,150
              
              
              -
              
              
              (60,910
              )Reimbursement
                  of investor's legal fees
              
              
              (63,889
              )
              
              -
              
              
              25,000
              
              
              -
              
              
              (38,889
              )Senior
                  Secured Convertible NotesAIR
                  discount
              
              
              (683,938
              )
              
              -
              
              
              268,830
              
              
              -
              
              
              (415,108
              )Total
              
              $
              10,340,113
              
              $
              -
              
              $
              332,980
              
              $
              -
              
              $
              10,673,093




**Interest:**Accrued
                    Argyle note 6%
                
                $
                -
                
                $
                53,460
                
                $
                -
                
                $
                (53,460
                )
                $
                -Argyle
                    note beneficial interest
                
                
                -
                
                
                814,389
                
                
                -
                
                
                (814,389
                )
                
                -Senior
                    Secured Convertible Notes 10%
                
                
                84,932
                
                
                744,991
                
                
                (250,083
                )
                
                (497,647
                )
                
                82,193Total
                
                $
                84,932
                
                $
                1,612,840
                
                $
                (250,083
                )
                $
                (1,365,496
                )
                $
                82,193


Non-cash
      interest expense is as follows:




Nine
                  months ended September 30,2006
              
              2005Amortization
                  of Senior Secured Convertible Notes
              
              $
              332,980
              
              $
              332,980Senior
                  Secured Convertible Notes 10% interest paid in common
                  stock
              
              
              497,647
              
              
              -Amortization
                  of Argyle note discount
              
              
              -
              
              
              11,000Accrual
                  of potential registration rights payment
              
              
              -
              
              
              234,000Liquidated
                  damages on the October 2005 and January 2006 financing
              
              
              437,817
              
              
              -Beneficial
                  conversion privileges of interest on Argyle note
              
              
              814,389
              
              
              574,134Amortization
                  of prepaid financing costs
              
              
              47,574
              
              
              34,463Total
                  non-cash interest expense
              
              $
              2,130,407
              
              $
              1,186,577




-17-
 **Table
            of Contents**


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


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




**Debt
                  Principal:**
              
              **Balance
                  at**
                **June
                  30, 2006**
              
              **Addition
                  or New Discount**
              
              **(Payment)
                  or Discount Amortization**
              
              **Conversion
                  to Equity**
              
              **Balance
                  at September 30, 2006**Argyle
                  note
              
              $
              1,188,000
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              1,188,000Senior
                  Secured Convertible Notes
              
              
              10,000,000
              
              
              -
              
              
              -
              
              
              -
              
              
              10,000,000Senior
                  Secured Convertible Notesbeneficial
                  conversion feature
              
              
              (73,960
              )
              
              -
              
              
              13,050
              
              
              -
              
              
              (60,910
              )Reimbursement
                  of investor's legal fees
              
              
              (47,222
              )
              
              -
              
              
              8,333
              
              
              -
              
              
              (38,889
              )Senior
                  Secured Convertible NotesAIR
                  discount
              
              
              (504,718
              )
              
              -
              
              
              89,610
              
              
              -
              
              
              (415,108
              )Total
              
              $
              10,562,100
              
              $
              -
              
              $
              110,993
              
              $
              -
              
              $
              10,673,093**Interest:**Accrued
                  Argyle note 6%
              
              $
              -
              
              $
              17,820
              
              $
              -
              
              $
              (17,820
              )
              $
              -Argyle
                  note beneficial interest
              
              
              -
              
              
              271,463
              
              
              -
              
              
              (271,463
              )
              
              -Senior
                  Secured Convertible Notes 10%
              
              
              82,193
              
              
              245,593
              
              
              -
              
              
              (245,593
              )
              
              82,193Total
              
              $
              82,193
              
              $
              534,876
              
              $
              -
              
              $
              (534,876
              )
              $
              82,193




Non-cash
      interest expense is as follows:




Three
                  months ended September 30,2006
              
              2005Amortization
                  of Senior Secured Convertible Notes
              
              $
              110,993
              
              $
              110,993Senior
                  Secured Convertible Notes 10% interest paid in common
                  stock
              
              
              245,593
              
              
              -Accrual
                  of potential registration rights payment
              
              
              -
              
              
              234,000Beneficial
                  conversion privileges of interest on Argyle note
              
              
              271,463
              
              
              271,463Amortization
                  of prepaid financing costs
              
              
              15,858
              
              
              14,937Total
                  non-cash interest expense
              
              $
              643,907
              
              $
              631,393




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





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 to allow for issuance of the shares pursuant to
      arrangements to fund working capital and other general corporate
      purposes.





Short-Swing
      Profits





Our
      Audit
      Committee determined that Robert A. Olins, our former 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 the delinquent reports and disgorged $22,273
      in


-18-
 **Table
            of Contents**




**SPATIALIGHT,
      INC.**


Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


“short
      swing profits” that he realized from the sales. These funds are recorded as an
      increase in additional paid in capital during the third quarter
      2006.





Exercise
      of Stock Options and Warrants in the Three and Nine Months Ended September
      30,
      2006





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





Issuance
      of Shares, Stock Options and Warrants During the Nine Months ended September
      30,
      2006





On
      September 26, 2006, when the price of our common stock was $2.20, we sold
      270,270 of our common shares in a private placement to certain institutional
      investors that have previously purchased our common shares in private
      transactions on several occasions and are currently shareholders of our Company.
      The purchase price of the common shares was $1.85 per share. The transaction
      included the issuance of warrants to purchase 89,189 common shares with an
      exercise price of $2.25 per share exercisable within five years from the date
      of
      issuance. We received $500,000 in gross proceeds, before issuance costs of
      $17,500, from the sale of these shares, which were used for working capital
      and
      other general corporate purposes. We are required under a registration rights
      agreement to file a registration statement for the resale of the shares within
      30 calendar days from the closing date and have the registration statement
      declared effective no later than 90 calendar days after the closing date. The
      registration rights agreement provides that if we do not meet the above
      deadlines, we may be required to pay an amount equal to 2% of the aggregate
      purchase price or $10,000 as partial liquidated damages when each of these
      dates
      occur and an additional 1% for each month thereafter with no contractual
      maximum.





In
      accordance with EITF 00-19, and the terms of the above warrants, the fair value
      of the warrants at inception was accounted for as a liability, with an
      offsetting reduction to the carrying value of the common stock. The warrant
      liability will be reclassified to equity upon the effective date of the
      registration statement. The fair value of the warrants at inception, of
      $137,966, was calculated using the Black-Scholes option pricing model, using
      the
      following assumptions: stock price $2.20, exercise price $2.25, volatility
      86%,
      risk free interest rate 4.56%, remaining contractual life 5 years and dividend
      yield of zero. On September 30, 2006, the fair value of the warrants was
      revalued and calculated at $129,279, using the Black-Scholes option pricing
      model, using the following assumptions: stock price $2.09, exercise price $2.25,
      volatility 86%, risk free interest rate 4.56%, remaining contractual life 5
      years and dividend yield of zero. The decrease of $8,687 is reflected as a
      gain
      from revaluation of warrants in the consolidated statement of operations during
      the three and nine months ended September 30, 2006.





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  -19-
 **Table
            of Contents**
  **SPATIALIGHT,
        INC.**
 Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


until
      the
      registration statement becomes effective. Based on the above determination,
      the
      Company had classified the $344,534 value of common stock subject to
      registration (net of $17,500 issuance costs and warrants valued at $137,966)
      as
      temporary equity as of September 30, 2006 related to the September 2006
      Financing.





On
      August
      31, 2006, when the price of our common stock was $2.27, we issued 109,143 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 August 31, 2006.





On
      August
      9, 2006, when the price of our common stock was $2.60, we issued 761,500 of
      our
      common shares in a private placement to an institutional investor (“August 2006
      Financing”). The purchase price of the common shares was $2.25 per share. We
      received $1,713,375 in gross proceeds, before issuance costs, from the sale
      of
      these shares, which were used for working capital and other general corporate
      purposes. We paid $110,000 to our former Executive Vice President of Strategic
      Planning to facilitate this transaction, which were costs directly related
      to
      the transaction, and recorded as a reduction of the gross proceeds. We are
      required under a registration rights agreement to file a registration statement
      for the resale of the shares within 30 calendar days from the closing date
      and
      have the registration statement declared effective no later than 90 calendar
      days after the closing date. 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. The institutional investor has waived
      any claim for liquidated damages based on the failure to file a registration
      statement within the time required until a reasonable time after the
      effectiveness of our universal shelf registration statement on Form S-3
      (Registration No. 333-137100). As described above, we have classified the
      $1,603,375 value of common stock subject to registration (net of issuance costs)
      as temporary equity as of September
      30, 2006 related to the August 2006 Financing.





