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**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      10-Q**


(Mark
      One)





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





For
      the
      quarterly period ended March 31, 2006





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





For
      the
      transition period from _______________ to
      _______________





Commission
      File Number 000-19828





**SPATIALIGHT,
      INC.**


(Exact
      name of registrant as specified in its charter)





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





Five
      Hamilton Landing, Suite 100, Novato, California 94949


(Address
      of principal executive offices)





(415)
      883-1693


(Issuer’s
      telephone number)





Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      past 12 months (or for such shorter period that the registrant was required
      to
      file such reports), and (2) has been subject to such filing requirements for
      the
      past 90 days.


Yes
x
      No o





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


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





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


Yes
o
      No x





APPLICABLE
      ONLY TO CORPORATE ISSUERS:





State
      the
      number of shares outstanding of each of the issuer’s classes of common equity,
      as of the latest practicable date: 39,948,500 common shares as of May 8,
      2006.







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SPATIALIGHT,
      INC.


Quarterly
      Report on Form 10-Q


For
      the
      Quarter Ended March 31, 2006





TABLE
      OF CONTENTS





**PART
                I**
            **FINANCIAL
                INFORMATION**Item
                1.
            Condensed
                Consolidated Financial StatementsCondensed
                Consolidated Balance Sheets as of March 31, 2006 and
                December 31, 2005
            3Condensed
                Consolidated Statements of Operations for the Three
                Months Ended March 31, 2006 and 2005
            4Condensed
                Consolidated Statement of Stockholders’ Equity
                (Deficit) for the Three Months Ended March 31, 2006
            5Consolidated
                Statements of Cash Flows for the Three Months
                Ended March 31, 2006 and 2005
            6Notes
                to Condensed Consolidated Financial
                Statements
            7Item
                2.
            Management’s
                Discussion and Analysis of Financial Condition and
                Results of Operations
            23Item
                3.
            Quantitative
                and Qualitative Disclosures about Market
                Risks
            35Item
                4.
            Controls
                and Procedures
            35**PART
                II**
            **OTHER
                INFORMATION**Item
                1.
            Legal
                Proceedings.
            36Item
                1A.
            Business
                Risks and Uncertainties.
            36Item
                2.
            Unregistered
                Sales of Securities and Use of
                Proceeds
            38Item
                3.
            Defaults
                Upon Senior Securities.
            38Item
                4.
            Submission
                of Matters to a Vote of Security
                Holders
            38Item
                5.
            Other
                Information
            38Item
                6.
            Exhibits
                and Reports on Form 8-K
            39Signatures
            40






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


Item
              1.
            Condensed
                Consolidated Financial Statements




SPATIALIGHT,
                  INC.CONDENSED
                  CONSOLIDATED BALANCE SHEETS
  March
                  31,
              
              December
                  31,2006
              
              2005ASSETS
              
              (unaudited)
              
              (Note
                  2)Current
                  assetsCash
                  and cash equivalents
              
              $
              1,387,411
              
              $
              42,565Accounts
                  receivable
              
              
              167,436
              
              
              139,676Inventory,
                  net
              
              
              432,813
              
              
              756,723Prepaids
                  and other current assets
              
              
              367,700
              
              
              255,157Prepaid
                  current non-cash interest to related party
              
              
              1,157,133
              
              
              1,157,133Total
                  current assets
              
              
              3,512,493
              
              
              2,351,254Property,
                  plant and equipment, net
              
              
              6,844,010
              
              
              6,813,520Prepaid
                  non-cash interest to related party
              
              
              2,024,982
              
              
              2,314,265Other
                  assets
              
              
              60,445
              
              
              73,437Total
                  assets
              
              $
              12,441,930
              
              $
              11,552,476LIABILITIES,
                  TEMPORARY EQUITY, AND STOCKHOLDERS' EQUITY (DEFICIT)Current
                  liabilitiesShort
                  term loans
              
              $
              2,087,797
              
              $
              572,025Short
                  term loan from a related party
              
              
              86,250
              
              
              224,384Accounts
                  payable
              
              
              1,243,832
              
              
              1,665,711Fair
                  value of warrants to purchase common stock
              
              
              790,688
              
              
              778,270Accrued
                  expenses and other current liabilities
              
              
              1,709,087
              
              
              1,389,427Total
                  current liabilities
              
              
              5,917,654
              
              
              4,629,817Senior
                  secured and related party convertible notes
              
              
              10,451,106
              
              
              10,340,113Total
                  liabilities
              
              
              16,368,760
              
              
              14,969,930Commitments
                  and contingenciesTemporary
                  equity:Common
                  stock, subject to registration, $0.01 par value;1,871,431
                  and 571,431 shares issued and outstanding atMarch
                  31, 2006 and December 31, 2005, respectively, net oforiginal
                  value of warrants of $958,625 at both March 31, 2006 andDecember
                  31, 2005 and issuance costs of $87,050 and $15,000at
                  March 31, 2006 and December 31, 2005, respectively
              
              
              4,360,324
              
              
              1,026,374Total
                  liabilities and temporary equity
              
              
              20,729,084
              
              
              15,996,304Stockholders'
                  equity (deficit):Common
                  stock, $.01 par value: 50,000,000 shares authorized;37,327,069
                  and 36,777,069 shares issued and outstanding,at
                  March 31, 2006 and December 31, 2005, respectively
              
              
              373,271
              
              
              367,771Additional
                  paid-in capital
              
              
              78,388,039
              
              
              76,631,925Other
                  comprehensive income
              
              
              250,046
              
              
              222,317Accumulated
                  deficit
              
              
              (87,298,510
              )
              
              (81,665,841
              )Total
                  stockholders' equity (deficit)
              
              
              (8,287,154
              )
              
              (4,443,828
              )Total
                  liabilities, temporary equity, and stockholders' equity
                  (deficit)
              
              $
              12,441,930
              
              $
              11,552,476See
                  accompanying notes to condensed consolidated financial
                  statements.






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SPATIALIGHT,
                  INC.CONDENSED
                  CONSOLIDATED STATEMENTS OF
                  OPERATIONS (Unaudited)
  Three
                  months ended
                March
                  31,2006
              
              2005Revenue
              
              $
              85,694
              
              $
              97,759Cost
                  of revenue
              
              
              (1,548,330
              )
              
              (69,844
              )Gross
                  margin
              
              
              (1,462,636
              )
              
              27,915Selling,
                  general and administrative expenses (including stock-basedgeneral
                  and administrative expenses of $668,837 and $99,050for
                  the periods ended March 31, 2006 and 2005, respectively)
              
              
              2,640,094
              
              
              1,806,315Research
                  and development expenses
              
              
              242,071
              
              
              493,496Total
                  operating expenses
              
              
              2,882,165
              
              
              2,299,811Operating
                  loss
              
              
              (4,344,801
              )
              
              (2,271,896
              )Other
                  income (expense):Interest
                  expense:Interest
                  expense
              
              
              (282,988
              )
              
              (267,135
              )Non-cash
                  interest expense
              
              
              (1,012,771
              )
              
              (277,592
              )Total
                  interest expense
              
              
              (1,295,759
              )
              
              (544,727
              )Gain
                  from revaluation of note purchase option and investment right
                  liabilities
              
              
              —
              
              
              651,235Loss
                  from revaluation of warrants
              
              
              (12,418
              )
              
              —Foreign
                  currency translation gain
              
              
              4,573
              
              
              —Interest
                  and other income
              
              
              16,536
              
              
              19,153Total
                  other income (expenses)
              
              
              (1,287,068
              )
              
              125,661Loss
                  before income tax expense
              
              
              (5,631,869
              )
              
              (2,146,235
              )Income
                  tax expense
              
              
              800
              
              
              2,300Net
                  loss
              
              $
              (5,632,669
              )
              $
              (2,148,535
              )Net
                  loss per share - basic and diluted
              
              $
              (0.15
              )
              $
              (0.06
              )Weighted
                  average shares used in computingnet
                  loss per share- basic and diluted
              
              
              38,590,722
              
              
              35,817,964See
                  accompanying notes to condensed consolidated financial
                  statements






