UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549







FORM
10-K








x
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For
theFiscalYear Ended December 31, 2007, or





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





For
      the transition period from __________ to
  _____________




Commission
File Number: 000-28063





DELTATHREE, INC.


(Exact
name of registrant as specified in charter)





Delaware
            13-4006766(State
      or other jurisdiction ofincorporation
      or organization)
            (I.R.S.
      employeridentification
      no.)75
      Broad Street, 31st Floor
              New York, New
      York
            10004(Address
      of principal executive offices)
            (Zip
      code)




Registrant's
telephone number, including area code: (212) 500-4850





Securities
registered pursuant to Section 12(b) of the Act:


Title of Each
      Class
            Name
      of Each Exchange on
              Which the Securities
      are RegisteredClass
      A Common Stock, par value $0.001 per share
            OTC
      Bulletin Board




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





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





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. Yes o No x




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





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or
any amendment to this Form 10-K. 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 o    
     Non-accelerated filer x




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





The
aggregate market value of the Class A Common Stock held by non-affiliates
of the Registrant based upon the closing price of the Class A Common Stock as
reported by the Nasdaq Stock Market on June 29, 2007 (the last business day of
the Registrant’s most recently completed second fiscal quarter) was $25,041,517.
Solely for purposes of this calculation, shares beneficially owned by directors
and officers of the Registrant and persons owning 5% or more of the Registrant's
Class A Common Stock have been excluded, in that such persons may be deemed
to be affiliates of the Registrant. Such exclusion should not be deemed a
determination or admission by the Registrant that such individuals or entities
are, in fact, affiliates of the Registrant.





As of
March 28, 2008, the Registrant had outstanding 32,870,105 shares of Class A
Common Stock, par value $0.001 per share.




Documents
incorporated by reference: None








DELTATHREE, INC.


2007
ANNUAL REPORT ON FORM 10-K





TABLE OF CONTENTS




PagePART
      IITEM
      1.
            Business
            1ITEM
      1A.
            Risk Factors
            15ITEM
      1B.
            Unresolved Staff Comments
            26ITEM
      2.
            Properties
            26ITEM
      3.
            Legal Proceedings
            26ITEM
      4.
            Submission of Matters to a Vote of Security
      Holders
            26PART
      IIITEM
      5.
            Market for Registrant's Common Equity, Related Stockholder
      Matters and Issuer Purchases of Equity Securities
            27ITEM
      6.
            Selected Financial Data
            28ITEM
      7.
            Management's Discussion and Analysis of Financial Condition
      and Results of Operations
            29ITEM
      7A.
            Quantitative and Qualitative Disclosures About Market
      Risk
            37ITEM
      8.
            Financial Statements and Supplementary
    Data
            37ITEM
      9.
            Changes in and Disagreements with Accountants on Accounting
      and Financial Disclosure
            37ITEM
      9A.
            Controls and Procedures
            37ITEM
      9B.
            Other Information
            38PART
      IIIITEM
      10.
            Directors, Executive Officers and Corporate
      Governance
            39ITEM
      11.
            Executive Compensation
            42ITEM
      12.
            Security Ownership of Certain Beneficial Owners and
      Management and Related Stockholder Matters
            47ITEM
      13.
            Certain Relationships and Related Transactions, and
      Director Independence
            48ITEM
      14.
            Principal Accounting Fees and Service
            49PART
      IVITEM
      15.
            Exhibits, Financial Statement Schedules
            50Index to Consolidated Financial
      Statements
            F-1








PART I





The
statements contained in this Annual Report on Form 10-K, or Annual Report, that
are not descriptions of historical facts may be forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. These
forward-looking statements are based on current expectations, estimates,
forecasts and projections about us, our future performance, the industries in
which we operate, our beliefs and our management’s assumptions. In addition,
other written or oral statements that constitute forward-looking statements may
be made by us or on our behalf. Words such as “expects,” “anticipates,”
“targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,”
“estimates,” variations of such words and similar expressions are intended to
identify such forward-looking statements. These statements are not guarantees of
future performance and involve certain risks, uncertainties and assumptions that
are difficult to assess. Therefore, actual outcomes and results may differ
materially from what is expressed or forecasted in such forward-looking
statements. Please see the section below entitled “Risk Factors” for detailed
information about the uncertainties and other factors that may cause actual
results to materially differ from the views stated in such forward-looking
statements. All forward-looking statements and risk factors included in this
Annual Report are made as of the date hereof, based on information available to
us as of the date hereof, and we assume no obligation to update any
forward-looking statement or risk factor, whether as a result of new
information, future events, changes in assumptions or otherwise.





Our
fiscal year ends on December 31 of each calendar year. Each reference to a
fiscal year in this Annual Report refers to the fiscal year ending December 31of
the calendar year indicated. Unless the context requires otherwise, references
to “we,” “us,” “our,” “the Company,” and “deltathree” refer to deltathree, Inc.
and its subsidiary deltathree, Ltd., collectively.





ITEM
1.   BUSINESS





Company
Overview





We are a
leading provider of integrated Voice over Internet Protocol, or VoIP, telephony
services, products, hosted solutions and infrastructure. We were founded in 1996
to capitalize on the growth of the Internet as a communications tool by
commercially offering Internet Protocol, or IP, telephony services. IP
telephony, or VoIP telephony, is the real time transmission of voice
communications in the form of digitized "packets" of information over the
Internet or a private network, similar to the way in which e-mail and other data
is transmitted. While we began as primarily a low-cost alternative source of
wholesale minutes for carriers around the world, we have evolved into one of the
premier providers of next generation communication services in the
world.





Today we
support tens of thousands of active users around the globe through our two
primary distribution channels: our service provider and reseller channel and our
direct-to-consumer channel. We offer a broad suite of private label VoIP
products and services as well as a back-office platform for service providers,
resellers, and corporate customers, such as incumbent telecommunications
providers, Internet service providers, or ISPs, cable companies, licensed VoIP
operators, and various corporate enterprises. Based on our customizable VoIP
solutions, these customers can offer private label telecommunications to their
own customer bases under their own brand name, a “white-label” brand (where no
brand name is indicated and different customers can offer the same product), our
iConnectHere, or ICH, brand, or the deltathree brand. At the same time, our
direct-to-consumer channel includes our iConnectHere offering (which provides
VoIP products and servicesdirectly to consumers
and small businesses online using the same primary platform) and our recently
established joip offering (which serves as the exclusive VoIP service provider
embedded in the Globarange cordless phones of Panasonic Communications Co.,
Ltd., or Panasonic, the world leader in consumer cordless phones). This
joip-enabled phone first became available in August 2007 and is currently
available in the United States, Canada, United Kingdom and Ireland, Germany,
Spain and Austria.





We have
built a privately-managed, state-of-the-art global telecommunications platform
using IP technology and offer our customers a unique suite of IP telephony
products, including PC-to-Phone and Broadband Phone products. We differentiate
ourselves from our competitors by providing a robust set of value-added services
and features that enable us to effectively address the challenges that have
traditionally made the provision of telecommunications services difficult, and
we offer our products and services to a global customer base in a fashion that
meets the disparate needs of this diverse customer base. Our operations
management tools include, among others: account provisioning; e-commerce based
payment processing systems; billing and account management; operations
management; web development; network management; and customer care. We are able
to provide our services at a cost per user that is generally lower than that
charged by traditional service providers because we minimize our network costs
by using efficient packet-switched technology and interconnecting to a wide
variety of termination options, which allows us to benefit from pricing
differences between vendors to the same termination points.




Prior to
1999, we focused on building a privately-managed, global network utilizing IP
technology, and our business primarily consisted of carrying and transmitting
traffic for communications carriers over our network. Beginning in 1999, we
began to diversify our offerings by layering enhanced IP telephony services over
our network. These enhanced services were targeted at consumers and were
primarily accessible through our consumer website. During 2000, we began
offering services on a co-branded or private-label basis to service providers
and other businesses to assist them in diversifying their product offerings to
their customer bases. In 2001, we continued to enhance our unique strengths
through our pioneering work with the Session Initiation Protocol, or SIP, an
Internet Engineering Task Force standard that has been embraced by industry
leaders such as Microsoft and Cisco. These efforts culminated in the launch of
our state-of-the-art SIP infrastructure, and in doing so we became the first
major VoIP service provider to deploy an end-to-end SIP network and services. In
recent years, we have continued our pioneering efforts in SIP and these efforts
have yielded significant new releases. For example, we released a next
generation SIP-based PC-to-Phone application, certified many new devices which
function as access points to our services, and added new features and new
calling plans to our offerings.





1




In 2004,
we announced our first major service provider contract, with Verizon
Communications Inc.  Since then, we have remained focused on
increasing the market penetration of our core VoIP solutions and continuing to
diversify and expand our customer base. For example, we diversified our base in
2006 by adding customers for our Hosted Consumer VoIP Solution in markets such
as instant messaging and cellular telecommunications. In 2007, we entered into
an agreement with Market America, a leading on-line shopping and one-to-one
marketing company, pursuant to which Market America launched its Voitel Home
Phone Service powered by our Hosted Consumer VoIP Solution platform. In
addition, we entered into an agreement with RCN Corporation, a leading provider
of video, data, and voice services to residential, business, and
commercial/carrier customers, to power its new Starpower Internet Phone Service.
As a result, we continued to sell an increasingly diverse set of VoIP products
and services to our growing Service Provider and Reseller base. Our product
strategy for reaching these customers focused on enhancing our service delivery
offering suite by successfully launching customizable modular and comprehensive
VoIP solutions, adding new features to our VoIP products, launching new
distribution lines for our consumer group, and upgrading our network capacity
and features.





As a
complement to the initiatives we have taken to organically expand our
businesses, we have also been evaluating opportunities for inorganic growth
through strategic acquisitions and unique collaborations. In February 2007, we
acquired the service provider and consumer business assets including the
customer bases of Go2Call.com, Inc., a privately held U.S.-based VoIP solutions
provider, for cash and our stock valued at approximately $7.0 million. Moreover,
we expect that our strategic collaboration with Panasonic, including our joip
offering, will present opportunities for growth as we expand into another market
by enabling Panasonic’s Globarange cordless phones to deliver our VoIP services
to consumers in various countries worldwide.





Going
forward, we expect to:





·
            continue
      to devote our resources to develop and expand our Service Provider and
      Reseller base and we expect our revenue from this key channel to represent
      a significant percentage of our total revenue in the foreseeable
      future;





·
            actively
      market our products and services to a large number of broadband operators,
      incumbent telecommunication providers, cable companies, ISPs, licensed
      VoIP operators, corporate enterprises, and consumer oriented retailers
      around the world; and





·
            pursue
      a targeted strategy of identifying and evaluating appropriate acquisition
      candidates and strategic collaborations that will continue to expand and
      diversify our customer base.




Industry
Background





VoIP is
increasingly becoming a widely used alternative technology that can replace
services provided by a traditional telephone network. VoIP technology translates
voice into data packets, transmits the packets over data networks such as the
Internet or privately managed networks (such as our network), and reconverts
them into voice at the destination. Unlike traditional telephone networks, VoIP
does not use dedicated circuits for each telephone call; instead, the same VoIP
network can be shared by multiple users for voice, data and video
simultaneously. This type of data network is more efficient than a dedicated
circuit network because the data network is not restricted by the one-call,
one-line limitation of a traditional telephone network and, as a result, greater
traffic can be transmitted over this data network. This improved efficiency
creates cost savings that can be passed on to consumers in the form of lower
rates or retained by the VoIP provider. Significant cost savings are also
achieved for international telephone calls carried over data networks primarily
because they bypass the international settlement process, which represents a
significant portion of international long distance tariffs. Additionally, VoIP
allows for features that are not available on traditional telephony networks -
particularly at the consumer level - including voice mail to email forwarding,
find me/follow me, web-based control of call forwarding preferences, user
account review/revision and a host of other features and functions.





IDC, a
market research firm, estimates that U.S. residential VoIP telephony subscribers
will grow at a 60% compound annual growth rate from 4.3 million VoIP subscribers
in 2005 to 44.0 million subscribers by the end of 2010. Beyond cost savings, we
believe that VoIP telephony technologies will further the potential for the
Internet to become the preferred medium of communications and commerce. As a
result, VoIP has experienced significant growth in recent years due
to:





·
            improved
      quality and reliability of VoIP calls due to technological advances,
      increased network development and greater bandwidth
    capacity;·
            new
      product development that allows VoIP providers to offer services not
      currently offered by traditional telephone companies;·
            greatly
      improved ease of use, whereby the end-user does not perceive a difference
      between use of a traditional telephone and a broadband
      telephone;·
            increasing
      demand for long distance communication services driven by the increased
      mobility of the global workforce; and·
            increasing
      demand for lower cost telephone service around the
  world.





2




As a
result of these growth trends, various service providers, enterprises and
consumers are continuing to procure offerings from VoIP providers such as
deltathree. Specifically, consumers in emerging markets are increasingly using
VoIP-enabled services, such as IP telephones, to realize significant cost
savings on long distance and international calls, while in markets where a
significant number of consumers have access to broadband internet services these
consumers are increasingly viewing VoIP as a viable and more affordable
substitute for their traditional telecommunications provider.





Accordingly,
many of the traditional telecommunications providers are looking to deploy VoIP
in addition to their current offerings in order not to lose their customers,
while cable companies, ISPs and other broadband providers are looking at VoIP
service offerings as a way to capture new revenue streams from existing and new
customers. These providers have two primary alternative means to develop and
deploy VoIP offerings: build them in-house or partner with a company like
deltathree and outsource all or a portion of the effort. Those seeking to offer
VoIP service offerings by developing an in-house service must learn a vastly
different set of platforms and integrate several additional components with
their existing systems, which requires the development of significant technical
expertise and the deployment and management of substantial capital expenditures.
Alternatively, a full service VoIP company, like deltathree, can provide these
service providers with the ability to outsource their VoIP services, and thereby
effectively reduce the upfront and ongoing cost of providing the service and
efficiently reduce the time to market and risks associated with developing and
maintaining an in-house VoIP service.





Our
Products and Services




Products





We have
built a privately-managed, global network using IP technology and offer our
customers a broad range and unique suite of IP telephony products. Our VoIP
products include:





PC-to-Phone. Our PC-to-Phone
offering enables a user to conveniently and inexpensively place a call to a
standard telephone anywhere in the world directly from a personal computer while
remaining on-line. In order to use this product, a user need only download our
software from our website and have access to the Internet. Once our PC-to-Phone
application is downloaded and a user account is established, the user is able to
place a call from the user's personal computer and, while browsing the Web,
speak to a party who uses a standard telephone.





We are
able to provide our PC-to-Phone offering at rates generally lower than those
charged for traditional circuit switched calls. We are able to do so because our
service utilizes packet-switched technology and routes calls directly from the
user’s Internet connection onto our privately-managed IP network and to the
called destination. This avoids access and other charges associated with
traditional international and domestic long distance telecommunications
services.





Broadband Phone. Our
Broadband Phone product is a complete phone replacement solution available to
business and consumer customers over the "last mile" through broadband
connections via cable modem, DSL or fixed wireless. Broadband Phone challenges
the traditional public switched telephone network, or PSTN, and circuit switched
networks with a full VoIP solution. With our high call quality, “always on”
reliability and increased functionality provided by the high bandwidth access
line, we are able to offer potential partners and their customers some of the
most sophisticated VoIP solutions available in the market through a highly
scalable, low-cost and easily implemented product. In addition to offering
capabilities similar to those offered by traditional telephony providers and
allowing users to use their existing phone, Broadband Phone enables a user to
conveniently operate features and retrieve voice mail through email, web or a
phone interface. For our potential partners, the turnkey or customizable
solution is delivered with our full back-end infrastructure, including customer
service for end users and service providers, pricing information, fulfillment,
billing, provisioning, local number portability, and fraud services.
Additionally, Broadband Phone is easily integrated (a variety of devices are
available to plug directly into a PC or IP network) so as to allow broadband
providers to begin delivering our voice solution rapidly.




Services





We
differentiate ourselves from our competitors by providing a robust set of
value-added services that enables us to effectively address the challenges that
have traditionally made the provision of telecommunications services difficult.
These operations management tools include the following:





·
            account provisioning:
      we provide our service provider and reseller customers with a dedicated
      Web page through which they can order additional services or accounts,
      generate and activate PINs and perform other customary implementation
      functions;





·
            payment processing
      systems: we provide our customers with a fraud detection and
      prevention system to permit secure credit card transactions over the
      Web;





·
            billing and account
      management: we provide our customers with real-time, Web-based
      access to billing records to check billing and usage information or to
      increase prepaid accounts;





·
            customer care: we have
      moved and consolidated traditional first tier customer care functions onto
      the Web for ease and flexibility and support this with second tier
      customer care via toll-free access;
and




·
              network
      operations care: we provide a Network Operations Center, or NOC,
      automated trouble ticket system, which enables our customers to submit,
      manage, and follow-up with technical questions and issues online.





3




The
provision of VoIP telephony products and services through our service provider
and reseller sales channel accounted for 85.4% of our total revenues in 2007,
while the provision of VoIP telephony through our direct-to-consumer channel
accounted for 12.9% of our total revenues in 2007.





Our
Distribution Channels





We
support tens of thousands of active users around the globe through our two
primary distribution channels: the service provider channel and our
direct-to-consumer channel. We market, support and distribute our products and
services to customers in these channels.





Service
Provider and Reseller Channel





We have
developed and intend to continue to develop high-value solutions for the large
number of service providers and resellers that are focused on providing their
customers with VoIP telephony products and services. A description of our
service provider and reseller offerings is provided below.





Hosted Consumer
VoIP Solution.  Our “Hosted Consumer
VoIP Solution” (formerly known as our Outsourced Platform Solution) leverages
our VoIP expertise and delivers to our service providers, resellers, and various
corporate customers a highly customizable, private-label suite of VoIP products
and services. Using our infrastructure, we enable these enterprises to offer
their customers any combination of our basic products and services, accessible
through a single account. We believe that our Hosted Consumer VoIP Solution
brings our customers the value-added services they need to leverage their strong
customer bases and generate new revenues. Our largest service provider customers
demand a completely customized offering, and we have built our platforms in a
manner that efficiently and effectively allows us to deploy a fully customized
VoIP offering in a very short amount of time, and at significantly reduced cost
when compared to the development of an in-house solution.





Our
“Launch Ready” Hosted Consumer VoIP Solution is a turnkey VoIP solution
specifically designed to provide our medium sized service provider customers
with the ability to rapidly and efficiently deploy advanced VoIP services to
their end customers. The “Launch Ready” solution enables us to deploy a full
VoIP solution in a very compressed period of time while still allowing for the
offering of a broad suite of services, features, and support services. We have
successfully used this solution as the basis for several of our trials and
transactions, and anticipate that it will continue to be the preferred platform
for our smaller service provider customers.





In 2007,
we continued to expand our target markets, and entered into an agreement with
Market America, a leading on-line shopping and one-to-one marketing company,
pursuant to which Market America launched its Voitel Home Phone Service powered
by our Hosted Consumer VoIP Solution platform.  In addition, we
entered into an agreement with RCN Corporation, a leading provider of video,
data, and voice services to residential, business, and commercial/carrier
customers, to power its new Starpower Internet Phone Service. In 2006, our
Hosted Consumer VoIP Solution was selected by ICQ Inc., the industry pioneer and
a leader in instant messaging, as one of the service providers of its
internet-based voice calling service offering. With this relationship,
ICQ’s instant messaging customers throughout the world, outside of the United
States, have access to VoIP services and features of deltathree (amongst
others).




We intend to continue to add new offerings to our suite of VoIP
products and services and strengthen our channels of distribution. As we take
such actions, customers can realize new revenue streams from their existing
customer base and make their own offering even more powerful and attractive. The
products and services delivered under our Hosted Consumer VoIP Solution are
supported at all times by our Network Operations Center and our customer care
center.





Convergence of
the Hosted Consumer VoIP Solution and the Reseller Program. For several
years we have offered businesses the opportunity to become resellers of our
services through our global reseller program. In the early years of the life of
our Company, these resellers met their customers’ needs by purchasing account
numbers in bulk at reseller specific rates, and they in turn resold these
accounts to private individuals under the deltathree brand, their own brand, or
as a white-label product. As our resellers became more sophisticated, we
introduced new features and functions that allowed them to develop their own
unique price plans and service bundles to more closely align their offerings
with their own customers’ unique needs. In addition, we developed, and intend to
continue to develop, increasingly sophisticated online toolsets to allow our
resellers to better manage their internal processes and enable them to utilize
our web-based customer care tools to provide customer service to their end-users
through their own customer service team. Moreover, in order to attract and
retain a variety of different resellers across the globe, we have continuously
tested and certified for use with our VoIP services and network many different
SIP devices manufactured by various vendors. We have certified many SIP devices
that operate in different network environments, such as dial-up, broadband,
cable, and satellite or Vsat. Based on these actions, we have increasingly set
ourselves apart from our competitors by moving from an undifferentiated source
of “telecom minutes” to a highly differentiated partner by providing these
customers with a full suite of tools to manage and grow their
business.





In
doing so, the lines of differentiation between service providers and resellers
continue to narrow as they grow increasingly similar. Both service providers and
resellers are looking to leverage their unique own brands by selling
sophisticated products and services to their own customers under their own
brand, with their own look and feel. As such, our reseller customers are looking
for advanced VoIP feature sets and applications to support their ability to
deliver unique calling plans and bundled services to their end customers. Our
customers’ desire for, and our ability to deliver, these increasingly
sophisticated offerings supported by a variety of certified devices in different
network environments is proving to be a critical competitive advantage in terms
of growing sales with existing customers, securing new customers, and converting
customers from other vendor platforms. In order to continue to provide our
reseller customers the best features and services available, we are constantly
assessing our customer needs and deploying new enhanced services for the VoIP
reseller market. During 2005 and 2006, we realized that our global reseller
business was aligned with our Hosted Consumer VOIP Solution business because
customers for both of these products and services already had access to the same
features and functions. We, therefore, decided to combine these customer groups.
We believe that this group will be more strategically aligned with the market
and we expect to benefit from synergies from both of these customer
bases.





4




Go2Call
Acquisition. We strengthened our service provider and reseller channel
and our direct-to-consumer channel and expanded our presence into new regions of
the world with our acquisition of the service provider and consumer business
assets, including the customer bases, of Go2Call. In connection with this asset
transaction, which was completed in February 2007, we paid to Go2Call
approximately $7.0 million in a combination of cash and our stock and did not
assume any liabilities other than the obligation to provide continued services
to the acquired customer bases. Go2Call has been a leader in the VoIP industry
and has delivered turnkey VoIP solutions to a variety of service providers,
including telecom carriers, ISPs, broadband providers and licensed VoIP
operators. Go2Call’s customer base consisted of approximately 95% service
providers and 5% consumers located in approximately 100 countries throughout the
world and, therefore, this strengthened our own customer base in most of these
countries. Due to Go2Call’s geographical mix of customers, this acquisition has
also brought us an increase in market penetration in certain key countries such
as Brazil and Vietnam where we traditionally have not had a strong presence.
Based on the similarity of offerings and customer bases and the complementary
geographical mix, we were able to transition the Go2Call customers to our
network in 2007.





Direct-to-Consumer Channel





Our
direct-to-consumer channel includes our recently established joip offering,
which serves as the exclusive VoIP service provider embedded in the Globarange
cordless phones of Panasonic (the world leader in consumer cordless phones) and
our iConnectHere offering, which provides VoIP products and services directly to
consumers and small businesses online. Prior to the recently launched joip
offering, ICH was traditionally our direct-to-consumer channel. A description of
these offerings is provided below.





joip: deltathree
and Panasonic strategic alliance. We believe that with joip, our recently
launched consumer brand, we have developed a unique, powerful, and innovative
offering in both the VoIP and the cordless telephone markets. In connection with
our strategic cooperation with Panasonic, which began in 2006, Panasonic and we
have created, developed and are offering joip-enabled Panasonic Globarange
telephones. Our joip offering is the exclusive VoIP service embedded in
Panasonic’s Globarange series of innovative hybrid two-line cordless phones,
which provide both landline and VoIP services. Because our VoIP services are
embedded in this hybrid cordless telephone, there is no requirement for any
software downloads, external adaptors or other complicated procedures. The
customers merely plug the phone into their broadband connection and are able to
communicate. Additionally, customers of the Globarange telephones are able to
talk to each other for free through the use of the joip services, and are also
be able to purchase a variety of enhanced features and value-added services.
Through our joip offering and extensive experience in VoIP services and
Panasonic’s consumer electronics expertise and vast distribution channels,
Panasonic and we aim to create a global community by providing free calling
between joip-enabled Globarange phones in all regions of the world. We commenced
the development and launch of this offering in August 2007. This phone is currently
available in the United States, Canada, United Kingdom and Ireland, Germany,
Spain and Austria.





We
believe that this offering has many unique competitive advantages, such
as:





·
            dual
      functionality, in that it supports both VoIP services and traditional
      landline services;





·
            end
      users maintain their traditional landline
  service;





·
            customers
      are able to speak to each other for
free;





·
            strong
      brand recognition, consumer electronic experience, and vast distribution
      channels of Panasonic;





·
            no
      set-up installation procedures, software downloads, external adaptors, or
      service contracts; and





·
            the
      joip-enabled phone can be purchased through the customary mass market
      distribution retailers and channels - providing for a traditional consumer
      purchase experience.





Due to
the features, functionality, and purchase experience, we believe that this
offering could have a significant impact in expanding VoIP technology from the
early adaptor phase into the mass market phase.





5




iConnectHere.iConnectHere demonstrates our products, services and hosting capabilities
to our reseller customers and service providers. Through iConnectHere, an
account holder can access all of our product offerings, including PC-to-Phone
and Broadband Phone. Additionally, iConnectHere permits us to collect usage
information on our products and services and enables us to provide our service
provider and reseller customers with key information and recommendations
regarding implementation of our products and services.




Through
iConnectHere, consumer users can:





·
            sign
      up for any of our services, including PC-to-Phone and Broadband
      Phone;




·
            download
      our software and/or order IP-based Broadband Phone
  devices;




·
            recharge
      their accounts, either by entering their credit card information or
      authorizing automatic recharging;




·
            send
      a PC-to-Phone call;




·
            check
      real-time billing and usage
information;




·
            communicate
      by e-mail with a customer service representative;
  and




·
            view
      answers to frequently-asked
questions.




Our Competitive Advantages





We
believe we have several core competitive advantages that will allow us to
maintain and expand our position as a leading provider of VoIP
services.





Experience and
Expertise in VoIP. We pioneered the development and deployment of
commercially viable VoIP products and standards, and in doing so we have become
a widely recognized provider of VoIP around the world. We have a proven track
record of deploying robust, modular or comprehensive VoIP offerings to some of
the most demanding large or mid-sized service providers, while successfully
managing our VoIP services around the world and across a variety of networks and
technologies. Over our twelve-year history, our engineering teams have
consistently demonstrated their ability to develop and deploy innovative
platforms (including what has become the dominant VoIP technology standard, SIP)
while our research and development team has created inventive new products,
feature enhancements and applications to improve the performance and quality of
our services (including our innovative joip offering, which we have developed in
connection with our strategic alliance with Panasonic). Our service provider and
reseller solutions leverage the leading edge platform we developed for our own
direct-to-consumer VoIP business and the lessons learned from first-hand
experience in developing and deploying VoIP services around the world for more
than a decade.




Scale.We deliver VoIP telephone services to
tens of thousands of active, paying consumer and business users in over 100
countries through our direct-to-consumer channel, our service provider
customers, and our global distribution network of approximately 400 resellers.
As end-users around the world continue to look for alternative and improved
telecommunications services, we can employ our products and services to a
growing distribution network and capitalize on our existing relationships to
partner with incumbent telecommunications providers, cable companies, ISPs,
licensed VoIP operators, and various corporate enterprises. We expect to be well
positioned to effectively and quickly deliver new products and services to large
numbers of consumers through large and small service providers, resellers and
our direct-to-consumer channel.





Strategic
Relationships. We
have established or expect to establish and expand our strategic relationships
with large and mid-sized incumbent telecommunications providers, cable
operators, ISPs, licensed VoIP operators, and various corporate enterprises.
Through our innovative collaboration with Panasonic and our joip offering, we
expect to develop a significant new market for our services and to have a
significant impact in expanding VoIP technology from the early adaptor phase
into the mass market phase. Through our relationships with companies such as
Level 3 Communications and XO Communications, we are able to obtain access to
high quality telecommunications services and networks at competitive prices, and
also obtain access to such companies’ existing and potential partners. We
believe our VoIP telephony platform, combined with our strategic relationships
with a variety of leading providers around the world, will enable us to continue
to differentiate ourselves from other VoIP providers.





6




Our Strategy





Our
strategy is to become a leading provider of VoIP telephony products and
services, worldwide. The following are key elements of our
strategy:





Capitalize on the
Growth of the VoIP Marketplace.We believe we are well
positioned to take advantage of the expected growth of the VoIP services and
cable telephony markets. IDC, a market research firm, estimates that U.S.
residential VoIP telephony subscribers will grow at a 60% compound annual growth
rate from 4.3 million VoIP subscribers in 2005 to 44.0 million subscribers by
the end of 2010.





Target Large to
Mid-sized Telecom Providers. Our service provider and
reseller channel will leverage its wins and experience to specifically target
large to mid-sized incumbent telecom providers and various corporate enterprises
in the U.S. and worldwide, as we believe these companies may be more likely to
buy our services than to build their own VoIP services, as a viable alternative
to more capital intensive and time consuming internal VoIP application
development programs. We believe our service and our expertise in VoIP reduce
these providers’ costs, time to market and risks associated with developing and
maintaining an in-house VoIP service.





Target Small to
Mid-sized Cable Providers. Our service provider and
reseller channel will leverage our demonstrated success in the deployment of
sophisticated VoIP solutions, and target small to mid-sized cable operators in
the U.S. and worldwide, whom we believe may be more likely to buy our services
than the larger companies in the cable space. We believe that they will seek out
the same incremental revenue opportunities as their larger peers, but may not
have the significant technical and financial resources required to develop an
internal cable telephony solution, such as the personnel to support network
operations, engineering, support and project management, and may therefore
instead embrace outsourcing as an effective manner to enter the marketplace. We
believe our service and our expertise in VoIP reduces their costs, time to
market and risks associated with developing and maintaining an in-house VoIP
service.





Create Global
Community with joip. Through our joip offering and extensive experience
in VoIP services and Panasonic’s leading consumer electronics expertise and vast
distribution channels, Panasonic and we aim to create a global community by
providing free calling between joip-enabled Globarange phones in all regions of
the world.  We are looking to leverage this strategic partnership to
develop our direct-to-consumer channel and build value by up-selling a variety
of enhanced features and value-added services to purchasers of these
phones.





Offer Flexible
and Modular Deployment Alternatives.We offer our service
providers and resellers a choice of deployment alternatives ranging from full
outsourcing to partial outsourcing through our modular offering suite. Depending
on the particular needs of each of our customers, we design our offering to fit
within their business objectives, available resources and desire level of
participation. We can develop and integrate specific features and functions into
our package, such as various network elements, access components, fulfillment,
and the specific feature/functions the provider can offer to its end-users. For
resource and capital constrained providers, we offer alternatives that require a
lower amount of human resources, development time and financial investment by
the customer.




Strategic
Acquisitions and Alliances. In addition to our strategy and actions to
grow organically as described above, we also actively evaluate and pursue
appropriate acquisition targets and collaborations that will continue to expand
and diversify our customer base. We analyze these initiatives to determine
whether they are complimentary to our business and can provide synergies.