Under
      the
      terms of the August 2006 Financing, we are obligated to prepare
      and file a registration statement which would allow the Company to offer and
      issue subscription rights to purchase a minimum of $20,000,000 of the Company’s
      common shares (the “Shelf Registration Statement”). In
      addition, Section 4.14 of the registration rights agreement required us to
      commence that subscription rights offering to its common shares if we did not
      successfully raise, within 30 days of the SEC declaring the Shelf Registration
      Statement effective (such 30th day being the “Additional Financing Deadline”),
      an additional $10,000,000 in financing through the sale of securities offered
      pursuant to the Shelf Registration Statement. On October 25, 2006, we entered
      an
      amendment to the terms of the August 2006 Financing that extends the Additional
      Financing Deadline if we raise at least $1,000,000 on or before the Additional
      Financing Deadline. The length of the extension depends on the amount of
      financing raised by us: if at least $1,000,000 is raised, then the Additional
      Financing Deadline is extended for an additional 30 days; if at least $5,000,000
      is raised, then the Additional Financing Deadline is extended for an additional
      60 days; and if at least $3,000,000, but less than $5,000,000, is raised, then
      the Additional Financing Deadline shall be extended for an additional number
      of
      days equal to 30 plus the product (rounded to the nearest integer) of (x) the
      fraction whose numerator is equal to the amount of money raised minus $3,000,000
      and whose denominator is equal to $2,000,000, and (y) 30. In addition, the
      amendment to the agreement provides that if we raise between $5,000,000
      and


-20-
 **Table
            of Contents**


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


$10,000,000
      by the Additional Financing Deadline, then we shall be required to raise,
      pursuant to the subscription rights offering required by Section 4.14, only
      an
      amount equal to the difference between $20,000,000 and such amount raised by
      the
      Additional Financing Deadline.





Because
      of our existing covenants with the holders of our Senior Secured Convertible
      Notes, which requires us to seek their consent before we agree to enter into
      additional material indebtedness, we will most likely try to raise the
      above-mentioned monies through the sale of additional common shares. We can
      offer no assurance that we will successfully raise the up-to-$10,000,000
      mentioned above, nor can we offer an assurance that we will issue subscription
      rights to our shareholders in the future. At present, we are considering all
      of
      our options and have not definitively determined how or whether we will raise
      the additional up-to-$10,000,000 which would allow us to avoid our obligation
      to
      make an offering of subscription rights to purchase our common shares. In
      connection with the August 2006 Financing, we have also agreed, for a period
      of
      one year following the closing of the August 2006 Financing, to refrain from,
      directly or indirectly, offering or selling any debt security that is, at any
      time during the life of the debt security and under any circumstance,
      convertible into or exchangeable for our common shares, unless we receive prior
      written consent from a majority of the purchasers of the August 2006 Financing.





In
      the
      event we default upon the foregoing obligations, the purchasers of securities
      in
      our August 2006 Financing are entitled to contractual damages and may also
      request that we specifically perform our obligations under the purchase
      agreement giving rise to our obligations. At present, we are unable to quantify
      the amount of contractual damages to which the purchasers would be entitled,
      and
      we are unable to estimate the likelihood that a court would grant any
      purchaser’s application that we specifically perform our
      obligations.





In
      June
      2006, when the price of our common stock was $2.59, 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.





On
      May
      31, 2006, when the price of our common 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, when the price of our common stock was $ 3.89, 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.


-21-
 **Table
            of Contents**




**SPATIALIGHT,
      INC.**


Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


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, when the price of our common stock was $2.79, 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, which were used for working capital and other
      general corporate purposes.





In
      mid-January 2006, when the price of our common stock ranged from $2.62 to $2.85,
      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
      were 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 occurred 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 May 12, 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. Of these shares,
      57,725 were included in our Form S-3 Amendment No. 3 (Registration No.
      333-137100) filed with the SEC on November 6, 2006. This registration statement
      has not yet been declared effective by the SEC.





As
      mentioned above, 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,


-22-
 **Table
            of Contents**




**SPATIALIGHT,
      INC.**


Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


$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 September 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 MEF
      (File
      No. 333-134626) filed by us on May 31, 2006.





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




Three
                  months ended September 30,
              
              Nine
                  months ended September 30,2006
              
              2005
              
              2006
              
              2005Options
                  granted to employees and directors
              
              $
              184,797
              
              $
              5,500
              
              $
              1,829,790
              
              $
              22,000Warrants
                  issued for services
              
              
              -
              
              
              73,387
              
              
              -
              
              
              164,187$
              184,797
              
              $
              78,887
              
              $
              1,829,790
              
              $
              186,187





-23-
 **Table
            of Contents**
  **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 facility in the
      United States at September 30, 2006, except for the following:




KoreaCash
              
              $
              251,051Accounts
                  receivable
              
              
              270,612Prepaid
                  expenses
              
              
              140,632Deposits
              
              
              13,923Building,
                  net
              
              
              4,422,385Machinery
                  and manufacturing equipment, net
              
              
              779,535Office
                  furniture and fixtures, net
              
              
              100,129Other
                  equipment and instruments, net
              
              
              850,660Inventory,
                  net
              
              
              279,071$
              7,107,998




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




Nine
                  months ended September 30,2006
              
              2005LCoS
                  (T-3) sets
              
              
              96
              %
              
              73
              %LCoS
                  (T-1) sets
              
              
              -
              
              
              5
              %Light
                  engine display units
              
              
              -
              
              
              1
              %Other
                  (primarily supporting electronics)
              
              
              4
              %
              
              21
              %Total
              
              
              100
              %
              
              100
              %


Of
      our
      total revenue in 2006, 96% was derived from the sales of our LCoS Sets and
      supporting electronics to LG Electronics, a customer located in South Korea.
      LG
      Electronics made up 100% of our accounts receivable balance at September 30,
      2006.


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 **Table
            of Contents**




**SPATIALIGHT,
      INC.**


Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


Note10.Inventory,
      net





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




September
                  30,
              
              December
                  31,2006
              
              2005Raw
                  materials
              
              $
              937,287
              
              $
              796,770Work-in-progress
              
              
              68,246
              
              
              17,043Finished
                  goods
              
              
              96,945
              
              
              294,2871,102,478
              
              
              1,108,100Inventory
                  reserve
              
              
              (793,810
              )
              
              (351,377
              )Total
                  inventory, net
              
              $
              308,668
              
              $
              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’s vested options to purchase 265,000 common shares of the Company
      awarded pursuant to his Time Accelerated Restricted Stock Award Plan expired
      on
      September 13, 2006. Pursuant to a General Release contract between Mr. Banzhaf
      and us, Mr. Banzhaf received 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
      September 2006, the Financial Accounting Standards Board (FASB) issued Statement
      No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 defines fair value,
      establishes a framework for measuring fair value in generally accepted
      accounting principles, and expands disclosures about fair value measurements.
      FAS 157 is intended to be applied in conjunction with other accounting
      pronouncements that require or permit fair value measurements. Although FAS
      157
      does not require any new fair value measurements, its application may change
      current practice for some entities. The definition of fair value contained
      in
      FAS 157 retains the exchange price notion inherent in earlier definitions of
      fair value. FAS 157 clarifies that the exchange price is the price in an orderly
      transaction between market participants to sell an asset or transfer a liability
      in the principal (or most advantageous) market for the asset or liability.
      The
      transaction to sell the asset or transfer the liability is a hypothetical
      transaction at the measurement date, considered from the perspective of a market
      participant that holds the asset or owes the liability. Accordingly, the
      definition focuses on the price that would be received to sell the asset or
      paid
      to transfer the liability at the measurement date (an exit price), not the
      price
      that would be paid to acquire the asset or received to assume the liability
      at
      the measurement date (an entry price). FAS 157 emphasizes that fair value is
      a
      market-based measurement, not an entity-specific measurement. Therefore, FAS
      157
      prescribes that a fair value measurement be determined based on the assumptions
      that market participants would use in pricing the asset or liability. As a
      basis
      for considering market participant assumptions in fair value measurements,
      FAS
      157 establishes a fair value hierarchy that distinguishes between (1) market
      participant assumptions developed based on market data obtained from sources
      independent of the reporting entity (observable inputs) and (2) the reporting
      entity’s own assumptions about market participant assumptions developed based on
      the best information available in the circumstances (unobservable inputs).
      FAS
      157 clarifies that market participant assumptions include,