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SPATIALIGHT,
                INC.CONDENSED
                CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
                (DEFICIT) (unaudited)THREE
                MONTHS ENDED MARCH 31, 2006


**ADDITIONAL**
              
              
              
              **OTHER**
              
              **TOTAL****COMMON
                  SHARES**
              
              **PAID-**
              
              **ACCUMULATED**
              
              **COMPRENSIVE**
              
              **STOCKHOLDERS'****STOCK**
              
              **AMOUNT**
              
              **IN
                  CAPITAL**
              
              **DEFICIT**
              
              **INCOME**
              
              **EQUITY
                  (DEFICIT)**Balance,
                  January 1, 2006
              
              
              36,777,069
              
              $
              367,771
              
              $
              76,631,925
              
              $
              (81,665,841
              )
              $
              222,317
              
              $
              (4,443,828
              )Exercise
                  of stock options and warrants
              
              
              50,000
              
              
              500
              
              
              39,745
              
              
              -
              
              
              -
              
              
              40,245Stock-based
                  compensation expense
              
              
              -
              
              
              -
              
              
              668,837
              
              
              -
              
              
              -
              
              
              668,837Issuance
                    of common shares, net of issuance costsof
                    $37,468
              
              
              500,000
              
              
              5,000
              
              
              1,047,532
              
              
              -
              
              
              -
              
              
              1,052,532Comprehensive
                  loss:Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              (5,632,669
              )
              
              -
              
              
              (5,632,669
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              27,729
              
              
              27,729Total
                  comprehensive loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (5,604,940
              )Balance,
                  March 31, 2006
              
              
              37,327,069
              
              $
              373,271
              
              $
              78,388,039
              
              $
              (81,665,841
              )
              $
              222,317
              
              $
              (8,287,154
              )


See
        accompanying notes to condensed consolidated financial
        statements




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SPATIALIGHT,
                  INC.CONDENSED
                  CONSOLIDATED STATEMENTS OF CASH FLOWS
                  (unaudited)
  Three
                  months ended
                March
                  31,2006
              
              2005Cash
                  flows from operating activities:Net
                  loss
              
              $
              (5,632,669
              )
              $
              (2,148,535
              )Adjustments
                  to reconcile net loss to net cash used in operating
                  activities:Inventory
                  reserve adjustment
              
              
              412,594
              
              
              —Depreciation
                  and amortization
              
              
              228,884
              
              
              119,284Stock-based
                  general and administrative expenses
              
              
              668,837
              
              
              99,050Non-cash
                  interest expense
              
              
              1,012,771
              
              
              277,592Gain
                  from revaluation of note purchase option and investment right
                  liabilities
              
              
              —
              
              
              (651,235
              )Loss
                  from revaluation of warrants
              
              
              12,418
              
              
              —Non-cash
                  foreign currency translation loss
              
              
              4,573
              
              
              —Accrued
                  interest on notes receivable from stockholder
              
              
              —
              
              
              (2,331
              )Loss
                  on sale of fixed assets
              
              
              1,545
              
              
              —Changes
                  in operating assets and liabilities:Accounts
                  receivable
              
              
              (27,760
              )
              
              218,346Inventory
              
              
              (88,684
              )
              
              (150,788
              )Prepaids
                  and other current assets
              
              
              (110,580
              )
              
              363,192Other
                  assets
              
              
              12,992
              
              
              15,294Accounts
                  payable
              
              
              (424,222
              )
              
              350,680Accrued
                  expenses and other current liabilities
              
              
              (294,798
              )
              
              (199,339
              )Net
                  cash used in operating activities
              
              
              (4,224,099
              )
              
              (1,708,790
              )Cash
                  flows from investing activities:Purchase
                  of property, plant and equipment
              
              
              (226,841
              )
              
              (3,310,285
              )Net
                  cash used in investing activities
              
              
              (226,841
              )
              
              (3,310,285
              )Cash
                  flows from financing actitivies:Proceeds
                  from issuance of short-term notes
              
              
              3,666,977
              
              
              —Payment
                  on short-term notes
              
              
              (2,306,320
              )
              
              —Proceeds
                  from the sale of common shares, net of fees
              
              
              4,386,482
              
              
              —Proceeds
                  from exercise of warrants and options
              
              
              40,245
              
              
              50,200Net
                  cash provided by financing activities
              
              
              5,787,384
              
              
              50,200Net
                  increase (decrease) in cash and cash equivalents
              
              
              1,336,444
              
              
              (4,968,875
              )Effect
                  of exchange rate changes on cash
              
              
              8,402
              
              
              (3,078
              )Cash
                  and cash equivalents at beginning of period
              
              
              42,565
              
              
              9,087,551Cash
                  and cash equivalents at end of period
              
              $
              1,387,411
              
              $
              4,115,598Supplemental
                  disclosure of cash flow information:Income
                  taxes paid during the period
              
              $
              800
              
              $
              800Interest
                  paid during the period
              
              $
              247,162
              
              $
              246,575See
                  accompanying notes to condensed consolidated financial
                  statements.


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**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
      T-3 LCoS Set, to our customers and prospective customers, who are located
      primarily in Asia. The T-3 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 or manufacturing light engines for incorporation into high
      definition televisions. Currently we are working with OEMs of high definition
      televisions, light engines for incorporation into high definition televisions
      and near-to-eye display devices.





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





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 three month period ended March
      31, 2006 are not necessarily indicative of results for the full fiscal year.
      The
      accompanying consolidated balance sheet at December 31, 2005 has been derived
      from the audited financial statements at that date.





The
      accompanying condensed consolidated financial statements have been prepared
      assuming we will continue as a going concern. As reported in our 2005 Annual
      Report on Form 10K/A filed with the SEC on April 11, 2006, we have suffered
      recurring operating losses and negative cash flows from operations. We have
      continued to suffer operating losses during the first three 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 Notes have
      occurred. We strongly dispute that any events of default have occurred that
      would allow the Noteholders to call the notes, and we plan to vigorously defend
      our position. We believe, after reviewing with outside counsel, with respect
      to
      each of the alleged events of default, that it is not probable that the
      Noteholders would prevail in calling the loans based on any of the alleged
      events of default; therefore, we have continued classifying the Notes as
      noncurrent liabilities in the accompanying 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 Notes, and prevail
      on their claim in a court of law, the Notes and related redemption premiums
      and
      liquidated damages would immediately become due and payable.




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**SPATIALIGHT,
      INC.**


Notes
      to
      Condensed Consolidated Financial Statements (Unaudited)




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





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





From
      inception through March 31, 2006, we have sustained recurring net losses from
      operations totaling approximately $87.3 million and at March 31, 2006, had
      total
      stockholders’ deficit of approximately $8.3 million and net negative working
      capital of approximately $2.4 million. During the three months ended March
      31,
      2006, we experienced a net cash increase of approximately $1.3 million. In
      the
      first quarter of 2006, cash was primarily provided by the net proceeds of
      approximately $3.3 million that we received from the sale of 1,300,000 of our
      common shares on January 12, 2006 at a purchase price of $2.62 per share and
      approximately $1.1 million that we received from the sale of 500,000 of our
      common shares on March 17, 2006 at a purchase price of $2.18 per share. The
      500,000 shares sold in March 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. Additional contributions
      came from the exercise of employee stock options. The funds from these
      financings were used to fund our operations for the first three months of 2006.
      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. We recognized net losses for the three months ended March 31,
      2006, of approximately $5.6 million.





We
      expect
      to meet our immediate cash needs and fund our immediate working capital
      requirements with our existing cash balances and from additional sources. Those
      sources include **** cash
      payments from our customers; the exercises of stock options and warrants; and
      additional sales of our common shares. There can be no assurances with respect
      to these potential sources. We believe that our current cash and cash
      equivalents as of March 31, 2006, combined with the proceeds of approximately
      $2.4 million from the sale of 750,000 of our common shares on April 7, 2006
      from
      a private placement of our common shares, as more fully described in Note 13
      will be sufficient to meet our capital and liquidity requirements through June
      2006.