Sales
and Marketing





We sell
and market our products and services through our Service Provider and Reseller
Channel and our Direct-to-Consumer Channel. We have a variety of customers
throughout the world and, therefore, our sales and marketing strategy is
customized to target each region, including specific local areas, in the world.
In general, our sales and marketing activities include:





·
            selecting,
      training, and deploying regional sales managers to sell, market and
      maintain support for our customers and potential
  partners;·
            attending,
      presenting, and participating at local industry trade
    venues;·
            developing,
      deploying and supporting local-specific product features and services,
      such as multiple language capabilities, different currency capabilities,
      and various payment methods;·
            pursuing
      strategic alliances with both customers, including licensed providers, and
      suppliers; and·
            using
      various on-line advertising and search strategies to target and optimize
      sales efforts.




7




Service Provider and Reseller
Channel





Service Provider
Sales.     We have developed and deployed a focused
sales team that specifically targets large and medium incumbent telecom
providers, mid-sized to smaller cable companies, ISPs and other broadband
service providers, virtual network operators, licensed VoIP operators, and
various corporate enterprises. This highly talented team markets to these
customer targets around the world, focusing on developed and developing markets
in the United States, Europe, Latin America and Asia. Our well-known success in
deploying sophisticated solutions to the most demanding large telecom providers
supplies us with significant leverage as we introduce these services to other
service providers.





Reseller
Program.   Our Reseller sales force contracts with smaller
service providers and resellers around the world, who in turn sell our products
and services, under their own brand, a white-label brand and/or our deltathree
brand to retailers, businesses, Internet cafés and others in their local
markets. Our experience in providing differentiated VoIP solutions in the
emerging international telecommunications environment enables us to effectively
enter new markets as they open to competition. This group will continue to
market to these resellers around the world, focusing on emerging markets in the
Middle East, Asia and Central and South America.





Using our
platform and solutions, resellers can quickly and easily sell our products to
their own customers in their own specific markets.





Direct-to-Consumer
Channel





joip: deltathree
and Panasonic strategic alliance. We launched our joip service and
Globarange offering with Panasonic in August 2007. In this strategic alliance
Panasonic will use its leading global experience and well-established product
distribution channels to market and sell the product in each applicable local
market. We will engage in a variety of targeted strategies through the use of
on-line media, direct marketing and inbound telemarketing to market our joip
offering. Panasonic and we, together, have begun to market the joip-enabled
Globarange phone to specific key channels.





iConnectHere.We have developed low-cost,
diversified promotional programs to stimulate demand for our iConnectHere
services. Our promotional programs include:





·
            On-line
      “affiliate” agent commission program. We have developed a Web-based
      agent program that allows for rapid agent enrollment and agent account
      maintenance. Agents may devise their own marketing programs, including
      Web-links, direct mail campaigns or co-branding of our services in select
      markets. Agents receive as commissions a percentage of revenue generated
      from end users who sign up for our services through the agent's
      website.





·
            Off-line
      “affiliate” agent commission program. Our off-line agent commission
      program allows non-Web agents to design their own marketing programs to
      solicit sales of our services. Off-line agents market and advertise
      through traditional channels such as newspaper and magazine
      advertisements, direct mail campaigns and telemarketing campaigns.
      Off-line agents receive a percentage of revenue generated from users who
      sign up for our services through the agent's
  programs.





Our
Infrastructure





Network





In order
to deliver leading VoIP products and services, we operate a privately-managed IP
telephony network. By managing our network, we have the ability to regulate
traffic volumes and to directly control the quality of service from each
originating point of presence, or POP, to the termination point via a variety of
termination options. Our ability to interconnect to a wide variety of
termination options increases the diversity and robustness of our network,
minimizes and eliminates single points of failure, and simultaneously allows us
to benefit from pricing differences between vendors to the same termination
points. In addition, our network allows us to avoid the significant transmission
delays associated with the Internet, which may impede delivery of high quality,
reliable services to our users.





In 2001,
we rolled out our state of the art SIP infrastructure. The SIP protocol is one
of the most advanced VoIP protocols and unlike its predecessors, which were
modeled after traditional telephony protocols, SIP has the ability to scale with
a distributed architecture and at a lower cost. SIP’s superior attributes also
include faster and more cost effective development and lower hardware
requirements, which allows us to incur lower capital expenditure costs. Our SIP
network currently powers the majority of our offerings.





Our
network is built around a high availability backbone that connects New York, Los
Angeles, Atlanta, London, Frankfurt and Hong Kong. In each of, and between,
these locations we maintain multiple interconnections or peering arrangements
with Internet backbone and voice providers. These points are strategically
located to allow access from our network to and from the Internet with the best
performance. While operating as a private extension of the Internet, our
backbone has a high level of security designed to isolate it from security
threats found on the public Internet.





8




Access to
our network is possible through several products and services. A call can
originate from the PC-to-Phone product using our downloadable software
application “soft-phones,” a Web browser, or Broadband Phone devices. These
calls enter our network from the Internet through our interconnection points. We
carefully manage each originating point and use innovative capacity planning
tools and techniques to provide the best and most cost effective service to
customers.





Our
network can terminate calls through our POPs and termination providers’ POPs.
Termination decisions are based on a sophisticated least cost routing system
which applies routing rules based on origination point, time of day, termination
cost and other factors. These rules are constantly updated to ensure maximum
economic and quality efficiency. Each termination port is carefully managed with
innovative capacity planning tools and techniques to provide the best and most
cost effective service to customers, along with multiple termination options to
ensure the highest possible levels of redundancy.





We are
party to service agreements with several telecommunications providers, including
competitive local exchange carriers, foreign post, telephone and telegraph
companies, Internet backbone providers and others. Pursuant to these agreements,
we can transport VoIP packets to our hubs and terminate calls throughout the
world in a cost effective and efficient manner.





Support




Our NOC
monitors and manages our network from a central location, seven days a week,
24 hours a day. The NOC monitors all aspects of our network, including the
routers, databases, switches, leased lines, Internet connections, gatekeepers
and gateways, to ensure that they are functioning at optimal levels. In the
event of a failure of any of these network components, NOC personnel are
provided with a real time, systems-generated notification via an instant
messaging system consisting of pagers, cellular phones, screen pop-ups and
e-mail, which identifies the malfunction so that proper measures can be taken to
restore service in a timely fashion. Our NOC utilizes a combination of
proprietary and leading industry technologies as well as unique applications
developed by us. The NOC serves all of the different parts of our operations
environment, including network nodes, Web servers and specific
applications.





We
provide customer support on various levels to different customers. With respect
to certain of our service provider and reseller customers, we provide customer
care and technical support directly to these customers, and they in turn provide
their own support directly to the end user. With some of our other service
provider and reseller customers, we provide customer care and technical support,
on behalf of the customer, directly to the end user. Customers of iConnectHere
receive technical support and customer care through e-mail support.





Our
services are supported by our on-line interactive customer service and billing
center, which enables an end user to set up an account, receive an account
number and a PIN, pay by credit card for services, find answers to frequently
asked questions and contact customer service representatives. Once a user has
established an account, the user can prepay for additional usage by credit card
as well as access real-time detailed information such as call logs and
transaction records. Through the on-line billing system, a user can personalize
the billing information to select the data most relevant to them. This on-line
interactive customer service and billing center is supported by a human customer
care contact center that provides voice and e-mail support to the
customers.





Suppliers





We
outsource to third-party vendors the provisioning of certain of our local
telecommunications services, including local phone numbers, access to the PSTN,
operator assistance, directory listings and assistance, E-911 emergency services
and local number portability. We also outsource the provisioning of our consumer
premises equipment, such as our analog telephone adapters, IP Phones and
gateways, and certain aspects of our customer care services. We do not rely on
any one specific vendor for providing these services, except for E-911 emergency
services and certain specific services of customer care. While we believe our
relations with our suppliers are good, we believe that we could replace our
suppliers if necessary and that although our ability to provide services to our
customers may be impacted in such a case we do not expect that this would have a
significantly adverse affect on our business, financial condition and results of
operation.





Proprietary
Rights





We rely
and expect to be able to rely on trademark and trade secret laws,
confidentiality agreements and other contractual arrangements with our
employees, strategic partners and others to protect our proprietary
rights.





We have
registered trademarks, and have filed applications for additional registrations,
for “deltathree®”, “iConnectHere.com®”, “joip®”, “joipy®”, “Click It®” and other
trademarks in the United States and internationally. In connection with our
acquisition of the Go2Call businesses, we acquired the “Go2Call®” trademark and
a variety of trade-marked derivatives of “Go2Call®”. However, these trademarks
may not provide adequate protection against competitive technology and may not
be held valid and enforceable if challenged. We do not own any registered
copyrights.




9





To
further safeguard our intellectual property, we have a policy that requires our
employees to execute confidentiality and technology ownership agreements when
they begin their relationships with us.





Regulation




Regulatory
Environment Overview





The use
of the Internet and private IP networks to provide voice service is a relatively
recent market development. Although the provision of such services is currently
not as regulated as traditional telephony services within the United States, the
Federal Communications Commission, or FCC, has applied some regulation to
certain types of VoIP services and is reviewing whether to apply additional
regulations to VoIP services. The United States Congress is also considering
whether to impose new and additional regulations on providers of VoIP services,
including us. In addition, several foreign governments have adopted or proposed
regulations that could be interpreted to restrict or prohibit the provision of
VoIP services. Other countries, however, have begun to open their markets to
competition from new Internet-based voice services. Regulation of Internet
telephony providers and services may materially and adversely affect our
business, financial condition, operating results and future prospects,
particularly if increased numbers of governments impose regulations restricting
the use and sale of IP telephony services.





Federal
Regulation





Regulatory Classification of VoIP
Services




To date,
the FCC has not imposed traditional common carrier regulation upon providers of
Internet communications services, but it has begun regulating this area on a
limited basis as outlined in this section. On February 12, 2004, the FCC
initiated a generic rulemaking proceeding concerning the provision of voice and
other services using IP technology, including assessing whether VoIP services
should be classified as information services or telecommunications services. In
November 2004, the FCC determined that VoIP services with certain
characteristics are interstate services subject to federal rather than state
jurisdiction. We believe that some of the VoIP services that we provide
constitute information services, while others are classified as “interconnected
VoIP services,” which are discussed more below. The FCC’s generic rulemaking
proceeding, however, could result in the FCC determining, for instance, that
certain types of Internet telephony should be regulated like basic
telecommunications services. Thus, Internet telephony could no longer be exempt
from access charges, which reimburse local carriers for use of their local
telephone network, telecommunications related regulatory obligations, or other
economic regulations typically imposed on traditional telecommunications
carriers.




The
imposition of access charges and other types of regulatory fees and charges or
the costs of complying with certain regulations could substantially increase our
costs of serving our customers in the U.S. We may have to increase our prices to
cover these costs, which could have a negative impact on our ability to compete
with other telephony providers. The imposition of certain regulations might also
negatively affect the incentives for companies to continue to develop IP
technologies to offer VoIP services because companies may need to divert
resources from research and development to comply with regulatory requirements.
It is also possible that the FCC might adopt a regulatory framework that is
unique to IP telephony providers or one where IP telephony providers are subject
to reduced regulatory requirements, which we believe would be good for us. We
cannot predict what additional regulations, or the extent of such regulation, if
any, the FCC may impose. We cannot predict when the FCC will issue a final
decision regarding the regulatory classification of VoIP services, the outcome
of the decision, or the result of any subsequent proceedings or actions that may
arise out of the FCC’s decision. As a result, we cannot assure you that some or
all of our products and services will not be more heavily regulated in the
future.




VoIP E-911 Matters




On
June 3, 2005, the FCC released an order and notice of proposed rulemaking
concerning VoIP emergency 911 services. The order set forth two primary
requirements for providers of "interconnected VoIP services", meaning VoIP
services that can be used to send and receive calls to or from users on the
PSTN. The order applies to our iConnectHere customers. We do not believe that we
are responsible for compliance with this order in connection with the services
sold to our customers who purchase our services for the provision of services
directly to end users. Clarification of this issue has been raised by similar
providers with the FCC, however, the FCC has not addressed it to date and we
cannot predict how the FCC would rule on this issue. Furthermore, depending on
the FCC’s ruling on this issue, we cannot predict whether we would be subject to
any third-party litigation in connection with such customers who resell our
services.




First,
the order required us to notify our iConnectHere customers of the differences
between the emergency services available through us and those available through
traditional telephony providers. We also had to receive affirmative
acknowledgment from all of our iConnectHere customers that they understand the
nature of the emergency services available through our service. On
September 27, 2005, the FCC's Enforcement Bureau released an order stating
that the Enforcement Bureau will not pursue enforcement actions against VoIP
providers, like us, that have received affirmative acknowledgement from at least
90% of their subscribers. We are required to file a report with the FCC
when we receive affirmative acknowledgments from 100% of our customer base. We
have received affirmative acknowledgment from more than 95% of our iConnectHere
customers that they understand the nature of the emergency services available
through our service, and thus we are substantially in compliance with the first
aspect of the FCC's June 3 order.




10




Second,
the order required us to provide enhanced emergency dialing capabilities, or
E-911, to all of our iConnectHere customers by November 28, 2005. Under the
terms of the order, we are required to use the dedicated wireline E-911 network
to transmit customers' 911 calls, callback number and customer-provided location
information to the emergency authority serving the customer's specified
location. On November 7, 2005, the FCC's Enforcement Bureau issued a Public
Notice with respect to that requirement. The Public Notice indicated that
providers who have not fully complied with the enhanced emergency dialing
capabilities requirement are not required to discontinue the provision of
services to existing clients, but that the FCC expects that such providers will
discontinue marketing their services and accepting new customers in areas in
which the providers cannot offer enhanced emergency dialing
capabilities.




We also
have taken many significant steps to comply with the enhanced emergency service
rules, but we were unable to comply with all of the requirements of the FCC's
order by the November 28, 2005 deadline. Almost all of our iConnectHere
customers currently receive E-911 service in conformity with the FCC’s order,
but some may not receive such service. These are customers who were receiving
service prior to the FCC’s deadline for compliance with the E-911 regulations.
The FCC permitted service providers to continue to provide service to those
existing customers rather than disconnect those customers. Pursuant to the FCC’s
requirement, after the implementation of the FCC E-911 requirements, we provide
services to customers only where we can provide the FCC required E-911 service.
We may be required to stop serving those iConnectHere customers to whom we
cannot provide the required enhanced emergency dialing capabilities that were
being serviced prior to the issuance of the FCC’s rules at any time, but this is
difficult to predict at this time.




The
FCC's June 3, 2005 order also included a notice of proposed rulemaking that
considers, among other things, whether interconnected VoIP providers must
transition to an emergency services system that would enable interconnected VoIP
providers to establish the location of their customers without the customer
providing location information. The comment period closed September 12,
2005. We do not know when the FCC may take further action in this proceeding. If
the FCC adopts additional regulatory obligations, implementing systems to comply
with the obligations could be time consuming and expensive.




See
"—Fees and Taxes" for a discussion of fees we may collect in the future in
connection with providing E-911.





Bundling of DSL and Voice Services
by Incumbent Telephone Companies





In
March 2005, the FCC ruled that state public utility commissions cannot
require that incumbent telecommunications carriers permit competing carriers to
provide voice service to retail customers over the same copper wires used by the
incumbent carriers to provide DSL service. As a result of this ruling, many
incumbent carriers no longer permit retail customers to purchase DSL as a
stand-alone service. This ruling makes our service much less attractive to
customers who obtain broadband Internet access through an incumbent
telecommunications carrier because the incumbent carrier can require them to buy
voice service together with DSL. While some incumbent carriers make DSL
available on a stand-alone basis, they have no legal obligation to do so and
could discontinue such offerings at any time. However, in connection with its
approval on October 31, 2005, of the mergers of SBC and AT&T and Verizon and
MCI, the FCC required each of the merged companies to offer DSL service for two
years from the implementation of stand-alone DSL service, but no more than three
years from the date of the FCC’s merger orders. The two combined companies also
agreed to offer “naked DSL” services for a period of thirty months from the
effective dates of the mergers as a condition for approval of their respective
mergers. These conditions could make our service more attractive to our
customers who obtain broadband Internet access through the merged entities. In
addition to the FCC's requirements, some states imposed conditions on their
approvals of the mergers that require the merged companies to offer stand-alone
DSL.





Communications
Assistance for Law Enforcement Act





The
Communications Assistance for Law Enforcement Act, or CALEA, requires certain
communications service providers to assist law enforcement agencies in
conducting lawfully authorized electronic surveillance. On
September 23, 2005, the FCC released an order concluding that CALEA applies
to interconnected VoIP providers. The FCC established a deadline of May 14,
2007, for VoIP providers to comply with the requirements of CALEA. In May 2006
the FCC released an order finding that broadband Internet access service
providers and interconnected VoIP providers are required to implement the same
type of CALEA requirements that have been applied to wireline telecommunications
carriers. These include obligations to (1) ensure that communications equipment,
facilities, and services meet interception assistance capability requirements
and (2) develop system security policies and procedures to define employee
supervision and record retention requirements. The FCC determined that
interconnected VoIP providers may rely on standards developed by industry
standards-setting bodies as a “safe harbor” for CALEA implementation and may use
trusted third parties as a reasonable method of achieving CALEA compliance. In
either case, however, the interconnected VoIP provider remains responsible for
compliance with the CALEA requirements.  As a result of the steps we
have taken, we believe that we comply with the CALEA.




11




Universal
Service Fund





The FCC
decided in June 2006 that interconnected VoIP service providers should be
required to contribute to the universal service fund, or USF, on an interim
basis. The amount of universal service contribution for interconnected VoIP
service providers is based on a percentage of revenues earned from end-user
interstate services. The FCC developed three alternatives under which an
interconnected VoIP service provider may elect to calculate its universal
service contribution: (1) an interim safe harbor that assumes 64.9% of the
provider’s end user revenues are interstate; (2) a traffic study to
determine an allocation for interstate end user revenues; or (3) actual
interstate and international end user revenues. If an interconnected VoIP
service provider calculates its universal service contributions based on its
actual percentage of interstate calls, the interstate classification of the
service might no longer apply, in which case the interconnected VoIP service
provider could be subject to regulation by each state in which it operates as
well as federal regulation. In addition, the FCC is considering a number of
proposals that could alter the way that the USF is assessed. For instance, the
FCC is considering an assessment based on the use of telephone numbers. The FCC
also is considering whether to apply universal service requirements to
interconnected VoIP service providers on a permanent basis, and how
contributions should be assessed in the future. Further, some states are looking
at whether VoIP services should be subject to state universal service
contribution requirements. We cannot predict how the courts, the FCC, and states
may rule on these matters. Any changes to the assessment and recovery rules for
universal service may affect our financial results.





Customer
Proprietary Network Information





On April
2, 2007, the FCC issued an order that tightened existing rules on protection and
use of Customer Proprietary Network Information, or CPNI, and extended coverage
of the CPNI rules to interconnected VoIP service providers (such as the
Company). Although the rules are aimed in large part at preventing the practice
of pretexting (in which a caller impersonates a phone customer to gain access to
his or her phone records), the rules impose greater obligations on us and other
companies like us to protect customer calling and network information and to
file formal certifications with the FCC regarding procedures for protecting this
information. Failure to comply is subject to FCC enforcement. The new rules went
into effect on December 8, 2007. We do not expect these rules, or our ability to
comply with them, to have a material adverse effect on our operations, financial
position or results of operations.





Intercarrier
Compensation





The
FCC is currently seeking comment concerning proposed reforms of the intercarrier
compensation system, which is a set of FCC rules and regulations by which
telecommunications carriers compensate each other for the use of their
respective networks. These rules and regulations affect the prices we pay to our
suppliers for access to the facilities and services that they provide to us,
such as termination of calls by our customers onto the public switched telephone
network. In addition, proceedings have been initiated to determine what
intercarrier compensation charges should apply to the termination of VoIP
traffic. We cannot predict what, if any, intercarrier compensation regulations
the FCC’s order may impose on VoIP providers.





Other FCC Proceedings That Could
Affect VoIP Services





There are
several other recent or ongoing FCC proceedings initiated by various persons
that relate to VoIP and other Internet services. Certain of the FCC’s
conclusions in these proceedings could have an effect on the VoIP industry
generally and on our business.





State
Regulation




Despite
the FCC’s actions and FCC rulings to the contrary, some state regulatory
authorities believe they retain jurisdiction to regulate the provision of, and
impose charges on, intrastate Internet and VoIP telephony services. Rulings by
the state commissions on the regulatory considerations affecting Internet and IP
telephony services could affect our operations and revenues, and we cannot
predict whether state commissions will be permitted to regulate the services we
offer in the future.





Fees
and Taxes





There
are numerous fees and taxes assessed on traditional telephone services that we
believe have not been applicable to us and that we have not paid in the past.
However, we may begin to collect and remit some of these fees and taxes in the
future. To the extent we increase the cost of services to our customers to
recoup some of the costs of compliance, this will have the effect of decreasing
any price advantage we may have.




Calls
to 911 are answered by public safety agencies supported by state and local taxes
and fees on traditional telephone companies. In the future, we may be required
to pay such fees to state and other authorities in connection with E-911. The
FCC has mandated that we provide E-911 services, but refrained from ordering
interconnected VoIP service providers from contributing to state funds. It is
reviewing the issue as part of its Further Notice of Proposed Rulemaking
concerning E-911 issues. A handful of states have addressed how VoIP providers
should contribute to support public safety agencies and in these states we may
be required to remit fees to the appropriate state agencies.






12




In
addition, it is possible that we will be required to collect and remit sales and
excise taxes in several states where we have not done so in the past. We are in
the process of discussing the applicability of sales and other taxes with
numerous states and we may proactively enter into discussions with additional
states as conditions warrant. If we determine that we need to collect and remit
sales and excise taxes, we will comply with the administrative rules existing in
that state.




States
have or may take the position that we should have collected sales and excise
taxes in the past. If so, they may seek to collect those past taxes from us and
impose fines, penalties or interest charges on us. Our payment of these past
taxes and related charges could have a material adverse effect on
us.




In
addition to sales and excise taxes, there are various state, municipal and local
taxes and fees that are applicable to traditional telephone companies that we
believe are not and should not be applicable to us. If, contrary to our belief,
we are or become subject to these taxes or fees, we will be required to pay or
collect and remit them, which would erode our price advantage when we compete
for customers. In addition, we could be required to pay these taxes or fees, and
related charges, retroactively. Our payment of these past taxes and fines,
penalties or interest charges could have a material adverse effect on
us.





International




The
regulatory treatment of Internet and Internet-based voice services, including IP
telephony or VoIP, outside of the United States varies widely from country to
country. A number of countries may prohibit Internet and IP telephony, while
other countries expressly permit but regulate Internet and IP telephony. Some
countries evaluate proposed Internet and IP telephony service on a case-by-case
basis to determine whether any regulation is necessary or whether it should be
regulated as a voice service or as another telecommunications or data service.
Finally, in many countries neither Internet nor IP telephony have been addressed
by legislation or regulatory action as of the date of this filing. Although we
strive to comply with applicable international IP telephony regulations, we
cannot be certain that we are in compliance with all of the relevant regulations
at any given point in time.





In 2002,
the European Commission adopted a set of directives for a new framework (New
Regulatory Framework) for electronic communications regulation that, in part,
attempts to harmonize the regulations that apply to services regardless of the
technology used by the provider. Under the New Regulatory Framework, there is no
distinction in regulation made based upon technology between switched or
packet-based networks. As a result of this technology neutral regulatory
approach, some types of IP telephony and VoIP services may be regulated like
traditional telephony services while others may remain free from regulation. The
European Commission has published a staff working paper aimed at clarifying the
conditions applicable to providers of IP-based services. The working paper
identifies various issues that may arise in relation to IP-based services
including the regulatory classification of Internet telephony and VoIP under the
New Regulatory Framework. The European Regulators Group (consisting of
regulators from European Union Member States and the European Commission) has
adopted a Common Statement for VoIP regulation. The European Commission
currently is reviewing how IP telephony services fit into the New Regulatory
Framework. Although the European Commission has recommended that a “light touch”
to regulation be taken, we cannot predict what future actions the European
Commission, member states, and courts reviewing the New Regulatory Framework may
take regarding IP telephony and related matters, or what impact, if any, such
actions may have on our business.





Based on
the European Commission's current position, we believe that most providers of IP
telephony would be subjected to no more than minimal regulation such as a
general authorizations or declaration requirements that may be imposed by the
European Union Member States, subject to the European Commission’s current
review of the issue. Several Member States have issued statements or regulations
concerning IP telephony and VoIP while others have issued consultations
requesting industry comments on the applicability of the New Regulatory
Framework to various IP telephony and VoIP services in their respective
countries. However, since the Commission's findings on IP telephony are not
binding on the Member States, we cannot assure you that the services provided
over our network will not be deemed “voice telephony” subject to heightened
regulation by one or more EU Member States. For example, the United Kingdom has
opened a proceeding to review the regulation of Internet-based voice services.
Although Member States are required to adhere to the New Regulatory Framework,
Member States may not take a uniform approach in regulating a particular
Internet-enabled service including IP telephony. We cannot predict the outcome
of these consultations or the manner in which Member States will implement the
New Regulatory Framework with respect to our particular services.





As we
make our services (particularly joip) available in foreign countries, and as we
facilitate sales by our network partners to end users located in foreign
countries, such countries may claim that we are required to qualify to do
business in the particular foreign country. Such countries may also claim that
we are subject to regulation, including requirements to obtain authorization for
the provision of voice telephony or other telecommunications services, or for
the operation of telecommunications networks.  Indeed, in connection
with the launch of our joip service, we have registered to provide the service
in various foreign countries and expect that we will be required to register in
additional foreign countries in the future. It is also possible that such
countries may claim that we are prohibited in all cases from providing our
services or conducting our business in those countries. Failure to qualify as a
foreign corporation in certain jurisdictions, or to comply with foreign laws and
regulations, may adversely affect our business. In addition, we cannot predict
how a regulatory or policy change of a particular country might affect the
provision of our services.







13





Our
network partners may also currently be, or in the future may become, subject to
requirements to qualify to do business in a particular foreign country, comply
with regulations (including requirements to obtain authorizations for the
provision of voice telephony or other telecommunications services or for the
operation of telecommunications networks) or cease providing services or
conducting their business as conducted in that country. We cannot be certain
that our network partners either are currently in compliance with any such
requirements, will be able to comply with any such requirements, and/or will
continue in compliance with any such requirements.





Other
Regulation Affecting the Internet





The
European Union has also enacted several directives relating to the Internet,
including regulations that address online commerce and data protection.
International governments are adopting and implementing privacy and data
protection regulations that establish certain requirements with respect to,
among other things, the confidentiality, processing and retention of personal
subscriber information. The potential effect, if any, of these data protection
rules on the development of our business remains uncertain.





Competition





We
compete primarily in the market for enhanced VoIP telephony. This market is
highly competitive and there are numerous competing service providers. We
believe that the primary competitive factors determining our success in the VoIP
telephony market are: quality of service and network capacity; the ability to
meet and anticipate customer needs through multiple service offerings and
feature sets; customer services; and price.





Future
competition could come from a variety of companies both in the Internet and
telecommunications industries. These industries include major companies who have
greater resources and larger subscriber bases than we have, and have been in
operation for many years. We also compete in the growing market of discount
telecommunications services including “pure play” VoIP service providers,
calling cards, prepaid cards, call-back services, dial-around or 10-10 calling
and collect calling services. In addition, some Internet service providers have
begun to aggressively enhance their real time interactive communications,
including instant messaging, PC-to-PC and PC-to-Phone services, and Broadband
phone services.





IP Telephony Providers. Many
companies provide, or are planning to provide, certain portions of the complete
communications solution we offer, including Net2Phone, Vonage, and
MediaRing.





Traditional Telecommunications
Carriers and Broadband Services Providers. Several traditional
telecommunications companies, such as AT&T, Sprint, Deutsche Telekom, and
Qwest Communications International, and established broadband services
providers, such as Time Warner, Comcast, and Cablevision, have announced VoIP
telephony services and products and/or their intention to offer such products
and services in both the United States and internationally. All of these
competitors are significantly larger than we are and have:





·
            substantially
      greater financial, technical and marketing
  resources;




·
            larger
      networks;




·
            a
      broader portfolio of services;




·
            stronger
      name recognition and customer
loyalty;




·
            well-established
      relationships with many of our target customers;
  and




·
            an
      existing user base to which they can cross-sell their
      services.










14


These and
other competitors may be able to bundle services and products that are not
offered by us together with VoIP telephony services, which could place us at a
significant competitive disadvantage. Many of our competitors enjoy economies of
scale that can result in lower cost structure for transmission and related
costs, which could cause significant pricing pressures within the industry. At
the same time, we see these potential competitors as potential customers, and
have organized our various service provider and reseller products and services
to meet the emergent needs of these companies.





Revenues
and Assets by Geographic Area





For the
year ended December 31, 2007, approximately $16.8 million, or 56.9%, of our
revenue was derived from international customers, and $12.7 million, or 43.1%,
was derived from customers in the United States. Most of our long-lived assets
are located in the United States. For more detailed information concerning our
geographic segments, see Note 13 to our financial statements included elsewhere
in this Annual Report.





Employees





As of
December 31, 2007, we employed 128 full-time and 20 part-time employees, of
which 124 were located in Israel and 24 were located in New York. We consider
our relationship with our employees to be good. None of our employees is covered
by collective bargaining agreements.





Available
Information





Our
Internet address is www.deltathree.com. Through a link at the Investor Relations
section of our website located at www.deltathree.com, we make available, free of
charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K, and all amendments to those reports as soon as reasonably
practicable after such materials have been electronically filed with, or
furnished to, the Securities and Exchange Commission, or SEC.





ITEM
1A.   RISK
FACTORS





Our
business, financial condition and results of operations and the trading price of
our common stock could be materially adversely affected by any of the following
risks as well as the other risks highlighted elsewhere in this Annual Report,
particularly the discussions about regulation, competition and intellectual
property. Additional risks and uncertainties not presently known to us or that
we currently deem immaterial also may impair our business
operations.




Risks
Related to our Company




We
have a history of losses and we are uncertain as to our future
profitability.





Except
for the year ended December 31, 2006, in which the Company reported net income
of approximately $500,000 but a net loss from operations of $52,000, the Company
has had a history of significant losses since its inception, and we may continue
to incur significant losses for the foreseeable future. We reported net losses
of $9.3 million in 2007 and $0.9 million in 2005. As of December 31, 2007,
our accumulated deficit was approximately $161.0 million. Our revenues may not
grow or even continue at their current level. Going forward, we will need to
increase our revenues and lower our current cost structure to obtain
profitability. If our revenues do not increase and/or if we are unable to reduce
our expenses, we may not be able to reach profitability again. We cannot assure
you that we will be able to obtain profitability on a quarterly or annual basis
in the future.


15


We
may not be able to expand our revenue.





Our
business strategy is to expand our revenue sources and our distribution channels
in order to include the provision of VoIP telephony to different customer
groups. We can neither assure you that we will be able to accomplish this nor
that this strategy will be profitable. Currently, our revenues are primarily
generated by sales of our VoIP telephony products and services through our
direct-to-consumer channel and our service provider and reseller sales channel
(including sales of our Hosted Consumer VoIP Solution). VoIP telephony from
these channels generated 98.3%, 94.6% and 96.1% of our total revenues in 2007,
2006 and 2005, respectively.





In the
future, we intend to generate increased revenues in VoIP telephony, from
multiple sources and customer bases, many of which are unproven. We expect that
our revenues for the foreseeable future will be dependent on, among other
factors:





·
            sales
      of our VoIP telephony products and services, including sales of our Hosted
      Consumer VoIP Solution;·
            acceptance
      and use of VoIP telephony;·
            expansion
      of our service and product offerings;·
            traffic
      levels on our network;·
            the
      effect of competition, regulatory environment, international long distance
      rates and access and transmission costs on our prices;
  and·
            continued
      improvement of our global network
quality.





We may
not be able to sustain our current revenues or successfully generate additional
revenues from the sale of VoIP telephony, including our Hosted Consumer VoIP
Solution.