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 **Table
            of Contents**




**SPATIALIGHT,
      INC.**


Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)





among
      other considerations, assumptions about risk, about the effect of a restriction
      on the sale or use of an asset and about the effect of credit risk (credit
      standing) on the fair value of a liability. FAS 157 expands disclosures about
      the use of fair value to measure assets and liabilities, and particularly the
      inputs used to measure fair value, in interim and annual periods subsequent
      to
      initial recognition. This statement is effective for fiscal years beginning
      after November 15, 2007.  We have not yet determined what impact this
      statement will have on our results of operations or financial
      position.





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.





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 155 amends
      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 155 permits
      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 155 is
      effective for all financial instruments acquired or issued during fiscal years
      beginning after September 15, 2006 (January 1, 2007 for the Company).
      We do not
      expect this statement to have a material impact on our 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


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 **Table
            of Contents**




**SPATIALIGHT,
      INC.**


Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


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.





**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.




*Audit
      Committee Investigations*





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,


-27-
 **Table
            of Contents**




**SPATIALIGHT,
      INC.**


Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


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 former 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.





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 although on April 28, 2006, we hired
      a
      part-time Director of Accounting and Finance.





As
      previously reported in our Quarterly Report on Form 10-Q filed with the SEC
      on
      August 9. 2006, our Audit Committee, with the assistance of independent legal
      counsel, conducted an investigation and review of transactions in the Company’s
      shares by Robert A. Olins, our former Chief Executive Officer, Secretary,
      Treasurer and a Director and determined that he failed to report the sale of
      an
      aggregate of


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 **Table
            of Contents**




**SPATIALIGHT,
      INC.**


Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)


70,556
      of
      our common shares in August 2005 and February 2006 at sales prices ranging
      from
      $5.30 to $3.00. The Audit Committee determined that there was no indication
      that
      Mr. Olins had access to material undisclosed information at the time of the
      transactions, that there was no intention to engage in the distribution of
      our
      securities without registration, and that the number of shares involved was
      insignificant. Pursuant to Section 16 of the Exchange Act, in July 2006, Mr.
      Olins filed the delinquent reports and disgorged $22,273 in “short-swing
      profits” that he realized from the sales.





*SEC
      Investigations*





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 and transactions in our securities by Mr. Olins and
      an
      entity he controls. We have received and responded to a request for all
      information relating to transactions in our securities by Mr. Olins and the
      entity he controls. We have been cooperating with the Staff with respect to
      this
      matter but are not aware of any violations of the securities laws except as
      set
      forth under “Audit Committee Investigations” above. At this date, we cannot
      determine whether we or our management will be adversely affected by these
      investigations.





*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 $391,000, or the difference
      between the two investor’s purchase price and lowest believed resale price,
      multiplied by the 340,000 shares that they purchased and then
      resold.


-29-
 **Table
            of Contents**




**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**





*Management
      changes*





On
      November 3, 2006, Robert A. Olins resigned as our Chief Executive Officer and
      a
      Director, effective immediately.





On
      November 3, 2006, the Company’s Board of Directors elected Don S. Suh, 49, as
      the Company’s Chief Executive Officer, replacing Robert A. Olins. For the past
      two years, Mr. Suh served as the Company’s Senior Vice President of Sales and
      Marketing. Formerly, he was a senior executive at LG Electronics in the United
      States, Asia and Europe.





In
      addition to the appointment of Don Suh, the Company announced the appointment
      of
      David F. Hakala, 54, as Chairman of the Board of Directors, replacing Lawrence
      Matteson who will remain on the Board through December 31, 2006. Dr. Hakala
      was
      also appointed as the Principal Accounting Officer. Dr. Hakala will continue
      in
      the capacity as Chief Operating Officer.


-30-
 **Table
          of Contents**




**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 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 August 9,
      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 September 30, 2006, and our results of operations for the three
      and nine months ended September 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
      the quarterly report on Form 10-Q for the period ended June 30, 2006), 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 first quarter of 2007, although there can be no
      assurance that deliveries will be fulfilled if we encounter further
      manufacturing difficulties, if LG Electronics takes them at a lower rate, if
      product specifications change further, or if adequate financing cannot be
      obtained to support on-going materials acquisition.  -31-
 **Table
            of Contents**


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. Recent performance has improved with elimination of the 100%
      testing, increases in product delivery quantities and improvements in day to
      day
      production consistency. 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 possibly as early as 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 nine months of 2006, the majority 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
      the majority of our anticipated future product deliveries for the remainder
      of
      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 was
      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.


-32-
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***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 have recently
      supported 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 there believe that if the LCoS technology gains greater
      acceptance in the high definition television marketplace, and if the 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


-33-
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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.





***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.
      We
      have agreed not to disclose the name of the developer at this time and 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 limited production of products for commercial sale 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 designed
      with
      potential 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.




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


-34-
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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.




At
      this
      time, we 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.





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  -35-
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obtaining
      the supply agreement with LG Electronics. The T-3 model is the central component
      of our ongoing customer acquisition strategy described above.





In
      the
      market place, whether plasma or DLP televisions, prices are decreasing rapidly.
      For this reason, in addition to the above-mentioned activities, we are focused
      on designing and developing a more cost effective model (T-4) to remain
      competitive.





***Audit
      Committee Investigations***





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 former 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.


-36-
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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 on April
      28, 2006, we hired a part-time Director of Accounting and Finance.




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.




As
      previously reported in our Quarterly Report on Form 10-Q filed with the SEC
      on
      August 9, 2006, our Audit Committee, with the assistance of independent counsel,
      conducted an investigation and review of transactions in the Company’s shares by
      Robert A. Olins, our former Chief Executive Officer, Secretary, Treasurer and
      a
      Director and determined that he 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. The Audit Committee determined that there was
      no
      indication that Mr. Olins had access to material undisclosed information at
      the
      time of the transactions, that there was no intention to engage in the
      distribution of our securities without registration, and that the number of
      shares involved was insignificant. Pursuant to Section 16 of the Exchange Act,
      in July 2006, Mr. Olins filed the delinquent reports and disgorged $22,273
      in
“short-swing profits” that he realized from the sales.




***SEC
      Investigations***




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 and transactions in our securities by Mr. Olins and
      an
      entity he controls. We have received and responded to a request for all
      information relating to transactions in our securities by Mr. Olins and the
      entity he controls. We have been cooperating with the Staff with respect to
      these matters but are not aware of any violations of the securities laws except
      as set forth under “Audit Committee Investigations” above. At this date, we
      cannot determine whether we or our management will be adversely affected by
      these investigations.





LIQUIDITY
      AND CAPITAL RESOURCES




As
      of
      September 30, 2006, we had approximately $0.3 million in cash and cash
      equivalents, an increase of approximately $0.2 million from the December 31,
      2005 balance of approximately $43,000. Our net


-37-
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            of Contents**




working
      capital deficiency at September 30, 2006 was approximately $3.2 million compared
      to approximately $3.4 million at December 31, 2005.





Net
      cash
      used in operating activities totaled approximately $2.4 million and $2.3 million
      for the three months ended September 30, 2006 and 2005, respectively and
      approximately $10.1 million and $7.8 million for the nine months ended September
      30, 2006 and 2005, respectively. Cash used in operating activities increased
      for
      the three and nine month periods ended September 30, 2006 as compared to the
      same periods in 2005 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 $0.2 million and $0.4 million
      for the three months ended September 30, 2006 and 2005, and approximately $0.5
      million and $3.9 million for the nine months ended September 30, 2006 and 2005,
      respectively. Cash used in investing activities during 2005 were related to
      building our South Korean manufacturing facility, whereas cash used in investing
      activities in 2006 were primarily related to purchases of equipment used in
      our
      South Korean facility. The building activities were completed during
      2005.