**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 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 Opinion 25, “ *Accounting
      for Stock Issued to Employees,* ”
(“APB
      25”) and related interpretations in accounting for our stock
      compensation.




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


We
      elected the modified prospective method in adopting SFAS 123R. 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 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. In accordance with the modified prospective
      method, the consolidated financial statements for periods prior to 2006 have
      not
      been restated to reflect SFAS 123R. Therefore, the results for the first quarter
      of 2006 are not directly comparable to the same period in the prior
      year.





Under
      the
      provisions of SFAS 123R, we recorded $668,837 of stock compensation, net of
      estimated forfeitures, in selling, general and administrative expenses, in
      our
      unaudited condensed consolidated statement of operations for the three months
      ended March 31, 2006. 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:


2006Dividend
                  yield
              
              
              —Expected
                  volatility
              
              
              92.80
              %Risk-free
                  interest rate
              
              
              4.60
              %Expected
                  lives (in years)
              
              
              5.21
                  to 5.46




The
      dividend yield of zero is based on the fact that we have never paid cash
      dividends and have no present intention to pay cash dividends. Expected
      volatility is based upon historical volatility of our common stock over the
      period commensurate with the expected life of the options. The risk-free
      interest rate is derived from the average U.S. Treasury Constant Maturity Rate
      during the period, which approximates the rate in effect at the time of the
      grant. Of our currently unvested options, 575,000 vest over six months, and
      the
      remaining over two years from the date of grant. Our options generally have
      a
      10-year term. The expected term is calculated using the simplified method
      prescribed by the SEC’s Staff Accounting Bulletin 107. Based on the above
      assumptions, the weighted-average fair values of the options granted under
      the
      stock option plans for the three months ended March 31, 2006 was $1.97. As
      required by SFAS No. 123R, we now estimate forfeitures of employee stock
      options and recognize compensation cost only for those awards expected to vest.
      Forfeiture rates are determined for four groups of employees - CEO,
      directors, senior management and all other employees - based on historical
      experience.  Estimated forfeitures are now adjusted to actual forfeiture
      experience as needed.




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 income (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 (dollars in thousands, except per-share data).




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


Three
                  months ended March 31,2005Net
                  loss as reported
              
              $
              2,148,535Add:
                  Stock-based employee/director compensationincluded
                  in reported net loss
              
              
              8,250Deduct:
                    total stock-based employee compensationdetermined
                    under fair value method for all awards
              
              
              (1,043,100
              )Proforma
                  net loss, as adjusted
              
              $
              (3,183,385
              )Loss
                  per share:Basic
                  and diluted, as reported
              
              $
              (0.06
              )Basic
                  and diluted, as adjusted
              
              $
              (0.09
              )





The
      assumptions used to determine the pro forma expenses under the Black-Scholes
      option model for the three months ended March 31, 2005 under SFAS 123 were
      based
      on the following assumptions: expected dividend yield: 0; expected volatility:
      89%; expected lives, in years: 4 ; and risk-free interest rate: 4.2%. In the
      pro
      forma information for periods prior to 2006, we accounted for forfeitures as
      they occurred.





A
      summary
      of options under the Company’s stock option plans as of December 31, 2005 and
      changes during the quarter ended March 31, 2006 are as follows (in thousands,
      except exercise price and contractual term):




Number
                  of
                Shares
              
              Weighted
                  Average Exercise Price
              
              Weighted
                  Average Remaining Contractual Term
                (in
                  years)
              
              Aggregate
                Intrinsic
                  ValueOutstanding
                  December 31, 2005
              
              
              5,882,394
              
              $
              4.06
              
              
              5.79Options
                  granted under the plan
              
              
              850,000
              
              $
              2.60Options
                  exercised
              
              
              (50,000
              )
              $
              0.80Options
                  forfeited and expired
              
              
              (52,500
              )
              $
              5.36Outstanding
                  March 31, 2006
              
              
              6,629,894
              
              $
              3.56
              
              
              6.13
              
              $
              5,158,706Options
                  vested and exercisableat
                  March 31, 2006
              
              
              5,242,394
              
              $
              3.55
              
              
              5.68
              
              $
              4,359,706
  Aggregate
          intrinsic value is the sum of the amounts by which the quoted market price
          of
          our stock exceeded the exercise price of the options at March 31, 2006,
          for
          those options for which the quoted market price was in excess of the exercise
          price (“in-the-money-options”). The total intrinsic value of options exercised
          was $112, 865 and $40,425 for the three month period end March 31, 2006
          and
          2005, respectively.
 As of March 31, 2006, total compensation cost
          of unvested options is $1.9 million. This cost is expected to be recognized
          through June 2007. We recorded no income tax benefits for stock-based
          compensation expense arrangements for the three months ended March 31,
          2006, as
          we have cumulative operating losses, for which a valuation allowance has
          been
          established.




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**SPATIALIGHT,
      INC.**


Notes
      to
      Condensed Consolidated Financial Statements (Unaudited)







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





Basic
      net
      loss per common share excludes dilution and is computed by dividing net loss
      by
      the weighted average number of common shares outstanding for the period. Diluted
      net loss per common share reflects the potential dilution that could occur
      if
      securities or other contracts to issue common shares were exercised or converted
      into common shares. The table below reflects potentially dilutive securities
      which were excluded from the computation of diluted net loss per share for
      the
      three months ended March 31, 2006 and 2005 because the effect of their assumed
      exercise would be antidilutive.




As
                  of March 31,2006
              
              2005Number
                  of
                Potentially
                Dilutive
                  Shares
              
              Weighted
                  Average Exercise/Conversion Price
              
              Number
                  of
                Potentially
                Dilutive
                  Shares
              
              Weighted
                  Average Exercise/Conversion PriceStock
                  options and warrants
              
              
              7,380,231
              
              $
              3.60
              
              
              6,917,761
              
              $
              4.01Convertible
                  notes
              
              
              3,404,807
              
              $
              3.29
              
              
              3,404,807
              
              $
              3.29Total
              
              
              10,785,038
              
              
              
              
              
              10,322,568





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





Property,
      plant and equipment include:


As
                    ofMarch
                    31,
                  2006
                
                December
                    31,
                  2005Building
                
                $
                4,497,652
                
                $
                4,360,663Other
                    equipment and instruments
                
                
                2,610,013
                
                
                2,659,653Machinery
                    and manufacturing equipment
                
                
                1,272,117
                
                
                1,141,726Office
                    furniture and fixtures
                
                
                461,037
                
                
                590,696Tooling
                
                
                371,700
                
                
                371,700Leasehold
                    improvements
                
                
                175,654
                
                
                175,654Computer
                    hardware and software
                
                
                349,148
                
                
                215,109Total
                    property, plant and equipment
                
                
                9,737,321
                
                
                9,515,201Accumulated
                    depreciation
                
                
                (2,893,311
                )
                
                (2,701,681
                )Property,
                    plant and equipment, net
                
                $
                6,844,010
                
                $
                6,813,520




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





Short-Term
      Loans





*Short-Term
      Loan From a Related Party*





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




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**SPATIALIGHT,
        INC.**
 Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)
 *Short-Term
        Loans*





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




Bank
              
              SHB
              
              KNB
              
              KEB
              
              PSB
              
              IBK
              
              TotalInterest
                  rate type
              
              
              Variable
                  (1
              )
              
              Variable
                  (2
              )
              
              Fixed
              
              
              Variable
                  (3
              )
              
              FixedInterest
                  rate at 3/31/06
              
              
              6.77
              %
              
              8.94
              %
              
              10.88
              %
              
              10.28
              %
              
              7.25
              %Maturity
                  date
              
              
              9/22/2006
              
              
              10/27/2006
              
              
              4/10/2006
              
              
              1/10/2007
              
              
              3/23/2007Maximum
                  amount of line
              
              
              200,000
              
              
              200,000
              
              
              300,000
              
              
              100,000
              
              
              1,500,000
              
              
              2,300,000Amount
                  outstanding at 3/31/06
              
              
              199,483
              
              
              197,277
              
              
              61,659
              
              
              99,132
              
              
              1,500,000
              
              
              2,057,551Remaining
                  available
              
              
              517
              
              
              2,723
              
              
              238,341
              
              
              868
              
              
              -
              
              
              242,449Approximate
                  US dollar equivalent
              
              $
              202,415
              
              $
              200,177
              
              $
              62,565
              
              $
              100,590
              
              $
              1,522,050
              
              $
              2,087,797
 
 (1)  
                  Yield ratio of annual bank debenture plus 1.857%(2)  
                  Yield ratio of annual industrial financial debenture plus
                  3.0%(3)  
                  Pusan Bank's internal market related base rate plus
                  5.56%




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, KEB extended
      the expiration date on the line of credit from April 10, 2006 to October 10,
      2006.