Decreasing
telecommunications prices may cause us to lower our prices to remain
competitive, which could prevent our future profitability.





Decreasing
telecommunications prices may diminish or eliminate the competitive pricing
advantage of our services. International and domestic telecommunications prices
have decreased significantly over the last few years in most of the markets in
which we operate, and we anticipate that prices will continue to be reduced in
all of the markets in which we do business or expect to do business. Users who
select our services (or our resellers’ or our Hosted Consumer VoIP customers’
services) to take advantage of the current pricing differential between
traditional telecommunications prices and our (or our customers’) prices may
switch to traditional telecommunications carriers as such pricing differentials
diminish or disappear, and we will be unable to use such pricing differentials
to attract new customers in the future. Such competition or continued price
decreases may require us to lower our prices to remain competitive, may result
in reduced revenue, a loss or decrease of customers and may prevent our future
profitability.





We
have a limited operating history upon which you can evaluate us.





Although
we commenced our operations in 1996, in 2000 we began to transform our business
from a provider of wholesale minutes to carriers to our current role as a
provider of VoIP solutions. We, therefore, have only a limited operating history
upon which you can evaluate our current business and prospects. You should
consider our prospects in light of the risks, expenses and difficulties we may
encounter as an early stage company in the new and rapidly evolving market for
VoIP telephony. These risks include our ability:





·
            to
      increase acceptance of our VoIP telephony products and services (including
      our Hosted Consumer VoIP Solution);·
            to
      compete effectively;


·
              to
      identify and enter into strategic alliances; and·
              to
      develop new products and keep pace with developing
    technology.


16




In
addition, because we expect an increasing percentage of our revenues to be
derived from our VoIP telephony products and services (including our Hosted
Consumer VoIP Solution), our past operating results may not be indicative of our
future results.





We
may need additional capital to finance our operations and grow our
business.





Due to
the nature of our industry, our future capital needs are difficult to predict.
Therefore, we may require additional capital to fund some or all of the
following:





·
            introduction
      and deployment of our new, or existing, products and services, including
      our joip offering;·
            enhancement
      and expansion of our network;·
            unanticipated
      opportunities;·
            strategic
      alliances, and potential acquisitions;·
            changing
      business conditions; and·
            unanticipated
      competitive pressures.





While we
believe we have sufficient funds to meet our working capital requirements for at
least the next fiscal year, if our cash flow from operations is not sufficient
to meet our capital expenditure and working capital requirements we will need to
raise additional capital. There can be no assurance that we will be able to
raise such additional capital on favorable terms or at all. If we will not have
sufficient funds to meet our working capital requirements and are unable to
obtain additional capital we will be required to reduce the scope of our
business, which could have a material adverse effect on our business, financial
condition, and results of operations.





Our acquisition activity could
disrupt our ongoing business and may present risks not contemplated at the time
of the transactions.





We
recently acquired the service provider and consumer businesses of Go2Call and we
may continue to acquire companies, businesses, products and technologies that
complement our strategic direction. These acquisitions may involve significant
risks and uncertainties, including:





·
            inability
      to successfully integrate the acquired technology and operations into our
      business and maintain uniform standards, controls, policies, and
      procedures;·
            distraction
      of management’s attention away from normal business
      operations;·
            challenges
      retaining the key employees of the acquired operation;·
            insufficient
      revenue generation to offset liabilities assumed;·
            expenses
      associated with the acquisition; and·
            unidentified
      issues not discovered in our due diligence process, including product
      quality issues and legal
contingencies.





Acquisitions
are inherently risky. We can not be certain that our previous or future
acquisitions will be successful and will not materially adversely affect the
conduct, operating results or financial condition of our business. We paid
approximately 60% of the purchase price for our Go2Call acquisition with shares
of our common stock. If we continue to issue common stock or other
equity-related purchase rights as consideration in future acquisitions, current
shareholders’ percentage ownership and earnings per share may become
diluted.


17





The
success of our VoIP telephony products and services is dependent on the growth
and public acceptance of VoIP telephony.




The
success of our VoIP telephony products and services is dependent upon future
demand for VoIP telephony systems and services. In order for the VoIP telephony
market to continue to grow, several things need to occur. Telephone and cable
service providers must continue to invest in the deployment of high speed
broadband networks to residential and business customers. VoIP networks must
improve quality of service for real-time communications, managing effects such
as packet jitter, packet loss, and unreliable bandwidth, so that toll-quality
service can be provided. VoIP telephony equipment and services must achieve a
similar level of reliability that users of the public switched telephone network
have come to expect from their telephone service. VoIP telephony service
providers must offer cost and feature benefits to their customers that are
sufficient to cause the customers to switch away from traditional telephony
service providers. Service providers and resellers must be willing to use
outsourced solutions providers for VoIP telephony. Furthermore, end users in
markets serviced by recently deregulated telecommunications providers are not
familiar with obtaining services from competitors of these providers and may be
reluctant to use new providers, such as us. We will need to devote substantial
resources to educate customers and end users about the benefits of VoIP
telephony solutions in general and our services in particular. For example,
although we believe that our joip offering embedded in Panasonic’s Globarange
cordless telephone may be an easy way to introduce and educate end users about
VoIP telephony, we cannot assure you that consumers will purchase this offering
or that they will use the VoIP features of this phone. If any or all of these
factors fail to occur, our business may decline.




Our
future success depends on the growth in the use of the internet as a means of
communications.





If the
market for VoIP telephony, in general, and our services in particular, does not
grow at the rate we anticipate or at all, we will not be able to increase our
number of users or generate revenues we anticipate. To be successful, VoIP
telephony requires validation as an effective, quality means of communication
and as a viable alternative to traditional telephone service. Demand and market
acceptance for recently introduced services are subject to a high level of
uncertainty. The Internet may not prove to be a viable alternative to
traditional telephone service for reasons including:





·
            inconsistent
      quality or speed of service, including power outages;·
            traffic
      congestion on the Internet;·
            potentially
      inadequate development of the necessary infrastructure;·
            lack
      of acceptable security technologies;·
            lack
      of timely development and commercialization of performance improvements;
      and·
            unavailability
      of cost-effective, high-speed access to the
  Internet.





If
Internet usage grows, the Internet infrastructure may not be able to support the
demands placed on it by such growth, or its performance or reliability may
decline. In addition, websites may from time to time experience interruptions in
their service as a result of power outages and other delays occurring throughout
the Internet network infrastructure. If these outages or delays occur
frequently, customers’ use of the Internet and our products and services as a
means of communications could decline or may not grow as we
anticipate.





Intense
competition could reduce our market share and decrease our revenue.





The
market for VoIP telephony is extremely competitive. Our competitors include both
start-up IP telephony service providers and established traditional
communications providers. Many of our existing competitors and potential
competitors have broader portfolios of services, greater financial, management
and operational resources, greater brand-name recognition, larger subscriber
bases and more experience than we have. In addition, many of our IP telephony
competitors use the Internet instead of a private network to transmit traffic.
Operating and capital costs of these providers may be less than ours,
potentially giving them a competitive advantage over us in terms of
pricing.





We also
compete in the growing market of discount telecommunications services including
calling cards, prepaid cards, call-back services, dial-around or 10-10 calling
and collect calling services. In addition, some Internet service providers have
begun to aggressively enhance their real time interactive communications,
focusing on instant messaging, PC-to-PC and PC-to-phone, and/or broadband phone
services.




18





In
addition, traditional carriers, cable companies and satellite television
providers are bundling services and products that we do not offer together with
internet telephony services. These services could include wireless
communications, voice and data services, Internet access, and cable television.
Although this provides us with the opportunity to offer these companies our
products and services as a way for them to offer internet telephony services,
these companies can also introduce these services on their own and may be able
to bundle the services at a single attractive price. This could make it more
difficult for us to compete against them with direct to consumer offerings of
our own.





If we are
unable to provide competitive service offerings, we may lose existing customers
and be unable to attract additional customers. In addition, many of our
competitors, especially traditional carriers, enjoy economies of scale that
result in a lower cost structure for transmission and related costs, which cause
significant pricing pressures within the industry. To remain competitive, we
must continue to invest significant resources in research and development, sales
and marketing, and customer support. We may not have sufficient resources to
make these investments or to make the technical advances necessary to be
competitive which, in turn, will cause our business to suffer.





Potential
fluctuations in our quarterly financial results may make it difficult for
investors to predict our future performance.





Our
quarterly operating results may fluctuate significantly in the future as a
result of a variety of factors, many of which are outside our control. The
factors generally within our control include:





·
            the
      rate at which we are able to attract users to purchase our VoIP telephony
      products and services, including our Hosted Consumer VoIP
      Solution;·
            the
      amount and timing of expenses to enhance marketing and promotion efforts
      and to expand our infrastructure; and·
            the
      timing of announcements or introductions of new or enhanced services by
      us.





The
factors outside our control include:





·
            the
      timing of announcements or introductions of new or enhanced services by
      our competitors;·
            regulations
      in various countries that prohibit us from providing our services
      cost-effectively or at all;·
            technical
      difficulties or network interruptions in the Internet or our
      privately-managed network; and·
            general
      economic and competitive conditions specific to our
    industry.





The
foregoing factors also may create other risks affecting our long-term success,
as discussed in the other risk factors.





We
believe that quarter-to-quarter comparisons of our historical operating results
may not be a good indication of our future performance, nor would our operating
results for any particular quarter be indicative of our future operating
results.





Our
success depends on our ability to handle a large number of simultaneous calls,
which our network may not be able to accommodate.





We
expect the volume of simultaneous calls to increase significantly as we expand
our operations. Our network hardware and software may not be able to accommodate
this additional volume. If we fail to maintain an appropriate level of operating
performance, or if our service is disrupted, our reputation could be hurt, we
could lose customers and our business, financial condition and results of
operations could be materially and adversely affected.


19




We
face a risk of failure of computer and communications systems used in our
business.





Our
business depends on the efficient and uninterrupted operation of our computer
and communications systems as well as those that connect to our network. We
maintain communications systems in facilities in New York, Los Angeles, Atlanta,
London, Frankfurt and Hong Kong.. Although we have designed our network to
reduce the possibility of disruptions or other outages, our systems and those
that connect to our network are subject to damage or interruption from natural
disasters, power loss, communications failure, hardware or software malfunction,
network failures, physical or electronic break-ins, sabotage, computer viruses,
intentional acts of terrorism or vandalism and other events that may be or may
not be beyond our control. Any system interruptions that cause our services to
be unavailable, including significant or lengthy telephone network failures or
difficulties for users in communicating through our network or portal, could
damage our reputation and result in a loss of users.





Substantially
all of the VoIP telephony calls made by our iConnectHere customers and a large
percentage of our service providers and reseller customers are connected through
local telephone companies and, at least in part, through leased facilities that
may become unavailable.





We are
not a local telephone company or a local exchange carrier. Our network covers
only portions of the United States. Accordingly, we must route parts of some
domestic and all international calls made by our ICH customers, and a large
percentage of our service provider and reseller customers, over leased
transmission facilities. In addition, because our network does not extend to
homes or businesses, we must generally route calls through a local telephone
company to reach our network and, ultimately, to reach their final
destinations.





In many
of the foreign jurisdictions in which we conduct or plan to conduct business,
the primary provider of significant in-country transmission facilities is the
national telephone company, which may be the only provider in that country.
Accordingly, we may have to lease transmission capacity at artificially high
rates from such a monopolistic provider, and consequently, we may not be able to
generate a profit on those calls. In addition, national telephone companies may
not be required by law to lease necessary transmission lines to us or, if
applicable law requires national telephone companies to lease transmission
facilities to us, we may encounter delays in negotiating leases and
interconnection agreements and commencing operations. Additionally, disputes may
result with respect to pricing, billing or other terms of these agreements, and
these disputes could affect our ability to continue to operate in these
countries, which may materially and adversely affect our business, financial
condition and results of operations.





Our
computer systems and operations may be vulnerable to security
breaches.





We
believe that the secure transmission of confidential information over the
Internet, such as credit card numbers, is essential in maintaining user
confidence in our services. Although we have developed systems and processes
that are designed to protect consumer information and prevent fraudulent credit
card transactions and other security breaches, our computer infrastructure is
potentially vulnerable to physical or electronic computer viruses, break-ins and
similar disruptive problems and security breaches that could cause
interruptions, delays or loss of services to our users. We rely on licensed
encryption and authentication technology to effect secure transmission of
confidential information, including credit card numbers. It is possible that
advances in computer capabilities or new technologies could result in a
compromise or breach of the technology we use to protect user transaction data.
A party that is able to circumvent our security systems could misappropriate
proprietary information or cause interruptions in our operations. Security
breaches also could damage our reputation and expose us to a risk of loss,
litigation and possible liability. Although we have experienced no security
breaches to date of which we are aware, we cannot guarantee you that our
security measures will prevent security breaches.





Operating
internationally exposes us to additional and unpredictable risks.





We intend
to continue to enter additional foreign markets and expand our existing
operations outside the United States. We cannot assure you that we will be
successful in expanding into additional international markets. In addition to
the uncertainty regarding our ability to generate revenue from foreign
operations and expand our international presence, there are certain risks
inherent in doing business on an international basis, including:




·
            political
      and economic instability;·
            legal
      uncertainty regarding liability, regulations, tariffs and other trade
      barriers;·
            fluctuations
      in exchange rates;·
            potentially
      adverse tax consequences;·
            action
      by foreign governments or foreign telecommunications companies to limit
      access to our services;·
            potentially
      weaker protection of intellectual property rights; and·
            uncertain
      market acceptance and difficulties in marketing efforts due to language
      and cultural differences.





20




We
have experienced losses as a result of fraud.





We have
experienced losses due to fraud. While in 2007 we experienced losses from fraud
of less than 1% of our revenues, callers have obtained our services without
rendering payment by unlawfully using our access numbers and personal
identification numbers. While we have continued to implement anti-fraud measures
in order to control losses relating to these practices, and these measures have
proven to be effective today, these measures may not in the future be sufficient
to effectively limit all of our exposure in the future from fraud and future
losses could rise significantly above current levels.





We
need to retain key personnel to support our products and ongoing
operations.





The
marketing and operations of our VoIP products and services will continue to
place a significant strain on our limited personnel, management, and other
resources. Our future success depends upon the continued services of our
executive officers and other key employees who have critical industry experience
and relationships that we rely on to implement our business plan. Except for Mr.
Shimmy Zimels, our Chief Executive Officer, and Mr. Lior Samuelson, our Chairman
of the Board, none of our officers or key employees is bound by employment
agreements for any specific term. The loss of the services of any of these
officers or key employees could delay the development and introduction of, and
negatively impact our ability to sell, our products which could adversely affect
our financial results and impair our growth. We currently do not maintain key
person life insurance policies on any of our employees.





Our
ability to provide our service is dependent upon third-party facilities and
equipment, the failure of which could cause delays or interruptions of our
service, damage our reputation, cause us to lose customers and limit our
growth.





Our
success depends on our ability to provide quality and reliable service, which is
in part dependent upon the proper functioning of facilities and equipment owned
and operated by third parties and is, therefore, beyond our control. Unlike
traditional wireline telephone service or wireless service, our service requires
our customers to have an operative broadband Internet connection and an
electrical power supply, which are provided by the customer's Internet service
provider and electric utility company, respectively, and not by us. The quality
of some broadband Internet connections may be too poor for customers to use our
services properly. In addition, if there is any interruption to a customer's
broadband Internet service or electrical power supply, that customer will be
unable to make or receive calls, including emergency calls, using our service.
We also outsource several of our network functions to third-party providers. For
example, we outsource the maintenance of our regional data connection points,
which are the facilities at which our network interconnects with the public
switched telephone network. If our third-party service providers fail to
maintain these facilities properly, or fail to respond quickly to problems, our
customers may experience service interruptions. Our customers have experienced
such interruptions in the past and will experience interruptions in the future.
In addition, our E-911 service is currently dependent upon a third-party
provider. Interruptions in service from this vendor could cause failures in our
customers' access to E-911 services. Furthermore, we outsource certain aspects
of our customer care services. Interruptions in our service caused by
third-party facilities or service providers have in the past caused and may in
the future cause us to lose customers, or cause us to offer substantial customer
credits, which could adversely affect our revenue and profitability. If
interruptions adversely affect the perceived reliability of our service, we may
have difficulty attracting new customers and our brand, reputation and growth
will be negatively impacted.





Third
parties might infringe upon our proprietary technology.





We cannot
assure you that the steps we have taken to protect our intellectual property
rights will prevent misappropriation of our proprietary technology. To protect
our rights to our intellectual property, we rely on a combination of trademark
and patent law, trade secret protection, confidentiality agreements and other
contractual arrangements with our employees, affiliates, strategic partners and
others. We may be unable to detect the unauthorized use of, or take appropriate
steps to enforce, our intellectual property rights. Effective trademark and
trade secret protection may not be available in every country in which we offer
or intend to offer our services. Failure to adequately protect our intellectual
property could materially harm our brand, devalue our proprietary content and
affect our ability to compete effectively. Further, defending our intellectual
property rights could result in significant financial expenses and managerial
resources.





Our services may infringe on the
intellectual property rights of others.





Third
parties may assert claims that we have violated a patent or infringed a
copyright, trademark or other proprietary right belonging to them. We
incorporate licensed third-party technology in some of our products and
services. In these license agreements, the licensors have agreed to indemnify us
with respect to any claim by a third party that the licensed software infringes
any patent or other proprietary right so long as we have not made changes to the
licensed software. We cannot assure you that these provisions will be adequate
to protect us from infringement claims. Any infringement claims, even if not
meritorious, could result in substantial monetary liability or may materially
disrupt the conduct of our business.





21




Risks
Related to our Industry





Government
regulation and legal uncertainties relating to IP telephony could harm our
business.





Historically,
voice communications services have been provided by regulated telecommunications
common carriers. We offer voice communications to the public for international
and domestic calls using IP telephony, and we do not operate as a licensed
telecommunications common carrier in any jurisdiction. Based on specific
regulatory classifications and recent regulatory decisions, we believe we should
not be regulated as a telecommunications common carrier in any of our markets.
However, the growth of IP telephony has led to close examination of its
regulatory treatment in many jurisdictions making the legal status of our
services uncertain and subject to change as a result of future regulatory
action, judicial decisions or legislation in any of the jurisdictions in which
we operate. Established regulated telecommunications carriers have sought and
may continue to seek regulatory actions to restrict the ability of companies
such as ours to provide services or to increase the cost of providing such
services. In addition, our services may be subject to regulation if regulators
distinguish phone-to-phone telephony service using IP technologies over
privately-managed networks such as our services from integrated PC-to-PC and
PC-originated voice services over the Internet. Some regulators may decide to
treat the former as regulated common carrier services and the latter as
unregulated enhanced or information services.





Application
of new regulatory restrictions or requirements to us could increase our costs of
doing business and prevent us from delivering our services through our current
arrangements. In such event, we would consider a variety of alternative
arrangements for providing our services, including obtaining appropriate
regulatory authorizations for our local network partners or ourselves, changing
our service arrangements for a particular country or limiting our service
offerings. Such regulations could limit our service offerings, raise our costs
and restrict our pricing flexibility, and potentially limit our ability to
compete effectively. Further, regulations and laws that affect the growth of the
Internet could hinder our ability to provide our services over the
Internet.





Our
international operations are also subject to regulatory risks, including the
risk that regulations in some jurisdictions will prohibit us from providing our
services cost-effectively or at all, which could limit our growth. Currently,
there are several countries where regulations prohibit us from offering service.
These regulations have had an impact on us in 2007, particularly in connection
with our offering of the joip service. We cannot assure you that these
conditions will not have a material effect on our revenues and growth in the
future. In addition, because customers can use our services almost anywhere that
a broadband Internet connection is available, including countries where
providing VoIP services is illegal, the governments of those countries may
attempt to assert jurisdiction over us, which could expose us to significant
liability and regulation. For a more detailed discussion of the regulation of IP
telephony, see "Regulation."





We
may not be able to keep pace with rapid technological changes in the
communications industry.





Our
industry is subject to rapid technological change. We cannot predict the effect
of technological changes on our business. In addition, widely accepted standards
have not yet developed for the technologies we use. We expect that new services
and technologies will emerge in the market in which we compete. These new
services and technologies may be superior to the services and technologies that
we use, or these new services may render our services and technologies
obsolete.





To be
successful, we must adapt to our rapidly changing market by continually
improving and expanding the scope of services we offer and by developing new
services and technologies to meet customer needs. Our success will depend, in
part, on our ability to license leading technologies and respond to
technological advances and emerging industry standards on a cost-effective and
timely basis. We will need to spend significant amounts of capital to enhance
and expand our services to keep pace with changing technologies.





The
success of our business is affected by customers' unimpeded access to broadband
service. Providers of broadband services may be able to block our services,
which could adversely affect our revenue and growth.





A portion
of our customers must have broadband access to the Internet in order to use our
service. Some providers of broadband access have taken measures that affect
their customers' ability to use our service, such as degrading the quality of
the data packets we transmit over their lines, giving those packets low
priority, giving other packets higher priority than ours, blocking our packets
entirely or attempting to charge their customers more for also using our
services. It is not clear whether suppliers of broadband access services have a
legal obligation to allow their customers to access and use our service without
interference. As a
result of recent decisions by the U.S. Supreme Court and the FCC, providers of
broadband services are subject to relatively light regulation by the FCC.
Consequently, federal and state regulators might not prohibit broadband
providers from limiting their customers' access to VoIP or otherwise
discriminating against VoIP providers. Interference with our service or higher
charges for using our service could cause us to lose existing customers, impair
our ability to attract new customers, and harm our revenue and
growth.





We are not currently accepting customers in areas where we cannot
provide E-911 service in conformity with the FCC’s rules. This has adversely
impacted the ability of ICH to accept new customers and may also have an adverse
effect on our sales to customers who resell our service.


22




Various
fees and taxes will increase our costs and our customers' cost of using our
services.




There
are numerous U.S. state and municipal and other fees and taxes assessed on
traditional telephone services that we believe have not been applicable to us
and that we have not paid in the past. However, we may begin to collect and
remit some of these fees and taxes in the future. To the extent we increase the
cost of services to our customers to recoup some of these costs of compliance
this will have the effect of decreasing any price advantage we may have.
Moreover, if we are subject to various state and municipal regulations and taxes
in the U.S., this would increase our costs of doing business, and adversely
affect our operating results and future prospects.




In
addition, it is possible that we will be required to collect and remit sales and
excise taxes in several states where we have not done so in the past. We are in
the process of discussing the applicability of sales, excise, and other taxes
with numerous states and we may proactively enter into discussions with
additional states as conditions warrant. In the states where we determine that
we need to collect and remit sales and excise taxes, we will comply with the
administrative rules existing in that state.




States
have taken or may take the position that we should have collected sales and
excise taxes in the past. If so, they may seek to collect those past taxes from
us and impose fines, penalties or interest charges on us. Our payment of these
past taxes and related charges could have a material adverse effect on
us.




There
may be risks associated with our ability to comply with funding requirements of
the USF and similar state or federal funds, or that our customers will cancel
service due to the impact of these or other price increases to their
service.




On
June 21, 2006, the FCC expanded the base of USF contributions to interconnected
VoIP providers. The Company may calculate its USF contribution based on any one
of three methods: (1) a safe harbor percentage of interstate revenue of 64.9% of
total VoIP service revenue, (2) a traffic study that has been approved by the
FCC, or (3) reporting based on actual interstate end user telecommunications
revenues. The Company is currently calculating its contribution based on the
safe harbor. We began contributing to the USF during the fourth fiscal quarter
of 2006, and as allowed by the FCC we began charging our end user subscribers a
USF surcharge fee equal to the USF contribution amounts we must contribute based
upon our subscribers' retail revenues. The USF contribution applies to the
revenue from our direct-to-consumer channel. In general, revenue from our
Service Provider and Reseller channel is not subject to the contribution because
most of our customers from this channel are exempt from USF or make their own
contribution. The impact of this price increase on our customers or our
inability to recoup the costs or liabilities in remitting USF contributions or
other factors could have a material adverse effect on our financial position,
results of operations and cash flows.





The FCC
continues to evaluate alternative methods for assessing USF charges, including
imposing an assessment on telephone numbers. The outcome of the FCC’s evaluation
cannot be determined at this time.




Risks
Related to our Relationship with Atarey





Atarey
exercises significant control over all matters submitted to a stockholder
vote.





Atarey
Hasharon Chevra Lepituach Vehashkaot Benadlan (1991) Ltd., or Atarey, owns
approximately 40% of the voting power and economic interest in us, and is the
largest holder of our stock. As long as Atarey continues to beneficially own
such a significant percentage of our capital stock and there are no other major
stockholders, Atarey will be able to exercise a significant influence over
decisions affecting us, including:





·
            composition
      of our board of directors and, through it, our direction and policies,
      including the appointment and removal of officers;·
            mergers
      or other business combinations;·
            acquisitions
      or dispositions of assets by us;·
            future
      issuances of capital stock or other securities by us;·
            incurrence
      of debt by us;·
            amendments,
      waivers and modifications to any agreements between us and
      Atarey;·
            payment
      of dividends on our capital stock; and·
            approval
      of our business plans and general business
  development.





23




In
addition, one of our five directors is an officer and/or director of Atarey, or
otherwise affiliated with Atarey. As a result, the ability of any of our other
stockholders to influence the management of our company is limited, which could
have an adverse effect on the market price of our stock.





A
third party may be deterred from acquiring our company.





Atarey’s
significant ownership could delay, deter or prevent a third party from
attempting to acquire control of us. This may have the effect of discouraging a
third party from making a tender offer or otherwise attempting to obtain control
of us, even though such a change in ownership would be economically beneficial
to us and our stockholders.




Risks
Related to our Common Stock




Volatility
of our stock price could adversely affect our stockholders.





From the
time that trading commenced in our common stock in November 1999, the
market price of our common stock has been highly volatile and may continue to be
volatile and could be subject to wide fluctuations in response to factors such
as:





·
            the
      market price for the stock of our major
  competitors;





·
            variations
      in our actual or anticipated quarterly operating results or those of our
      competitors;·
            announcements
      by us or our competitors of technological innovations;·
            introduction
      of new products or services by us or our competitors;·
            conditions
      or trends in the Internet industry;·
            changes
      in the market valuations of other Internet companies;·
            announcements
      by us or our competitors of significant acquisitions;·
            our
      entry into strategic partnerships or joint ventures;
and·
            sales
      of our common stock by Atarey.





All of
these factors are, in whole or part, beyond our control and may materially
adversely affect the market price of our common stock regardless of our
performance.





Investors
may not be able to resell their shares of our common stock following periods of
volatility because of the market's adverse reaction to such volatility. In
addition, the market price for shares of telecommunications, Internet-related
and technology companies has dramatically decreased. We cannot assure you that
our common stock will trade at the same levels of other telecommunications or
Internet stocks or that telecommunications or Internet stocks in general will
sustain their current market prices.


24




The
delisting of our common stock from The Nasdaq Capital Market may adversely
affect the market price and liquidity of our stock, as well as our business and
operations.




Our
common stock was delisted from The Nasdaq Capital Market, and began to be listed
and traded on the OTC Bulletin Board, on March 28, 2008. As disclosed in the
Form 8-K filed by us on March 25, 2008, on March 19, 2008 we received
notification from The Nasdaq Stock Market indicating that trading would be
suspended and the common stock delisted from the Nasdaq Capital Market at the
opening of business on March 28, 2008, unless we chose to appeal Nasdaq’s
determination.   We had received notice from The Nasdaq Stock
Market on September 17, 2007 indicating that we were not in compliance with
Marketplace Rule 4310(c)(4) because the bid price of the common stock had closed
below $1.00 for the previous 30 consecutive business days.  We were
provided a period until March 17, 2008 to regain compliance with Rule 4310(c)(4)
at which time, if we had not regained compliance, Nasdaq would determine whether
we met the Nasdaq Capital Market initial listing criteria set forth in Nasdaq
Marketplace Rule 4310(c) except for the bid price requirement.  The
notification from Nasdaq stated that the Company had not regained compliance
with Rule 4310(c)(4) and does not meet the initial listing criteria. The Company
chose not to appeal Nasdaq’s determination.





The
suspension of trading and delisting of our shares from The Nasdaq Capital
Market, and listing and trading on the OTC Bulletin Board, may adversely affect
the market price of our common stock, as well as the liquidity of the market for
our shares which, as a result, may adversely affect the ability of our
stockholders to purchase and sell their shares in an orderly manner, or at all.
Furthermore, the delisting of our shares could damage our general business
reputation and impair our ability to raise additional funds. Any of the
foregoing events could have a material adverse effect on our business, financial
condition and operating results.





We
do not intend to pay dividends.





We have
never declared or paid any cash dividends on our common stock. We intend to
retain any future earnings to finance our operations and to expand our business
and, therefore, do not expect to pay any cash dividends in the foreseeable
future.





Risks
Related to our Israel-based Office





We
may be negatively impacted by changes in political, military and/or economic
conditions.





Since the
establishment of the State of Israel in 1948, a number of armed conflicts have
taken place between Israel and its Arab neighbors and a state of hostility,
varying from time to time in intensity and degree, has led to security and
economic problems for Israel. A peace agreement between Israel and Egypt was
signed in 1979 and a peace agreement between Israel and Jordan was signed in
1994. However, as of the date hereof Israel has not entered into any peace
agreement with Syria or Lebanon.





Despite
peace related developments, certain countries, companies and organizations
continue to participate in a boycott of Israeli firms. We do not believe that
the boycott has had a material adverse effect on us, but there can be no
assurance that restrictive laws, policies or practices directed towards Israel
or Israeli-based businesses will not have an adverse impact on our business or
financial condition in the future.





Our costs
of operations have at times been affected by changes in the cost of our
operations in Israel resulting from changes in the value of the Israeli shekel
relative to the U.S. dollar. Recently, the weakening of the dollar relative to
the shekel has significantly increased the costs of our Israeli operations,
stated in U. S. dollars.





Israel’s
economy has been subject to numerous destabilizing factors, including a period
of rampant inflation in the early- to mid-l980s, low foreign exchange reserves,
fluctuations in world commodity prices and military conflicts. The Israeli
Government has, for these and other reasons, intervened in the economy by
utilizing, among other means, fiscal and monetary policies, import duties,
foreign currency restrictions and control of wages, prices and exchange rates.
The Israeli Government has periodically changed its policies in all these areas.
Although we derive most of our revenues outside of Israel, a substantial portion
of our expenses are incurred in Israel and are affected by economic conditions
in the country.





All of
these factors are, in whole or part, beyond our control and may materially
adversely affect on our business, financial condition and operating results, or
market price of our common stock regardless of our performance.





We may be negatively impacted by
employees being called for army service.





Generally,
all male adult citizens and permanent residents of Israel under the age of 41
are, unless exempt, obligated to perform up to 36 days of military reserve
duty annually. Additionally, all such residents are subject to being called to
active duty at any time under emergency circumstances. Furthermore, some of our
officers and employees are currently obligated to perform annual reserve duty.
While we have operated effectively under these requirements since we began
operations, no assessment can be made as to the full impact of such requirements
on our workforce or business if conditions should change, and no prediction can
be made as to the effect on us of any expansion of such
obligations.





25




ITEM 1B. UNRESOLVED STAFF COMMENTS





Not
applicable.




ITEM 2.
  PROPERTIES





We lease
our executive offices at 75 Broad Street, New York, New York at an annual cost
of approximately $731,000, which increases annually to
$815,000 for the final year of the lease. The term of the lease is until July
2010, with an option to extend the lease for an additional five years. In
October 2003 we entered into a sub-lease agreement with a third party to
sub-lease approximately 30% of the overall New York office space. The annual
sub-lease income was $156,000 for 2007, increasing annually to $168,000 for the
final year of the sub-lease, and the term extends until July 2010.