Net
      cash
      provided by financing activities in the three months ended September 30, 2006
      and 2005 were approximately $2.4 million and $3.0 million, respectively, and
      approximately $10.9 million and $3.3 million for the nine months ended September
      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 in mid-January 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,
      which was repaid early in the second 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 $1.6 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. In the third quarter of 2006, cash
      was
      primarily provided by the net proceeds of approximately $1.6 million that we
      received from the sale of 761,500 of our common shares on August 9, 2006 at
      a
      purchase price of $2.25 and net proceeds of approximately $482,500 that we
      received from the sale of 270,270 of our common shares with warrants on
      September 26, 2006 at a purchase price of $1.85 per share.





We
      expect
      to meet our immediate cash needs and fund our immediate working capital
      requirements with the following sources: 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.
      If
      we are unable to obtain additional funds on reasonable terms, we may be unable
      to continue our operations at current levels beyond November 2006, or at
      all.





RESULTS
      OF OPERATIONS





*Three
      months ended September 30, 2006 and 2005*





*Revenue* . ** We
      recognized revenue of approximately $298,000 and $58,000 during the quarters
      ended September 30, 2006 and 2005, respectively. The increase of $240,000 or
      over four times that of the previous period reflects recent reduced bottlenecks
      from our manufacturing facility in South Korea,  -38-
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which
      benefited from our previously announced transition in August 2006 to quality
      control sampling rather than 100% test of each production unit for certain
      characteristics. 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 third quarter
      2006 and 2005.




Three
                months ended September 30,2006
            
            2005LCoS
                (T-3) sets
            
            
            100
            %
            
            62
            %Other
                (primarily supporting electronics)
            
            
            —
            
            
            38
            %Total
            
            
            100
            %
            
            100
            %


Revenue
      from one customer, LG Electronics, accounted for 100% and 61% of our total
      revenue for the three months ended September 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* .
      Gross
      margin decreased from approximately $1,000 during the third quarter of 2005
      to
      negative gross margin of approximately $1,367,000 during the third quarter
      2006.
      The third quarter of 2006 includes the costs to operate our South Korean
      manufacturing facility. We were in the process of building this facility during
      the third 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
      $1,733,000 and $1,657,000 during the three months ended September 30, 2006
      and
      2005, respectively, an increase of $76,000 or 5%. Significantly contributing
      to
      the increase were increased legal and audit fees of approximately $263,000
      and
      $72,000, respectively, primarily related to the routine review of our
      registration statements on Forms S-3 as well as involvement with the ongoing
      SEC
      investigation. $125,000 of the increase relates to a severance agreement
      pursuant to the resignation of Mr. Fabian, our former Assistant Vice President
      of Business and Legal Affairs and Corporate Counsel. Additional increases were
      due to increased administrative expenses in our South Korean facility.
      Offsetting these increases were reductions of approximately $403,000 or
      approximately 30% in wages and benefits due to an approximately 30% reduction
      in
      headcount.





*Stock-based
      compensation included in selling, general and administrative
      costs.* Stock-based compensation was approximately $185,000 and $79,000 for the three
      months ended September 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 third quarter of 2005 included the value of a warrant issued for investor
      relation 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.


-39-
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            of Contents**




*Research
      and development costs* .
      Research and development costs were approximately $270,000 and $1,081,000 in
      the
      three months ended September 30, 2006 and 2005, respectively, a decrease of
      $811,000 or 75%. During the third 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 third quarter of 2006.





*Interest
      expense.* Interest
      expense for the three months ended September 30, 2006 decreased approximately
      $231,000 from $271,000 during third quarter 2005 to $40,000 for the third
      quarter 2006. Approximately $246,000 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 third quarter of 2005.





*Non-cash
      interest expense.* ** Non-cash
      interest expense was approximately $644,000 and $631,000 for the three months
      ended September 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 former
      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 the market price on
      the
      date of receipt 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
      $246,000 of increase in the three months ended September 30, 2006 as compared
      to
      the same period in 2005 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 an accrual in the third quarter
      of 2005 of approximately $234,000 relating to potential liquidated damages
      in
      connection with the registration rights agreement entered into as part of the
      November 2004 Financing. The above-mentioned liquidated damages accrual was
      reversed in the fourth quarter of 2005 due to our belief that no liquidated
      damages are owed. Please refer to footnote 7 in the unaudited condensed
      consolidated financial statements for further details.





*Nine
      months ended September 30, 2006 and 2005*





*Revenue* . ** We
      recognized revenue of approximately $443,000 and $197,000 during the nine months
      ended September 30, 2006 and 2005, respectively. The increase of $246,000 or
      nearly 1.25 times that of the previous period reflects recent reduced
      bottlenecks from our manufacturing facility in South Korea, which benefited
      from
      previously announced transition in August 2006 to quality control sampling
      rather than 100% test of each production unit for certain characteristics.
      Revenue in both periods was derived primarily from sales of LCoS Sets to LG
      Electronics.


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




Nine
                  months ended September 30,2006
              
              2005LCoS
                  (T-3) sets
              
              
              96
              %
              
              73
              %LCoS
                  (T-1) sets
              
              
              -
              
              
              5
              %Light
                  engine display units
              
              
              -
              
              
              1
              %Other
                  (primarily supporting electronics)
              
              
              4
              %
              
              21
              %Total
              
              
              100
              %
              
              100
              %


Revenue
      from one customer, LG Electronics, accounted for 96% and 73% of our total
      revenue for the nine months ended September 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 $19,000 during the first
      three quarters of 2005 to negative gross margin of approximately $4,373,000
      during the first three quarters of 2006. The first three quarters of 2006
      includes the costs to operate our South Korean manufacturing facility. We were
      in the process of building this facility during the first three quarters 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 three quarters of 2006 includes a reserve
      of
      approximately $442,000, which was recorded to reserve the remaining value of
      our
      T-1 LCoS Set inventory and 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.





*Selling,
      general and administrative costs.* Cash-based selling, general and administrative costs were approximately
      $5,623,000 and $5,136,000 during the nine month periods ended September 30,
      2006
      and 2005, respectively, an increase of $487,000 or 9%. Significantly
      contributing to the increase were increased legal and audit fees of
      approximately $838,000 and $52,000, respectively, primarily related to the
      routine review of our registration statements on Forms S-3, our Annual Report
      on
      Form 10-K for the year ended December 31, 2005, our quarterly reports on Form
      10-Q as well as involvement with the ongoing SEC investigation. Additionally,
      $125,000 of the increase relates to a severance agreement pursuant to the
      resignation of Mr. Fabian, our former Assistant Vice President of Business
      and
      Legal Affairs and Corporate Counsel. We also incurred increased recruiting
      expense of $99,000 and public relations expense of $85,000. Offsetting these
      increases were reductions of approximately $414,000 or approximately 30% in
      wages and benefits due to an approximately 30% reduction in headcount.
      Additional reductions were recorded in travel, shipping, insurance, consulting
      and supplies and tools expense in the aggregate of approximately $298,000 due
      to
      reduced expenditures incurred in getting our manufacturing facility in South
      Korea operational.





*Stock-based
      compensation included in selling, general and administrative
      costs.* Stock-based compensation was approximately $1,830,000 and $186,000 in the nine
      months ended September 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


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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 three quarters of 2005 included the value of two warrants issued
      for
      sales and investor relation 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 $923,000 and $2,740,000 for
      the nine months ended September 30, 2006 and 2005, respectively, a decrease
      of
      $1,817,000 or 66%. During the first three quarters 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 three quarters of
      2006.





*Interest
      expense.* Interest
      expense for the nine months ended September 30, 2006 decreased approximately
      $451,000 or 56% from $806,000 during the first three quarters of 2005 to
      $355,000 for the first three quarters of 2006. Approximately $498,000 of the
      decrease is due to issuing our common shares in lieu of cash to the Senior
      Secured Noteholders for the payment of two quarters’ interest. The decrease is
      partially offset by interest incurred on the short-term South Korean debt
      facilities. No comparable facilities existed during the first three quarters
      of
      2005.