On
      March
      24, 2006, the Industrial Bank of Korea (IBK) committed itself to extend a
      secured line of credit (the “March Facility”) of up to 1.5 billion Korean Won
      (or approximately $1.5 million in U.S. dollars) to SLK. As of March 31, 2006,
      SLK had drawn down approximately $1.5 million on the March Facility for working
      capital purposes and to repay certain of its outstanding indebtedness. As
      discussed in Note 13 - Subsequent Events, the March Facility was terminated
      and
      all monies repaid on April 6, 2006.





Related
      Party and Senior Secured Convertible notes outstanding at March 31, 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 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.




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**SPATIALIGHT,
        INC.**
 Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)
 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 March 31, 2006, total prepaid interest on the Argyle
      notes for the period April 1, 2006 to December 31, 2008 is $3,182,115 with
      $1,157,133 classified as a current asset, and $2,024,982 classified as a
      non-current asset in the accompanying condensed consolidated balance sheets.





Non-cash
      interest expense includes $271,463 and $151,335 for the three months ended
      March
      31, 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
      March
      31, 2006, the carrying value of the Argyle notes totaled $1,188,000 representing
      the unpaid principal balance *.*





*November
      2004 Financing:*





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




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


The
      Senior Secured Convertible Notes are convertible, at the option of their
      holders, into our common shares at the conversion price of $9.72 per share.
      The
      Senior Secured Convertible Notes are senior to notes that we issued to Argyle,
      which, as noted above, is wholly owned by Robert A. Olins, our Chief Executive
      Officer, Secretary, Treasurer and a Director. The holders of our Senior Secured
      Convertible Notes have a senior security interest in substantially all of our
      assets, except those located in South Korea. 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 2004
      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 2004 Notes, Smithfield Fiduciary LLC (“Smithfield”), an
      affiliate of Highbridge Capital Management, LLC, notified us only with respect
      to the second alleged event 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 their 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 2004 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 Note - 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
      Note
      - Based upon a claim that we did not make a November 2005 interest payment;
      and
      (iii) Entering into unpermitted debt financing transactions prohibited pursuant
      to Section 4(a) (xi) of their Note - Based upon a claim that certain debt
      financing transactions that we have entered into are not permitted under the
      Note.





We
      believe, after review with outside legal counsel, that these allegations lack
      merit and would not entitle the Noteholders to call the Senior Secured
      Convertible Notes and 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 the Portside
      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 the 2004 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 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 their 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.




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


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
      Noteholders were entitled to call the Senior Secured Convertible 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 the Notes 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 Notes. As a result, in accordance with, FAS 5, “ *Accounting
      for Contingencies,”* we have
      continued to classify the Senior Secured Convertible Notes as a long-term
      obligation in our balance sheet at March 31, 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 March 31,
      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.




Activity
      in notes payable for the three months ended March 31, 2006 is as
      follows:




**Debt
                  Principal:**
              
              **Balance
                  at December 31, 2005**
              
              **Addition
                  or New Discount**
              
              **(Payment)
                  or Discount Amortization**
              
              **Conversion
                  to Equity**
              
              **Balance
                  at**
                **March
                  31,**
                **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
              )
              
              —
              
              
              13,050
              
              
              —
              
              
              (87,010
              )Reimbursement
                  of investor's legal fees
              
              
              (63,889
              )
              
              —
              
              
              8,333
              
              
              —
              
              
              (55,556
              )Senior
                  Secured Convertible NotesAIR
                  discount
              
              
              (683,938
              )
              
              —
              
              
              89,610
              
              
              —
              
              
              (594,328
              )Total
              
              $
              10,340,113
              
              $
              —
              
              $
              110,993
              
              $
              —
              
              $
              10,451,106**Interest:**Accrued
                  Argyle note 6%
              
              $
              —
              
              $
              17,820
              
              $
              —
              
              $
              (17,820
              )
              $
              —Argyle
                  note beneficial interest
              
              
              —
              
              
              271,463
              
              
              —
              
              
              (271,463
              )
              
              —Senior
                  Secured Convertible Notes 10%
              
              
              84,932
              
              
              247,923
              
              
              (247,923
              )
              
              —
              
              
              84,932Total
              
              $
              84,932
              
              $
              537,206
              
              $
              (247,923
              )
              $
              (289,283
              )
              $
              84,932




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**SPATIALIGHT,
      INC.**


Notes
      to
      Condensed Consolidated Financial Statements (Unaudited)





Non-cash
      interest expense is as follows:


Three
                  months ended
                March
                  31,2006
              
              2005Amortization
                  of Senior Secured Convertible Notes
              
              $
              110,993
              
              $
              110,993Amortization
                  of Argyle note discount
              
              
              —
              
              
              5,500Liquidated
                  damages on the October 2005 andJanuary
                  2006 financings
              
              
              614,457
              
              
              —Beneficial
                  conversion privileges of intereston
                  Argyle note
              
              
              271,463
              
              
              151,335Amortization
                  of prepaid financing costs
              
              
              15,858
              
              
              9,763Total
                  non-cash interest expense
              
              $
              1,012,771
              
              $
              277,592




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





Exercise
      of Stock Options and Warrants in the Three Months Ended March 31,
      2006





During
      the first quarter of 2006, 50,000 common shares were issued upon the exercise
      of
      employee/director stock options. No warrants were exercised during the first
      quarter of 2006. Total cash received from option exercises for the three months
      ended March 31, 2006 was $40,245.





Issuance
      of Shares, Stock Options and Warrants During the Three Months ended March 31,
      2006





On
      March
      17, 2006, we sold 500,000 of our common shares at a purchase price of $2.18
      per
      share to certain institutional investors. Those shares were included in our
      Post-Effective Amendment No. 6 to Form S-3 "shelf" registration statement (File
      No. 333-122392), as post-effectively amended through February 14, 2006. The
      purchase price was based upon the five-day volume weighted average price of
      our
      common shares through March 16, 2006, discounted by five percent. We received
      net proceeds of approximately $1.1 million, intended for working capital and
      other general corporate purchases. As of the date of this filing, 250,000 of
      our
      common shares included in our currently effective "shelf" registration statement
      have not been sold.





In
      mid-January 2006, we issued and sold 1,300,000 of our common shares in a private
      placement to three institutional investors. The purchase price of the common
      shares was $2.62 per share. We received approximately $3.3 million in net
      proceeds from the sale of these shares, which were used for working capital
      and
      other general corporate purposes, including the repayment of certain short-term
      debt obligations. We are required under a registration rights agreement, to
      file
      a registration statement for the resale of the shares within 30 calendar days
      after January 12, 2006 and have the registration statement declared effective
      no
      later than 90 calendar days after January 12, 2006. The latter may be extended
      to no later than 120 calendar days if the registration statement is subject
      to
      review, comments or other actions by the SEC. As the registration statement
      was
      not filed by February 11, 2006 or declared effective prior to April 12, 2006,
      we
      may be required to pay an amount equal to 5% of the aggregate purchase price
      or
      $170,300 as partial liquidated damages when each of these dates occur and an
      additional $170,300 for every 30 days thereafter up to six months. After six
      months, the percentage increases to 10% or $340,600 for each additional 30
      days.
      We have included $448,457 as liquidated damages in non-cash interest expense
      through March 31, 2006. The registration statement related to these shares
      was
      filed with the SEC on May 5, 2006.