We lease
a 1,290 square meter office, which houses our research and development
facilities, in Jerusalem, Israel, at an annual cost of
$220,000.  In September 2005, we signed an amendment that extended our
lease term through December 2009. We have an option to further extend the term
of the lease for an additional five years through December
2014.




ITEM 3.   LEGAL
PROCEEDINGS





On or
about August 30, 2007, one of our vendors commenced an action in the Southern
District of New York against us for breach of contract, copyright infringement,
breach of the duty of good faith and fair dealing and replevin relating to a
license agreement that we entered into with the vendor in 2005 to license the
vendor's software. In addition, the vendor sought a temporary
restraining order and preliminary injunction prohibiting us from using the
software during the course of the litigation. The temporary restraining order
was denied, however
we have since stopped using such vendor’s software and have begun using software
provided by a different vendor.On February 4, 2008, we filed a motion
for partial summary judgment, to which the other side submitted a
reply.  Although we denied any liability, we argued that the agreement
between us and such vendor clearly limits the amount of our total liability to
the aggregate amounts we had paid such vendor ($111,350).  Rather than
incur the costs and expenses (including attorneys’ fees) that would be required
to defend the action – which we believe would certainly be greater than $111,350
– we petitioned the court to require the vendor to accept such amount from us as
a full and final settlement of all amounts owing between the parties and, upon
our tendering such amount, to dismiss the case.  The court has not yet
ruled on this motion.  In the event that our motion is not granted, we
plan to continue to defend the action and do not anticipate that this will be a
material event in the event liability is found.





We, as
well as certain of our former officers and directors, were named as
co-defendants in a number of purported securities class actions in United States
District Court for the Southern District of New York, arising out of our initial
public offering, or IPO, in November 1999.  In addition, a number of
other issuers and underwriters of public offerings of such issuers (including
the underwriters of our IPO) were named as defendants in such class action suits
in connection with such public offerings. A proposed omnibus settlement between
the plaintiffs and certain issuer defendants (including us) was suspended when
the district court signed a stipulation terminating the settlement approval
process. The case is currently being litigated against a small number of focus
issuers (which does not include the Company) selected by the district court. If
the settlement does not occur, and litigation against us recommences, we believe
that we have meritorious defenses to the claims us and we intend to defend the
case vigorously.




We are
not a party to any other material litigation and are not aware of any other
pending or threatened litigation that could have a material adverse effect on us
or our business taken as a whole.




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







No
matters were submitted to a vote of security holders during the fourth quarter
of the year ended December 31, 2007.


26




PART
II




ITEM
5.MARKET
FOR REGISTRANT'S COMMON EQUITY RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
OF EQUITY SECURITIES





Market
Information





Our
common stock is currently listed on the OTC Bulletin Board under the symbol
“DDDC”. The listing of our common stock was transferred from The Nasdaq National
Market (where it had traded since November 22, 1999) to The Nasdaq Capital
Market effective on September 17, 2002, and from The Nasdaq Capital Market to
the OTC Bulletin Board effective on March 28, 2008.





The
following table sets forth the per share range of high and low closing sales
prices of our common stock for the periods indicated:





High
              
              LowYear
      ended December 31, 2006First
      quarter
              
              
              3.42
              
              2.52Second
      quarter
              
              
              3.19
              
              2.32Third
      quarter
              
              
              2.15
              
              1.56Fourth
      quarter
              
              
              2.03
              
              1.22Year
      ended December 31, 2007First
      quarter
              
              
              1.83
              
              1.32Second
      quarter
              
              
              1.79
              
              1.24Third
      Quarter
              
              
              1.25
              
              0.66Fourth
      Quarter
              
              
              0.77
              
              0.40Year
      ended December 31, 2008First
      Quarter (through March 28, 2008)
              
              
              0.49
              
              0.15




Holders





As of
March 28, 2008, we had 167 holders of record of the 32,870,105 outstanding
shares of our common stock. This does not reflect persons or entities that hold
their stock in nominee or "street" name through various brokerage
firms.





Dividend
Policy





We have
never declared or paid any cash dividends on our capital stock. We do not
anticipate paying any cash dividends on our capital stock in the foreseeable
future. We currently intend to retain future earnings, if any, to finance our
operations and to expand our business. Any future determination to pay cash
dividends will be at the discretion of our board of directors and will be
dependent upon our financial condition, operating results, capital requirements
and other factors that our board of directors considers
appropriate.





Recent
Sales of Unregistered Securities





None.




Purchases
of Equity Securities by the Issuer and Affiliated Persons





None.


27





ITEM 6.SELECTED FINANCIAL
DATA




You
should read the selected consolidated financial data together with our
consolidated financial statements and related notes and the section of this
Annual Report entitled "Management's Discussion and Analysis of Financial
Condition and Results of Operations." Brightman Almagor & Co., a member
firm of Deloitte Touche Tohmatsu, independent certified public accountants,
audited our historical financial statements since inception. The selected
financial data for each of the years in the three-year period ended December 31,
2007, and as of December 31, 2007 and 2006 is derived from our audited financial
statements that have been included in this Annual Report. The selected financial
data as of December 31, 2003, 2004 and 2005 and for the years ended December 31,
2003 and 2004 is derived from consolidated financial statements that have not
been included in this Annual Report.


Year Ended December 31,2003
                  
                  
                  2004
                  
                  
                  2005
                  
                  
                  2006
                  
                  
                  2007(In
      thousands)Statement
      of Operations Data:Revenues
                  
                  $
                  13,162
                  
                  
                  $
                  21,069
                  
                  
                  $
                  29,714
                  
                  
                  $
                  37,953
                  
                  
                  $
                  29,477Costs
      and operating expenses:Cost
      of revenues
                  
                  
                  (8,393
                  )
                  
                  
                  (13,791
                  )
                  
                  
                  (18,698
                  )
                  
                  
                  (24,375
                  )
                  
                  
                  (21,107
                  )Research
      and development expenses
                  
                  
                  (2,326
                  )
                  
                  
                  (2,531
                  )
                  
                  
                  (3,228
                  )
                  
                  
                  (4,043
                  )
                  
                  
                  (4,669
                  )Selling
      and marketing expenses
                  
                  
                  (3,325
                  )
                  
                  
                  (3,274
                  )
                  
                  
                  (4,173
                  )
                  
                  
                  (4,956
                  )
                  
                  
                  (5,068
                  )General
      and administrative expenses
                  
                  
                  (2,062
                  )
                  
                  
                  (2,194
                  )
                  
                  
                  (2,912
                  )
                  
                  
                  (3,088
                  )
                  
                  
                  (2,952
                  )Depreciation
      and amortization
                  
                  
                  (5,584
                  )
                  
                  
                  (2,731
                  )
                  
                  
                  (1,931
                  )
                  
                  
                  (1,543
                  )
                  
                  
                  (2,644
                  )Write
      down of intangible asset
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (2,680
                  )Total
      costs and operating expenses
                  
                  
                  (21,690
                  )
                  
                  
                  (24,521
                  )
                  
                  
                  (30,942
                  )
                  
                  
                  (38,005
                  )
                  
                  
                  (39,120
                  )Loss
      from operations
                  
                  
                  (8,528
                  )
                  
                  
                  (3,452
                  )
                  
                  
                  (1,228
                  )
                  
                  
                  (52
                  )
                  
                  
                  (9,643
                  )Other
      non-operating income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  13Interest
      income, net
                  
                  
                  245
                  
                  
                  
                  269
                  
                  
                  
                  418
                  
                  
                  
                  620
                  
                  
                  
                  442Income
      taxes
                  
                  
                  (57
                  )
                  
                  
                  (66
                  )
                  
                  
                  (44
                  )
                  
                  
                  (61
                  )
                  
                  
                  (126
                  )Net
      loss
                  
                  $
                  (8,340
                  )
                  
                  $
                  (3,249
                  )
                  
                  $
                  (854
                  )
                  
                  $
                  507
                  
                  
                  $
                  (9,314
                  )Net
      loss per share – basic and diluted
                  
                  $
                  (0.29
                  )
                  
                  $
                  (0.11
                  )
                  
                  $
                  (0.03
                  )
                  
                  $
                  0.02
                  
                  
                  $
                  (0.29
                  )Weighted
      average shares outstanding  – basic and diluted
                  
                  
                  28,989
                  
                  
                  
                  29,316
                  
                  
                  
                  29,672
                  
                  
                  
                  29,771
                  
                  
                  
                  32,427
 December 31,2003
                      
                      
                      2004
                      
                      
                      2005
                      
                      
                      2006
                      
                      
                      2007(In
      thousands)Balance
      Sheet Data:Cash
      and cash equivalents
                      
                      $
                      1,682
                      
                      
                      $
                      4,856
                      
                      
                      $
                      3,847
                      
                      
                      $
                      3,790
                      
                      
                      $
                      1,649Short-term
      investments
                      
                      
                      16,442
                      
                      
                      
                      10,527
                      
                      
                      
                      10,648
                      
                      
                      
                      12,067
                      
                      
                      
                      5,883Working
      capital
                      
                      
                      14,820
                      
                      
                      
                      10,285
                      
                      
                      
                      10,264
                      
                      
                      
                      12,182
                      
                      
                      
                      4,522Long
      –term investments
                      
                      
                      --
                      
                      
                      
                      1,095
                      
                      
                      
                      1,216
                      
                      
                      
                      1,085
                      
                      
                      
                      1,085Total
      assets
                      
                      
                      23,643
                      
                      
                      
                      22,273
                      
                      
                      
                      21,504
                      
                      
                      
                      22,395
                      
                      
                      
                      17,299Total
      stockholder's equity
                      
                      
                      19,141
                      
                      
                      
                      16,025
                      
                      
                      
                      15,561
                      
                      
                      
                      16,618
                      
                      
                      
                      12,024


28




ITEM
7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS


The
following discussion of our financial condition and results of operations should
be read together with our consolidated financial statements and the related
notes thereto included elsewhere in this Annual Report. This discussion contains
certain forward-looking statements that involve substantial risks and
uncertainties. When used in this report, words such as “anticipate,” “believe,”
“estimate,” “expect,” “target,” “goal,” “project,” “intend,” “plan,” “believe,”
“seek,” variations of such words and similar expressions as they relate to our
management or us are intended to identify such forward-looking statements. Our
actual results, performance or achievements could differ materially from those
expressed in, or implied by, these forward-looking statements. Factors that
might cause such a difference include, but are not limited to, those discussed
in “Risk Factors.” Historical operating results are not necessarily indicative
of the trends in operating results for any future period.





Overview





We are a
leading provider of integrated VoIP telephony services, products, hosted
solutions, and infrastructure. We were founded in 1996 to capitalize on the
growth of the Internet as a communications tool by commercially offering IP
telephony services. While we began as primarily a low-cost alternative source of
wholesale minutes for carriers around the world, we have evolved into one of the
premier providers of next generation communication services in the
world.





Today we
support tens of thousands of active users around the globe through our two
primary distribution channels: our service provider and reseller channel and our
direct-to-consumer channel. We offer a broad suite of private label VoIP
products and services as well as a back-office platform for service providers,
resellers, and corporate customers, such as incumbent telecommunications
providers, Internet service providers, or ISPs, cable companies, licensed VoIP
operators, and various corporate enterprises. Based on our customizable VoIP
solutions, these customers can offer private label telecommunications to their
own customer bases, under their own brand name, a white-label brand, our
iConnectHere, or ICH, brand, or the deltathree brand. At the same time, our
direct-to-consumer channel includes our iConnectHere offering (which provides
VoIP products and services directly to consumers and small businesses online
using the same primary platform) and our recently establishedjoip offering (which
serves as the exclusive VoIP service provider embedded in the Globarange
cordless phones of Panasonic, the world leader in consumer cordless phones).
This joip-enabled phone first became available in August 2007 and is currently
available in the United States, Canada, United Kingdom and Ireland, Germany,
Spain and Austria.





In our
service provider and reseller channel, we combined our global reseller program
with our Hosted Consumer VoIP Solution. We gradually moved in this direction in
2005 and 2006 because we realized that the lines of differentiation between
service provider customers and reseller customers continue to narrow as these
customers grow increasingly similar. Both resellers and service providers are
looking to leverage their own unique brands by selling sophisticated products
and services to their own customers under their own brand, with their own look
and feel. As such, our reseller customers are looking for advanced VoIP feature
sets and applications to support their ability to deliver unique calling plans
and bundled services to their end customers.  For
several years we have offered businesses the opportunity to become resellers of
our services through our global reseller program. In the early years of the life
of our Company, these resellers met their customers’ needs by purchasing account
numbers in bulk at reseller specific rates, and they in turn resold these
accounts to private individuals under the deltathree brand, their own brand, or
as a “white-label”. As our resellers became more sophisticated, we introduced
new features and functions that allowed them to develop their own unique price
plans and service bundles to more closely align their offerings with their own
customers’ unique needs. In addition, we developed, and continue to develop,
increasingly sophisticated online toolsets to allow our resellers to better
manage their internal processes and enable them to utilize our web-based
customer care tools to provide customer service to their end-users through their
own customer service team. During 2005 and 2006, we realized that our global
reseller business model was aligned with our Hosted Consumer VOIP Solution
business model because customers for both of these products and services already
had access to the same features and functions. We, therefore, decided to combine
these customer groups. We believe that this group will be more strategically
aligned with the market and we expect to benefit from synergies from both of
these customer bases.





Within
the new Service Provider and Reseller Channel, in 2007 we entered into an
agreement with Market America, a leading on-line shopping and one-to-one
marketing company, pursuant to which Market America launched its Voitel Home
Phone Service powered by our Hosted Consumer VoIP Solution platform. In
addition, we entered into an agreement with RCN Corporation, a leading provider
of video, data, and voice services to residential, business, and
commercial/carrier customers, to power its new Starpower Internet Phone
Service.





Our
direct-to-consumer channel includes our recently established joip offering,
which serves as the exclusive VoIP service provider embedded in the Globarange
cordless phones of Panasonic, and our iConnectHere offering. Prior to the launch
of our joip offering, iConnectHere was traditionally our direct-to-consumer
channel. iConnectHere demonstrates our products, services and hosting
capabilities to our reseller customers and service providers. Through
iConnectHere, an account holder can access all of our product offerings,
including PC-to-Phone and Broadband Phone. Additionally, iConnectHere permits us
to collect usage information on our products and services and enables us to
provide our service provider and reseller customers with key information and
recommendations regarding implementation of our products and services. As for
our joip offering, Panasonic and we have created, developed and are offering
joip-enabled Panasonic Globarange telephones pursuant to our strategic
cooperation which began in 2006. Our joip offering serves as the exclusive VoIP
service embedded in Panasonic’s Globarange series of innovative hybrid 2-line
cordless phones, which provide both landline and VoIP services. Because our VoIP
services are embedded in this hybrid cordless telephone, there is no requirement
for any software downloads, external adaptors or other complicated procedures.
Additionally, customers of the Globarange telephones will be able to talk to
each other for free through the use of the joip service, and will also be able
to purchase a variety of enhanced features and value-added services. This phone
first became available in August 2007. Through our joip offering and extensive
experience in VoIP services and Panasonic’s consumer electronics expertise and
vast distribution channels, Panasonic and we aim to create a global community by
providing free calling between joip-enabled Globarange phones in all regions of
the world as we expand our reach in our direct to consumer channel.





29




As a
complement to the initiatives we plan to take to organically expand our
businesses, we have also been evaluating opportunities for inorganic growth
through strategic acquisitions and unique collaborations. In February 2007, we
acquired the service provider and consumer businesses, including the customer
bases, of Go2Call for cash and our stock valued at approximately $7.0
million.





Going
forward, we expect to:





·
            continue
      to devote our resources to develop and expand our Service Provider and
      Reseller base and we expect our revenue from this key channel to represent
      a significant percentage of our total revenue in the foreseeable
      future;





·
            actively
      market our products and services to a large number of broadband operators,
      incumbent telecommunication providers, cable companies, ISP’s, licensed
      VoIP operators, corporate enterprises, and consumer oriented retailers
      around the world; and





·
            pursue
      a targeted strategy of identifying and evaluating appropriate acquisition
      candidates and collaborations that will continue to expand and diversify
      our customer base.





Trends
in Our Industry and Business





A number
of factors in our industry and business have a significant effect on our results
of operations and are important to an understanding of our financial statements.
These trends include:





Overall Economic Factors: Our
operations and earnings are affected by local, regional and global events or
conditions that affect supply and demand for telecommunications products and
services. These events or conditions are generally not predictable and include,
among other things, general economic growth rates and the occurrence of economic
recessions; changes in demographics, including population growth rates and
consumer preferences. Our strategy and execution focus is predicated on an
assumption that these factors will continue to promote strong desire for the
utilization of telephony products and services and that the cost and feature
advantages of VoIP alternatives will not be negatively impacted by unforeseen
changes in these factors.





Industry:    The
telecommunications industry is highly competitive. In recent years we have seen
new sources of supply for our underlying infrastructure that have reduced our
overall costs of operation, including both advances in telecommunications
technology and advances in technology relating to telecommunications usage, and
have enjoyed the benefits of competition among these suppliers for a relatively
limited amount of viable customers. These decreases were driven largely by
reduced vendor pricing associated with our increased purchasing power and, to a
lesser extent, cost savings associated with an increasing portion of calls
between users of our own services, which have no termination costs associated
with them. A key component of our competitive position, particularly given the
number and range of competing communications products, is our ability to manage
operating expenses successfully, which requires continuous management focus on
reducing unit costs and improving efficiency.





Consumer Demand: There is
significant competition within the traditional telecommunications marketplaces
(landline and wireless) and also with other emergent “next generation”
telecommunications providers, including IP telecommunications providers, in
supplying the overall telecommunications needs of businesses and individual
consumers, and several of the larger traditional telecommunications companies
have announced intentions to merge, which will create even larger competitors.
We compete with other telecommunications firms in the sale and purchase of
various products and services in many national and international markets and
employ all methods of competition that are lawful and appropriate for such
purposes. A key component of our competitive position, particularly given the
commodity-based nature of many of our products, is our ability to sell to a
growing demand base for alternative communications products, in both the
developed and developing global marketplace.





Within
the developed global marketplace, our ability to sell broadband VoIP telephony
products and services is directly linked to the significant growth rate of
broadband adoption, and we expect this trend to continue. We benefit from this
trend because our service requires a broadband Internet connection and our
potential addressable market increases as broadband adoption
increases.





Within
the developing areas of the world, our ability to sell alternative telephony
products and services is linked to both the increasing baseline economic trends
within these countries as well as the growing desire for individuals and
businesses to communicate and do business outside of their own countries. We
expect these trends to continue, and benefit from them because both the ability
to afford long distance calls and the desire to make them increases as a
result.




Political Factors: Our
operations and earnings have been, and may in the future be, affected from time
to time in varying degree by political instability and by other political
developments and laws and regulations, such as forced divestiture of assets;
restrictions on production, imports and exports; war or other international
conflicts; civil unrest and local security concerns that threaten the safe
operation of company facilities; price controls; tax increases and retroactive
tax claims; expropriation of property; cancellation of contract rights; and
telecommunications regulations. Both the likelihood of such occurrences and
their overall effect upon us vary greatly from country to country and are not
predictable. At the same time, VoIP is becoming legal in more countries as
governments seek to increase competition, and this affects us in a positive
manner as service providers and resellers seek to meet their customers’
telecommunications needs with newly available solutions. Both the likelihood of
VoIP legalization and its overall effect upon us vary greatly from country to
country and are not predictable.





Regulatory Factor:
  Our business has developed in an environment largely free from
regulation. However, the United States and other countries have begun to examine
how VoIP services should be regulated, and a number of initiatives could have an
impact on our business. These initiatives include the assertion of state
regulatory and taxing authorities over us, FCC rulemaking regarding emergency
calling services, CALEA, CPNI and electronic privacy, and proposed reforms for
the inter-carrier compensation system. Complying with regulatory developments
will impact our business by increasing our operating expenses, including legal
fees, requiring us to make significant capital expenditures or increasing the
taxes and regulatory fees we pay. We may impose additional fees on our customers
in response to these increased expenses. This would have the effect of
increasing our revenues per customer, but not our profitability, and increasing
the cost of our services to our customers, which would have the effect of
decreasing any price advantage we may have.


30




Project Factors: In addition
to the factors cited above, the advancement, cost and results of particular
projects depend on the outcome of: negotiations with potential partners,
governments, suppliers, customers or others; changes in operating conditions or
costs; and the occurrence of unforeseen technical difficulties or enhancements.
The likelihood of these items occurring and its overall positive or negative
effect upon us vary greatly from project to project and are not
predictable.





Risk Factors: See “—Risk
Factors” for a discussion of the impact of market risks, financial risks and
other uncertainties.




Revenues




Our
revenues are derived mainly from resellers, service providers, and end-users of
our VoIP telephony products and services, including PC-to-Phone, and Broadband
Phone. All revenues are recognized at the time the services are performed. The
provision of VoIP telephony products and services through our service provider
and reseller sales efforts (including sales of our Hosted Consumer VoIP
Solution) accounted for 85.2% and 73.7% of our total revenues in 2007 and 2006,
respectively, while the provision of VoIP telephony (primarily PC-to-Phone)
through iConnectHere accounted for 13.4% and 22.4% of our total revenues in 2007
and 2006, respectively.




Costs
and Operating Expenses




Costs and
operating expenses consist of cost of revenues, research and development
expenses, selling and marketing expenses, general and administrative expenses,
non-cash stock compensation, write-down of intangible assets and depreciation
and amortization.





·
            Cost
      of revenues consist primarily of access, termination and transmission
      costs paid to carriers that we incur when providing services and fixed
      costs associated with leased transmission lines. The term of our contracts
      for leased transmission lines is generally one year or less, and either
      party can terminate with prior
notice.





·
            Research
      and development expenses consist primarily of costs associated with
      establishing our network and the initial testing of our services and
      compensation expenses of software developers involved in new product
      development and software maintenance. In the future, these expenses may
      fluctuate as a percentage of revenue depending on the project undertaken
      during the reporting period. Since our inception, we have expensed all
      research and development costs in each of the periods in which they were
      incurred.





·
            Selling
      and marketing expenses consist primarily of expenses associated with our
      direct sales force incurred to attract potential service provider,
      reseller, and corporate customers and advertising and promotional expenses
      incurred to attract potential consumer users of
    iConnectHere.




·
            General
      and administrative expenses consist primarily of compensation and benefits
      for management, finance and administrative personnel, occupancy costs and
      legal and accounting fees, as well as the expenses associated with being a
      public company, including the costs of directors' and officers'
      insurance.




·
            Write-down
      of intangible assets consists of management’s assessment of the remaining
      value of the intangible assets acquired by the Company in the purchase of
      certain assets of Go2Call.




·
              Depreciation
      and amortization consists of the depreciation calculated on the Company’s
      fixed assets for the fiscal year ended December 31, 2007, and the
      amortization of the intangible assets acquired by the Company in the
      purchase of certain assets of
Go2Call.





We have
not recorded any income tax benefit for net losses and credits incurred for any
period from inception to December 31, 2007.  The utilization of these
losses and credits depends on our ability to generate taxable income in the
future. Because of the uncertainty of our generating taxable income going
forward, we have recorded a full valuation allowance with respect to these
deferred assets.





Critical
Accounting Policies





The SEC
defines critical accounting policies as those that are, in management's view,
most important to the portrayal of a company's financial condition and results
of operations and most demanding on their calls on judgment, often as a result
of the need to make estimates about the effect of matters that are inherently
uncertain and may change in subsequent periods. We believe our most critical
accounting policies relate to:







Revenue recognition and deferred
revenue: We
record revenue from Internet telephony services based on minutes (or fractions
thereof) of customer usage. We record revenue from related services based on
completion of the specific activities associated with the services. We record
payments received in advance for prepaid services and services to be supplied
under contractual agreements as deferred revenue until such related services are
provided. We estimate the allowance for doubtful accounts by reviewing the
status of significant past due receivables and analyzing historical bad debt
trends and we then reduce accounts receivables by such allowance for doubtful
accounts to expected net realizable value.


31




Long-lived Assets: We assess
the impairment of long-lived assets whenever events or changes in circumstances
indicate that the carrying value may not be recoverable. Factors we consider
important which could trigger an impairment review include the
following:





·
            significant
      decrease in the market price of a long-lived asset (asset
      group);·
            significant
      adverse change in the extent or manner in which a long-lived asset (asset
      group) is being used or in its physical condition;·
            significant
      adverse change in legal factors or in the business climate that could
      affect the value of a long-lived asset (asset group), including an adverse
      action or assessment by a regulator;·
            accumulation
      of costs significantly in excess of the amount originally expected for the
      acquisition of the long-lived asset (asset group);·
            current
      period operating or cash flow loss combined with a history of operating or
      cash flow losses or a projection or forecast that demonstrates continuing
      losses associated with the use of a long-lived asset (asset group);
      and·
            current
      expectation that, more likely than not, a long-lived asset (asset group)
      will be sold or otherwise disposed of significantly before the end of its
      previously estimated useful life.




We determine the recoverability of long-lived assets based on an
estimate of undiscounted future cash flows resulting from the use of the asset
and its eventual disposition. Such estimation process is highly subjective and
involves significant management judgment. Determination of impairment loss from
long-lived assets to be disposed of is reported at the lower of carrying amount
or fair value less costs to sell.




Results
of Operations





The
following table sets forth the statement of operations data presented as a
percentage of revenues for the periods indicated:


Year Ended
December 31,2007
                  
                  
                  2006
                  
                  
                  2005Revenues:Total
      revenues
                  
                  
                  100.0
                  
                  
                  
                  100.0
                  
                  
                  
                  100.0Costs
      and operating expenses:Cost of revenues
                  
                  
                  71.6
                  
                  
                  
                  64.2
                  
                  
                  
                  62.9Research and development
      expenses
                  
                  
                  15.8
                  
                  
                  
                  10.7
                  
                  
                  
                  10.9Selling and marketing
      expenses
                  
                  
                  17.2
                  
                  
                  
                  13.1
                  
                  
                  
                  14.0General and administrative
      expenses (exclusive of non-cashcompensation
      expense)
                  
                  
                  10.0
                  
                  
                  
                  8.1
                  
                  
                  
                  9.8Write down of intangible
      asset
                  
                  
                  9.1
                  
                  
                  
                  -
                  
                  
                  
                  -Depreciation and
      amortization
                  
                  
                  9.0
                  
                  
                  
                  4.1
                  
                  
                  
                  6.5Total
      costs and operating expenses
                  
                  
                  132.7
                  
                  
                  
                  100.1
                  
                  
                  
                  104.1Loss
      from operations
                  
                  
                  (32.7
                  )
                  
                  
                  (0.1
                  )
                  
                  
                  (4.1
                  )Other
      non-operating income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Interest
      income, net
                  
                  
                  1.5
                  
                  
                  
                  1.6
                  
                  
                  
                  1.4Income
      taxes
                  
                  
                  (0.4
                  )
                  
                  
                  (0.2
                  )
                  
                  
                  (0.1
                  )Net
      Income (loss)
                  
                  
                  (31.6
                  )%
                  
                  
                  1.3
                  %
                  
                  
                  (2.9
                  )%


32




Comparison of 2007 and 2006




Revenues


Revenues overall decreased approximately $8.5 million or 22.4% to
approximately $29.5 million in 2007 from approximately $38.0 million in
2006.  All of our revenue channels were affected. Revenues from VoIP
telephony through our service provider and reseller sales efforts (both pre-paid
and post-paid) decreased approximately $6.2 million or 19.8% from approximately
$31.3 million in 2006 to approximately $25.1 million in 2007.  In
addition, revenues from VoIP telephony (primarily PC-to-Phone) through
iConnectHere decreased approximately $1.8 million or 31.6% from approximately
$5.7 million in 2006 to approximately $3.8 million in 2007. Revenues generated
by our Hosted Consumer VoIP Solution division decreased by approximately $0.9
million or 13.8% from $6.5 million in 2006 to approximately $5.6 million in
2007.





Our
revenue decrease can be attributed to a number of factors, the most important
being an increasingly competitive VoIP market causing market rates to decline.
We made a decision not to change our existing policy regarding retaining certain
margin rates and thus did not significantly lower our rates. As a result, the
number of minutes on our network utilized by our resellers and end-users
dropped by approximately 29% from 538 million in 2006 to 380 million in
2007.





Furthermore,
our reseller revenues, which made up approximately 65% of our overall revenues
in both 2006 and 2007, were adversely affected by regulatory problems in key
destinations. In addition, the introduction of several competitors offering
lower prices than ours to our biggest markets further adversely affected our
revenues. Revenues generated by resellers we acquired in the Go2Call acquisition
amounted to approximately $3.0 million or 15.4% of our reseller revenues in
2007.





Revenues
generated by ICH declined by approximately $1.8 million or 33.3% from $5.7
million in 2006 to $3.8 million in 2007. This resulted in part from a decision
we made to invest our time and resources in other areas.





Revenues
from our Hosted Consumer VoIP Solution division decreased by approximately $0.9
million or 13.8%from $6.5 million in 2006 to $5.6 million in 2007, largely due
to the expiration of our agreement with SBC.





No
customer accounted for ten percent or more of our sales during
2007.




Costs
and Operating Expenses




Cost of
revenues.  Cost of revenues decreased by $3.3 million or 13.5%
from $24.4 million in 2006 to $21.1 million in 2007.  Although
our network rent cost increased by 37.5% from $0.8 million in 2006 to $1.1
million in 2007, our termination cost decreased by 20.1% from $19.9 million
in 2006 to $15.9 million in 2007. The main reason for the decrease in cost
of revenues was a reduction in the amount of traffic being terminated over
our network.





Research and
development expenses.  Research and development expenses
increased by $0.7 million or 17.5% from $4.0 million in 2006 to
$4.7 million in 2007. Salary expenses increased by 16.6% to $3.5 million in
2007 from $3.0 million in 2006. The main reason for the increase was the cost
associated with the development of the new services associated with joip and
enhancements to our existing services.





Selling and
marketing expenses.  Selling and marketing expenses increased
by $0.1 million or 2.0% to $5.1 million in 2007 from $5.0 million in 2006. The
cost of our selling and marketing personnel increased by approximately 8,3% to
$2.6 million in 2007 from $2.4 million in 2006 due to an increase in branding
and promotional activities.




General and
administrative expenses.  General and administrative expenses
decreased by $0.1 million or 3.2% to $3.0 million in 2007 from $3.1 million in
2006.





Depreciation and
amortization.  Depreciation and amortization increased by $1.1
million or 73.3% from $1.5 million in 2006 to $2.6 million in 2007 due to a
higher relative level of capital expenditures in 2006 compared to prior years
and periodic amortization of intangible assets.





Loss
from Operations





Loss from
operations increased by $9.5 million or 9,500% from $0.1 million in 2006 to $9.6
million in 2007, due primarily to the decrease in revenues, increase in costs
and operating expenses (including selling and marketing expenses) and a one time
amortization charge.


33




Interest
Income, Net




We earned interest income of $0.4
million in 2007 compared to $0.6 million in 2006 due primarily to interest
earned on the  remaining proceeds from our IPO.





Income
Taxes, Net




We paid net income taxes of $126,000 in
2007 compared to $61,000 in 2006.




Net
Income/Loss




Net Income decreased by $9.8 million or
1,960% from $0.5 million in 2006 to a loss of $9.3 million in 2007, due to the
foregoing factors.





Comparison
of 2006 and 2005




Revenues




Revenues
increased approximately $8.3 million or 27.9% to approximately $38.0 million in
2006 from approximately $29.7 million in 2005. Revenues from VoIP telephony
through our service provider and reseller sales increased approximately $9.4
million or 37.9% to approximately $30.2 million in 2006 from approximately $21.9
million in 2005, due primarily to a greater number of PC-to-Phone and Broadband
Phone calls being placed by an increasing user base. Revenues from VoIP
telephony (primarily PC-to-Phone) through iConnectHere decreased approximately
$0.9 million or 13.6% to approximately $5.7 million in 2006 from approximately
$6.6 million in 2005 due primarily to a lower number of PC-to-Phone and
Broadband Phone calls being placed by a decreasing user base. No customer
accounted for ten percent or more of our sales during 2006.