*Non-cash
      interest expense.* ** Non-cash
      interest expense was approximately $2,130,000 and $1,187,000 for the nine months
      ended September 30, 2006 and 2005, respectively, an increase of $943,000 or
      79%.
      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 former 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 the market price on the date of receipt 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
      $498,000 of increase in the nine months ended September 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 two
      quarters’ 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. This increase is partially offset by an accrual in the third quarter
      of 2005 of approximately $234,000 relating to potential liquidated damages
      in
      connection with the registration rights agreement entered into as part of the
      November 2004 Financing. The above-mentioned liquidated damages accrual was
      reversed in the fourth quarter of 2005 due to our belief that no liquidated
      damages are owed. Please refer to footnote 7 in the unaudited condensed
      consolidated financial statements for further details.


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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.




*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


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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.





**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 September 30, 2006, our cash and cash equivalents totaled approximately
      $281,000. Short term debt under our South Korean lines of credit totaled
      approximately $830,000 at September 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


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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
      September 30, 2006, we had no hedging contracts. During the first nine months
      of
      2006, the foreign currency transaction gains, realized and unrealized, were
      not
      material.





**Item
      4. Controls and Procedures.**




**Disclosure
      Controls and Procedures.** As
      of
      September 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).




*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
      September 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.


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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
      October 10, 2006, the Board of Directors adopted an updated the Audit Committee
      Charter, adopted a Compensation Committee Charter and ratified the Disclosure
      Committee Charter.





On
      September 6, 2006, the Board of Directors adopted our updated Corporate Code
      of
      Business Conduct and Ethics. The updated Code included, among other changes,
      the
      requirement for an annual certification by all employees of compliance with
      the
      code. We have subsequently received certifications from our
      employees.





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.





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. Additionally,
      we
      have implemented information technology controls and procedures that will likely
      prevent unauthorized access to the accounting and financial systems used in
      the
      US, and ensure that the accounting and financial records are recoverable in
      the
      event of a disaster.


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





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





None.
      See
      our discussion of the SEC investigation being conducted, which is described
      under “Part I Item 2, Management’s Discussion and Analysis of Financial
      Condition and Results of Operations - Overview U.S. Securities and Exchange
      Commission Investigation and Related Matters.”





**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
      are confronted by serious liquidity concerns.**




As
      of the
      date hereof, we have very limited financial resources and will be unable to
      continue operations beyond November 2006 unless we obtain significant additional
      financing. Our operations to date have consumed substantial amounts of cash
      and
      will continue to require substantial amounts of capital in the future. In order
      to remain competitive, we must continue to make significant investments
      including further investments in research and development, equipment, and
      expansion of our facilities and production activities. Our $10,000,000 of Senior
      Secured Convertible Notes, issued in November 2004, are scheduled to mature
      on
      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 last sale price of our common shares on Nasdaq on November 6,
      2006, was $2.10 per share. Unless the Noteholders decide to convert their notes
      prior to November 30, 2007, then we will be required to repay to the Noteholders
      the entire $10,000,000 principal amount of the notes on that maturity date.




Taking
      into account our current financial condition, we will require significant
      additional financing to satisfy our increasing working capital requirements
      in
      2006 and thereafter. The report of our independent registered public accounting
      firm, Odenberg, Ullakko, Muranishi & Co. LLP, included in our Annual Report
      on Form 10-K/A filed with the SEC on April 11, 2006, raised substantial doubt
      with respect to our ability to continue as a going concern.




In
      the
      past, we have maintained our financial condition and liquidity primarily through
      private sales of our common shares (both registered and unregistered),
      convertible note financing, and the payment of exercise prices on our warrants
      and options. We have no assurance that outstanding stock options and warrants
      will be exercised in the future to any significant extent. Reliance on private
      equity purchase agreements and public offerings and exercises of derivative
      securities to finance our current and future operations entails the additional
      risks of our inability to sell our common shares or other securities and an
      insufficient number of derivative securities being exercised owing to the
      prevailing market prices of our underlying common shares. Additionally, any
      additional sales of our common stock may have a dilutive effect on the value
      of
      our outstanding shares. In the event that we are unable to obtain further
      financing on satisfactory terms, or at all, or if we are unable to generate
      sales sufficient to offset our costs, or if our costs of development and
      operations are greater than we anticipate, we may be unable to increase the
      size
      of our business at the rate desired or may be required to delay, reduce, or
      cease certain or all of our operations, any of which could materially harm
      our
      business and financial results.


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**Certain
      of the holders of the Senior Secured Convertible Notes issued by us in November
      2004 have made claims of default.**




As
      previously disclosed in our Current Report on Form 8-K, filed December 19,
      2005,
      holders of $9,000,000 principal amount of our Senior Secured Convertible Notes
      have alleged that we have defaulted in the payment of the installment of
      interest due November 30, 2005 on these Senior Secured Convertible Notes. In
      addition, one of these holders, who holds $4,500,000 principal amount of the
      Senior Secured Convertible Notes, has alleged that we have defaulted in our
      failure to maintain the effectiveness of the registration statement on Form
      S-3
      pertaining to the Senior Secured Convertible Notes (Registration No. 333-122391)
      in such manner as to permit such holder to sell its shares pursuant to that
      registration statement. That holder of $4,500,000 principal amount of the Senior
      Secured Convertible Notes, as previously disclosed in our Current Report on
      Form
      8-K, filed February 14, 2006, has also alleged that we have defaulted under
      the
      terms of the Senior Secured Convertible Notes by entering into certain types
      of
      debt financing transactions. As a consequence of these alleged defaults, these
      holders have demanded the immediate redemption of the principal amount of their
      Senior Secured Convertible Notes plus a redemption premium of $675,000 to each
      of them. We do not believe that we have defaulted in the payment of interest
      on
      the Senior Secured Convertible Notes, and we believe that the registration
      statement has remained effective, that we have not entered into any debt
      financing transactions that would constitute a breach or failure in any material
      respect, and that we are otherwise in compliance with the relevant provisions
      of
      the Senior Secured Convertible Notes. At this date, we cannot predict what
      actions, if any, will be undertaken by any of the holders of the Senior Secured
      Convertible Notes, but we will contest any adverse actions as we believe that
      these allegations lack merit and would not entitle the holders of the Senior
      Secured Convertible Notes either to call such notes or to other remedies that
      they are seeking.




**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.


-48-
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            of Contents**




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.




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.  -49-
 **Table
            of Contents**


**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 nine months 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.




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. ****





**We
      are the subject of an investigation by the staff of the SEC regarding the
      circumstances surrounding our filing of certain consents of the independent
      registered accounting firm BDO Seidman, LLP without requisite authorization
      and
      transactions in our securities by our former Chief Executive
      Officer.**




We
      have
      been advised by the staff of the SEC that it is conducting an investigation
      into
      the circumstances surrounding our filing of consents of the independent
      registered accounting firm BDO Seidman, LLP, without requisite authorization,
      which consents were filed as Exhibit 23.1 to amendments to our registration
      statements on Form S-3 (Nos. 333-122391 and 333-122392) filed with the SEC
      on
      July 27, 2005. The consents would have allowed us to incorporate by
      reference into each of the prospectuses constituting a part of the
      above-referenced registration statements, the reports of BDO Seidman, LLP on
      our
      consolidated financial statements for the years ended December 31, 2002 and
      2003. Our current independent registered accounting firm, Odenberg, Ullakko,
      Muranishi & Co. LLP (OUM) has since provided us with a new report with
      respect to each of the three years ended December 31, 2004 and we were not
      requested to amend or restate the financial statements contained in our annual
      reports on Form 10-K for any of the three fiscal years ended December 31, 2004
      in connection with the issuance of OUM’s new report. We have also received
      notice that the SEC is investigating transactions in our securities by Mr.
      Robert Olins, our former Chief Executive Officer. We have been cooperating
      and
      intend to continue to cooperate with the SEC in connection with these matters.
      In addition, the audit committee of our board of directors has concluded a
      review and investigation of these matters. As of this date, we cannot determine
      whether we or our management will be adversely affected by these investigations.
      See “Audit Committee Investigations” and “SEC investigation” under Part I. Item
      2 for further information concerning the circumstances underlying the SEC
      investigation and the audit committee investigation and report with respect
      to
      these matters.