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


The
      emerging issues task force (“EITF”) is currently reviewing the accounting for
      securities with liquidated damages clauses as stated in EITF 05-04, “The Effect
      of a Liquidated Damages Clause on a Freestanding Financial Instrument Subject
      to
      EITF 00-19”. There are currently several views as to how to account for this
      type of transaction and the EITF has not yet reached a consensus. In accordance
      with EITF 00-19, “Accounting for Derivative Financial Instruments Indexed To,
      and Potentially Settled in the Company’s Own Stock,” and EITF 05-04, because the
      maximum potential liquidated damages as described above may be greater than
      the
      difference in fair values between registered and unregistered shares, the value
      of the common stock subject to registration should be classified as temporary
      equity until the registration statement becomes effective. Based on the above
      determination, the Company has classified the $3,333,950 value of common stock
      subject to registration as temporary equity as of March 31, 2006 related to
      the
      January 2006 Financing. Additionally, $1,026,374 related to our October 2005
      equity financing continues to be classified as temporary equity at March 31,
      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. We have included $56,000
      as liquidated damages in non-cash interest for the first quarter of 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 $110,000 as liquidated damages in non-cash interest
      expense through March 31, 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.





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


Three
                  months ended
                March
                  31,2006
              
              2005Options
                  granted to employees and directors
              
              $
              668,837
              
              $
              8,250Warrants
                  issued for services
              
              
              —
              
              
              90,800$
              668,837
              
              $
              99,050




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





Our
      chief
      operating decision-maker is our Chief Executive Officer. The chief operating
      decision-maker reviews only financial information prepared on a basis
      substantially consistent with the accompanying condensed consolidated financial
      statements of operations. Therefore, we have determined that we operate in
      a
      single business segment. All of our assets are located at our facilities in
      the
      United States at March 31, 2006, except for the following:




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


Korea
              
              Hong
                  Kong
              
              Japan
              
              TotalCash
              
              $
              1,150,823
              
              $
              —
              
              $
              —
              
              
              1,150,823Accounts
                  receivable
              
              
              153,279
              
              
              
              
              
              
              
              
              153,279Prepaid
                  expenses
              
              
              138,727
              
              
              
              
              
              
              
              
              138,727Deposits
              
              
              10,502
              
              
              
              
              
              
              
              
              10,502Building,
                  net
              
              
              4,349,772
              
              
              —
              
              
              —
              
              
              4,349,772Machinery
                  and manufacturing equipment, net
              
              
              719,883
              
              
              —
              
              
              —
              
              
              719,883Office
                  furniture and fixtures, net
              
              
              106,606
              
              
              —
              
              
              —
              
              
              106,606Other
                  equipment and instruments, net
              
              
              746,329
              
              
              —
              
              
              —
              
              
              746,329Inventory,
                  net
              
              
              253,775
              
              
              109,164
              
              
              4,228
              
              
              367,167$
              7,629,696
              
              $
              109,164
              
              $
              4,228
              
              $
              7,743,088
 The
      following table summarizes our product revenue percentages for the three months
      ended March 31, 2006 and 2005.




Three
                  months ended
                March
                  31,2006
              
              2005LCoS
                  (T-3) sets
              
              
              85
              %
              
              69
              %LCoS
                  (T-1) sets
              
              
              —
              
              
              10
              %Light
                  engine display units
              
              
              —
              
              
              2
              %Other
                  (primarily supporting electronics)
              
              
              15
              %
              
              19
              %Total
              
              
              100
              %
              
              100
              %


Of
      our
      total revenue in 2006, 82% was derived from the sales of our LCoS Sets to LG
      Electronics, a customer located in South Korea. The remaining 18% was derived
      from the sales of our LCoS Sets to ThinTek Optronics, our customer in Taiwan.
      LG
      Electronics made up 92% of our accounts receivable balance at March 31, 2006.





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





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


March
                  31,
              
              December
                  31,2006
              
              2005Raw
                  materials
              
              $
              999,372
              
              $
              796,770Work-in-progress
              
              
              63,136
              
              
              17,043Finished
                  goods
              
              
              134,277
              
              
              294,2871,196,785
              
              
              1,108,100Inventory
                  reserve
              
              
              (763,972
              )
              
              (351,377
              )Total
                  inventory
              
              $
              432,813
              
              $
              756,723







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**SPATIALIGHT,
        INC.**
 Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)
  **Note
                11.**
              **Recent
                  Accounting Pronouncements**





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).
      The Company does not
      expect this statement to have a material impact on its consolidated financial
      statements .





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 in the first quarter of 2006 .





**Note
              12.**
            **Commitments
                and Contingencies**




*Alleged
      Events of Default on Senior Secured Convertible Notes*





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





*Legal
      Proceedings*





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





*U.S.
      Securities and Exchange Commission Investigation*





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




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


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





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





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




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


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





*Other
      matters*





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





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





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





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
              13.**
            **Subsequent
                Events**





*April
      2006 Financing*





On
      April
      7, 2006, we sold 750,000 of our common shares at a purchase price of $3.26
      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
      Number 333-122392), as post-effectively amended through February 14, 2006,
      which
      was declared effective by the SEC in July 2005. We received net proceeds of
      approximately $2.4 million from the transaction.




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**SPATIALIGHT,
        INC.**
 Notes
        to
        Condensed Consolidated Financial Statements (Unaudited)
 *Termination
        of March 2006 Credit Facility*





On
      April
      6, 2006, SLK, our wholly-owned subsidiary terminated the 1.5 billion Korean
      Won
      line of credit (the “March Facility”) established on March 24, 2006 with the
      Industrial Bank of Korea (IBK) by repaying all monies borrowed as well as
      certain prepayment and finance charges. IBK has released its lien on SLK’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.




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





*This
      Form 10-Q contains certain forward-looking statements within the meaning of
      Section 21E of the Securities and Exchange Act of 1934, as amended, which
      statements are subject to the Safe Harbor provisions created by that statute.
      In
      this report, the words “anticipates,” “believes,” “expects,” “future,”
“intends,” and similar expressions identify forward-looking statements. Such
      statements are subject to certain risks and uncertainties, including, but not
      limited to, those discussed herein, those contained in this Part II Item 1A
      and
      those discussed in the Company’s Annual Report on Form 10-K/A - Amendment No. 1
      as filed with the Securities and Exchange Commission on April 11, 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 March 31, 2006, and our results of operations for the three
      months ended March 31, 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.
      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 (see Exhibit 10.5 to
      our
      2004 Annual Report on Form 10-K/A filed with the SEC on December 29, 2005),
      providing for us to sell our T-3 LCoS Sets to LG Electronics. Our supply
      agreement with LG Electronics provides that we will be their exclusive supplier
      of three-chip LCoS microdisplay products for twelve months beginning from the
      date that we commenced shipments under that agreement. Furthermore, our
      agreement provides that LG Electronics will have the exclusive right in South
      Korea to purchase T-3 microdisplay products from us for the twelve months
      beginning from the date that we commenced shipments under that agreement. In
      July 2005, we commenced delivering a limited quantity of commercial production
      LCoS Sets to LG Electronics. Under the July 2004 agreement, LG Electronics
      agreed to purchase from us a minimum of 21,000 LCoS Sets during an initial
      six-month delivery period, which was originally scheduled to commence in January
      2005, subject to LG Electronics' completion of pre-production requirements.
      Our
      July 2005 product delivery to LG Electronics included a smaller quantity of
      LCoS
      Sets than was originally contemplated under the July 2004 agreement for the
      first delivery month. We delivered those LCoS Sets in July 2005 based upon
      our
      expectation that in the immediate future we would receive a firm purchase order
      from LG Electronics.





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 six-month delivery period
      purchase commitment. In October 2005, we publicly announced that we had received
      the formal written qualification letter from LG Electronics stating that we
      have
      met certain agreed upon technical specifications (which had been the subject
      of
      prior informal approval in July 2005). We later agreed with LG Electronics
      to
      move the initial six-month delivery period to November 2005 through April 2006.
      We subsequently agreed with LG Electronics, through a series of communications,
      that the initial purchase order for 9,300 LCoS Sets may be filled over a period
      of time that will extend beyond April 2006. We currently expect that we will
      be
      able to fulfill the initial order for 9,300 LCoS Sets by the end of the summer
      of 2006. This revised schedule has been based primarily upon changing
      expectations about our production output capacity and will allow us to conduct
      a
      focused ramp up of our LCoS Set production in South Korea.