Overall,
our revenue growth can be attributed to the increase in the number of active
accounts on our network of $146,400 or 52.5%, if you compare the growth from the
fourth quarter of 2005 to the fourth quarter of 2006. In addition, the number of
minutes on net was 583.0 million, an increase of 202.1 million or 53.1% as
compared to the year ended December 31, 2005. The growth in active users and
minutes are significant improvements operationally.  Further, the Company
believes that the increase in active users is a good indication of prospective
growth in the future and that the increased level of promotions on our network
during the fourth quarter will translate into stronger customer sales going
forward.




Costs
and Operating Expenses







Cost of
revenues. Cost of revenues increased by $5.7 million or 30.5% to
$23.4 million in 2006 from $18.7 million in 2005, due primarily to an
increase in the amount of traffic being terminated.




Research and
development expenses. Research and development expenses increased by
$0.8 million or 25.0% to $4.0 million in 2006 from $3.2 million
in 2005, due to increased personnel costs associated with the development of new
services and enhancements to our existing services.





Selling and
marketing expenses. Selling and marketing expenses increased by $0.8
million or 19.0% to $5.0 million in 2006 from $4.2 million in 2005, due to an
increase in branding and promotional activities.





General and
administrative expenses. General and administrative expenses increased by
$0.2 million or 6.9% to $3.1 million in 2006 from $2.9 million in 2005,
primarily due to increased personnel and occupancy costs.





Depreciation and
amortization. Depreciation and amortization decreased by $0.4 million or
21.1% to $1.5 million in 2006 from $1.9 million in 2005, due to a lower relative
level of capital expenditures in 2006 compared to prior years.





Loss
from Operations





Loss from
operations changed by $1.2 million or 95.8% to $0.1 million in 2006 from $1.2
million in 2005, due primarily to the decrease in costs and operating expenses,
including selling and marketing expenses.





Interest
Income, Net





We earned
interest income of $0.6 million in 2006 compared to $0.4 million in 2005 due
primarily to moderately higher interest rates earned on the moderately reduced
balance of the remaining proceeds from our initial public
offering.


34




Income
Taxes, Net





Income
tax expense remained consistent at $0.1 million for 2006 and 2005. Although the
Company had net income of $0.5 million, we expect that our net operating loss
carryforwards will protect most of the net income in 2006 and going
forward.




Net
Income/Loss







Net
Income increased $1.4 million or 155.6% to $0.5 million in 2006 from a loss of
$0.9 million in 2005, due to the foregoing factors.





Liquidity
and Capital Resources





Since our
inception in June 1996, we have incurred significant operating and net
losses due in large part to the start-up and development of our operations. For
the year ended December 31, 2007, our Net Loss from Operations increased by
$9.5 million or 9,400% from $0.1 million in 2006 to $9.6 million in
2007.  To date, the Company has an accumulated deficit of
approximately $160.8 million.





As of
December 31, 2007, we had cash and cash equivalents of approximately $1.6
million, restricted cash and short-term investments of approximately $5.9
million, and long-term investments of approximately $1.1 million, or a total of
cash, cash equivalents, restricted cash and investments of $8.6 million, a
decrease of $8.3 million from December 31, 2006.  In addition, we had
working capital of approximately $4.5 million, down from $12.2 million in 2006
or a net change of $7.7 million.  The decrease in cash, restricted
cash, and short and long term investments was primarily caused by a combination
of the net cash used in operating activities of approximately $5.1 million, cash
used in the purchase of certain assets of Go2Call of approximately $2.5 million
and cash used to purchase property and equipment of approximately $0.7
million.  In addition, the Company invested significantly in
developing the joip network.  During 2007, our average monthly cash
burn was approximately $0.5 million (including cash used in our operations and
our capital expenditures), and for the fourth quarter of 2007 the average
monthly cash burn increased to approximately $0.6 million.  Looking
forward, we estimate that the average monthly cash burn rate for the first
quarter of 2008 increased to approximately $0.8 million, and in total will
result in an overall cash burn for the quarter of approximately $2.5
million.  The increase in the cash burn during the first quarter of
2008 is the result of an overall decrease in sales, as well as certain working
capital commitments from 2007 that were paid in 2008.  On March 24,
2008, our management and Board of Directors formulated a plan that we believe
will conserve cash going forward by realigning our cost structure with our
current business model.  Accordingly, we have begun to reduce our
operations and expenses (including a significant reduction in work force) in
order to immediately reduce the cash burn rate.   Based on our
plan, we believe that if we are able to maintain our current revenues we will be
able to immediately reduce our cash burn to approximately $250,000 per
month.  We believe that the Company will have enough cash for the next
twelve months without any increase in our current revenues.  In
addition, with the assistance of outside strategic consultants we have begun the
process of examining ways to possibly increase our current revenues by
growing our current sales and/or entering into new sales
channels.




Cash used
in or provided by operating activities is net income adjusted for certain
non-cash items and changes in assets and liabilities. We had negative cash flow
from operating activities of approximately $5.1 million during 2007 compared
with positive cash flow from operating activities of approximately
$2.0 million during 2006.  The decrease in our cash generated
from operating activities was primarily driven by our net loss of $9.3 million
plus changes in working capital of approximately $1.8 million which were offset
by our write-off of a portion of the intangible assets we acquired in the
Go2Call transaction of $2.7 million and depreciation and amortization of $2.6
million.  As described above, we have begun a process of immediately
reducing our expenses (including a significant reduction in work force) in order
to halt the continuing loss from operations.




Net cash
used in investing activities is generally driven by our annual capital
expenditures and changes in our short and long term investments.  In
2007, we spent $0.7 million on capital expenditures, reduced our investments by
$6.2 million and used approximately $2.5 million in cash to purchase the assets
of Go2Call, for a net use of cash of $3.0 million. In 2006, we spent $0.9
million on capital expenditures and increased our investments by $1.4 million,
for a net increase of $2.2 million. In 2008, we have budgeted capital
expenditures of approximately $0.8million in connection
with the upgrade of our primary data center. We have secured capital leases for
much of the hardware that has been purchased to date in accordance with our
budget for 2008 and will continue to draw down on our investments until such
time as we are able to halt the cash burn.


On
February 19, 2007, the Company completed the purchase of certain assets of
Go2Call, including the assumption of certain deferred income, for approximately
$7.7 million.  The Company paid approximately $2.5 million in cash and
issued approximately 3.0 million shares of our common stock. Additionally, the
Company paid approximately $0.5 million in transaction-related costs and
expenses.




Financing
cash flows consist primarily of proceeds from exercise of employee options.
During 2007 and 2006 our employees exercised options of $0.03 million and $0.07
million, respectively.


35




We
obtained our funding from our utilization of the remaining proceeds from our
IPO, offset by positive or negative cash flow from our operations. These
proceeds are maintained as cash, restricted cash, and short and long term
investments. To the extent that the current trends remain steady and we are not
able to execute the plan that we adopted on March 24, 2008, we will be required
to raise additional funds for our ongoing operations. Additional financing may
not be available when needed or, if available, such financing may not be on
terms favorable to us. If additional funds are raised through the issuance of
equity securities, our existing stockholders may experience significant
dilution. If additional funds are raised through the issuance of debt
securities, we may not be able to obtain additional subsequent financing, if
necessary, if the debt security contains certain covenants restricting our
ability to obtain additional financing while such debt security is outstanding.
We cannot assure you that any third party will be willing or able to provide
additional capital on favorable terms or at all.





Contractual
Obligations and Commercial Commitments





The
following table sets forth our future contractual obligations and commercial
commitments in total, for each of the next five years and
thereafter:


Payments due by period (in thousands of
      dollars)Contractual obligations
                
                Total
                
                
                Less than 1 year
                
                
                1-3 years
                
                
                3-5 years
                
                
                More than 5yearsReal
      estate leases
                
                
                3,801
                
                
                
                1,074
                
                
                
                1,829
                
                
                
                449
                
                
                
                449Auto
      leases
                
                
                667
                
                
                
                354
                
                
                
                313
                
                
                
                -
                
                
                
                -Capital
      leases
                
                
                213
                
                
                
                69
                
                
                
                144
                
                
                
                -
                
                
                
                -Purchase
      obligations
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Total
                
                
                4,681
                
                
                
                1,497
                
                
                
                2,286
                
                
                
                449
                
                
                
                449


Off-Balance Sheet Arrangements





None.





Certain
Factors That May Affect Future Results of Operations





The SEC
encourages companies to disclose forward-looking information so that investors
can better understand a company's future prospects and make informed investment
decisions. This Annual Report on Form 10-K contains such "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995, as amended.





Words
such as "may," "anticipate," "estimate," "expects," "projects," "intends,"
"plans," "believes" and words and terms of similar substance used in connection
with any discussion of future operating or financial performance, identify
forward-looking statements. All forward-looking statements are management's
present expectations of future events and are subject to a number of risks and
uncertainties that could cause actual results to differ materially and adversely
from those described in the forward-looking statements. These risks include, but
are not limited to, those set forth under the heading "Risk Factors" contained
in Item 1A of this Annual Report on Form 10-K.


36




In light
of these assumptions, risks and uncertainties, the results and events discussed
in the forward-looking statements contained in this Annual Report on Form 10-K
or in any document incorporated by reference might not occur. Stockholders are
cautioned not to place undue reliance on the forward-looking statements, which
speak only as of the date of this Annual Report on Form 10-K. We are not under
any obligation, and we expressly disclaim any obligation, to update or alter any
forward-looking statements, whether as a result of new information, future
events or otherwise. All subsequent forward-looking statements attributable to
deltathree or to any person acting on our behalf are expressly qualified in
their entirety by the cautionary statements contained or referred to in this
section.





ITEM
7A.   QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISKS





The
federal securities law requires that we describe and quantify our potential
losses from market risk sensitive instruments attributable to reasonably
possible market changes. Market risk sensitive instruments include all financial
or commodity instruments and other financial instruments (such as investments
and debt) that are sensitive to future changes in interest rates, currency
exchange rates, commodity prices or other market factors. We believe our
exposure to market risk is not material.




ITEM 8.   FINANCIAL STATEMENTS AND
SUPPLEMENTARY DATA





The
Company's Consolidated Financial Statements required by this Item are set forth
in Item 15 beginning on page 50 of this Annual Report.





ITEM 9.
CHANGES IN AND DISAGREEMENTS
WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE




None.


ITEM 9A.
  CONTROLS AND
PROCEDURES




(a)  
Evaluation of Disclosure
Controls and Procedures. Our principal executive officer and principal
financial officer, after evaluating the effectiveness of our disclosure controls
and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and
internal control over financial reporting (as defined in Exchange Act Rules
13a-15(f) and 15d-15(f)) as of the end of the period covered by this Annual
Report on Form 10-K, has concluded that, based on such evaluation, our
disclosure controls and procedures were adequate and effective to ensure that
material information relating to us, including our consolidated subsidiaries,
was made known to them by others within those entities, particularly during the
period in which this Annual Report on Form 10-K was being
prepared.
  (b)  Management’s Report on Internal
Control over Financial Reporting.  Management is responsible
for establishing and maintaining adequate internal control over financial
reporting of the Company. We maintain internal control over financial reporting
designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles.  Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate. Therefore, internal control
over financial reporting determined to be effective provides only reasonable
assurance regarding the reliability of financial reporting and the preparation
of financial statements for external purposes in accordance with generally
accepted accounting principles.
  Under the
supervision and with the participation of our Chief Executive Officer and Chief
Financial Officer, management has evaluated internal control over financial
reporting by the Company using the framework for effective internal control
established in Internal Control—Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission.Management has assessed
the effectiveness of the Company’s internal controls over financial reporting as
of December 31, 2007. Based on this assessment, we believe that the
internal control over financial reporting of the Company was effective as of
December 31, 2007. In connection with this assessment, there were no
material weaknesses in the Company’s internal control over financial reporting
identified by management.
  This
Annual Report does not include an attestation report of the Company's registered
public accounting firm regarding internal control over financial reporting.
Management's report was not subject to attestation by the Company's registered
public accounting firm pursuant to temporary rules of the SEC that permit the
Company to provide only management's report in this Annual Report.
 (c)  Changes in Internal
Controls.  There were no changes in our internal control over
financial reporting, identified in connection with the evaluation of such
internal control, which occurred during the fourth quarter of our last fiscal
year that have materially affected, or are reasonably likely to materially
affect, our internal control over financial
reporting.


37




ITEM 9B.
  OTHER
INFORMATION





Listed
below for our named executive officers (as determined in the Summary
Compensation Table set forth in the Executive Compensation section below) are
the salaries that were awarded during fiscal 2007, the bonuses that were earned
for performance during 2007 but awarded in 2008, and the salaries that have been
established for fiscal 2008. Bonuses for fiscal 2008 have not yet been
determined.




Executive Officer
                
                2007 Salary ($)
                
                2007 Bonus(1) ($)
                
                2008 Salary ($)Shimmy
      Zimels
                  Chief
      Executive Officer and President
                
                
                258,005
                (2)
                0
                
                
                258,005
                (2)Guy
      Gussarsky
                  Executive VP Sales and
      Business Development
                
                
                13,015
                (3)
                0
                (4)
                
                0
                (4)Richard
      Grant
                  Senior VP of Finance and
      Treasurer
                
                
                175,000
                
                0
                
                
                175,000




(1)
            Bonus
      shown is the aggregate amount of bonuses earned by the executive in 2007,
      under our Amended and Restated 1999 Performance Incentive Plan, for his
      performance during 2007.(2)
            Salary
      is pursuant to Mr. Zimels’ employment agreement.(3)
            This
      amount represents Mr. Gussarsky’s salary and commissions through the date
      of his resignation on February 14, 2007.(4)
            Mr.
      Gussarsky resigned effective as of February 14,
  2007.




38




PART
III





ITEM 10.
  DIRECTORS, EXECUTIVE
OFFICERS AND CORPORATE GOVERNANCE





The
Board of Directors





Our
Amended and Restated Certificate of Incorporation provides that a director shall
hold office until the annual meeting for the year in which his or her term
expires except in the case of elections to fill vacancies or newly created
directorships. Each director is elected for a one-year term. Each of the
nominees is now serving as director on our Board. Set forth below are the name,
age and the positions and offices held by each of our directors, his principal
occupation and business experience during at least the past five years and the
names of other publicly-held companies of which he serves as a
director.





Noam
Bardin, 36, Mr. Bardin served as Chairman of the Board from April 2002
until January 2008.  Since January 2007, Mr. Bardin has been the Chief
Executive Officer of Arootz, Inc., a private broadband TV content enabler and
network provider.  Mr. Bardin co-founded deltathree and served as Chief
Executive Officer and President of deltathree from July 2000 through June 2002.
 Mr. Bardin served as Vice President of Technology and Chief Technology
Officer of deltathree since June 1997, before being named President and Chief
Executive Officer in April 2000.  He served as Global Network Director of
deltathree from November 1996 to May 1997. Prior to founding deltathree, he
served as Director of Operations at Ambient Corporation.  Mr. Bardin earned
a B.A. in Economics from the Hebrew University (Jerusalem) and an M.P.A. from
the Harvard University Kennedy School of Government.





Ilan
Biran, 61,
Director. Mr. Biran has served as a director of deltathree since December 2003.
Mr. Biran brings a wealth of business and management experience from the telecom
and defense industries. From January 2004 through June 2006, Mr. Biran has
served as the Chairman of YES Satellite Television, one of the leading satellite
television companies in Israel. From 1999 to 2003, Mr. Biran served as the
President and Chief Executive Officer of Bezeq Ltd. - the Israeli PTT, with
annual sales of over $2 billion and approximately 16,000 employees. Mr. Biran
holds the rank of Major General (res.) in the Israeli Defense Force where, as
Commander of the IDF's Central Command, he played an active role in reaching the
peace agreements with Jordan. From 1996 to 1999, he served as the Director
General of the Israeli Ministry of Defense, and prior to that command, he held a
wide variety of senior-level positions in other Israeli units, since 1964. Mr.
Biran holds a B.A. in Economics and Business Administration from Bar-Ilan
University, and holds an Associate Diploma in Strategy and Political Economic
Research from Georgetown University. He is also a graduate of the U.S. Marine
Corps Command and Staff College. In addition, Mr. Biran's public activities
include: serving as the Israeli Prime Minister's Special Coordinator for POWs
and MIAs, and since 1996, has served as the Chairman of the Board of Directors
of the Israeli Oil Refineries, Ltd.


39




Benjamin
Broder, 44, Director. Mr. Broder has served as a director of deltathree
since July 24, 2005. As of 2002, Mr. Broder has served as the Finance Director
of Atarey. From 1996 to 2001, Mr. Broder worked as the chief financial officer
of a telecom start-up company and a bio-tech start-up company. Previously, Mr.
Broder also held various positions with several leading banks, including HSBC,
Bank Hapoalim, and Bank of Israel. Mr. Broder earned a B.S. degree in Economics
from University of London. Mr. Broder is a Chartered Accountant in the U.K. and
a C.P.A. in Israel.





Lior
Samuelson, 57, Chairman of the Board. Mr. Samuelson has served as a
director of deltathree since August 2001 and as Chairman of the Board since
January 2008. Since August 1999, Mr. Samuelson has served as a Co-Founder and
Principal of Mercator Capital. His experience includes advising clients in the
Technology, Communications and Consumer sectors on mergers, acquisitions and
private placements. From March 1997 to August 1999, Mr. Samuelson was the
President and Chief Executive Officer of PricewaterhouseCoopers Securities.
Prior to that, he was the President and Chief Executive Officer of The Barents
Group, a merchant bank specializing in advising and investing in companies in
emerging markets. Mr. Samuelson was also the Co-Chairman of Peloton Holdings, a
Private Equity management company. Before that, he was a managing partner with
KPMG and a senior consultant at Booz, Allen & Hamilton. Mr. Samuelson earned
B.S. and M.S. degrees in Economics from Virginia Polytechnic
University.





Shimmy
Zimels, 42, Chief Executive Officer and President and Director. Mr.
Zimels has served as Chief Executive Office and President since June 2002, and
served as Vice President of Operations and Chief Operating Officer of deltathree
since June 1997, before being named President and Chief Executive Officer in
June 2002. Prior to joining deltathree, Mr. Zimels was the Controller and Vice
President of Finance at Net Media Ltd., a leading Israel based Internet Service
Provider, from June 1995 to June 1997. From April 1991 to May 1995, Mr. Zimels
was a senior tax auditor for the Income Tax Bureau of the State of Israel. Mr.
Zimels graduated with distinction from Hebrew University with a degree in
Economics and Accounting and holds a Masters in Economics from Hebrew
University.





Executive
Officers and Key Employees





Set forth
below is a brief description of the present and past business experience of each
of the persons who currently serve as our executive officers or key employees
who are not also serving as directors.





Richard Grant, 44, Senior Vice
President of Finance and Treasurer. Mr. Grant joined deltathree on January 23,
2006. Mr. Grant is a Certified Public Accountant. Prior to his employment with
deltathree, Mr. Grant was a co-founder and Chief Financial Officer of Tel2Net,
Inc., a technology infrastructure service company. From 2001 through 2003, Mr.
Grant served as a Senior Manager for Marotta, Gund, Budd and Dzera LLP, a
business restructuring consulting company. Prior to Marotta, Gund, Mr. Grant was
a Senior Manager at KPMG LLP in the Audit Division, and a Senior Manager at
Arthur Andersen LLP in the Transaction Advisory Services Group. Mr. Grant earned
a B.A. in Business Administration-Accounting at Adelphi University.





Efraim Baruch, 32, Senior Vice
President of Operations and Technology. In January 2007, Mr. Baruch became our
Senior Vice President of Operations and Technology. Mr. Baruch has been with
deltathree since 1998. Mr. Baruch began working with deltathree as an engineer
in the Network Operation Center (NOC), and soon after specialized in the
management of data networks and security at the Wide Area Network (WAN)
department. During the past four years he has headed the deltathree VoIP data
and security departments, along with managing the overall responsibility of the
total uptime in the deltathree worldwide network. Mr. Baruch received his B.A.
in Computer Science from Hadassah College and is a CCNP (Cisco Certified Network
Professional).





Peter Friedman, 37, General
Counsel and Secretary. In October 2007, Mr. Friedman became our General Counsel
and Secretary. Mr. Friedman’s experience is in the areas of securities offerings
and compliance, mergers and acquisitions, corporate governance, venture capital
financing, technology licensing, joint ventures, and general corporate and
commercial matters. Before joining deltathree, Mr. Friedman served as Senior
Associate of Outside Counsel Solutions, a division of IDT Corporation that
outsources U.S. legal services. Prior to that, Mr. Friedman was associated with
the law firms of Weil, Gotshal & Manges, LLP, Lowenstein Sandler PC and
Kronish Lieb Weiner & Hellman, LLP. Mr. Friedman holds a B.A. from Brown
University and a J.D. from New York University School of Law.





Board
of Directors and Committees of the Board




Our
Amended and Restated Certificate of Incorporation provides that the number of
members of our Board shall be not less than three and not more than thirteen.
There are currently five directors on the Board. At each annual meeting of
stockholders, directors are elected to hold office for a term of one year and
until their respective successors are elected and qualified. All of the officers
identified above under “Executive Officers” serve at the discretion of our
Board.





The Board
had nine regular meetings during the fiscal year ended December 31, 2007. During
the fiscal year ended December 31, 2007, each member of the Board participated
in at least 75% of all Board and applicable committee meetings held during the
period for which he was a director. Except for Mr. Zimels, none of our other
directors attended our 2007 Annual Stockholder Meeting. The Board has
established an Audit Committee and a Compensation Committee., but dissolved the
Nominating and Governance Committee as of September 11, 2006. The functions of
the remaining committees and their current members are set forth
below.


40




Due to a
decrease in the number of members of the Board after our 2006 Annual
Stockholders Meeting, our Board members determined that it is efficient and
important for each member to actively participate in all matters that were
previously the responsibility of the Nominating and Governance Committee. As
such, each of our Board members participates in, among other matters, the
following nominating and governance-related matters:





·
            identifying
      and recommending qualified candidates for director, and recommending the
      director nominees for our annual meetings of
  stockholders;·
            conducting
      an annual review of the Board’s performance;·
            recommending
      the director nominees for each of the Board committees;
  and·
            developing
      and recommending our company’s corporate governance
      guidelines.





Furthermore,
our Board adopted a nominating and governance policy that was based on the
former Nominating and Governance Committee Charter. This policy outlines our
Board’s goals, responsibilities, and procedures related to nominating and
governance matters.  In this regard, our
Board may consider candidates recommended by stockholders as well as from other
sources such as other directors or officers, third party search firms or other
appropriate sources. For all potential candidates, the Board may consider all
factors it deems relevant, such as a candidate’s personal integrity and sound
judgment, business and professional skills and experience, independence,
knowledge of the industry in which we operate, possible conflicts of interest,
diversity, the extent to which the candidate would fill a present need in the
Board, and concern for the long-term interests of our stockholders. In general,
persons recommended by stockholders will be considered on the same basis as
candidates from other sources. If a stockholder wishes to nominate a candidate
to be considered for election as a director at our 2008 Annual Meeting of
Stockholders using the procedures set forth in the Company's Amended and
Restated By-laws, it must follow the procedures described under "Nomination of
Directors" in our By-laws. If a stockholder wishes simply to propose a candidate
for consideration as a nominee by our Board, it should submit any pertinent
information regarding the candidate to the Chairman of the Board by mail at 75
Broad Street, New York, New York 10004.





The
Compensation Committee is responsible for:





·
            evaluating
      our compensation policies;·
            determining
      executive compensation, and establishing executive compensation policies
      and guidelines; and·
            administering
      our stock option and compensation
plans.





As part
of these responsibilities, the Compensation Committee determines the
compensation of our Chief Executive Officer, and conducts its decision making
process with respect to this issue without the presence of the Chief Executive
Officer. The Compensation Committee had four meetings during 2007. Benjamin
Broder (Chairman) and Ilan Biran are the current members of the Compensation
Committee.





The Audit
Committee is responsible for:





·
            recommending
      to the Board the appointment of the firm selected to serve as our
      independent auditors and monitoring the performance of such
      firm;


·
            reviewing
      and approving the scope of the annual audit and evaluating with the
      independent auditors our annual audit and annual financial
      statements;·
            reviewing
      with management the status of internal accounting
  controls;·
            evaluating
      issues having a potential financial impact on us which may be brought to
      the Audit Committee’s attention by management, the independent auditors or
      the Board;·
            evaluating
      our public financial reporting documents; and·
            reviewing
      the non-audit services to be performed by the independent auditors, if
      any, and considering the effect of such performance on the auditor's
      independence.




41




Ilan
Biran (Chairman) and Noam Bardin are the current members of the Audit Committee.
The Board has determined that each of Mr. Bardin and Mr. Biran are “audit
committee financial experts,” as the SEC has defined that term in Item 401
of Regulation S-K. The Audit Committee had six meetings during
2007.





Section
16(a) Beneficial Ownership Reporting Compliance





Section
16(a) of the Securities Exchange Act of 1934, as amended, or the Exchange Act,
requires our directors and executive officers and persons who own more than 10%
of a registered class of our equity securities to file with the SEC initial
reports of ownership and reports of changes in beneficial ownership of our
common stock and other equity securities. Directors, officers and holders of
more than 10% of any class of our equity securities are required by SEC
regulations to furnish us with all Section 16(a) forms they file.





To our
knowledge, based solely upon our review of the copies of such reports furnished
to us, we believe that all of our directors, officers and holders of more than
10% of any class of our equity securities have complied with the applicable
Section 16(a) reporting requirements, except that one report of change in
beneficial ownership, covering one transaction, was not filed by Ilan
Biran.





Code
of Conduct and Ethics




On March
25, 2004, we adopted a Corporate Code of Conduct and Ethics applicable to all
employees and directors of deltathree, including our principal executive
officer, principal financial and accounting officer and controller. There were
no changes made to the Corporate Code of Conduct and Ethics during 2007. The
text of the Corporate Code of Conduct and Ethics is posted on the Corporate
Governance section of our website at www.deltathree.com and will be made
available to stockholders without charge, upon request, in writing to the
Secretary at 75 Broad Street, New York, New York 10004. We intend to post on our
website and include in a Current Report on Form 8-K filed with the SEC any
amendments to, or waivers from, our Code of Conduct and Ethics that apply to our
principal executive officer, principal financial and accounting officer and
controller. We have all of our new employees certify that they have read and
understand our Corporate Code of Conduct and Ethics, and, periodically, we also
ask our existing employees to certify that they have reviewed our Corporate Code
of Conduct and Ethics.




ITEM 11.   EXECUTIVE
COMPENSATION




Summary
Compensation Table





The
following table shows the total compensation paid or accrued during the fiscal
year ended 2007 to (1) our Chief Executive Officer (principal executive officer,
principal financial officer, and principal accounting officer), and (2) our two
next most highly compensated executive officers whose total compensation
exceeded $100,000 during the fiscal year ended 2007. The table includes one
additional former executive who would have been among the three most highly
compensated executive officers except for the fact that he was not serving as an
executive officer of the Company as of the end of 2007.  These executive
officers are referred to in this Annual Report as our “named executive
officers”.


Name
      and Principal Position
                Year
                
                Salary ($)
                
                Bonus ($)
                
                Stock
      Awards ($)
                
                Option
      Awards($)
                
                All
      Other
                  Compensation
      ($)
                
                Total ($)Shimmy
      Zimels,
                  Chief
      Executive Officer and President (principal executive officer, principal
      financial officer, and principal accounting officer)
                2007
                
                258,005
                (1)
                0
                
                0
                
                0
                
                0
                
                258,005Guy
      Gussarsky (2),
                  Former
      Executive Vice President ofSales
      and Business Development
                2007
                
                13,015
                (3)
                0
                
                0
                
                0
                
                0
                
                13,015Richard
      Grant,
                  Senior
      Vice President of Finance and Treasurer
                2007
                
                175,000
                
                0
                
                0
                
                0
                
                0
                
                175,000


(1)
            Mr.
      Zimels was entitled to receive a base salary of $264,971, but voluntarily
      waived his right to receive any additional salary for 2007.  See
      “- Employment Agreement
      with Mr. Shimmy Zimels” below.(2)
            Mr.
      Gussarsky resigned effective as of February 14, 2007.




(3)
            Includes
      both base and commission components of Mr. Gussarsky’s
    salary.





42


Employment
Agreement with Mr. Shimmy Zimels





We
currently have an employment agreement in place with Mr. Zimels, with the
following principal terms:





·
            The
      agreement was effective from April 26, 2004 through August 31, 2006and, thereafter,
      is automatically extended for the same duration on the expiration date and
      on each expiration date thereafter unless either party provides the other
      party with written notice of non-renewal at least ninety days prior to
      expiration of the then-current term, provided that Mr. Zimels provides
      notice of renewal to the Compensation Committee six months prior to
      expiration of the then-current
term.





·
            Mr.
      Zimels’ base salary is increased on each January 1 by an amount equal to
      the base salary then in effect, multiplied by the applicable cost of
      living index during the prior year. Mr. Zimels was entitled to receive a
      base salary of $264,971 during 2007, which represented an increase of
      $6,966 from his base salary 2006, but voluntarily waived his right to
      receive the additional amounts; likewise, in 2008, Mr. Zimels was entitled
      to receive a base salary of $274,775, which represented an increase of
      $9,804 from the base salary he was entitled to receive in 2007, but
      voluntarily waived his right to receive any amounts in addition to his
      base salary for 2006. The employee’s base salary, as adjusted for cost of
      living increases, may be further increased at the option and in the
      discretion of our Board.





·
            For
      principal terms contained in Mr. Zimels’ employment agreement pertaining
      to termination and change of control, see the subsection below titled
      “Termination of Employment and Change-in-Control Arrangements” in this
      Annual Report.





Outstanding Equity Awards at Fiscal
Year-End





The
following table shows grants of stock options and grants of unvested stock
awards outstanding on December 31, 2007 to each of the named executive officers
named in the Summary Compensation Table.


Option
      Awards
                
                Stock
      AwardsName
                Grant Date (1)
                
                Number
      of
                  Securities
                  Underlying
                  Unexercised
                  Options
                  (#) Exercisable
                
                Number
      of
                  Securities
                  Underlying
                  Unexercised
                  Options
                  (#) Unexercisable
                
                Option
      Exercise
                  Price ($)
                
                Option
      Expiration
                  Date
                
                Number
      of Shares
                  or
      Units of Stock
                  That
      Have Not
                  Vested (#)
                
                Market
      Value of
                  Shares
      or Units of
                  StockThat
      Have Not
                  Vested ($)Shimmy
      Zimels
                12/31/2000
                
                130,000
                
                
                
                1.38
                
                12/31/20083/16/2001
                
                39,000
                
                
                
                1.13
                
                3/16/20083/12/2002
                
                100,000
                
                
                
                1.02
                
                3/12/200911/4/2003
                
                85,000
                
                
                
                1.76
                
                11/4/201012/22/2004
                
                80,000
                
                
                
                2.86
                
                12/22/20147/31/2006
                
                
                
                
                
                
                
                
                
                30,000
                (2)
                37,800
                (3)Guy
      Gussarsky(4)
                7/31/2006
                
                
                
                
                
                
                
                
                
                25,000
                
                0Richard
      Grant
                1/23/2006
                
                16,666
                
                33,334
                (5)
                3.02
                
                1/23/2016


(1)
              For better
      understanding of this table, we have included an additional column showing
      the grant date of the stock options and the restricted shares of common
      stock.(2)
              Restricted shares of
      our common stock were granted on July 31, 2006 and vest as follows: 8,400
      on the first anniversary of the grant date, 9,900 on the second
      anniversary of the grant date, and 11,700 on the third anniversary of the
      grant date, provided Mr. Zimels remains an employee of the Company on such
      date.(3)
              The market value of
      the stock awards is determined by multiplying the number of shares times
      $0.401, the closing price of our common stock on The Nasdaq Capital Market
      on December 31, 2007, the last day of our fiscal year.(4)
              Mr.
      Gussarsky resigned effective as of February 14, 2007.(5)
              Options
      to purchase 16,666 shares of common stock vested oneach
      of January 23, 2007, andJanuary 23, 2008. The remaining options
      will vest on January 23, 2009.