-50-
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            of Contents**




**We
      may be subject to lawsuits relating to our use of a registration statement
      that
      did not contain an authorized consent of BDO Seidman LLP or as a result of
      findings from the investigation into transactions in our securities by our
      former Chief Executive Officer.**




As
      disclosed under “Audit Committee Investigations” and “SEC investigation” under
      Part I. Item 2, we filed, as part of amendment numbers 5 and 6 to a registration
      statement (File No. 333-122391) registering shares for resale by certain selling
      shareholders (the “Financing Registration Statement”) and as part of amendment
      numbers 3 and 4 to a “shelf” registration statement (File No. 333-122392), an
      unauthorized consent of BDO Seidman LLP 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 financial statements into these registration statements when
      initially filed and 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 amendments to the registration statement before it was
      declared effective. These amendments were filed with the SEC on July 27, 2005.
      Subsequently, our current independent registered public accountants, OUM,
      re-audited our consolidated financial statements for fiscal years 2003 and
      2002.
      OUM has given its consent to incorporate by reference into the registration
      statement its report related to the 2002 and 2003 financial
      statements.




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 amendment 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 staff
      of
      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 of 1933, as amended (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 the maximum amount of potential damages pursuant to Section 11
      claims from direct purchasers, which we would fully contest, would be $391,000,
      or the difference between the two investors’ purchase price and lowest believed
      resale price, multiplied by the 340,000 shares that they purchased and then
      resold.  -51-
 **Table
            of Contents**


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 **.** Any
      such
      lawsuit could also result in further volatility in the market price of our
      common shares **.** Nothing
      set forth in the foregoing statement constitutes an express or implied admission
      by us of any liability under Section 11 of the Securities Act or
      otherwise.




As
      disclosed under “Audit Committee Investigations” and “SEC Investigations”
contained in “Part 2 - Management’s Discussion and Analysis”, our Audit
      Committee determined that Robert A. Olins, our former 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 Securities Exchange
      Act of 1934, as amended (the “Exchange Act”), Mr. Olins has filed delinquent
      reports and disgorged $22,273 in “short-swing profits” that he realized from the
      sales. We have been advised by the SEC that they are investigating the
      transactions in our securities by Mr. Olins and an entity which he controls,
      and
      have received and responded to a request from the SEC requesting documentation
      relating to all transactions by Mr. Olins and the entity which he controls.
      We
      have no knowledge of any other transactions by Mr. Olins, or this entity, that
      would be a violation of the Securities Act or the Exchange Act. If the SEC
      determines that these or other transactions by Mr. Olins were a violation of
      the
      Securities Act, it is conceivable that such transactions could be imputed to
      us
      and the SEC could seek to impose remedies against us, or private individuals
      could file litigation against us for damages.




We
      are
      unable to estimate the probability of liability or the amount of any penalties
      or damage claims that might arise, which may be material to our financial
      condition. We believe that Mr. Olins will disgorge any “short swing profits” if
      it is determined that he or the entity he controls engaged in transactions
      that
      violated Section 16 of the Exchange Act. Any action by the SEC or lawsuit
      alleging securities law violations could require us to expend significant
      financial and managerial resources and could also result in further volatility
      in the market price of our common shares **.** Nothing
      set forth in the foregoing statement constitutes an express or implied admission
      by us of any liability under the Securities Act, the Exchange Act or
      otherwise.




**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 November 6, 2006, was $2.10 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.  -52-
 **Table
            of Contents**


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 expand 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 holders’ 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.





**We
      have a history of losses and expect to incur losses in the future and therefore
      cannot assure you that we will achieve profitability.**




We
      have
      incurred operating losses to date and have experienced cash shortages. For
      the
      nine months ended September 30, 2006 and the fiscal year ended December 31,
      2005, we incurred net losses of approximately $15.1 million and $14 million,
      respectively. In addition, we had an accumulated deficit of approximately $96.8
      million as of September 30, 2006. We expect additional losses as we continue
      spending for commercial scale production and other business activities as well
      as further research and development of our products. As a result, we will need
      to generate substantial sales to support our costs of doing business before
      we
      can begin to recoup our operating losses and accumulated deficit and achieve
      profitability.




**We
      may be subject to liability if we default on our obligations to raise additional
      capital as required in the purchase documents related to our private placement
      of common shares in August 2006.**




Under
      the
      terms of the August 2006 Financing, we must raise an additional $10,000,000
      by the end of the 30 th day
      following the date the SEC declares effective the registration statement (such
      30 th day
      being the “Additional Financing Deadline”) of which this prospectus is a part
      (the “Registration Effective Date”) for us to avoid our obligation under the
      purchase documents related to the August 2006 Financing to commence a
      subscription rights offering to our shareholders to purchase our common shares
      having an aggregate value of at least $20,000,000 on or before the Registration
      Effective Date. Because of our existing covenants with the holders of our Senior
      Secured Convertible Notes, which requires us to seek their consent before we
      agree to enter into additional material indebtedness, we will most likely try
      to
      raise the $10,000,000 through the sale of additional common shares. We can
      offer
      no assurance that we will successfully raise $10,000,000 nor can we offer an
      assurance that we will issue subscription rights to our shareholders in the
      future. At present, we are considering all of our options and have not
      definitively determined how or whether we will raise the additional $10,000,000,
      which would allow us to avoid our obligation to make an offering of subscription
      rights to purchase our common shares. In connection with the August 2006
      Financing, we have also agreed, for a period of one year following the closing
      of the August 2006 Financing, to refrain from, directly or
      indirectly,


-53-
 **Table
            of Contents**




offering
      or selling any debt security that is, at any time during the life of the debt
      security and under any circumstance, convertible into or exchangeable for our
      common shares, unless we receive prior written consent from a majority of the
      purchasers of the August 2006 Financing.




On
      October 25, 2006, the Securities Purchase Agreement in the August 2006 Financing
      was amended to extend the deadline if the Company raises at least $1,000,000
      on
      or before the Registration Effective Date. The length of the extension depends
      on the amount of financing raised by the Company: if at least $1,000,000 is
      raised, then the deadline is extended for an additional 30 days; if at least
      $5,000,000 is raised, then the deadline is extended for an additional 60 days;
      and if at least $3,000,000, but less than $5,000,000, is raised, then the
      deadline is extended for an additional number of days equal to 30 plus the
      product (rounded to the nearest integer) of (x) the fraction whose numerator
      is
      equal to the amount of money raised minus $3,000,000 and whose denominator
      is
      equal to $2,000,000, and (y) 30. In addition, the amendment to the agreement
      provides that if we raise between $5,000,000 and $10,000,000 by the Additional
      Financing Deadline, then we shall be required to raise, pursuant to the
      subscription rights offering required by Section 4.14, only an amount equal
      to
      the difference between $20,000,000 and such amount raised by the Additional
      Financing Deadline. We are considering all of our options and have not
      definitively determined how or whether we will raise the additional $10,000,000
      which would allow us to avoid our obligation to make an offering of subscription
      rights to purchase our common shares.





In
      the
      event that we default upon the foregoing obligations, the purchasers of
      securities in our August 2006 Financing are entitled to contractual damages
      and
      may also request that we specifically perform our obligations under the purchase
      agreement giving rise to our obligations. At present, we are unable to quantify
      the amount of contractual damages to which the purchasers would be entitled,
      and
      we are unable to estimate the likelihood that a court would grant any
      purchaser’s application that we specifically perform our
      obligations.




**We
      are subject to lengthy development periods and product acceptance cycles, which
      may significantly harm our business.**




Our
      business model requires us to develop microdisplays that perform better than
      existing technologies, manufacture our LCoS Sets in bulk, and sell the resulting
      LCoS Sets to OEMs who will then incorporate them into their products. OEMs
      make
      the determination during their product development programs whether to
      incorporate our LCoS Sets and/or display units in their products. This requires
      us to invest significant amounts of time and capital in designing our LCoS
      Sets
      before we can be assured that we will generate any significant sales to our
      customers or even recover our investment. If we fail to recover our investment
      in the LCoS Sets, it could seriously harm our financial condition. In addition,
      the acceptance of new technologies developed by our competitors could limit
      the
      time period that our products may be demanded by our customers.  -54-
 **Table
            of Contents**


**We
      incur substantial operational and research and development costs in connection
      with products and technologies that may not be successful.**




We
      currently have nine full-time engineering personnel based in California working
      on microdisplays. We currently have nine full-time engineering and 78 full-time
      manufacturing personnel based in South Korea. This staffing creates significant
      operational and research and development costs that may not be recouped. Even
      if
      our current LCoS Sets become accepted and/or successful, we must continue to
      employ, and may increase in number, our engineering and manufacturing personnel
      to develop future generations of our microdisplays because of the rapid
      technological changes in our industry. As a result, we expect to continue
      incurring significant operational and research and development
      costs.