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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 and problems
      that we have experienced in increasing our manufacturing volumes. These
      manufacturing problems were principally attributable to external variables
      in
      the manufacturing environment including temperature, humidity and dust particle
      presence. These manufacturing problems occurred during the alignment coating,
      glue application and cell lamination portions of our manufacturing process,
      which are highly susceptible to those external variables. Until recently, those
      portions of the manufacturing process were being carried out in our production
      facility in California. We have attempted to address our manufacturing problems
      by recently relocating these portions of our manufacturing process to our
      production facility in South Korea, where we believe that 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, in recent tests and production runs, it appears that we are no
      longer experiencing the production problems attributable to the external
      variables specified above. However, in April 2006, we experienced certain
      production problems that we believe are attributable to flaws in the silicon
      wafers that we obtained from our supplier. We are working with that supplier
      to
      attempt to remedy these flaws that we believe are causing the problems in our
      production.





Our
      entire manufacturing operations are now conducted at the facility in South
      Korea. The transfer of those specific portions of the process caused a delay
      in
      manufacturing operations while production equipment was physically transferred
      from California to South Korea and South Korean employees are being trained
      to
      use that equipment. The final phase of this transition occurred during the
      first
      quarter of 2006. We believe that having manufacturing take place in one location
      will allow us to maintain a higher level of quality controls over LCoS Set
      production, which we expect will increase our long-term manufacturing yields
      and
      improve our ability to produce sufficient quantities of LCoS Sets to meet future
      quantity demands from LG Electronics and other customers and prospective
      customers. The potential negative impact upon our results of operations that
      could be caused by additional difficulties in manufacturing our LCoS Sets are
      described under the Risk Factors section of our Annual Report on Form 10-K,
      as
      amended.





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. LG Electronics has also announced that it intends
      LCoS product rollouts into the South Korean consumer market in the near future.
      LG Electronics recently communicated to its distributors that it has postponed
      its plans to introduce its 71” and 62” LCoS televisions into the U.S.
      marketplace. LG 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. Although LG Electronics has advised
      us
      that it is maintaining future plans for expansion into the United States and
      other markets, there can be no assurances as to the timing of those rollouts.
      We
      believe that delays in LG Electronics' initial product rollouts have been based
      upon revisions to our delivery schedule and our problems in ramping up
      production that have occurred over time.




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In
      2005,
      a substantial percentage of our product deliveries, which were in small
      quantities, were made to LG Electronics. Based upon our agreement with LG
      Electronics and our present expectations, it is likely that a substantial
      percentage of our anticipated future product deliveries in the first half of
      2006 will be made to LG Electronics as well. In the event that we are unable
      to
      ramp up our delivery volumes to LG Electronics by the end of July 2006, we
      believe that it is reasonably likely that LG Electronics may discontinue
      actively doing business with us.  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 occurred through all four quarters of 2005, and we have continued
      to
      deliver to date. 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. We have continuing business relationships
      with
      customers and prospective customers in Taiwan, including ThinTek. We are
      maintaining our plans to ship our products to ThinTek and prospective Taiwanese
      customers in 2006. We cannot provide assurance concerning the quantities of
      our
      products that we will sell to ThinTek and other prospective customers in the
      future.




***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, has commenced sales of 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 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.




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




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




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***Other
      Business Development***





We
      are
      currently continuing to develop working relationships with prospective
      customers, located primarily in Japan and other parts of the Pacific Rim region.
      These prospective customers fall into two general categories: 1) television
      manufacturers and 2) light engine suppliers. We have provided samples of our
      LCoS Sets to certain of these prospective customers, but we do not have any
      formal agreements with these parties. While we have made significant progress
      with respect to product integration and negotiating purchase orders with certain
      of these prospective customers, we cannot assure that we will receive any
      purchase orders 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.





***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 and personal media players,
      which will enable the viewing of broadband content, cable and satellite
      television, music videos as well as playing of video games, all with the
      experience of high definition large screen television. The device will
      be designed to minimize the weight and maximize the comfort of the
      eyeglasses by locating the LCoS microdisplays and control functions in the
      wireless phone, PDA or personal media player, with the video signal transmitted
      to the eyeglass through optical fiber. We are in the process
      of developing a new dual imager solution for this display
      application.  We believe that 3-D near-to-eye display products represent a
      growing segment of the consumer electronics sector and we intend to
      actively pursue business opportunities in this market, although there
      can be no assurances that we will be able to derive meaningful sales from this
      market.




***Manufacturing
      of LCoS Sets***





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




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We
      are
      currently training our operators and supervisors in key processes and equipment
      familiarization. We recently completed the process of moving all of our
      manufacturing operations to South Korea, which included physically moving all
      manufacturing equipment that remained in California as of the end of 2005.
      As
      part of the transition to full-scale manufacturing, we experienced some
      manufacturing problems. These manufacturing problems have been principally
      attributable to external variables in the manufacturing environment including
      temperature, humidity and dust particle presence. The manufacturing problems
      have occurred during the alignment coating, glue application and cell lamination
      portions of our manufacturing process, which are highly susceptible to those
      external variables such as dust particle presence, temperature and humidity.
      Until recently, those portions of the manufacturing process were being carried
      out in our production facility in California. We have attempted to address
      our
      manufacturing problems by recently relocating these portions of our
      manufacturing process to our production facility in South Korea, where we
      believe that 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, in recent tests and production runs,
      it
      appears that we are no longer experiencing the production problems attributable
      to the external variables specified above. However, in April 2006 we experienced
      certain production problems that we believe are attributable to flaws in the
      silicon wafers used for our backplane that we obtained from our supplier. We
      are
      working with that supplier to attempt to remedy these flaws that we believe
      are
      causing the problems in our production. Potential difficulties in manufacturing
      process 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 and under Risk Factors in our Annual Report on Form 10-K/A filed with the
      SEC
      on April 11, 2006.





See
      “Status of Business with LG Electronics, Inc.” for a detailed discussion of
      manufacturing problems that we are experiencing and its effect upon our
      business.




***Business
      Strategy***





We
      are
      currently offering one core product, our T-3 LCoS Set, to our customers and
      prospective customers, all of whom are located primarily in Asia. Our LCoS
      Set
      is comprised of three of our proprietary SpatiaLight imagEngineTM LCoS
      microdisplays. They are constructed with a silicon chip, a layer of liquid
      crystals and a glass cover plate in contrast to the more common construction
      of
      liquid crystals sandwiched between two glass plates. Our displays are also
      known
      as, and commonly referred to as, liquid crystal on silicon (LCoS), liquid
      crystal displays (LCD), active matrix liquid crystal displays and spatial light
      modulators. Another former product that we no longer offer to our customers,
      except out of current inventory, is the display unit, which is comprised of
      an
      LCoS Set fitted onto a light engine.





Our
      T-3
      LCoS Set, which is the only model we currently manufacture, 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 that higher
      resolution product will be significantly greater.




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
      in
      the direction of more LCoS Sets and less display units. 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. Beginning in the first quarter of 2006, we are actively
      offering only LCoS Sets to our customers and prospective customers.




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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. While we currently sell a minor 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 obtaining the supply agreement with LG Electronics.
      The
      T-3 model is the central component of our ongoing customer acquisition strategy
      described above.





***Certain
      Developments***





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 to Amendment Nos. 5 and 6 to the
      Financing Registration Statement and to Amendment Nos. 3 and 4 to the Shelf
      Registration Statement in order to incorporate by reference their report on
      our
      consolidated financial statements for the fiscal years ended December 31, 2002
      and 2003, respectively. Although we received the requisite authorized consents
      from BDO Seidman to incorporate by reference their report on the consolidated
      financial statements into the Financing Registration Statement and the Shelf
      Registration Statement when initially filed and in subsequent amendments thereto
      (and BDO Seidman has not withdrawn these subsequent consents), we did not
      receive the requisite authorization from BDO Seidman to file its consent as
      an
      exhibit to the penultimate and final pre-effective amendments to either the
      Financing Registration Statement or the Shelf Registration Statement (i.e.
      Amendment Nos. 5 and 6 and Amendment Nos. 3 and 4 to the respective registration
      statements). The penultimate and final pre-effective amendments to both the
      Financing Registration Statement and the Shelf Registration Statement were
      filed
      with the SEC on July 27, 2005.