43


Director
Compensation





The
following table shows the total compensation paid or accrued during the fiscal
year ended 2007 to each of our directors.




Name
                  
                  Fees
      Earned orPaid
      inCash ($)
                  
                  Stock
                    Awards
      ($)(1)
                  
                  All
      Other
                    Compensation($)
                  
                  Total ($)Noam
      Bardin
                  
                  15,000
                  
                  23,755
                  (2)
                  0
                  
                  38,755Ilan
      Biran
                  
                  15,000
                  
                  18,796
                  (3)
                  0
                  
                  33,796Benjamin
      Broder
                  
                  15,000
                  
                  15,336
                  (4)
                  0
                  
                  30,336Lior
      Samuelson
                  
                  15,000
                  
                  15,336
                  (5)
                  0
                  
                  30,336Shimmy
      Zimels (6)
                  
                  0
                  
                  0
                  
                  0
                  
                  0




(1)
            See
      Note 2(p) and Note 9 to our audited consolidated financial statements
      included elsewhere in this Annual Report for details as to the assumptions
      used to determine the fair value of the stock awards.(2)
            Consists
      of $4,496 and $1,499 representing the compensation expense incurred by us
      in fiscal year 2007 in connection with the issuances of 18,000 and 6,000
      restricted shares of our common stock on September 4, 2007 as the form of
      payment for board and chairman services and for services as a member of
      the audit committee, respectively, for the period from the 2007 annual
      stockholders’ meeting though and until the company’s next annual
      stockholders’ meeting in 2008, calculated in accordance with SFAS 123R,
      all of which fully vest on September 4, 2008. The restricted share grants
      were made pursuant to the 2006 Non-Employee Director Stock
      Plan.(3)
            Represents the compensation expense incurred by us in
      fiscal year 2007 in connection with the issuance of 16,000 restricted
      shares of our common stock on September 4, 2007 as the form of payment for
      board and committee chairman services for the period from the 2007 annual
      stockholders’ meeting though and until the company’s next annual
      stockholders’ meeting in 2008, calculated in accordance with SFAS 123R,
      all of which fully vest on September, 2008. The restricted share grants
      were made pursuant to the 2006 Non-Employee Director Stock
      Plan.(4)
            Represents
      the compensation expense incurred by us in fiscal year 2007 in connection
      with the issuance of 14,000 restricted shares of our common stock on
      September 4, 2007 as the form of payment for board and committee chairman
      services for the period from the 2007 annual stockholders’ meeting though
      and until the company’s next annual stockholders’ meeting in 2008,
      calculated in accordance with SFAS 123R, all of which fully vest on
      September 4, 2008. The restricted share grants were made pursuant to the
      2006 Non-Employee Director Stock Plan.(5)
            Represents
      the compensation expense incurred by us in fiscal year 2007 in connection
      with the issuance of 14,000 restricted shares of our common stock on
      September 4, 2007 as the form of payment for board and audit committee
      services for the period from the 2007 annual stockholders’ meeting though
      and until the company’s next annual stockholders’ meeting in 2008,
      calculated in accordance with SFAS 123R, all of which fully vest on
      September 4, 2008. The restricted share grants were made pursuant to the
      2006 Non-Employee Director Stock Plan.(6)
            Mr.
      Zimels is a management director, who is not entitled to any fees or awards
      other than the compensation he receives as our Chief Executive Officer and
      President. See “Executive Compensation - Summary Compensation Table” in
      this Annual Report for further
information.





Director
Compensation Policy




At our
Annual Meeting on September 4, 2007, each of our non-employee directors (Noam
Bardin, Ilan Biran, Benjamin Broder, and Lior Samuelson) became eligible to
receive $15,000 for their services as directors through the date of our next
Annual Meeting. In this regard, we paid $15,000 to each non-employee director in
2007. Directors are reimbursed for the expenses they incur in attending meetings
of the Board and Board committees.




We reimburse each member of our Board of Directors who is not an
employee for reasonable travel and other expenses in connection with attending
meetings of the Board of Directors.





Prior to
our Annual Meeting on September 8, 2006, our non-employee directors also
received grants of stock options pursuant to our 2004 Non-Employee Director
Stock Option Plan. This option plan is described below. At our 2006 Annual
Meeting, our stockholders approved, based on our Board’s recommendation, the
2006 Non-Employee Director Stock Plan. The 2006 Non-Employee Director Stock Plan
replaced our 2004 Non-Employee Director Stock Option Plan which was terminated,
except with respect to outstanding options previously granted thereunder. The
2006 Non-Employee Director Stock Plan is described below.


44




2004
Non-Employee Director Stock Option Plan





The
purposes of the 2004 Non-Employee Director Stock Option Plan, as amended, or the
Director Plan, are to enable us to attract, maintain and motivate qualified
directors and to enhance a long-term mutuality of interest between our directors
and shareholders of our common stock by granting our directors options to
purchase our shares.





The
Director Plan provides for the automatic grant of nonstatutory stock options.
Options granted under the Plan are not intended to qualify as “incentive stock
options” within the meaning of Section 422 of the Internal Revenue Code of 1986,
as amended, or the Code. The aggregate number of shares of common stock that may
be issued under the Director Plan shall not exceed (a) 851,216 shares, plus (b)
such additional shares of common stock as are represented by Options previously
granted under the 1999 Directors Plan which are cancelled or expire after the
date of stockholder approval of the Director Plan without delivery of shares of
stock by the Company.





Initial Option Awards. Each
director who is not an employee of the Company will be granted options to
acquire 10,000 shares of common stock on the date he or she joins the
Board.





Subsequent Option Awards. On
the first business day after each annual meeting of stockholders of the Company
occurring during the term of the Plan, each non-employee director who meets the
guidelines for Board service and who continues to be a non-employee director
following such annual meeting shall automatically be granted an option to
purchase 10,000 shares of common stock; provided that no Subsequent Option Award
shall be made to any non-employee director who has not served as a director of
the Company, as of the time of such annual meeting, for at least six
months.





Committee Chairman Awards.
Each non-employee director who is appointed as chairman of a standing committee
of the Board (and has not served as the chairman of such committee immediately
prior to the appointment) shall be automatically granted an option to purchase
10,000 shares of common stock on the date of such appointment. Each non-employee
director who serves as a chairman of the full Board or of a standing committee
of the Board other than the audit committee, and who meets the guidelines for
Board service, immediately following each annual meeting of the Company’s
stockholders, shall be granted an option to purchase an additional 10,000 shares
of common stock; provided that no Committee Chairman Award shall be made to any
non-employee director who has not served as a director of the Company, as of the
time of such annual meeting, for at least six months, and no Committee Chairman
Award shall be made to any Eligible Director who has received a Committee
Chairman award for such service on the same committee within the past six
months.





Audit Committee Service
Awards. Each non-employee director who is appointed as a member of the
audit committee of the Board (and has not served as a member of such committee
immediately prior to that appointment) shall be automatically granted an option
to purchase 10,000 shares of common stock on the date of such appointment. Each
non-employee director who serves as a member of the audit committee of the
Board, and who meets the guidelines for Board service, immediately following
each annual meeting of the Company’s stockholders, shall be granted an option to
purchase an additional 10,000 shares of common stock; provided that no Audit
Committee Service Award shall be made to any non-employee director who has not
served as a director of the Company, as of the time of such annual meeting, for
at least six months, and no Audit Committee Award shall be made to any Eligible
Director who has received an Audit Committee award for such service within the
past six months. In addition, the chairman of the audit committee of the Board
shall be granted an additional option to purchase 5,000 shares of common
stock.




Notwithstanding the foregoing, a non-employee director shall
receive a maximum number of options to purchase 30,000 shares of common stock
during any single calendar year. The exercise price per share of common stock of
each option granted pursuant to the Plan shall be equal to the fair market value
per share on the date of grant. If not previously exercised, each option shall
expire on the earlier of (i) the tenth anniversary of the date of the grant
thereof and (ii) on the first anniversary of the termination of the non-employee
director’s status as a director of the Company. Each option granted under the
Plan shall become fully vested and exercisable on the first anniversary of the
date of grant. In addition, options granted pursuant to the Plan will become
exercisable in full upon a “change in control” as defined in the Plan. The Plan
terminates at the close of business on September 23, 2014, unless sooner
terminated by action of the Board or stockholders of the
Company.




2006
Non-Employee Director Stock Plan





The
purposes of the 2006 Stock Plan are to enable us to attract, maintain and
motivate qualified directors and to enhance a long-term mutuality of interest
between our directors and stockholders of our common stock by granting our
directors restricted stock.





General. The 2006 Stock Plan
provides for the automatic grant of restricted stock. The aggregate number of
shares of restricted stock that may be issued under the 2006 Stock Plan shall be
500,000 shares. A grant of restricted stock is a grant of shares of our common
stock that, at the time of issuance, are subject to certain forfeiture
provisions, and thus are restricted as to transferability until such forfeiture
restrictions have lapsed. The restrictions on the restricted stock issued
pursuant to the Plan relate to continued service on the company’s board of
directors (lapsing on a monthly basis). If we reacquire (at not more than its
original issuance price) any shares of restricted stock or if any shares of
restricted stock are forfeited, or otherwise cancelled or terminated, such
shares which were subject to such restricted stock award shall again be
available for issuance from time to time pursuant to the 2006 Stock
Plan.


45




Except to
the extent restricted under the terms of the 2006 Stock Plan, a non-employee
director granted a restricted stock award will have the right to receive
dividends or any other distributions paid with respect to those shares. During
the restricted period (i.e., prior to the lapse of applicable forfeiture
provisions), the restricted stock generally may not be sold, transferred,
pledged, hypothecated, margined, or otherwise encumbered by the non-employee
director.





Administration. The 2006
Stock Plan is administered by the Board. The Board may delegate its powers and
functions hereunder to a duly appointed committee of the Board. The Board shall
have full authority to interpret the Plan; to establish, amend and rescind rules
for carrying out the Plan; to administer the Plan; to incorporate in any option
agreement such terms and conditions, not inconsistent with the Plan, as it deems
appropriate; to construe the respective restricted stock agreements and the
Plan; and to make all other determinations and to take such steps in connection
with the Plan as the Board, in its discretion, deems necessary or desirable for
administering the Plan.




Non-Discretionary
Grants:





Initial Restricted Stock
Awards. Each director who is not an employee of the Company will be
granted 8,000 shares of restricted stock on the date he or she joins the
Board.





Subsequent Restricted Stock
Awards. On the first business day after each annual meeting of
stockholders of the Company occurring during the term of the Plan commencing
with the Meeting, each non-employee director who meets the guidelines for Board
service and who continues to be a non-employee director following such annual
meeting shall automatically be granted 8,000 shares of restricted stock;
provided that no Subsequent Restricted Stock Award shall be made to any
non-employee director who has not served as a director of the Company, as of the
time of such annual meeting, for at least six months.




Committee
Chairman Awards. Each non-employee director who is appointed as chairman
of a standing committee of the Board (and has not served as the chairman of such
committee immediately prior to the appointment) shall be automatically granted
6,000 shares of restricted stock on the date of such appointment. Each
non-employee director who serves as a chairman of the full Board or of a
standing committee of the Board other than the audit committee, and who meets
the guidelines for Board service, immediately following each annual meeting of
the Company’s stockholders, commencing with the Meeting, shall be granted an
additional 6,000 shares of restricted stock; provided that no Committee Chairman
Award shall be made to: any non-employee director who has not served as a
director of the Company, as of the time of such annual meeting, for at least six
months, and no Committee Chairman Award shall be made to any Eligible Director
who has received a Committee Chairman award for such service on the same
committee within the past six months.





Audit Committee Service
Awards. Each non-employee director who is appointed as a member of the
audit committee of the Board (and has not served as a member of such committee
immediately prior to that appointment) shall be automatically granted 6,000
shares of restricted stock on the date of such appointment. Each non-employee
director who serves as a member of the audit committee of the Board, and who
meets the guidelines for Board service, immediately following each annual
meeting of the Company’s stockholders, commencing with the Meeting, shall be
granted an additional 6,000 shares of restricted stock; provided that no Audit
Committee Service Award shall be made to any non-employee director who has not
served as a director of the Company, as of the time of such annual meeting, for
at least six months, and no Audit Committee Award shall be made to any Eligible
Director who has received an Audit Committee award for such service within the
past six months. In addition, the chairman of the audit committee of the Board
shall be granted an additional 2,000 shares of restricted stock.





Annual Limitation. There is
no annual limitation on the maximum number of shares of restricted stock to be
granted to a non-employee director during any single calendar year.





Forfeiture. Each share of
restricted stock under the Plan shall become fully vested and nonforfeitable
upon the first anniversary of the date of grant. If a non-employee director
ceases to serve as a member of the Board for any reason (including, resignation,
failure to stand for re-election or failure to be re-elected), any award of
restricted stock shall become vested and nonforfeitable as to that number of
shares which is equal to the number of shares of common stock subject to such
award times a fraction, the numerator of which is the number of days actually
served as a director during the restricted period and the denominator of which
is the total number of days during the restricted period. Any portion of any
restricted stock that has not become nonforfeitable at the date of a
non-employee director’s termination of service shall be forfeited as of such
date.





Change in Control.
Notwithstanding anything to the contrary in the Plan, shares of restricted stock
granted pursuant to the Plan will become fully vested and nonforfeitable in full
upon a “change in control.” A “change in control” shall arise if, at any time
while the non-employee director is a member of the Company’s Board any one or
more of the following events occurs:





(i) The
Company is merged, consolidated or reorganized into or with another corporation,
or other entity and, as a result thereof, less than 50% of the outstanding stock
or other capital interests of the surviving, resulting or acquiring corporation,
person, or other entity is owned, in the aggregate, by the stockholder or
stockholders of the Company immediately prior to such merger, consolidation or
reorganization;





(ii) The
Company sells all or substantially all of its business or assets (or both) to
any other corporation, person, or other entity, less than 50% of the
outstanding, voting stock or other capital interests of which are owned, in the
aggregate, by the stockholders of the Company, directly or indirectly,
immediately prior to or after such sale; or





(iii) Any
“Person” (as such term is used in Sections 13(d) and 14(d) of the Exchange Act)
other than a Person who is an affiliate as of the effective date of the Plan
becomes the “Beneficial Owner” (as defined in Rule 13d-3 under the Exchange
Act), directly or indirectly, of securities of the Company representing 50% or
more of the total voting power represented by the Company’s then outstanding
voting securities (excluding for this purpose the Company or its affiliates or
any employee benefit plan of the Company) pursuant to a transaction or a series
of related transactions which the Board of Directors does not
approve.




Transferability
of Awards. No shares of restricted stock under the Plan shall be
transferable by the non-employee otherwise than by will or under the applicable
laws of descent and distribution, unless such transfer shall be (a) acceptable
under Rule 16b-3 and is approved by the Board or its authorized delegate or (b)
if the restricted stock agreement pursuant to which the restricted stock grant
is made so provides, by gift or domestic relations order, to (i) the spouse,
children or grandchildren of such non-employee director (collectively, “Family
Members”), (ii) a trust or trusts for the exclusive benefit of such Family
Members, or (iii) a partnership or limited liability company in which such
Family Members and trusts for the exclusive benefit of such Family Members are
the only partners or members, as the case may be.


46




Termination and Amendment.
This Plan shall terminate at the close of business on September 23, 2014, unless
sooner terminated by action of the Board or stockholders of the Company. The
Board at any time or from time to time may amend this Plan to effect (i)
amendments necessary or desirable in order that this Plan and the options
granted thereunder shall conform to all applicable laws and regulations and (ii)
any other amendments deemed appropriate. Notwithstanding the foregoing, (i) the
provisions of the Plan relating to (A) the number of shares to be granted under
the Plan or subject to any restricted stock award granted to any non-employee
director, (B) the timing of any restricted stock grant and (C) the material
terms of the restricted stock (including, without limitation, the time of any
such grant) may not be amended without the approval of the Company’s
stockholders and (ii) the Board may not effect any amendment that would require
the approval of the stockholders of the Company under any applicable laws or the
listing requirements of the Nasdaq Stock Market (if applicable to the Company at
the time such amendment is adopted or will be effective) unless such approval is
obtained.





ITEM 12.
  SECURITY OWNERSHIP OF
CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS





The
following table sets forth information with respect to the beneficial ownership
of shares of our common stock as of January 31, 2008by:





·
            each
      person whom we know beneficially owns more than 5% of our common
      stock;·
            each
      of our directors individually;·
            each
      of our named executive officers individually; and·
            all
      of our directors and executive officers as a
  group.




Unless
otherwise indicated, to our knowledge, all persons listed below have sole voting
and investment power with respect to their shares of common stock. Each person
listed below disclaims beneficial ownership of their shares, except to the
extent of their pecuniary interests therein. Shares of common stock that an
individual or group has the right to acquire within 60 days of January 31, 2008
pursuant to the exercise of options are deemed to be outstanding for the purpose
of computing the percentage ownership of such person or group, but are not
deemed outstanding for the purpose of calculating the percentage owned by any
other person listed.





Number
                
                Percentage(1)Shares of deltathree Class A
      Common Stock
      Beneficially OwnedPrincipal
      Stockholder:Atarey
      Hasharon Chevra Lepituach Vehashkaot Benadlan (1991) Ltd.
                
                
                11,927,677
                
                36.3
                %7
      Giborey Israel St., P.O. Box 8468South
      Netanya Industrial Zone 42504, IsraelExecutive
      Officers and Directors:Noam
      Bardin(2)(3)(9)
                
                
                588,366
                
                1.8
                %Shimmy
      Zimels(2)(4)
                
                
                528,469
                
                1.6
                %Ilan
      Biran (2)(5)(9)
                
                
                105,849
                
                *Benjamin
      Broder (2)(6)(9)
                
                
                42,000
                
                *Lior
      Samuelson (2)(7)(9)
                
                
                82,000
                
                *Richard
      Grant (2)(8)
                
                
                50,000
                
                *All
      Directors and Executive Officers as a group (6 persons)
      (10)
                
                
                1,396,684
                
                4.1
                %
 
 *
              Less than
    1%.
  (1)
                Percentage
      of beneficial ownership is based on 32,870,105 shares of common stock
      outstanding as of January 31, 2008.
 (2)
                The
      address for the director or executive officer listed is c/o the
      Company.
 (3)
                Includes
      (a) 187,366shares of common stock, (b) options to purchase 365,000shares of common stock and (c) 36,000 restricted shares of
      common stock.
  (4)
                Includes
      (a) 64,469 shares of common stock, (b) options to
      purchase 434,000 shares of common stock and (c) 30,000
      restricted shares of common stock.
  (5)
                Includes
      (a) options to purchase 89,849 shares of common stock and
      (b) 16,000 restricted shares of common
  stock.
 (6)
                Includes
      (a) options to purchase 20,000 shares of common stock and
      (b) 22,000 restricted shares of common
  stock.
 (7)
                Includes
      (a) options to purchase 60,000 shares of common stock and
      (b) 22,000 restricted shares of common
  stock.
 (8)
                Includes options
      to purchase 50,000 shares of common
stock.
 (9)
                All
      restricted share grants to our non-employee directors fully vest and are
      not subject to forfeiture upon the first anniversary of the date of grant,
      provided the individual is serving as a director upon such date. The
      grants are subject to partial vesting in the event the director no longer
      serves as a director upon the first anniversary
  date.
   (10)
                Includes (a) 251,835
      shares of common stock, (b) options to purchase 1,018,849 shares of
      common stock and (c) 126,000 restricted shares of our common
      stock.


47




Equity
Compensation Plan Information


The
following table provides certain aggregate information with respect to shares of
our common stock that may be issued under our equity compensation plans in
effect as of December 31, 2007.




Plan
      Category
                
                Number of Securities to be Issued Upon Exercise
      of Outstanding Options, Warrants and Rights(1)
                
                Weighted Average Exercise Price of Outstanding
      Options, Warrants and
      Rights
                
                
                Number of Securities Remaining Available for
      Future Issuance Under Equity Compensation Plans (excluding securities
      reflected in first column)(2)Equity
      Compensation Plans Approved by Security Holders (3)
                
                1,560,020
                
                $
                1.91
                
                
                3,337,875Equity
      Compensation Plans not Approved by Security Holders
                
                N/A
                
                
                N/A
                
                
                
                N/ATotal
                
                1,560,020
                
                $
                1.91
                
                
                3,337,875
  (1)
                Does
      not include 178,540 restricted shares of our common stock that had
      been granted under our equity compensation plans as of December 31,
      2007.
  (2)
                During
      the first quarter of 2008, we issued to our employees under our 2004 Stock
      Incentive Plan restricted units to acquire 240,000 shares of our common
      stock and options to acquire approximately 1,4000,000 shares of our common
      stock.


(3)
            These
      plans consist ofour 2004 Stock
      Incentive Plan and 2006 Non-Employee Director Stock Plan. The table also
      includes information for our 1999 Directors’ Plan and our 1999 Employee
      Stock Incentive Plan, both of which have expired. Additionally, our 2004
      Non-Employee Director Stock Option Plan was terminated, except with
      respect to outstanding options previously granted
    thereunder.




ITEM 13.
  CERTAIN RELATIONSHIPS
AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE





We are
not, and have not been during the last two fiscal years, a party to any
related-party transactions. All transactions between us and our officers,
directors, principal stockholders and affiliates must be reviewed and approved
in advance by the Audit Committee.


48




ITEM 14.
  PRINCIPAL ACCOUNTING
FEES AND SERVICES




The
following table presents fees for professional audit services rendered by
Brightman Almagor & Co. for the audit of the Company's annual financial
statements for the years ended December 31, 2007, and December 31, 2006, and
fees billed for other services rendered by Brightman Almagor & Co. during
those periods.




2007
                
                
                2006Audit
      fees
                
                $
                65,000
                
                
                $
                62,500Audit
      related fees
                
                
                −
                
                
                
                −Tax
      fees
                
                
                16,500
                
                
                
                18,500All
      other fees
                
                
                -
                
                
                
                −Total
                
                $
                81,500
                
                
                $
                81,000


In the
above table, in accordance with the SEC’s definitions and rules, “audit fees”
are fees we paid Brightman Almagor & Co. for professional services for the
audit of our annual financial statements and review of financial statements
included in our quarterly reports filed with the SEC, as well as for work
generally only the independent auditor can reasonably be expected to provide,
such as statutory audits and consultation regarding financial accounting and/or
reporting standards; “audit-related fees” are fees billed by Brightman Almagor
& Co. for assurance and related services that are reasonably related to the
performance of the audit or review of our financial statements; “tax fees” are
fees for tax compliance, tax advice and tax planning; and “all other fees” are
fees billed by Brightman Almagor & Co for any services not included in the
first three categories.




Policy on Audit Committee Pre-Approval of Audit and Permissible
Non-Audit Services of Independent Auditors




Consistent
with SEC policies regarding auditor independence, the Audit Committee has
responsibility for appointing, setting compensation and overseeing the work of
the independent auditor. In recognition of this responsibility, the Audit
Committee has established a policy to pre-approve all audit and permissible
non-audit services provided by the independent auditor.




Prior to
engagement of the independent auditor for the next year's audit, management will
submit an aggregate of services expected to be rendered during that year for
each of four categories of services to the Audit Committee for
approval.




1. Audit
services include audit work performed in the preparation of financial
statements, as well as work that generally only the independent auditor can
reasonably be expected to provide, including comfort letters, statutory audits,
and attest services and consultation regarding financial accounting and/or
reporting standards.




2. Audit-Related
services are for assurance and related services that are traditionally performed
by the independent auditor, including due diligence related to mergers and
acquisitions, employee benefit plan audits, and special procedures required to
meet certain regulatory requirements.




3. Tax
services include all services performed by the independent auditor's tax
personnel except those services specifically related to the audit of the
financial statements, and includes fees in the areas of tax compliance, tax
planning, and tax advice.




4. Otherservices are those associated with services not captured in the other
categories. The Company generally does not request such services from the
independent auditor.





Prior to
engagement, the Audit Committee pre-approves these services by category of
service. The fees are budgeted and the Audit Committee requires the independent
auditor and management to report actual fees versus the budget periodically
throughout the year by category of service. During the year, circumstances may
arise when it may become necessary to engage the independent auditor for
additional services not contemplated in the original pre-approval. In those
instances, the Audit Committee requires specific pre-approval before engaging
the independent auditor.




The Audit
Committee may delegate pre-approval authority to one or more of its members. The
member to whom such authority is delegated must report, for informational
purposes only, any pre-approval decisions to the Audit Committee at its next
scheduled meeting.




49


PART
IV




ITEM 15.   EXHIBITS,
FINANCIAL STATEMENT SCHEDULES







(a)(1)
Financial Statements.





The
Consolidated Financial Statements filed as part of this Annual Report are
identified in the Index to Consolidated Financial Statements on page F-1
hereto.





(a)(2)
Financial Statement Schedules.





Financial
Statement Schedules have been omitted because the information required to be set
forth therein is not applicable or is shown on the financial statements or notes
thereto.




(a)(3)
Exhibits.





The
following exhibits are filed herewith or are incorporated by reference to
exhibits previously filed with the SEC.





Exhibit
              Number
            
            Description2.1
            
            Asset
      Transfer Agreement dated February 17, 2007 by and between deltathree, Inc.
      and Go2Call.com, Inc. (Incorporated by reference to Exhibit 2.1 of our
      Current Report on Form 8-K, filed on February 20,
2007).3.1.1
            
            Form
      of Restated Certificate of Incorporation of deltathree, Inc. (Incorporated
      by reference from our registration statement on Form S-1
      (Registration No. 333-122242)).3.1.2
            
            Form
      of Amendment to Restated Certificate of Incorporation of deltathree, Inc.
      (Incorporated by reference to our Annual Report on Form 10-K/A, filed
      on April 30, 2001).3.2
            
            Form
      of Amended and Restated By-laws of deltathree, Inc. (Incorporated by
      reference from our registration statement on Form S-1 (Registration
      No. 333-122242)).4.1
            
            Specimen
      Certificate of Class A Common Stock (Incorporated by reference from our
      registration statement on Form S-1 (Registration
      No. 333-122242)).4.2
            
            Specimen
      Certificate of Class B Common Stock (Incorporated by reference from our
      registration statement on Form S-1 (Registration
      No. 333-122242)).10.1
            
            Form
      of deltathree, Inc. 1999 Stock Incentive Plan (Incorporated by reference
      from our registration statement on Form S-1 (Registration
      No. 333-122242)).+10.2
            
            Form
      of deltathree, Inc. 1999 Employee Stock Purchase Plan (Incorporated by
      reference from our registration statement on Form S-1 (Registration
      No. 333-122242)).10.3
            
            Form
      of deltathree, Inc. 1999 Performance Incentive Plan (Incorporated by
      reference from our registration statement on Form S-1 (Registration
      No. 333-122242)).+10.4
            
            Form
      of deltathree, Inc. 1999 Directors’ Plan (Incorporated by reference from
      our registration statement on Form S-1 (Registration
      No. 333-122242)).+10.5
            
            Employment
      Agreement, effective as of April 26, 2004, between Shimmy Zimels and
      deltathree, Inc. (Incorporated by reference to our Annual Report on
      Form 10-K/A, filed on April 29,
2004).+




50




10.6
            
            2004
      Stock Incentive Plan (Incorporated by reference to our registration
      statement on Form S-8 (Registration
      No. 333-86503)).+10.7
            
            2004
      Non-Employee Director Stock Option Plan (Incorporated by reference to our
      registration statement on Form S-8 (Registration
      No. 333-86503)).+10.8
            
            Form
      of Option Agreement Pursuant to 2004 Stock Incentive Plan (Incorporated by
      reference to our Annual Report on Form 10-K, filed on March 31,
      2005).+10.9
            
            Form
      of Option Agreement Pursuant to 2004 Non-Employee Director Stock Option
      Plan (Incorporated by reference to our Annual Report on Form 10-K, filed
      on March 31, 2005).+10.10
            
            Executive
      and Director Compensation Arrangements (Incorporated by reference to our
      Annual Report on Form 10-K, filed on March 31, 2005).+10.11
            
            First
      Amendment to the deltathree, Inc. 2004 Stock Incentive Plan, dated as of
      December 20, 2005 (Incorporated by reference to Exhibit 10.1 to our
      Current Report on Form 8-K, filed on December 21,
  2005).+10.12
            
            First
      Amendment to the deltathree, Inc. 2004 Non-Employee Director Stock Option
      Plan, dated as of December 20, 2005 (Incorporated by reference to Exhibit
      10.2 of our Current Report on Form 8-K, filed on December 21,
      2005).+10.13
            
            Registration
      Rights Agreement dated February 19, 2007 by and between deltathree, Inc.
      and Go2Call.com, Inc. (Incorporated by reference to Exhibit 2.1 of our
      Current Report on Form 8-K, filed on February 20,
2007).10.14
            
            deltathree,
      Inc. Amended and Restated 1999 Performance Incentive Plan (Incorporated by
      reference to Exhibit 10.1 of our Current Report on Form 8-K, filed on July
      11, 2006).+10.15
            
            Deltathree,
      Inc. 2006 Non-Employee Director Stock Plan (Incorporated by reference to
      Exhibit 10.1 of our Current Report on Form 8-K, filed on September 8,
      2006).+10.16*
            
            Form
      of Restricted Unit Agreement Pursuant to 2004 Stock Incentive
      Plan.+10.17
            
            Employment
      Agreement, dated as of February 1, 2008, between Lior Samuelson and
      deltathree, Inc. (Incorporated by reference to our Current Report on
      Form 8-K, filed on February 4, 2008).+14.1
            
            deltathree,
      Inc. Corporate Code of Conduct and Ethics (Incorporated by reference to
      our Annual Report on Form 10-K, filed on March 30,
    2004).21.1*
            
            Subsidiaries
      of deltathree, Inc.23.1*
            
            Consent
      of Brightman Almagor & Co.31.1*
            
            Certification
      of the Chief Executive Officer, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.31.2*
            
            Certification
      of the Chief Financial Officer, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.32*
            
            Certifications
      of the Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.





*  
Filed herewith.




+   Management contract or
compensatory plan.


51




Index to Consolidated Financial
Statements


Report of Independent Registered Accounting
      Firm
            
            
            F-2Consolidated Balance Sheets as of
      December 31, 2007 and 2006
            
            
            F-3Consolidated Statements of Operations
      for the years ended December 31, 2007, 2006, and 2005
            
            
            F-4Statements of Stockholders’ Equity for
      the years ended December 31, 2007, 2006, and 2005
            
            
            F-5Consolidated Statements of Cash Flows for the
      years ended December 31, 2007, 2006, and 2005
            
            
            F-6Notes to Consolidated Financial
      Statements
            
            
            F-7




F-1




REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM




To the
Board and Stockholders of


deltathree,
Inc.







We have
audited the accompanying consolidated balance sheets of deltathree, Inc. ("the
Company") and its subsidiary as of December 31, 2007 and 2006 and the related
consolidated statements of operations, stockholders' equity and cash flows for
each of the three years in the period ended December 31, 2007. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.




We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company’s internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the consolidated financial position of the Company and
its subsidiary as of December 31, 2007 and 2006, and the consolidated results of
its operations and its consolidated cash flows for each of the three years in
the period ended December 31, 2007 in conformity with U.S. generally accepted
accounting principles.