**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 and a nuclear device, has not
      impacted our operations in South Korea, but we can provide no assurances that
      continued tension will not negatively affect our operations.




**If
      the high definition television market does not continue to develop and if other
      potential markets for our products do not materialize, then our business will
      likely be significantly harmed.**




High
      definition television programming has only recently become available to
      consumers, and widespread market acceptance, although anticipated, is uncertain
      at this time. The market demand for high definition televisions is considered
      contingent upon widespread acceptance of high definition television programming.
      Our current sales and marketing efforts are focused on OEMs of high definition
      televisions and OEMs of light engines designed for incorporation into high
      definition televisions. Therefore, if the market for high definition televisions
      does not continue to grow and develop, then we will have significant difficulty
      selling our products, which will have a material adverse effect on our results
      of operations.




Various
      potential target markets for our products, including projectors, monitors,
      and
      portable microdisplays, are uncertain and may be slow to develop. In addition,
      companies in those markets could utilize competing technologies. For us to
      succeed in selling our products in these potential markets we must offer
      end-product manufacturers higher quality and less expensive microdisplay
      products than our competitors, and the manufacturers themselves will also have
      to develop commercially successful products using our products. In the event
      that we attempt to market and sell our products in these potential target
      markets, and we are not able to succeed in selling our products into these
      potential markets, then our results of operations and overall business may
      be
      negatively affected.


-55-
 **Table
            of Contents**




**If
      our products do not become widely accepted by our customers or the end-users,
      our business could be significantly harmed.**




Our
      LCoS
      Sets may not be accepted by a widespread market **.** Even
      if
      we successfully obtain customer orders, our customers may determine not to
      introduce or may terminate products utilizing the technology for a variety
      of
      reasons, including the following:




•
            superior
                technologies developed by our
                competitors;




•
            price
                considerations; and




•
            lack
                of anticipated or actual market demand for the
                products.




**We
      cannot assure you that we will obtain additional purchase orders from our
      current or prospective customers, or, if we do, that such orders will generate
      significant revenues.**




Even
      though in the past we have received purchase orders for our LCoS Sets and/or
      display units from LG Electronics and from certain Chinese and Taiwanese OEMs,
      and may receive additional purchase orders from prospective customers, sales
      to
      manufacturers in the electronics industry are subject to severe competitive
      pressures, rapid technological change and product obsolescence. In addition,
      purchase orders received from our customers other than LG Electronics are for
      limited quantities. Customers may, at any time, cancel purchase orders or
      commitments or reduce or delay orders, thereby increasing our inventory and
      overhead risks. Therefore, despite the purchase orders received from current
      customers and other purchase orders that we may receive from prospective
      customers, we cannot assure you that these orders will result in significant
      revenues to us.




**If
      our customers’ products are not successful, our business would be materially
      harmed.**




We
      do not
      currently sell any products to end-users. Instead, we design and manufacture
      various product solutions that our customers (i.e., OEMs) may incorporate into
      their products. As a result, our success depends almost entirely upon the
      widespread market acceptance of our customers’ products. Any significant absence
      of, or slowdown in the demand for our customers’ products would materially harm
      our business.




Our
      dependence on the success of the products of our customers exposes us to a
      variety of risks, including our need to do the following:




·
            
            maintain
                customer satisfaction with our design and manufacturing
                services;




·
            
            match
                our design and manufacturing capacity with customer demand and maintain
                satisfactory delivery schedules;




·
            
            anticipate
                customer order patterns, changes in order mix, and the level and
                timing of
                orders that we can meet; and




·
            
            adjust
                to the cyclical nature of the industries and markets we
                serve.




Our
      failure to address these risks may cause us to lose sales or our sales to
      decline.  -56-
 **Table
            of Contents**


**The
      high definition television industry is highly competitive, which may result
      in
      lost sales or lower gross margins.**




We
      serve
      the highly competitive high definition television industry that is characterized
      by price erosion, rapid technological change and competition from major domestic
      and international companies. This intense competition could result in downward
      pricing pressures, lower sales, reduced margins and lower market
      share.




Companies
      competing in the LCoS microdisplay market include Sony Corporation and Victor
      Company of Japan, Limited (“JVC”). A major competitor of ours in the reflective
      microdisplay market is Texas Instruments, which, rather than using liquid
      crystals in the display, is producing a micro-mechanical structure of moving
      mirrors on a silicon backplane, a technology known as digital light processing,
      or DLP. Texas Instruments has had significant success selling its DLP products
      to its customers in the business front projector market and the rear projection
      high definition television market. Some of our competitors, including Texas
      Instruments, Sony, and JVC, have greater market recognition, larger customer
      bases, and substantially greater financial, technical, marketing, distribution
      and other resources than we possess. As a result, they may be able to introduce
      new products and respond to customer requirements more quickly and effectively
      than we can.




Rapid
      and
      significant technological advances have characterized the microdisplay market.
      There can be no assurance that we will be able to effect any significant
      technological advances or that we will have sufficient funds to invest in new
      technologies or products or processes. Although we believe that our displays
      have specifications and capabilities, which equal or exceed that of commercially
      available liquid crystal displays (“LCD”), cathode ray tube (“CRT”) and DLP
      based display products, the manufacturers of these products may develop further
      improvements of their existing technology that would eliminate or diminish
      our
      anticipated advantage. The acceptance of our LCoS Sets and/or display units
      will
      be dependent upon the pricing, quality, reliability and useful life of these
      products compared to competing technologies, as to which there can be no
      assurance.




Our
      competitive position also may suffer if one or more of our customers decide
      to
      design and manufacture their own microdisplay products, to contract with our
      competitors, or to use alternative technologies. In addition, customers in
      the
      television manufacturing industry typically develop a second source. Second
      source suppliers may win an increasing share of our customers’ product
      demands.




Our
      ability to compete successfully depends on a number of factors, both within
      and
      outside our control. These factors include the following:




·
            our
                success in designing and manufacturing new display
                technologies;




·
            our
                ability to address the needs of customers;




·
            the
                quality, performance, reliability, features, ease of use, pricing,
                and
                diversity of our display products;




·
            foreign
                currency fluctuations, which may cause a foreign competitor’s products to
                be priced significantly lower than our
                displays;




·
            the
                quality of our customer services;




·
            the
                efficiency of our production sources;
                and




·
            the
                rate at which customers incorporate our displays into their own
                products.





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**Fluctuations
      in the exchange rate of the United States dollar and foreign currencies could
      have a material adverse effect on our financial performance and
      profitability.**




A
      portion
      of our costs is denominated in foreign currencies, including the Korean Won
      and
      the Euro. As a result, changes in the exchange rates of these currencies or
      any
      other applicable currencies to the U.S. dollar will affect our costs of good
      sold and operating margins, and could result in exchange losses. We cannot
      fully
      predict the impact of future exchange rate fluctuations on our profitability.
      From time to time, we may engage in exchange rate hedging activities in an
      effort to mitigate the impact of exchange rate fluctuations, although we have
      not engaged in any such hedging activities to date. We cannot offer assurance
      that any hedging technique we may implement will be effective. If it is not
      effective, we may experience reduced operating margins.