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





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




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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 draft Audit Committee Report, in
      December 2005, Mr. Olins made the $50,000 payment to reimburse the Company.
      To
      date, our Board of Directors has not been supplemented with a financial expert
      and we have not hired a fulltime CFO or Controller. As of April 28, 2006, we
      have hired a part-time Director of Accounting and Finance.





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





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 the consolidated financial statements appearing in our 2004 Annual
      Report on Form 10-K/A 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
      Amendment No. 6 to both the Financing Registration Statement and the Shelf
      Registration Statement were declared effective by the SEC.





LIQUIDITY
      AND CAPITAL RESOURCES




As
      of
      March 31, 2006, we had approximately $1.4 million in cash and cash equivalents,
      an increase of approximately $1.3 million from the December 31, 2005 balance
      of
      approximately $43,000. Our net working capital deficiency at March 31, 2006
      was
      approximately $2.4 million compared to approximately $2.3 million at December
      31, 2005.





Net
      cash
      used in operating activities totaled approximately $4.2 million and $1.7 million
      for the three months ended March 31, 2006 and 2005, respectively, representing
      an increase of approximately $2.5 million. The increase in cash used in
      operating activities in 2006 is primarily associated with operating our
      manufacturing facility prior to its being at full operating
      capacity.




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Net
      cash
      used in investing activities totaled approximately $0.2 million and $3.3 million
      for the three months ended March 31, 2006 and 2005, respectively. Cash used
      in
      investing activities during 2005 were related to building our South Korean
      manufacturing facility. These building activities were completed during
      2005.





Net
      cash
      provided by financing activities in the three months ended March 31, 2006 and
      2005 were approximately $5.8 million and $50,000, respectively. In the first
      quarter of 2006, cash was primarily provided by the net proceeds of
      approximately $3.3 million that we received from the sale of 1,300,000 of our
      common shares on January 12, 2006 at a purchase price of $2.62 per share and
      approximately $1.1 million that we received from the sale of 500,000 of our
      common shares on March 17, 2006 at a purchase price of $2.18 per share. The
      500,000 shares sold on March 17, 2006 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. We borrowed
      an additional approximately $1.4 million on our lines of credit with South
      Korean banks during the first quarter of 2006. Additional contributions came
      from the exercise of employee stock options. In 2005, cash was provided
      primarily from the exercise of employee stock options and warrants.





We
      expect
      to meet our immediate cash needs and fund our immediate working capital
      requirements with our existing cash balances and from additional sources. Those
      sources include proceeds of approximately $2.4 million that we received from
      the
      sale of 750,000 of our common shares on April 10, 2006, cash payments from
      our
      customers; the exercises of stock options and warrants; and additional sales
      of
      our common shares and/ or derivative securities. There can be no assurances
      with
      respect to these potential sources. We believe that our current cash and cash
      equivalents as of March 31, 2006, combined with the proceeds of approximately
      $2.4 million from the sale of 750,000 of our common shares on April 7, 2006
      from
      a private placement of our common shares, as more fully described in Note 13,
      will be sufficient to meet our capital and liquidity requirements for our
      operations through June 2006. We will be required to raise significant amounts
      of additional capital to continue to fund our operations on a going forward
      basis. To raise additional capital, we plan to sell the remaining 250,000 common
      shares that we have available for sale under a currently effective “shelf”
registration statement. We also believe that we will be required to complete
      additional equity and/or debt financings in 2006. If we are unable to obtain
      additional funds on reasonable terms, we may be unable to continue our
      operations at current levels, or at all.





RESULTS
      OF OPERATIONS





*Three
      months ended March 31, 2006 and 2005*





*Revenue* . ** We
      recognized revenue of approximately $86,000 and $98,000 during the quarter
      ended
      March 31, 2006 and 2005, respectively. Revenue in both periods was derived
      primarily from sales of LCoS Sets to LG Electronics.





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


Three
                  months ended
                March
                  31,2006
              
              2005LCoS
                  (T-3) sets
              
              
              85
              %
              
              69
              %LCoS
                  (T-1) sets
              
              
              —
              
              
              10
              %Light
                  engine display units
              
              
              —
              
              
              2
              %Other
                  (primarily supporting electronics)
              
              
              15
              %
              
              19
              %Total
              
              
              100
              %
              
              100
              %







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Revenue
      from one customer, LG Electronics, accounted for 82% and 69% of our total
      revenue for the three months ended March 31, 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 was reduced from approximately $28,000 during the first quarter of 2005
      to negative gross margin of approximately $1,463,000 during the first quarter
      2006. The first quarter of 2006 includes the costs to operate our South Korean
      manufacturing facility. We were in the process of building this facility during
      the first quarter of 2005 but had no operational expenses related to it. As
      long
      as our production capabilities and therefore sales continue to lag behind the
      costs to run this facility, we will continue to experience negative gross
      margins. Additionally, cost of revenue during the first quarter of 2006 includes
      a reserve of approximately $413,000, which was recorded to reserve the remaining
      value of our T-1 LCoS Set inventory as well as a percentage of our light engine
      inventory. We believe there are still opportunities to sell both products,
      but
      we have shifted our focus to the manufacture and sale of our T-3 LCoS Set
      products. We are not currently manufacturing either the T-1 LCoS Set or the
      light engine products and their sales were minimal during 2005.





*Selling,
      general and administrative costs.* Cash-based selling, general and administrative costs were approximately
      $1,971,000 and $1,710,000 during the three months ended March 31, 2006 and
      2005,
      respectively, an increase of $261,000 or 15%. Contributing to the increase
      was
      approximately $215,000 of wages, office supplies and other general and
      administrative expenses related to our new South Korean facility. Additional
      increases included $92,000 for freight, primarily related to shipments of
      equipment and supplies to our South Korean facility, and increased consulting
      costs of $72,000 related to the requirements of complying with the
      Sarbanes-Oxley Act of 2002. Legal fees increased by approximately $183,000
      related to the routine review of our registration statements on Forms S-3 and
      our Annual Report on Form 10-K for the year ended December 31, 2005 as well
      as
      involvement with the ongoing SEC investigation. These increases were partially
      offset by decreases in general office expenses of approximately $166,000 due
      to
      a reduction of staff and activities in our California offices as well as timing
      differences. Additionally, salary and wage expense for administrative personnel
      decreased by approximately $135,000.





*Stock-based
      compensation included in selling, general and administrative
      costs.* Stock-based compensation was approximately $669,000 and $99,000 in the three
      months ended March 31, 2006 and 2005, respectively. We
      adopted Statement of Financial Accounting Standards No. 123 (revised 2004),
“ *Share-Based
      Payment* ,”
(“SFAS
      123R”) effective January 1, 2006. SFAS 123R requires the recognition of the fair
      value of stock compensation in net income (loss). We recognize the stock
      compensation expense over the requisite service period of the individual
      grantees, which generally equals the vesting period. All of our stock
      compensation is accounted for as an equity instrument. Prior to January 1,
      2006, we followed Accounting Principles Board (“APB”) Opinion 25, “ *Accounting
      for Stock Issued to Employees,* ”
and
      related interpretations in accounting for our stock compensation. Expenses
      in
      the first quarter of 2005 included the value of a warrant issued for sales
      services as well as expense related to stock options issued to an employee
      in
      2003 at an exercise price lower than the fair market value of the stock on
      the
      date of grant expensed over the vesting period.




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*Research
      and development costs* .
      Research and development costs were approximately $242,000 and $493,000 in
      the
      three months ended March 31, 2006 and 2005, respectively, a decrease of $251,000
      or 51%. During the first quarter of 2005, significant effort was expended on
      developing the LCoS Sets to meet LG Electronics’ new specifications as well as
      ramping up the South Korean plant to prepare for commercial scale production.
      These efforts neared completion towards the end of 2005, resulting in reduced
      expenses during the first quarter of 2006.