/s/Brightman Almagor &
Co.


Certified
Public Accountants


A member
firm of Deloitte Touche Tohmatsu





Tel Aviv,
Israel


March 27,
2008


F-2




DELTATHREE,
INC.
 CONSOLIDATED BALANCE SHEETS
 ($ in
thousands)
  December 31,2007
                
                
                2006ASSETSCurrent
      assets:Cash
      and cash equivalents
                
                $
                1,649
                
                
                $
                3,790Restricted
      cash and short-term investments (Note 3)
                
                
                5,883
                
                
                
                12,067Accounts
      receivable, net (Note 4)
                
                
                1,061
                
                
                
                1,286Prepaid
      expenses and other current assets (Note 5)
                
                
                526
                
                
                
                444Inventory
                
                
                193
                
                
                
                155Total
      current assets
                
                
                9,312
                
                
                
                17,742Restricted
      cash and long –term investments (Note 3)
                
                
                1,085
                
                
                
                1,085Property
      and equipment:Telecommunications
      equipment
                
                
                18,219
                
                
                
                18,147Furniture,
      fixtures and other
                
                
                679
                
                
                
                639Leasehold
      improvements
                
                
                4,870
                
                
                
                4,677Capital
      leases
                
                
                225
                
                
                
                -Computers
      hardware & software
                
                
                8,946
                
                
                
                8,47432,939
                
                
                
                31,937Less
      accumulated depreciation
                
                
                (30,057
                )
                
                
                (28,479
                )Property and equipment,
      net
                
                
                2,882
                
                
                
                3,458Goodwill,
      net
                
                
                2,002
                
                
                
                -Other
      intangible assets, net
                
                
                1,902
                
                
                
                -Deposits
                
                
                116
                
                
                
                110Total
      assets
                
                $
                17,299
                
                
                $
                22,395LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Current
      portion of capital leases (Note 7)
                
                $
                69Accounts
      payable
                
                
                2,505
                
                
                $
                2,916Deferred
      revenues
                
                
                551
                
                
                
                1,099Other
      current liabilities (Note 6)
                
                
                1,665
                
                
                
                1,545Total
      current liabilities
                
                
                4,790
                
                
                
                5,560Long-term
      liabilities:Capital
      leases - net of current portion (Note 7)
                
                
                144
                
                
                
                -Severance
      pay obligations (Note 8)
                
                
                341
                
                
                
                217Total
      current liabilities
                
                
                485
                
                
                
                217Total
      liabilities
                
                
                5,275
                
                
                
                5,777Commitments
      and contingencies (Note 9)Stockholders’
      equity (Note 10):Share
      capitalClass
      A Common stock, - par value $0.001; authorized 75,000,000
      shares;issued
      and outstanding: 32,870,105 at December 31, 2007;29,808,214
      at December 31, 2006
                
                
                33
                
                
                
                30Additional
      paid-in capital
                
                
                172,747
                
                
                
                168,030Accumulated
      deficit
                
                
                (160,756
                )
                
                
                (151,442
                )Total
      stockholder's equity
                
                
                12,024
                
                
                
                16,618Total
      liabilities and stockholder's equity
                
                $
                17,299
                
                
                $
                22,395
  The
accompanying notes are an integral part of these consolidated financial
statements.


F-3




DELTATHREE,
INC.


CONSOLIDATED STATEMENTS OF
OPERATIONS


($ in
thousands, except share data)


2007
                  
                  
                  
                  2006
                  
                  
                  
                  2005Revenues
      (Note 13):
                  
                  $
                  29,477
                  
                  
                  $
                  37,953
                  
                  
                  $
                  29,714Costs
      and operating expenses:Cost
      of revenues (exclusive of $599, $615 and $822depreciation
      included in a separate line below, respectively)
                  
                  
                  21,107
                  
                  
                  
                  24,375
                  
                  
                  
                  18,698Research
      and development expenses (Note 11)
                  
                  
                  4,669
                  
                  
                  
                  4,043
                  
                  
                  
                  3,228Selling
      and marketing expenses
                  
                  
                  5,068
                  
                  
                  
                  4,956
                  
                  
                  
                  4,173General
      and administrative expenses
                  
                  
                  2,952
                  
                  
                  
                  3,088
                  
                  
                  
                  2,912Write
      down of intangible asset
                  
                  
                  2,680
                  
                  
                  
                  –
                  
                  
                  
                  –Depreciation
      and amortization
                  
                  
                  2,644
                  
                  
                  
                  1,543
                  
                  
                  
                  1,931Total
      costs and operating expenses
                  
                  
                  39,120
                  
                  
                  
                  38,005
                  
                  
                  
                  30,942Loss
      from operations
                  
                  
                  (9,643
                  )
                  
                  
                  (52
                  )
                  
                  
                  (1,228
                  )Other
      non operating income
                  
                  
                  13
                  
                  
                  
                  –
                  
                  
                  
                  –Interest
      income, net
                  
                  
                  442
                  
                  
                  
                  620
                  
                  
                  
                  418Loss
      before income taxes
                  
                  
                  (9,188
                  )
                  
                  
                  568
                  
                  
                  
                  (810
                  )Income
      taxes (Note 12)
                  
                  
                  126
                  
                  
                  
                  61
                  
                  
                  
                  44Net
      loss
                  
                  $
                  (9,314
                  )
                  
                  $
                  507
                  
                  
                  $
                  (854
                  )Net
      loss per share-basic and diluted
                  
                  $
                  (0.29
                  )
                  
                  $
                  0.02
                  
                  
                  $
                  (0.03
                  )Basic
      weighted average number of shares outstanding
                  
                  
                  32,427,118
                  
                  
                  
                  29,771,470
                  
                  
                  
                  29,671,820Diluted weighted average number of shares outstanding
                  
                  
                  32,427,118
                  
                  
                  
                  30,129,011
                  
                  
                  
                  29,671,820


The
accompanying notes are an integral part of these consolidated financial
statements.


F-4





DELTATHREE,
INC.


STATEMENTS OF STOCKHOLDER’S
EQUITY


($ in
thousands, except share data)




Class A Common StockNumber
      of OutstandingShares
              
              
              Number
      of Treasury
                Shares
              
              
              Amount
              
              
              Additional
      Paid-in Capital
              
              
              Treasury
      Stock(at Cost)
              
              
              AccumulatedDeficit
              
              
              Total
      Stockholders'
                EquityBalance
      at January 1, 2005
              
              
              29,381,313
              
              
              
              257,600
              
              
              
              29
              
              
              
              167,301
              
              
              
              (210
              )
              
              
              (151,095
              )
              
              
              16,025Exercise
      of employee options
              
              
              357,919
              
              
              
              
              
              
              
              1
              
              
              
              389
              
              
              
              
              
              
              
              
              
              
              
              390Loss
      for the year
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (854
              )
              
              
              (854
              )Balance
      at December 31, 2005
              
              
              29,739,232
              
              
              
              257,600
              
              
              
              30
              
              
              
              167,690
              
              
              
              (210
              )
              
              
              (151,949
              )
              
              
              15,561Cancellation
      of treasury stock
              
              
              
              
              
              
              (257,600
              )
              
              
              
              
              
              
              (210
              )
              
              
              210
              
              
              
              
              
              
              
              –Exercise
      of employee options
              
              
              68,982
              
              
              
              
              
              
              
              –
              *
              
              
              550
              
              
              
              
              
              
              
              
              
              
              
              550Loss
      for the year
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              507
              
              
              
              507Balance
      at December 31, 2006
              
              
              29,808,214
              
              
              
              –
              
              
              
              30
              
              
              
              168,030
              
              
              
              –
              
              
              
              (151,442
              )
              
              
              16,618Go2Call
      acquisition
              
              
              2,959,831
              
              
              
              
              
              
              
              3
              
              
              
              4,200
              
              
              
              
              
              
              
              
              
              
              
              4,203Exercise
      of employee options
              
              
              35,000
              
              
              
              
              
              
              
              –
              *
              
              
              32
              
              
              
              
              
              
              
              
              
              
              
              32Vesting
      of restricted shares
              
              
              67,060
              
              
              
              
              
              
              
              –
              *Share
      based compensation
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              485
              
              
              
              
              
              
              
              
              
              
              
              485Loss
      for the year
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (9,314
              )
              
              
              (9,314
              )Balance
      at December 31, 2007
              
              
              32,870,105
              
              
              
              –
              
              
              $
              33
              
              
              $
              172,747
              
              
              $
              –
              
              
              $
              (160,756
              )
              
              $
              12,024


* 
Less than $1 thousand.





The
accompanying notes are an integral part of these consolidated financial
statements.


F-5


DELTATHREE,
INC.


CONSOLIDATED STATEMENTS OF CASH FLOWS


($ in
thousands)


Year ended December 31,2007
              
              
              2006
              
              
              2005Cash
      flows from operating activities:Net
      (loss) income
              
              $
              (9,314
              )
              
              $
              507
              
              
              $
              (854
              )Adjustments
      to reconcile net loss to net cash (used in) provided by operating
      activitiesWrite
      down for intangible asset
              
              
              2,680
              
              
              
              –
              
              
              
              –Depreciation
      and amortization
              
              
              1,576
              
              
              
              1,543
              
              
              
              1,931Amortization
      of intangible asset
              
              
              1,068
              
              
              
              –
              
              
              
              –Stock
      based compensation
              
              
              485
              
              
              
              480
              
              
              
              –Capital
      gain, net
              
              
              –
              
              
              
              (1
              )
              
              
              –Liability
      for severance pay, net
              
              
              124
              
              
              
              62
              
              
              
              51Provision
      for losses on accounts receivable
              
              
              110
              
              
              
              25
              
              
              
              –Exchange
      rates differences on deposits, net
              
              
              (6
              )
              
              
              –
              
              
              
              –Changes
      in operating assets and liabilities;Decrease
      (Increase) in accounts receivable
              
              
              115
              
              
              
              (608
              )
              
              
              (378
              )(Increase)
      decrease in prepaid expenses other current assets
              
              
              (82
              )
              
              
              168
              
              
              
              (84
              )(Increase)
      decrease in inventory
              
              
              (38
              )
              
              
              87
              
              
              
              (49
              )(Decrease)
      increase in accounts payable
              
              
              (778
              )
              
              
              (988
              )
              
              
              203(Decrease)
      increase in deferred revenues
              
              
              (1,172
              )
              
              
              755
              
              
              
              (109
              )Increase
      (decrease) in other current liabilities
              
              
              120
              
              
              
              5
              
              
              
              (494
              )4,202
              
              
              
              1,528
              
              
              
              1,071Net
      cash (used in ) provided by operating activities
              
              
              (5,112
              )
              
              
              2,035
              
              
              
              217Cash
      flows from investing activities:Purchase
      of property and equipment
              
              
              (724
              )
              
              
              (883
              )
              
              
              (1,376
              )Proceeds
      from sale of property and equipment
              
              
              -
              
              
              
              14
              
              
              
              -Long
      term investment, net
              
              
              -
              
              
              
              131
              
              
              
              (121
              )Decrease
      (increase) in  short-term investments
              
              
              6,184
              
              
              
              (1,419
              )
              
              
              (121
              )Purchase
      of Go2Call operations, net
              
              
              (2,509
              )Net
      change in deposits
              
              
              -
              
              
              
              (5
              )
              
              
              2Net cash provided by (used in )
      investing activities
              
              
              2,951
              
              
              
              (2,162
              )
              
              
              (1,616
              )Cash
      flows from financing activities:Payment
      of capital leases
              
              
              (12
              )
              
              
              -
              
              
              
              -Proceeds
      from exercise of employee options
              
              
              32
              
              
              
              70
              
              
              
              390Net cash provided by financing
      activities
              
              
              20
              
              
              
              70
              
              
              
              390(Decrease)
      increase in cash and cash equivalents
              
              
              (2,141
              )
              
              
              (57
              )
              
              
              (1,009
              )Cash
      and cash equivalents at beginning of year
              
              
              3,790
              
              
              
              3,847
              
              
              
              4,856Cash and cash equivalents at
      end of year
              
              
              1,649
              
              
              
              3,790
              
              
              
              3,847Supplemental
      disclosures of cash flow information:Cash
      paid for:Taxes
              
              
              108
              
              
              
              68
              
              
              
              21Supplemental
      schedule of non cash investing and financing activities:Acquisition
      of fixed assets on credit
              
              
              -
              
              
              
              -
              
              
              
              44Acquisition
      of capital leases
              
              
              225
              
              
              
              -
              
              
              
              -Cancellation
      of treasury stock
              
              
              -
              
              
              
              210
              
              
              
              -


Supplemental
      schedule of acquisition of Go2CallFixed
      assets
                
                $
                51Goodwill
                
                $
                2,002Intangible
      asset
                
                $
                5,650Accounts
      payable
                
                $
                (367
                )Deferred
      revenues
                
                $
                (624
                )Stock
      issuance
                
                $
                (4,203
                )Total
                
                $
                2,509


The
accompanying notes are an integral part of these consolidated financial
statements.


F-6




DELTATHREE,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





Note 1
-The
Company





deltathree,
Inc. (the "Company"), a Delaware corporation, is a global provider of integrated
Voice over Internet Protocol (VoIP) telephony services. The Company was founded
in 1996 to capitalize on the growth of the Internet as a communication tool by
commercially offering Internet Protocol (IP) telephony services. IP telephony is
the real time transmission of voice communications in the form of digitized
“packets” of information over the public Internet or a private network, similar
to the way in which e-mail and other data is transmitted. The Company’s business
currently includes the transmission of voice and data traffic for communications
carriers, the provision of enhanced Web-based and other communications services
to individual consumers and the provision of a total “Hosted Consumer VoIP
Solution” that enables corporate customers and service providers to offer
private label telecommunications to their customer bases.




Prior to
the end of the first quarter of 2008, the Company initiated a process of
attempting to realign its cost structure with its current business model and
began to reduce its operations and expenses (including a significant reduction
in work force) in order to immediately reduce its cash burn rate.  In
addition, with the assistance of outside strategic consultants the Company began
the process of examining ways to possibly increase its current revenues by
growing its current sales and/or entering into new sales
channels.




Note 2
-Summary
of significant accounting policies





a. Basis of
presentation




The
financial statements have been prepared in conformity with U.S. generally
accepted accounting principles.




b.   Principles of
consolidation




The
consolidated financial statements include the accounts of the Company and its
subsidiary. All significant inter-company accounts and transactions have been
eliminated.


c. Financial statements in U.S.
dollars





The
reporting currency of the Company is the U.S. dollar ("dollar"). The dollar is
the functional currency of the Company and its subsidiary. Transactions and
balances originally denominated in dollars are presented at their original
amounts. Non-dollar transactions and balances are re-measured into dollars in
accordance with the principles set forth in Statement of Financial Accounting
Standards ("SFAS") No. 52. All exchange gains and losses from translation of
monetary balance sheet items resulting from transactions in non-dollar
currencies are recorded in the statement of operations as they
arise.





d.   Use of
estimates





The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported and disclosed in the consolidated financial
statement and the accompanying notes. Actual results could differ from those
estimates




On an
ongoing basis, the company evaluates it estimates, including those related to
allowances for doubtful accounts receivable, the amortization of deferred
revenue associated with customer accounts, the useful lives of property and
equipment and the value of common stock, common stock options, and restricted
stock for the purpose of determining stock-based compensation. The Company bases
its estimates on historical experience, available market information,
appropriate valuation methodologies, including the Black and Scholes option
model and on various other assumptions that are believed to be reasonable, the
results of which from the basis for making judgments about the carrying values
of assets and liabilities.


e.   Cash and cash
equivalents
  The
Company maintains cash with investment grade financial institutions. Cash
equivalents consist of short-term, highly liquid investments that are readily
convertible into cash with
original maturities of three months or less.




F-7


f .     Restricted
Cash
  Restricted
cash represents amounts held in certificates of deposit and money market funds
to support stand-by-letters of credit used as security for third party
vendors.




g.   Marketable
securities
  The
Company accounts for its investments in marketable securities using SFAS No.
115, "Accounting for Certain Investments in Debt and Equity Securities" (“SFAS
No. 115”). Management determines the appropriate classification of its
investments in marketable securities at the time of purchase and reevaluates
such determinations at each balance sheet date. Securities for which the Company
does not have the intent or ability to hold to maturity are classified as
available-for-sale. Available-for-sale securities are stated at fair value, with
the unrealized gains and losses reported as a separate component of
shareholders' equity under accumulated other comprehensive gain or loss. The
Company has not recorded any unrealized gains or losses to
date.




h.   Inventory


Inventory
consists of the cost of customer equipment and is at the lower of cost
(principally on a standard cost basis which approximates FIFO) or
market.
  i.     Property and
equipment




Property
and equipment are stated at cost. Depreciation is calculated using the
straight-line method over the estimated useful lives of the depreciable assets,
which range from two to five years. Leasehold improvements are amortized based
on the straight-line method over the shorter of the term of the lease, or the
estimated useful life of the improvements.




j.     Long lived assets


The
Company applies the provisions of SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets. This statement requires that long-lived assets
and certain identifiable intangible assets be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. Recoverability of assets to be held and used is measured
by a comparison of the carrying amount of an asset to undiscounted future net
cash flows expected to be generated by the asset. If such assets are considered
to be impaired, the impairment to be recognized is measured by the amount by
which the carrying amount of the assets exceeds the fair value of the
assets.




k.    
Impairment of Goodwill and Intangible Asset


The
Company evaluates its long-lived tangible and intangible assets for impairment
in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” and
SFAS No.144, “Accounting for the Impairment or Disposal of Long-Lived Assets,”
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable. Goodwill is subject to an annual test for
impairment. If such assets are considered to be impaired, the impairment to
be recognized is measured by the amount by which the carrying amount of the
assets exceeds the fair value of the assets. As of December 31, 2007, the
Company amortized $2,680,000 from the asset’s book value.




l.     Revenue
recognition
  The
Company recognizes revenues from Internet telephony services based on minutes
(or fractions thereof) of customer usage. The Company records payments received
in advance for prepaid services and services to be supplied under contractual
agreements as deferred revenue until such related services are
provided.


m.     Cost of revenues


Cost of
revenues consists primarily of direct costs that the Company pays to third
parties in order to provide telephony services. These costs include access,
transmission and interconnection charges that the Company pays to other access
providers to terminate domestic and international phone calls on the public
switched telephone network. In addition, these costs include the cost to lease
phone numbers, to co-locate in other telephone companies' facilities. These
costs also include taxes that the Company pays on telecommunications services
from our suppliers.




F-8


n.    Research and development
expenses


Research
and development expenses are expensed as incurred and consist primarily of
payroll and facilities charges associated with the research and development of
our current and
future products.


o.     Income taxes


The
Company provides for income taxes using the liability approach defined by SFAS
No. 109, Accounting for Income Taxes. Deferred tax assets and liabilities are
recognized for the expected tax consequences between the tax bases of the assets
and liabilities and their reported amounts. Valuation allowances are established
when necessary to reduce deferred tax assets to the amount expected to be
realized and are reversed at such time that realization is believed to be more
likely than not.




p.
    Stock-based
compensation
  Prior to
the adoption of Statement of Financial Accounting Standards No. 123(R) (“SFAS
123(R)”), the Company accounted for employee stock-based compensation in
accordance with Accounting Principles Board Opinion No. 25, “Accounting for
Stock Issued to Employees” and in accordance with FASB Interpretation No. 44.
Pursuant to these accounting pronouncements, the Company recorded compensation
for stock options granted to employees over the vesting period of the options
based on the difference, if any, between the exercise price of the options and
the market price of the underlying shares at that date. Deferred compensation is
amortized to compensation expense over the vesting period of the options. In
accordance with the modified prospective transition method that the Company used
in adopting SFAS 123(R) as of January 1, 2006, the consolidated
financial statements prior to 2006 have not been restated to reflect, and do not
include, the possible impact of SFAS 123(R).




Had
compensation cost for the Company's option plans been determined on the basis of
the fair value at the grant dates in accordance with the provisions of SFAS No.
123 “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, the
Company's pro forma net loss and pro forma basic and diluted net loss per share
for 2005 would have been as follows:




Year
      ended December 31, 2005Pro
      forma net loss:Net
      loss for the year, as reported
                
                $
                (854
                )Add:
      stock-based compensation determined under SFAS 123
                
                
                (367
                )Pro
      forma net loss
                
                $
                (1,221
                )Net
      loss per share - basic and diluted:As
      reported
                
                $
                (0.03
                )Pro
      forma
                
                $
                (0.04
                )


The
following assumptions were used for the fiscal year 2005: dividend yield of
0.00% for all periods; risk-free interest rate of 4.0% and 3.2% respectively; an
expected life of 3-years for all
periods; a volatility rate of 78% and 87% respectively.




Because
the determination of the fair value of all options granted includes an expected
volatility factor and since additional option grants are expected to be made
each year, the above pro forma disclosures are not representative of the pro
forma effects of reported net income for future years.




q.     Restricted shares


The
Company has granted restricted shares to retain, reward and motivate those
employees who are deemed critical to the future success of the Company. The
restricted share plan has been approved by the Board of Directors. We record
compensation expense associated with non-vested restricted shares that have been
granted in accordance with SFAS No. 123(R). In accordance with the
aforementioned statement, we calculate compensation expense on the date of grant
(number of shares granted multiplied by the fair value of our common stock on
the date of grant) and recognize this expense, adjusted for forfeitures, ratably
over the applicable vesting period.




r.     Net Income (loss) per
share


Basic and
diluted net income (loss) per share have been computed in accordance with SFAS
No. 128, "Earnings Per Share", using the weighted average number of common stock
outstanding. Diluted earnings per share give effect to all potential dilutive
issuances of ordinary shares that were outstanding during the period. A total of
1,061,427 incremental shares were excluded from the calculation of diluted net
loss per ordinary share for 2005.


F-9




s.     Concentration of credit risk




The
Company is subject to concentrations of credit risk, which consist principally
of cash and cash equivalents, short-term investments and trade accounts
receivable.




The
Company maintains its cash balances at various financial institutions. The
Company performs periodic evaluations of the relative credit standing of these
institutions.
  The
majority of the Company's non-carrier customers prepay for their services. The
Company establishes an allowance for doubtful accounts based upon factors
surrounding the credit
risk of customers, historical trends and other information.


t.     Fair value of financial
instruments





The
financial instruments of the Company consist mainly of cash and cash
equivalents, short-term investments, current accounts receivable, accounts
payable and long-term liabilities. In view of their nature, the fair value of
the financial instruments included in working capital of the Company is usually
identical or close to their carrying amounts.




u.     Derivatives





The
Company applies the provisions of Statement of Financial Accounting Standard
(SFAS) No. 133, “Accounting for Derivative Instruments and Hedging
Activities,” as amended. The standard requires the Company to recognize all
derivatives on the balance sheet at fair value. Derivatives that are not hedges
must be adjusted to fair value through the statement of operations. If the
derivative is a hedge, depending on the nature of the hedge, changes in the fair
value of derivatives will either be offset against the change in fair value of
the hedged assets, liabilities or firm commitments through earnings, or
recognized in other comprehensive income (loss) until the hedged item is
recognized in earnings. The ineffective portion of a derivative’s change in fair
value will be immediately recognized in earnings. The Company use of derivatives
is immaterial.




v.    
Reclassification





Certain
prior years’ amounts have been reclassified in conformity with the current
year's financial statements presentation.





w.    
Recently issued accounting
standards





In July
2006, the FASB issued FASB Interpretation No. 48, “Accounting for
Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109”
(FIN 48). FIN 48 clarifies the accounting for uncertainty in income
taxes by prescribing the recognition threshold a tax position is required to
meet before being recognized in the financial statements. It also provides
guidance on derecognition, classification, interest and penalties, accounting in
interim periods, disclosure, and transition. FIN 48 is effective for fiscal
years beginning after December 15, 2006 and is required to be adopted by
the Company in 2007. The adoption of FIN 48 did not have a material impact
on the Company's consolidated results of operations and financial
condition.




In
September 2006, the FASB issued SFAS No. 157, “Fair Value
Measurements” (SFAS 157). SFAS 157 provides guidance for using fair
value to measure assets and liabilities. It also responds to investors’ requests
for expanded information about the extent to which companies’ measure assets and
liabilities at fair value, the information used to measure fair value, and the
effect of fair value measurements on earnings. SFAS 157 applies whenever
other standards required (or permit) assets or liabilities to be measured at
fairvalue, and
does not expand the use of fair value in any new circumstances. SFAS 157 is
effective for financial statements issued for fiscal years beginning after
November 15, 2007. The Company is currently evaluating the effect that the
adoption of SFAS 157 will have on its consolidated results of operations
and financial condition and is not yet in a position to determine such
effects.


F-10






In
February 2007, the FASB issued FASB No. 159, The Fair Value Option for
Financial Assets and Financial Liabilities—Including an Amendment of FASB
Statement No. 115. This standard permits an entity to choose to measure
many financial instruments and certain other items at fair value. Most of the
provisions in FASB No. 159 are elective; however, the amendment to FASB
No. 115, Accounting for Certain Investments in Debt and Equity Securities,
applies to all entities with available-for-sale and trading securities. The fair
value option established by FASB No. 159 permits all entities to choose to
measure eligible items at fair value at specified election dates. A business
entity will report unrealized gains and losses on items for which the fair value
option has been elected in earnings (or another performance indicator if the
business entity does not report earnings) at each subsequent reporting date. The
fair value option: (a) may be applied instrument by instrument, with a few
exceptions, such as investments otherwise accounted for by the equity method;
(b) is irrevocable (unless a new election date occurs); and (c) is
applied only to entire instruments and not to portions of instruments. FASB
No. 159 is effective as of the beginning of an entity’s first fiscal year
that begins after November 15, 2007. The Company does not expect the
adoption of FASB No. 159 to have a material impact on its consolidated
financial statements.





In December 2007, the FASB issued FASB 141(R), “Business
Combinations”, of which the objective is to improve the relevance,
representational faithfulness and comparability of the information that a
reporting entity provides in its financial reports about a business combination
and its effects. The new standard requires the acquiring entity in a business
combination to recognize all (and only) the assets acquired and liabilities
assumed in the transaction; establishes the acquisition-date fair value as the
measurement objective for all assets acquired and liabilities assumed; and
requires the acquirer to disclose to investors and other users all of the
information they need to evaluate and understand the nature and financial effect
of the business combination.FASB 141(R) is effective for fiscal years
beginning after December 15, 2008. The Company does not expect the adoption of
FASB No. 141(R) to have a material impact on its consolidated financial
statements.





Note 3
-Investment
in marketable securities and deposits





As
previously noted under Marketable Securities in Note 2, the Company concluded
that it was appropriate to classify investments in Auction Rate Securities as
short-term investments. Auction Rate Securities generally have long-term stated
maturities; however, these investments have characteristics similar to
short-term investments because at pre-determined intervals, generally every 7 to
90 days, there is a new auction process at which these securities are reset to
current interest rates. The Company classifies all of its short-term investments
as available-for-sale securities. As of
March 27, 2008, the Company had approximately $225,000 in auction rate
securities that had not been liquidated.The following is a summary of
our restricted cash and available-for-sale securities as of December 31, 2007
and 2008.




a. Restricted
cash and short-terminvestments




Comprised
as follows:


December 31,2007
                
                
                2006($ in
      thousands)Restricted
      cash (money market funds)*
                
                $
                481
                
                
                $
                283Auction
      rate securities
                
                
                3,675
                
                
                
                10,725Bank
      deposits
                
                
                1,727
                
                
                
                1,0595,883
                
                
                
                12,067
  b .     Restricted
cash and long-terminvestments
  Comprised
as follows:
  December 31,2007
                
                2006($ in
      thousands)Restricted  cash
      (money market funds)*
                $
                1,085
                
                $
                1,085$
                1,085
                
                $
                1,085


*
Restricted cash represents amounts held in certificates of deposit and money
market funds to support stand-by letters of credit used as security for third
party vendors.


F-11




Note
4 -Accounts
receivable, net




Accounts
receivable are stated net of an allowance for doubtful accounts of approximately
$110,000 and $25,000 at December 31, 2007 and 2006,
respectively.




Note 5
-Prepaid expenses and other
current assets




Prepaid
expenses and other current assets consist of the following:


December 31,2007
                
                2006($ in
      thousands)Government
      of Israel (VAT refund and other)
                $
                74
                
                $
                39Deposits
      with suppliers
                
                61
                
                
                60Prepaid
      expenses
                
                308
                
                
                274Other
                
                83
                
                
                71Total
      prepaid expenses and other current assets
                $
                526
                
                $
                444
  Note 6 -Other current
liabilities
 
 Other
current liabilities consist of the following:
 December 31,2007
                      
                      2006($ in
      thousands)Accrued
      expenses
                      $
                      1,176
                      
                      $
                      867Employees
      and related expenses
                      
                      427
                      
                      
                      616Other
                      
                      62
                      
                      
                      62Total
      other current liabilities
                      $
                      1,665
                      
                      $
                      1,545


F-12


Note
7 -Capital
leases - net of current portion




During
the fourth quarter of 2007the Company entered
into a number of non-cancelable capital leases from various
suppliers that amounted to approximately $225,000. The
Company entered into such capital leases to obtain equipment for its new data
site.Future minimum non-cancelable lease payments required after
December 31, 2007 are as follows:




2008
              
              $
              692009
              
              
              762010
              
              
              682011
      and
      thereafter
              
              
              -Total
      capital
      leases
              
              $
              213


Note 8 -Severance pay
obligations




deltathree
Ltd., the Company's Israeli subsidiary, is subject to certain Israeli law and
labor agreements that determine the obligations of deltathree Ltd. to make
severance payments to dismissed employees and to employees leaving the Company
under certain other circumstances. The obligation for severance pay benefits, as
determined by Israeli law, is based upon length of service and the employee's
most recent salary. This obligation is partially funded through regular deposits
made by deltathree, Ltd. into unaffiliated companies for managers' insurance
policies. Amounts funded are controlled by the fund trustees and insurance
companies and are not under the control and management of deltathree,
Ltd.
  Expenses
(income) relating to employee termination benefits were $19,942, $11,860 and
$62,368 for the years ended December 31, 2007, 2006 and 2005,
respectively.




The
aggregate value of the insurance policies as of December 31, 2007 and 2006 was
$910,452 and $920,843, respectively.




Note 9 - Commitments and
contingencies




a. Lease
commitments





The
Company leases offices in New York City for the headquarters of its United
States operation with an initial cost of approximately $731,000, increasing
annually to $815,000 during the final year of the lease. The lease extends until
July 2010 with an option to extend the lease for an additional five
years.





On
October 2003 the Company entered into a sub-lease agreement with a third party
to sub-lease approximately thirty percent of the overall the New York office
space. The annual sub-lease income in 2007 was approximately $156,000,
increasing annually to $168,000 during the final year of the lease. The
sub-lease extends until July 2010.





Rent
expense, net was $628,000, $ 650,000 and 653,202 for the years ended December
31, 2007, 2006 and 2005, respectively.





In
addition, on September 2005 the Israeli subsidiary signed an amendment to its
lease agreement that extended the lease term through December 2009 and increased
the total space in the Israel office by 250 square meters, bringing the
aggregate office space to 1,290 square meters, at an annual cost of $220,000.
According to the terms of this amendment, the Israeli subsidiary has an option
to further extend the term of the lease for an additional five years, ending in
December 2014.