**Our
      operating results are subject to significant fluctuations.**




Our
      results of operations have varied significantly from quarter-to-quarter and
      are
      likely to vary significantly in the future, making it difficult to predict
      our
      future operating results. Accordingly, we believe that quarter-to-quarter
      comparisons of our operating results are not meaningful and should not be relied
      upon as an indicator of our future performance. Some of the factors that cause
      our operating results to fluctuate include the following:




·
            introductions
                of displays and market acceptance of new generations of
                displays;




·
            timing
                of expenditures in anticipation of future orders;




·
            changes
                in our cost structure;




·
            availability
                of labor and components;




·
            pricing
                and availability of competitive products and services;




·
            the
                timing of orders;




·
            the
                volume of orders relative to the capacity we can contract to produce;




·
            evolution
                in the life cycles of customers’ products; and




·
            changes
                or anticipated changes in economic
                conditions.




**If
      we lose our key personnel or are unable to attract and retain additional
      personnel, our ability to compete could be harmed.**




Our
      development and operations depend substantially on the efforts and abilities
      of
      our senior management and qualified technical personnel. Our products require
      sophisticated production, research and development and technical support. The
      competition for qualified management and technical personnel is intense. The
      loss of services of one or more of our key employees or the inability to add
      key
      personnel could have a material adverse affect on us, particularly since
      currently we do not have any insurance policies in place to cover that
      contingency. Our success will depend upon our ability to attract and retain
      highly qualified scientific, marketing, manufacturing, financial and other
      key
      management personnel. We face intense competition for the limited number of
      people available with the necessary technical skills and understanding of our
      products and technology. We cannot assure you that we will be able to attract
      or
      retain such personnel or not incur significant costs in order to do
      so.


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**Our
      future success depends on our ability to protect our proprietary technology
      and
      our registered intellectual property.**




We
      believe that our success depends in part on protecting our proprietary
      technology. We rely on a combination of patent, copyright, trademark and trade
      secret laws, as well as confidentiality and assignment of inventions agreements
      from our employees, consultants and advisors and other contractual provisions,
      to establish and protect our intellectual property rights. If we are unable
      to
      protect our intellectual property from use by third parties, our ability to
      compete in the industry will be harmed, however, policing unauthorized use
      of
      our products and technology is difficult. Despite our efforts to protect our
      proprietary rights, we face the following risks:




·
            pending
                patent applications may not be issued;




·
            patents
                issued to us may be challenged, invalidated, or circumvented;




·
            unauthorized
                parties may obtain and use information that we regard as proprietary
                despite our efforts to protect our proprietary rights;




·
            others
                may independently develop similar technology or design around any
                patents
                issued to us;




·
            breach
                of confidentiality agreements;




·
            intellectual
                property laws may not protect our intellectual property; and




·
            effective
                protection of intellectual property rights may be limited or unavailable
                in some foreign countries, such as China, in which we may operate.
                Specifically, although we consider the following unlikely because
                of the
                complex technological structure of our products, one or more of our
                current or prospective Chinese, Korean or Taiwanese customers, or
                their
                respective employees or other persons including our competitors,
                that have
                or gain access to our products for testing purposes, may seek to
                misappropriate or improperly convert to their own use our intellectual
                property and a lack of adequate remedies and impartiality under the
                Chinese, Korean, Taiwanese and other foreign legal systems may adversely
                impact our ability to protect our intellectual
                property.




There
      can
      be no assurance that we will have adequate remedies or the resources to pursue
      those remedies in the event any of the foregoing materializes. Failure to
      protect our intellectual property would limit our ability to produce and market
      our products in the future, which would materially adversely affect our revenues
      generated by the sale of such products. In addition, third parties could assert
      that our products and technology infringe their patents or other intellectual
      property rights. As a result, we may become subject to future patent
      infringement claims or litigation, the defense of which is costly,
      time-consuming and diverts the attention of management and other
      personnel.




**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 years ended December 31, 2005 and 2004, 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  -59-
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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.
      However, as of April 2006, we hired a part-time Director of Accounting and
      Finance. This individual’s primary responsibility is to perform the above
      mentioned functions. 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 did not have a
      disclosure committee until October 2006, we lack adequate controls and
      procedures over inventory, we lack information technology controls and
      procedures that would likely prevent unauthorized access to some of our
      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 are in the process of
      addressing these items and will issue an updated report with our annual report
      on Form 10K in early 2007. We may 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.




**Political,
      economic and regulatory risks associated with international operations may
      limit
      our ability to do business abroad.**




A
      substantial number of our customers, manufacturers and suppliers are located
      outside of the United States, principally in the Far East. Our international
      operations are subject to political and economic conditions abroad, and
      protectionist trade legislation in either the United States or foreign
      countries, such as a change in the current tariff structures, export or import
      compliance laws, or other trade policies, any of which could adversely affect
      our ability to manufacture or sell displays in foreign markets and to purchase
      materials or equipment from foreign suppliers. Certain of our current purchase
      order agreements with customers are governed by foreign law and therefore are
      subject to uncertainty with regard to their enforceability.




**We
      do not pay cash dividends.**




We
      have
      never paid any cash dividends on our common shares and do not anticipate that
      we
      will pay cash dividends in the near future. Moreover, under the terms of our
      November 2004 Financing, we are prohibited from paying cash dividends while
      the
      Senior Secured Convertible Notes issued in the November 2004 Financing remain
      outstanding. Instead, we intend to apply any future earnings, as to which there
      can be no assurances, to the satisfaction of our obligations, and development
      and expansion of our business.




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





On
      September 26, 2006, we privately sold 270,270 of our common shares and warrants
      to purchase 89,189 of our common shares at $2.25 per share for five years in
      a
      private placement to certain institutional investors that have previously
      purchased our common shares. The purchase price of the common shares was $1.85
      per share. The common shares and warrants were sold pursuant to an exemption
      from registration under Section 4(2) of the Securities Act of 1933, as
      amended.  We received


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$500,000
      in gross proceeds, before issuance costs, from the sale of these shares, which
      will be used for working capital and other general corporate purposes.





On
      August
      9, 2006, we issued 761,500 of our common shares in a private placement to an
      institutional investor. The purchase price of the common shares was $2.25 per
      share. The common shares were sold pursuant to an exemption from registration
      under Section 4(2) of the Securities Act of 1933, as amended. We received
      $1,713,375 in gross proceeds, before issuance costs, from the sale of these
      shares, which were used for working capital and other general corporate
      purposes.





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





As
      previously disclosed in our Current Report on Form 8-K, filed December 19,
      2005,
      holders of $9,000,000 principal amount of our Senior Secured Convertible Notes
      have alleged that we have defaulted in the payment of the installment of
      interest due November 30, 2005. In addition, one of these holders, who holds
      $4,500,000 principal amount of the Senior Secured Convertible Notes, has alleged
      that we have defaulted in our failure to maintain the effectiveness of the
      registration statement on Form S-3 pertaining to the Senior Secured Convertible
      Notes in such manner as to permit such holder to sell its shares pursuant to
      that registration statement and that we have defaulted under the terms of the
      Senior Secured Convertible Notes by entering into certain types of debt
      financing transactions. As a consequence of these alleged defaults, these
      holders have demanded the immediate redemption of the principal amount of their
      Senior Secured Convertible Notes plus a redemption premium of $675,000 to each
      of them. We do not believe that we have defaulted in the payment of interest
      or
      any other provisions of the Senior Secured Convertible Notes.




**ITEM
      4.****Submission
      of Matters to a Vote of Security Holders**





None.





**ITEM
      5.****Other
      Information**




None.


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




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*


10.7
            Securities
                Purchase Agreement among SpatiaLight, Inc. and certain Purchasers
                dated as
                of September 26, 2006*


10.8
            Registration
                Rights Agreement among SpatiaLight, Inc. and certain Purchasers dated
                as
                of September 26, 2006*


10.9
            Warrant
                to Purchase 62,432 Common Shares - Bluegrass Growth Fund
                LP*


10.10
            Warrant
                to Purchase 26,757 Common Shares - Bluegrass Growth Fund
                Ltd.*


10.11
            First
                Amendment to Securities Purchase Agreement among SpatiaLight, Inc.
                and
                certain Purchasers dated as of October 25,
                2006*


31.1
            Rule
                13a-14(a)/15d-14(a) Certification of David F.
                Hakala


32.1
            Certification
                of David F. Hakala 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.


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**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: 
      Februar y
      2,
      2007






SpatiaLight,
      Inc.






By: 
      /s/ David F. Hakala


David
      F.
      Hakala


Chief
      Executive Officer, Chief Operating Officer,


Principal
      Financial and Accounting Officer


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