*Interest
      expense.* Interest
      expense for the three months ended March 31, 2006 increased approximately
      $16,000 from $267,000 during first quarter 2005 to $283,000 for the first
      quarter 2006. The increase is due to interest incurred on the short-term South
      Korean debt facilities. No comparable facilities existed during the first
      quarter of 2005.





*Non-cash
      interest expense.*  ** Non-cash
      interest expense was approximately $1,013,000 and $278,000 for the three months
      ended March 31, 2006 and 2005, respectively. Non-cash interest expense includes
      expense associated with the amortization of the beneficial conversion price
      of
      shares issued to prepay interest on the notes payable to Argyle Capital
      Management Corporation, a company wholly owned by Robert A. Olins, our Chief
      Executive Officer, Secretary, Treasurer, Principal Financial and Accounting
      Officer and a Director. The beneficial conversion interest represents the excess
      value of the shares received or receivable at current market prices over the
      $0.50 per share conversion price. Also included in non-cash interest expense
      is
      the amortization of note discounts and note financing costs of the Senior
      Secured Convertible Notes.  The
      increase in the three months ended March 31, 2006 as compared to the same period
      in 2005 primarily related to the accrual of approximately $614,000 relating
      to
      potential liquidated damages in connection with the registration rights
      agreement entered into as part of the October 2005 Financing and the January
      2006 Financing.





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.






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*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.


*Share-based
        Payments -* Effective
        January 1, 2006 we adopted SFAS 123R using the modified prospective method
        and therefore have not restated prior periods’ results.  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.
  Calculating
        stock-based compensation expense 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.  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.  In addition, we are required to estimate the expected forfeiture
        rate and only recognize expense for those shares expected to vest.  We
        estimate the forfeiture rate based on historical experience of our stock-based
        awards that are granted, exercised and cancelled.  If our actual forfeiture
        rate is materially different from our estimate, the stock-based compensation
        expense could be significantly different from what we have recorded in the
        current period.  See Note 4—“Stock-Based Compensation” in the
        condensed consolidated financial statements for additional
        information.






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*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.




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**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. 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 March 31, 2006, our cash and
      cash
      equivalents totaled approximately $1.4 million.





*Foreign
      Currency Risk.* We
      are
      exposed to foreign exchange rates fluctuations as we convert the financial
      statements of our foreign subsidiary into U.S. dollars in consolidation. If
      there is a change in foreign currency exchange rates, the conversion of the
      foreign subsidiary's financial statements into U.S. dollars will lead to a
      translation gain or loss which is recorded as a component of other comprehensive
      income or loss. Changes in the functional currency value of these assets and
      liabilities create fluctuations that will lead to a transaction gain or loss.
      During the first quarter of 2006, the foreign currency transaction gains,
      realized and unrealized, were not material.





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




**Disclosure
      Controls and Procedures.** As
      of
      March 31, 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.




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*Conclusion
      regarding the Effectiveness of Disclosure Controls and
      Procedures.* **** As
      of
      March 31, 2006, our CEO conducted evaluations of our disclosure controls and
      procedures. As defined under Sections 13a-15(e) and 15d-15(e) of the Exchange
      Act, the term “disclosure controls and procedures” means controls and other
      procedures of an issuer that are designed to ensure that information required
      to
      be disclosed by the issuer in the reports that it files or submits under the
      Exchange Act is recorded, processed, summarized and reported, within the time
      periods specified in the SEC’s rules and forms. Disclosure controls and
      procedures include, without limitation, controls and procedures designed to
      ensure that information required to be disclosed by an issuer in the reports
      that it files or submits under the Exchange Act is accumulated and communicated
      to the issuer’s management, including the issuer’s CEO, to allow timely
      decisions regarding required disclosure. Based on his evaluation, as described
      in Item 9A “Controls and Procedures” in our Annual report on Form 10-K/A filed
      with the SEC on April 11, 2006, the CEO has concluded that our disclosure
      controls and procedures were not effective to ensure that material information
      is recorded, processed, summarized and reported by management on a timely basis
      in order to comply with our disclosure obligations under the Exchange Act,
      and
      the rules and regulations promulgated thereunder.




**Changes
      in Internal Controls**





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.





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





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





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





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





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




**We
      are currently manufacturing and shipping our LCoS Sets in limited commercial
      quantities, but if we encounter 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 principally due to
      problems that we have experienced in certain specific portions of our
      manufacturing process, which, until January 2006, were being carried out in
      our
      production facility in California. To resolve some of these difficulties we
      have
      relocated these portions of our manufacturing process to our production facility
      in South Korea, where we have qualified manufacturing personnel and a new
      facility designed to our specifications. Recently, we have experienced certain
      production problems at our facility in South Korea that we believe are
      attributable to flaws in the silicon wafers that we obtained from our supplier
      TSMC.  See
“LG
      Electronics, Inc.” contained in “About SpatiaLight” for a more detailed
      discussion of manufacturing difficulties that we have experienced. By having
      manufacturing take place in one location, we expect to be able to maintain
      a
      higher level of quality controls over our LCoS Set production. However, 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.




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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 maintained and improved further or if we incur
      unanticipated future 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
      process as well as the costs of operating our South Korean manufacturing
      facility. Unanticipated further problems in manufacturing our LCoS Sets could
      also cause production delays that might lead our current and prospective
      customers to seek other sources, which would negatively affect our operating
      results.





In
      addition, the complexity of our manufacturing processes will increase as the
      sophistication of our LCoS Sets increases, and such complexities may lend to
      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 or failed to do so. We do not have reliable information
      about why other companies have failed 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 or air transportation with the Far East could significantly
      harm our operations. Furthermore, we believe that recent lots of silicon wafers
      that we have received from a supplier have contained flaws that have materially
      harmed our manufacturing yields. Unless we are able to work with that supplier
      to significantly reduce or eliminate these flaws in the silicon wafers, we
      will
      likely experience low manufacturing yields, which will substantially harm our
      results of operations.





Our
      LCoS
      Sets are assembled by combining the silicon backplanes with electronic
      components. 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 current 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.




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**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,
      most of our revenue was derived from LG Electronics. Based upon our agreement
      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 therefore 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. In the event that we are unable to ramp up our delivery volumes to
      LG
      Electronics by the end of July 2006, we believe that it is reasonably likely
      that LG Electronics may discontinue actively doing business with us. 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. ****





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





In
      mid-January 2006, we issued and sold 1,300,000 of our common shares in a private
      placement to three institutional investors. The common shares were sold in
      reliance upon an exemption from registration available to issuers under Section
      4(2) of the Securities Act of 1933, as amended, and under Rule 506 of the rules
      promulgated by the SEC pursuant to the Securities Act.  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.





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


None.





**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**





(a)
                Exhibits





4.1
            Restated
                Certificate of Incorporation*


4.2
            Bylaws*


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


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





(b)
            Report
                on Form 8-K:





The
      Company filed five reports on Form 8-K during the quarter ended March 31, 2006.
      Information regarding the items reported is as follows:


Date
                  Filed
              Item
                  Reported OnJanuary
                  19, 2006
              Item
                  1.01.Entry
                  into a Material Definitive Agreement; andItem
                  3.02.Unregistered
                  Sales of Equity SecuritiesFebruary
                  14, 2006
              Item
                  2.04.Triggering
                  Events That Accelerate or Increase a Direct FinancialObligation or an Obligation under an Off Balance Sheet
                  ArrangementMarch
                  14, 2006
              Item
                  2.02Results
                  of Operations and Financial ConditionMarch
                  23, 2006
              Item
                  1.01.Entry
                  into a Material Definitive Agreement





*
            Previously
                filed.






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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.




**SPATIALIGHT,
              INC.**Date: May
              10,
              2006
            By:
            /s/ ROBERT
              A.
              OLINSName:  
                Robert A. Olins
              Title:    
                Chief Executive Officer, Principal Financial
              and
                Accounting Officer






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