Rent
expense, net was $220,000, $ 200,000 and $209,000 for the years ended December
31, 2007, 2006 and 2005, respectively




b.   Legal
proceedings
  On or
about August 30, 2007, one of our vendors commenced an action in the Southern
District of New York against us for breach of contract, copyright infringement,
breach of the duty of good faith and fair dealing and replevin relating to a
license agreement that we entered into with the vendor in 2005 to license the
vendor's software. In addition, the vendor sought a temporary
restraining order and preliminary injunction prohibiting us from using the
software during the course of the litigation. The temporary restraining order
was denied, however
we have since stopped using such vendor’s software and have begun using software
provided by a different vendor. On February 4, 2008, we filed a motion
for partial summary judgment, to which the other side submitted a
reply.  Although we denied any liability, we argued that the agreement
between us and such vendor clearly limits the amount of our total liability to
the aggregate amounts we had paid such vendor ($111,350).  Rather than
incur the costs and expenses (including attorneys’ fees) that would be required
to defend the action – which we believe would certainly be greater than $111,350
– we petitioned the court to require the vendor to accept such amount from us as
a full and final settlement of all amounts owing between the parties and, upon
our tendering such amount, to dismiss the case.  The court has not yet
ruled on this motion.  In the event that our motion is not granted, we
plan to continue to defend the action and do not anticipate that this will be a
material event in the event liability is found.


F-13




We, as
well as certain of our former officers and directors, were named as
co-defendants in a number of purported securities class actions in United States
District Court for the Southern District of New York, arising out of our initial
public offering (our “IPO”) in November 1999.  In addition, a number
of other issuers and underwriters of public offerings of such issuers (including
the underwriters of our IPO) were named as defendants in such class action suits
in connection with such public offerings. A proposed omnibus settlement between
the plaintiffs and certain issuer defendants (including us) was suspended when
the district court signed a stipulation terminating the settlement approval
process. The case is currently being litigated against a small number of focus
issuers (which does not include the Company) selected by the district court. If
the settlement does not occur, and litigation against us recommences, we believe
that we have meritorious defenses to the claims us and we intend to defend the
case vigorously.




The
Company is not a party to any other material litigation and is not aware of any
other pending or threatened litigation that could have a material adverse effect
on it or its business
taken as a whole.




c.   Other marketing and cooperation
agreements
  The
Company has entered into marketing and cooperation agreements with various other
companies that maintain sites on the Web. Pursuant to certain of these
agreements, the Company is obligated to pay commissions based on revenues
derived from such Web links.
  d.   Stand-by letters of
credit


At March
27, 2008, the company had stand-by letters of credit totaling $1.5 million,
which were issued to guarantee certain contractual obligations, and are secured
by certificates of deposit and money market funds at the Company’s banks. These
amounts are recorded in the restricted cash and investments line items on the
consolidated balance sheets.




e.   Regulation


To date,
the FCC has not imposed traditional common carrier regulation upon providers of
Internet communications services, but it has begun regulating this area on a
limited basis as outlined in this section. On February 12, 2004, the FCC
initiated a generic rulemaking proceeding concerning the provision of voice and
other services using IP technology, including assessing whether VoIP services
should be classified as information services or telecommunications services. In
November 2004, the FCC determined that VoIP services with certain
characteristics are interstate services subject to federal rather than state
jurisdiction. The FCC's determination has been appealed to a federal court of
appeals. The Company believes that some of the VoIP services that it provides
constitute information services while others are classified as “interconnected
VoIP services,” which are discussed more below. The FCC’s generic rulemaking
proceeding, however, could result in the FCC determining, for instance, that
certain types of Internet telephony should be regulated like basic
telecommunications services. Thus, Internet telephony could no longer be exempt
from access charges, which reimburse local carriers for use of their local
telephone network, telecommunications related regulatory obligations, or other
economic regulations typically imposed on traditional telecommunications
carriers.





The
imposition of access charges and other types of regulatory fees and charges or
the costs of complying with certain regulations could substantially increase the
Company’s costs of serving its customers in the U.S. The Company may have to
increase its prices to cover these costs, which could have a negative impact on
the Company’s ability to compete with other telephony providers. The Company
cannot predict what additional regulations, or the extent of such regulation, if
any, the FCC may impose. The Company also cannot predict when the FCC will issue
a final decision, the outcome of the decision, or the result of any subsequent
proceedings or actions that may arise out of the FCC’s decision. As a result,
the Company cannot assure you that some or all of its products and services will
not be more heavily regulated in the future.




On
June 3, 2005, the FCC released an order and notice of proposed rulemaking
concerning VoIP emergency 911 services. The order set forth two primary
requirements for providers of "interconnected VoIP services", meaning VoIP
services that can be used to send and receive calls to or from users on the
public switched telephone network. The order applies to the Company’s
iConnectHere customers. The Company does not believe that it is responsible for
compliance with this order in connection with the services sold to its customers
who purchase its services for the provision of services directly to end users.
Clarification of this issue has been raised by similar providers with the FCC,
however, the FCC has not addressed it to date and the Company cannot predict how
the FCC would rule on this issue. Furthermore, depending on the FCC’s ruling on
this issue, the Company cannot predict whether it would be subject to any
third-party litigation in connection with such customers who resell the
Company’s services.




First,
the order required the Company to notify its iConnectHere customers of the
differences between the emergency services available through the Company and
those available through traditional telephony providers. The Company also had to
receive affirmative acknowledgment from all of the iConnectHere customers that
they understand the nature of the emergency services available through the
service. On September 27, 2005, the FCC's Enforcement Bureau released an
order stating that the Enforcement Bureau will not pursue enforcement actions
against VoIP providers, like the Company, that have received affirmative
acknowledgement from at least 90% of their subscribers. The Company is required
to file a report with the FCC when it receives affirmative acknowledgments
from 100% of its customer base. The Company has received affirmative
acknowledgment from more than 95% of the iConnectHere customers that they
understand the nature of the emergency services available through the Company’s
service, and thus the Company believes it is substantially in compliance with
the first aspect of the FCC's June 3 order.




Second,
the order required the Company to provide enhanced emergency dialing
capabilities, or E-911, to all of the iConnectHere customers by
November 28, 2005. Under the terms of the order, the Company is required to
use the dedicated wireline E-911 network to transmit customers' 911 calls,
callback number and customer-provided location information to the emergency
authority serving the customer's specified location.


F-14




On
November 7, 2005, the FCC's Enforcement Bureau issued a Public Notice with
respect to that requirement. The Public Notice indicated that providers who have
not fully complied with the enhanced emergency dialing capabilities requirement
are not required to discontinue the provision of services to existing clients,
but that the FCC expects that such providers will discontinue marketing their
services and accepting new customers in areas in which the providers cannot
offer enhanced emergency dialing capabilities.




The
Company also has taken many significant steps to comply with the enhanced
emergency service rules, but it was unable to comply with all of the
requirements of the FCC's order by the November 28, 2005 deadline. Some of
the Company’s iConnectHere customers currently receive E-911 service in
conformity with the FCC’s order, but a number of iConnectHere customers do not
receive such service. These are customers who were receiving service prior to
the FCC’s deadline for compliance with the E-911 regulations. The FCC permitted
service providers to continue to provide service to those existing customers
rather than disconnect those customers. Pursuant to the FCC’s requirement, after
the implementation of the FCC E-911 requirements, the Company provides services
to customers only where it can provide the FCC required E-911 service. The
Company may be required to stop serving those iConnectHere customers to whom it
cannot provide the required enhanced emergency dialing capabilities that were
being serviced prior to the issuance of the FCC’s rules at any time, but this is
difficult to predict at this time.





In orders
issued in September 2005 and May 2006, the FCC also has determined that
interconnected VoIP providers must comply with the Communications Assistance for
Law Enforcement Act, or CALEA, which requires providers to assist law
enforcement agencies in conducting lawfully authorized electronic surveillance.
The FCC established a deadline of May 14, 2007 for VoIP providers to comply
with the requirements of CALEA. As a result of the steps we have taken, we
believe that we comply with the CALEA.




The FCC decided in June 2006 that interconnected VoIP service
providers should be required to contribute to the universal service fund on an
interim basis. The amount of universal service contribution for interconnected
VoIP service providers is based on a percentage of revenues earned from end user
interstate services. Additional changes to the assessment and recovery rules for
universal service may affect our financial results.





On April
2, 2007, the FCC issued an order that tightened existing rules on protection and
use of Customer Proprietary Network Information, or CPNI, and extended coverage
of the CPNI rules to interconnected VoIP service providers (such as the
Company). Although the rules are aimed in large part at preventing the practice
of pretexting (in which a caller impersonates a phone customer to gain access to
his or her phone records), the rules impose greater obligations on us and other
companies like us to protect customer calling and network information and to
file formal certifications with the FCC regarding procedures for protecting this
information. Failure to comply is subject to FCC enforcement. The new rules went
into effect on December 8, 2007. We do not expect these rules, or our ability to
comply with them, to have a material adverse effect on our operations, financial
position or results of operations.




Note 10
-Stockholders'
equity
  a.   Share capital


Following
the Company's initial public offering, effective December 1999, the
Company's stock was listed on The Nasdaq National Market System. On September
17, 2002 the listing of the Company’s common stock was transferred from The
Nasdaq National Market to The Nasdaq Capital Market. On March 28, 2008, the Company’s
common stock was delisted from The Nasdaq Capital Market and began to be listed
and traded on the OTC Bulletin Board (OTCBB).




b.   Stock
Options




In
November 1999, the Company’s Board established the 1999 Stock Incentive Plan.
Under this plan, 4,000,000 shares of Class A were reserved for issuance upon
exercise of awards to be granted. On September 23, 2004 the Board of Directors
adopted the 2004 Stock Incentive Plan and it was subsequently approved by the
stockholders at the annual meeting on November 8, 2004. This plan replaced the
1999 Stock Incentive Plan.   Under the 2004 Stock Incentive Plan, the
Compensation Committee is authorized to grant options for 759,732 shares of
common stock (which represents 4,000,000 shares of common stock reserved under
the 1999 Stock Incentive Plan less the amount of shares represented by awards
previously granted under the 1999 Stock Incentive Plan and exercised or
outstanding as of September 28, 2004), plus (b) such additional shares of common
stock as are represented by awards previously granted under the 1999 Stock
Incentive Plan which are cancelled or without delivery of shares of stock by the
Company. In addition, the Company’s compensation committee may grant both
incentive and non-incentive stock options for shares of Class A Common Stock of
the Company. The options generally have a term of seven years and become
exercisable in three equal installments commencing on the first anniversary of
the date of the grant. The purchase price per share payable upon exercise of an
option is no less than the fair market value of the share at the date of
grant.





In
November 1999, the Company adopted the 1999 Directors’ Compensation Plan. Under
this plan, 600,000 shares of Class A were reserved for issuance upon exercise of
awards to be granted to non-employee directors. On September 23, 2004 the Board
of Directors adopted the 2004 Non-employee Director Stock Option Plan and it was
subsequently approved by the stockholders at the annual meeting on November 8,
2004. This plan replaced the 1999 Director’ Plan.   Under the 2004
Non-employee Director Stock Option Plan, the Compensation Committee is
authorized to grant options for 351,216 shares of common stock (which represents
600,000 shares of common stock reserved under the 1999 Directors’ Compensation
Plan less the amount of shares represented by awards previously granted under
the 1999 Directors’ Compensation Plan and exercised or outstanding as of
September 28, 2004), plus (b) such additional shares of common stock as are
represented by awards previously granted under the 1999 Directors’ Compensation
Plan which are cancelled or without delivery of shares of stock by the Company.
The options generally have a term of seven years and become exercisable
commencing on the first anniversary of the date of the grant. The purchase price
per share payable upon exercise of an option is no less than the fair market
value of the share at the date of grant.


F-15




At the
Company’s 2005 Annual Shareholders Meeting, the shareholders approved an
amendment to the Company’s 2004 Stock Incentive Plan to increase the number of
options to purchase shares of our common stock under that plan by 2,000,000, and
also approved an amendment to the Company’s 2004 Non-Employee Director Stock
Option Plan to increase the number of options to purchase shares of our common
stock under that plan by 500,000.




As of
December 31, 2007, options to purchase 1,560,020shares of Class A Common Stock were exercisable and outstanding with
exercise prices ranging between $1.02 and $10.25
per share.




A summary
of the status of the Company’s stock option plans as of December 31, 2007, 2006
and 2005 and changes during the years then ended, is presented
below:




December 31, 2007
                
                December 31, 2006
                
                December 31, 2005Number of
                  Options
                
                Weighted
                  average
                  Exercise price
                
                Number of
                  Options
                
                Weighted
                  average
                  Exercise price
                
                Number of
                  Options
                
                Weighted
                  average
                  Exercise priceOptions
      outstanding at beginning of year
                
                2,330,835
                
                $
                2.06
                
                
                2,762,686
                
                $
                2.58
                
                
                3,066,939
                
                $
                2.50Granted
      during the year
                
                -
                
                
                -
                
                
                105,000
                
                
                3.17
                
                
                120,000
                
                
                3.06Exercised
      during the year
                
                35,000
                
                
                0.89
                
                
                68,982
                
                
                1.04
                
                
                352,253
                
                
                1.10Forfeited
      during the year
                
                735,815
                
                
                1.02
                
                
                467,869
                
                
                5.53
                
                
                72,000
                
                
                6.72Outstanding
      at end of year
                
                1,560,020
                
                
                1.91
                
                
                2,330,835
                
                
                2.06
                
                
                2,762,686
                
                $
                2.58Weighted
      average fair value of options granted during the year
                $
                0.00-
                
                
                
                
                $
                3.17
                
                
                
                
                $
                3.06


F-16




Additional
information regarding options outstanding as of December 31, 2007 is as
follows:




Options
      Outstanding
                
                
                Options
      ExercisableRange
      of
                  Exercise Prices
                
                
                Number
      of
                  Outstanding
                
                
                Weightedaverage
                  Remaining
                  Contractual
                  Life (Years)
                
                
                Weighted
                  Average
                  Exercise Price
                
                
                Number
      of
                  Exercisable
      Options
                
                
                Weighted
                  Average
                  Exercise Price$
                0.74 – $1.02
                
                
                
                363,266
                
                
                
                1.1
                
                
                
                1.01
                
                
                
                363,266
                
                
                
                1.01$
                1.13 – $1.38
                
                
                
                510,458
                
                
                
                1.2
                
                
                
                1.23
                
                
                
                510,458
                
                
                
                1.23$
                1.75 – $2.15
                
                
                
                161,348
                
                
                
                2.9
                
                
                
                1.81
                
                
                
                161,348
                
                
                
                1.81$
                2.85 – $3.20
                
                
                
                514,348
                
                
                
                5.7
                
                
                
                2.95
                
                
                
                481,015
                
                
                
                2.95$
                10.25
      – $15.00
                
                
                
                10,600
                
                
                
                1.3
                
                
                
                10.25
                
                
                
                10,600
                
                
                
                10.251,560,020
                
                
                
                3.8
                
                
                $
                1.91
                
                
                
                1,526,687
                
                
                $
                1.88


c.   Restricted shares of the Company’s
Common Stock





During
the year ended December 31, 2007, the Company granted restricted shares of the
Company’s common stock to retain, reward, and motivate those employees who
are deemed critical to the future success of the Company. The restricted shares
of common stock were granted pursuant to the Company’s 2004 Stock Incentive
Plan, which was approved by the Board of Directors and stockholders of the
Company.  The
restricted shares are subject to certain forfeiture provisions, and therefore
are restricted as to transferability until such forfeiture restrictions have
lapsed. The restrictions relate to continued service with the Company. The
vesting period for such restricted shares of common stock is typically three
years. The intrinsic value of the restricted shares of common stock issued to
employees of the Company is amortized as of the date of grant to compensation
expense over the vesting period of such grant.




During  2007,
the Company recognized approximately $154,775 of compensation expense related to
the amortization of the restricted shares of common stock. During 2007, the
Company granted a total of 15,000 restricted shares of common stock to its
employees.




d.   Non-employee restricted stock
plan


On July
5, 2006, the Board approved the 2006 Non-Employee Director Stock Plan (“2006
Stock Plan”) and it was subsequently approved by the stockholders at the annual
meeting on September 8, 2006. The 2006 Stock Plan provides for the automatic
grant of restricted stock. With the adoption of this plan, the 2004 Non-employee
Stock Option Plan was terminated except with respect to outstanding options
previously granted thereunder. The 2006 Stock Plan permits only the grant of
restricted shares to purchase shares of our common stock. The aggregate number
of shares of restricted stock that may be issued under the 2006 Stock Plan shall
be 500,000 shares, which represents the number of additional shares underlying
potential option grants that were available under the 2004 Non-Employee
Option Plan approved for issuance by our stockholders at our 2004 annual
stockholders’ meeting. A grant of restricted stock under the 2006 Stock Plan is
a grant of shares of the common stock that, at the time of issuance, are subject
to certain forfeiture provisions, and thus are restricted as to transferability
until such forfeiture restrictions have lapsed. The restrictions on the
restricted stock issued pursuant to the Plan relate to continued service on the
Company’s board of directors (lapsing on a monthly basis). If the Company
reacquires (at not more than its original issuance price) any shares of
restricted stock or if any shares of restricted stock are forfeited, or
otherwise cancelled or terminated, such shares which were subject to such
restricted stock award shall again be available for issuance from time to time
pursuant to the 2006 Stock Plan. At December 31, 2007, no shares of restricted
stock were awarded to non-employee directors under the plan.


F-17




Note 11
-Research
and development expenses




Research
and development expenses consist of the following:
 Year
      ended December 31,($ in
      thousands)2007
                
                2006
                
                
                2005Salaries
      and related expenses
                $
                3,498
                
                $
                2,370
                
                
                $
                2,331Consulting
      and advisory fees
                
                235
                
                
                297
                
                
                
                101Travel
                
                104
                
                
                816
                
                
                
                104Other
                
                832
                
                
                560
                
                
                
                692Total
      research and development expenses
                $
                4,669
                
                $
                4,043
                
                
                $
                3,228


Note 12
-Income
taxes




a. Provision
for income taxes




No
provision for income taxes was required for the years ended December 31, 2007,
2006 and 2005 due to net losses in these periods.




b.   Tax loss
carryforwards




As of
December 31, 2007, the Company had net operating loss carryforwards generated in
the U.S. and Israel of approximately $67,910,000 -and $6,376,000, respectively.
The Company's U.S. net operating loss carryforwards will expire at various dates
between 2012 and 2025 if not utilized. In addition, a portion of those net
operating loss carryforwards could be subject to limitation due to changes in
ownership of the Company. The Company's net operating losses generated in Israel
may be carried forward indefinitely. The Israeli subsidiary received final tax
assessments through the tax year ended December 31, 1999.


F-18


c.
  In
accordance with SFAS No. 109, the components of deferred income taxes are as
follows:
  December 31,2007
                  
                  2006($ in
      thousands)Net
      operating losses carryforwards
                  $
                  26,042
                  
                  $
                  20,822Less
      valuation allowance
                  
                  (26,042
                  )
                  
                  (20,822
                  )Net
      deferred tax assets
                  $
                  —
                  
                  $
                  —
 As of
December 31, 2007, and 2006, a valuation allowance of $26,042,000 and
$20,822,000, respectively, is provided as the realization of the deferred tax
assets are not assured.




Year ended December 31,2007
                
                2006
                
                2005(US$ in
      thousands)Domestic
                $
                (9,497
                )
                $
                250
                
                $
                (782
                )Foreign
                
                309
                
                
                257
                
                
                (28
                )Total
                $
                (9188
                )
                $
                507
                
                $
                (810
                )


Note 13
-Segment
reporting, geographical information and major customers




The
Company operates in one business segment, IP Telephony services, and makes
business decisions and allocates resources accordingly.




The
following table summarizes the Company’s revenues and long-lived assets by
country. Revenue is attributed to geographic region based on the location of the
customers. Long-lived assets are attributed to geographic region based on the
country in which the assets are located.


F-19
 Year ended December 31,2007
                
                2006
                
                2005($ in
      thousands)Revenues:United
      States
                $
                12,677
                
                $
                16,855
                
                $
                9,573Europe
                
                5,682
                
                
                2,758
                
                
                1,378South
      America
                
                3,949
                
                
                6,703
                
                
                3,603Far
      East
                
                2,559
                
                
                5,092
                
                
                5,009Middle
      East
                
                3,744
                
                
                5,238
                
                
                8,551Other
                
                866
                
                
                1,307
                
                
                1,600Total
      revenues
                $
                29,477
                
                $
                37,953
                
                $
                29,714Revenues
      from  major customers exceeding 10% of revenues:Master
      Reseller – A
                
                --
                %
                
                --
                %
                
                --
                %
  December 31,2007
                    
                    
                    2006($ in
      thousands)Long-lived
      assets:United
      States
                    2,363
                    
                    
                    
                    3,068Israel
                    385
                    
                    
                    
                    297Europe
                    68
                    
                    
                    
                    93Other
                    66
                    
                    
                    
                    -Total
      long-lived assets
                    2,882
                    
                    
                    
                    3,458
 F-20


SelectedQuarterly
      Financial Information (Unaudited)Three Months Ended,March 31
                
                
                June 30
                
                
                September 30
                
                
                December 31($ in
      thousands, except per share data)2007Total
      revenues
                
                $
                8,312
                
                
                $
                7,602
                
                
                $
                7,260
                
                
                $
                6,303Costs
      and operating expenses:Cost
      of revenues
                
                
                5,276
                
                
                
                5,551
                
                
                
                5,284
                
                
                
                4,996Research
      and development expenses
                
                
                1,136
                
                
                
                1,107
                
                
                
                1,154
                
                
                
                1,273Selling
      and marketing expenses
                
                
                1,227
                
                
                
                1,318
                
                
                
                1,267
                
                
                
                1,256General
      and administrative expenses
                
                
                612
                
                
                
                649
                
                
                
                902
                
                
                
                789Write
      down of intangible asset
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                2,680Depreciation
      and amortization
                
                
                568
                
                
                
                774
                
                
                
                783
                
                
                
                519Total
      costs and operating expenses
                
                
                8,819
                
                
                
                9,399
                
                
                
                9,390
                
                
                
                11,513Loss
      from operations
                
                
                (507
                )
                
                
                (1,797
                )
                
                
                (2,130
                )
                
                
                (5,210
                )Other
      non operating income
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                13Interest
      income, net
                
                
                120
                
                
                
                175
                
                
                
                97
                
                
                
                50Profit
      (Loss) before income taxes
                
                
                (387
                )
                
                
                (1,622
                )
                
                
                (2,033
                )
                
                
                (5,147
                )Income
      taxes
                
                
                10
                
                
                
                17
                
                
                
                91
                
                
                
                8Net
      Profit (loss)
                
                $
                (397
                )
                
                $
                (1,639
                )
                
                $
                (2,124
                )
                
                $
                (5,155
                )Net
      loss per share - basic and diluted
                
                $
                (0.01
                )
                
                $
                (0.05
                )
                
                $
                (0.06
                )
                
                $
                (0.16
                )Basic
      weighted average number of shares outstanding
                
                
                31,288,130
                
                
                
                32,781,545
                
                
                
                32,795,045
                
                
                
                32,843,752Diluted
      weighted average number of shares outstanding
                
                
                31,288,130
                
                
                
                32,781,545
                
                
                
                32,795,045
                
                
                
                32,843,7522006Total
      revenues
                
                $
                10,749
                
                
                $
                9,966
                
                
                $
                8,537
                
                
                $
                8,701Costs
      and operating expenses:Cost
      of revenues
                
                
                7,194
                
                
                
                6,166
                
                
                
                5,331
                
                
                
                5,684Research
      and development expenses
                
                
                1,080
                
                
                
                1,044
                
                
                
                961
                
                
                
                958Selling
      and marketing expenses
                
                
                1,202
                
                
                
                1,271
                
                
                
                1,276
                
                
                
                1,207General
      and administrative expenses
                
                
                932
                
                
                
                732
                
                
                
                693
                
                
                
                731Depreciation
      and amortization
                
                
                371
                
                
                
                379
                
                
                
                389
                
                
                
                404Total
      costs and operating expenses
                
                
                10,779
                
                
                
                9,592
                
                
                
                8,650
                
                
                
                8,984Loss
      from operations
                
                
                (30
                )
                
                
                374
                
                
                
                (113
                )
                
                
                (283
                )Interest
      income, net
                
                
                129
                
                
                
                148
                
                
                
                162
                
                
                
                181Profit
      (Loss) before income taxes
                
                
                99
                
                
                
                522
                
                
                
                49
                
                
                
                (102
                )Income
      taxes
                
                
                11
                
                
                
                26
                
                
                
                19
                
                
                
                5Net
      loss
                
                $
                88
                
                
                $
                496
                
                
                $
                30
                
                
                $
                (107
                )Net
      loss per share - basic and diluted
                
                $
                (0.00
                )
                
                $
                0.02
                
                
                
                0.00
                
                
                $
                (0.00
                )Basic
      weighted average number of shares outstanding
                
                
                29,741,307
                
                
                
                29,745,897
                
                
                
                29,788,403
                
                
                
                29,807,755Diluted
      weighted average number of shares outstanding
                
                
                30,673,141
                
                
                
                30,604,982
                
                
                
                29,907,650
                
                
                
                29,807,755
 F-21


SIGNATURES




Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this Annual Report on Form 10-K to be
signed on its behalf by the undersigned, thereunto duly authorized, in New York,
New York on March 31, 2008.




DELTATHREE,
      INC.By:
            /s/Shimmy
      ZimelsShimmy
      Zimels
              Chief
      Executive Officer and President
              (Principal
      Executive Officer, Principal Financial Officer and Principal Accounting
      Officer)




KNOW ALL
MEN BY THESE PRESENTS, that each person whose signature appears below
constitutes and appoints Shimmy Zimels his true and lawful attorney-in-fact,
acting alone, with full power of substitution, for and in the name, place and
stead of the undersigned, in any and all capacities to sign any and all
amendments to this Annual Report, and to file the same, with all exhibits
thereto, and other documents in connection therewith, with the Securities and
Exchange Commission, and hereby grants to such attorney-in-fact and agents full
power and authority to do and perform each and every act and thing requisite and
necessary to be done, as fully to all intents and purposes as the undersigned
might or could do in person, hereby ratifying and confirming all that said
attorney-in-fact and agent or his substitutes, may lawfully do or cause to be
done by virtue thereof.





Pursuant
to the requirements of the Securities Exchange Act of 1934, this Annual Report
has been signed by the following persons in the capacities and on the dates
indicated:





Signature
            
            Title
            
            Date/s/Shimmy Zimels
            
            Chief
      Executive Officer, President and
      Director(Principal
      Executive Officer, Principal Financial
      Officer and Principal Accounting
      Officer)
            
            March
      31, 2008/s/Noam Bardin
            
            Director
            
            March
      31, 2008/s/Ilan Biran
            
            Director
            
            March
      31, 2008/s/Benjamin Broder
            
            Director
            
            March
      31, 2008/s/Lior Samuelson
            
            Chairman
      of the Board of Directors
            
            March
      31, 2008




52




EXHIBIT
INDEX





The
following documents are filed as exhibits to this report on Form 10-K or
incorporated by reference to exhibits previously filed with the Securities and
Exchange Commission.




Exhibit
              Number
            
            Description2.1
            
            Asset
      Transfer Agreement dated February 17, 2007 by and between deltathree, Inc.
      and Go2Call.com, Inc. (Incorporated by reference to Exhibit 2.1 of our
      Current Report on Form 8-K, filed on February 20,
2007).3.1.1
            
            Form
      of Restated Certificate of Incorporation of deltathree, Inc. (Incorporated
      by reference from our registration statement on Form S-1
      (Registration No. 333-122242)).3.1.2
            
            Form
      of Amendment to Restated Certificate of Incorporation of deltathree, Inc.
      (Incorporated by reference to our Annual Report on Form 10-K/A, filed
      on April 30, 2001).3.2
            
            Form
      of Amended and Restated By-laws of deltathree, Inc. (Incorporated by
      reference from our registration statement on Form S-1 (Registration
      No. 333-122242)).4.1
            
            Specimen
      Certificate of Class A Common Stock (Incorporated by reference from our
      registration statement on Form S-1 (Registration
      No. 333-122242)).4.2
            
            Specimen
      Certificate of Class B Common Stock (Incorporated by reference from our
      registration statement on Form S-1 (Registration
      No. 333-122242)).10.1
            
            Form
      of deltathree, Inc. 1999 Stock Incentive Plan (Incorporated by reference
      from our registration statement on Form S-1 (Registration
      No. 333-122242)).+10.2
            
            Form
      of deltathree, Inc. 1999 Employee Stock Purchase Plan (Incorporated by
      reference from our registration statement on Form S-1 (Registration
      No. 333-122242)).10.3
            
            Form
      of deltathree, Inc. 1999 Performance Incentive Plan (Incorporated by
      reference from our registration statement on Form S-1 (Registration
      No. 333-122242)).+10.4
            
            Form
      of deltathree, Inc. 1999 Directors' Plan (Incorporated by reference from
      our registration statement on Form S-1 (Registration
      No. 333-122242)).+10.5
            
            Employment
      Agreement, effective as of April 26, 2004, between Shimmy Zimels and
      deltathree, Inc. (Incorporated by reference to our annual report on
      Form 10-K/A, filed on April 29, 2004).+10.6
            
            2004
      Stock Incentive Plan (Incorporated by reference to our registration
      statement on Form S-8 (Registration
      No. 333-86503)).+10.7
            
            2004
      Non-Employee Director Stock Option Plan (Incorporated by reference to our
      registration statement on Form S-8 (Registration
      No. 333-86503)).+10.8
            
            Form
      of Option Agreement Pursuant to 2004 Stock Incentive Plan (Incorporated by
      reference to our Annual Report on Form 10-K, filed on March 31,
      2005).+10.9
            
            Form
      of Option Agreement Pursuant to 2004 Non-Employee Director Stock Option
      Plan (Incorporated by reference to our Annual Report on Form 10-K, filed
      on March 31, 2005).+10.10
            
            Executive
      and Director Compensation Arrangements (Incorporated by reference to our
      Annual Report on Form 10-K, filed on March 31, 2005).+10.11
            
            First
      Amendment to the deltathree, Inc. 2004 Stock Incentive Plan, dated as of
      December 20, 2005 (Incorporated by reference to Exhibit 10.1 to our
      Current Report on Form 8-K, filed on December 21,
  2005).+10.12
            
            First
      Amendment to the deltathree, Inc. 2004 Non-Employee Director Stock Option
      Plan, dated as of December 20, 2005 (Incorporated by reference to Exhibit
      10.2 of our Current Report on Form 8-K, filed on December 21,
      2005).+10.13
            
            Registration
      Rights Agreement dated February 19, 2007 by and between deltathree, Inc.
      and Go2Call.com, Inc. (Incorporated by reference to Exhibit 2.1 of our
      Current Report on Form 8-K, filed on February 20,
2007).10.14
            
            deltathree,
      Inc. Amended and Restated 1999 Performance Incentive Plan (Incorporated by
      reference to Exhibit 10.1 of our Current Report on Form 8-K, filed on July
      11, 2006).+10.15
            
            Deltathree,
      Inc. 2006 Non-Employee Director Stock Plan (Incorporated by reference to
      Exhibit 10.1 of our Current Report on Form 8-K, filed on September 8,
      2006).+10.16*
            
            Form
      of Restricted Unit Agreement Pursuant to 2004 Stock Incentive
      Plan.+10.17
            
            Employment
      Agreement, dated as of February 1, 2008, between Lior Samuelson and
      deltathree, Inc. (Incorporated by reference to our Current Report on
      Form 8-K, filed on February 4, 2008).+14.1
            
            deltathree,
      Inc. Corporate Code of Conduct and Ethics (Incorporated by reference to
      our annual report on Form 10-K, filed on March 30,
    2004).21.1*
            
            Subsidiaries
      of deltathree, Inc.23.1*
            
            Consent
      of Brightman Almagor & Co.31.1*
            
            Certification
      of the Chief Executive Officer, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.31.2*
            
            Certification
      of the Chief Financial Officer, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.32*
            
            Certifications
      of the Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.





*  
Filed herewith.




+  
Management contract or compensatory plan.


53