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
the Fiscal Year Ended December 31, 2008, 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 of incorporation or organization)
                (I.R.S.
      employer identification no.)419
      Lafayette Street, Second Floor
                  New York, New York
                10003(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:None.





Securities registered pursuant to
Section 12(g) 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





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 oNon-accelerated
      filer   o
                    (Do
      not check if a smaller reporting company)
                  Smaller
      reporting company 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 bidof the Class A Common
Stock as reported by the OTC Bulletin Board on June 30, 2008 (the last business
day of the Registrant’s most recently completed second fiscal quarter) was
$3,288,254. 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
April 6, 2009, the Registrant had outstanding 71,932,405 shares of Class A
Common Stock, par value $0.001 per share.




Documents
incorporated by reference: None




Table of Contents




DELTATHREE, INC.


2008
ANNUAL REPORT ON FORM 10-K





TABLE OF
CONTENTS




PagePART
      IITEM
      1.
                    Business
                    3ITEM
      1A.
                    Risk
      Factors
                    12ITEM
      2.
                    Properties
                    19ITEM
      3.
                    Legal
      Proceedings
                    19ITEM
      4.
                    Submission of
      Matters to a Vote of Security Holders
                    19PART
      IIITEM
      5.
                    Market for
      Registrant's Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
                    20ITEM
      6.
                    Selected Financial
      Data
                    21ITEM
      7.
                    Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                    22ITEM
      8.
                    Financial Statements
      and Supplementary Data
                    30ITEM
      9.
                    Changes in and
      Disagreements with Accountants on Accounting and Financial
      Disclosure
                    30ITEM
      9A(T).
                    Controls and
      Procedures
                    30ITEM
      9B.
                    Other
      Information
                    30PART
      IIIITEM
      10.
                    Directors,
      Executive Officers and Corporate Governance
                    31ITEM
      11.
                    Executive
      Compensation
                    34ITEM
      12.
                    Security Ownership
      of Certain Beneficial Owners and Management and Related Stockholder
      Matters
                    37ITEM
      13.
                    Certain
      Relationships and Related Transactions, and Director
      Independence
                    38ITEM
      14.
                    Principal
      Accounting Fees and Services
                    39PART
      IVITEM
      15.
                    Exhibits, Financial Statement
      Schedules
                    40Signatures
                    41Index to
      Consolidated Financial Statements
                    F-1







Table of Contents




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 “Item 1A. Risk Factors” in this Annual Report 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 31
of the calendar year indicated. Unless the context requires otherwise,
references to “we,” “us,” “our,” “the Company,” and “deltathree” refer to
deltathree, Inc. and its subsidiaries, collectively.





ITEM1.  
BUSINESS





Company
Overview





We are a
well-known 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, or
VoIP telephony.  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 a
well-known provider of next generation communication services.





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 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 (in which no brand name is indicated and
different customers can offer the same product), 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 joip
offering (which serves as the exclusive VoIP service provider embedded in the
Globarange cordless phones of Panasonic Communications).





We have
built a privately-managed, state-of-the-art global telecommunications platform
using IP technology and offer our customers a suite of IP telephony products,
including PC-to-Phone and Broadband Phone products. We provide a robust set of
value-added services and features that enable us to 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, in 2007we 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.





In 2004,
we announced our first major service provider contract with Verizon
Communications to provide the Verizon VoiceWing VoIP service.  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 Starpower
Internet Phone Service.  On January 15, 2009, we received notice from
Verizon that no later than May 15, 2009, our service provider contract with
Verizon would be terminated pursuant to the terms of the
agreement.  Verizon is not required to pay us any termination
penalties or fees in connection with its termination of the agreement, and
following the termination date we will not receive any more revenue as a result
of this agreement.  In addition, on February 5, 2009, we entered into
a Termination, Settlement Agreement and Mutual Release with RCN, pursuant to
which the service agreement between us and RCN was terminated and RCN
transferred to us some of the subscribers to the VoIP service we had been
providing to RCN under the agreement. In addition, RCN paid us a termination fee
of $230,000.





As a
complement to the initiatives we have taken to attempt to organically expand our
businesses, we have also evaluated opportunities for growth through acquisitions
and strategic relationships. 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. However, in 2008 we
wrote-off approximately $2.0 million in goodwill and approximately $1.6 million
in intangible assets acquired in the Go2Call transaction. Through our joip
offering we attempted to expand into other product and geographic consumer
markets, but in 2008 we recognized only $119,000in revenues from our
service agreement with Panasonic and we do not expect that this will be a
significant source of revenue in the future. In addition, as discussed below
under “ - Transaction with D4 Holdings”, on February 12, 2009, we consummated a
transaction with D4 Holdings LLC, or D4 Holdings, a Delaware limited liability
company, pursuant to which, among other things, D4 Holdings acquired (i)
39,000,000 shares of our common stock, representing approximately 54.3% of the
total number of issued and outstanding shares of common stock following the
transaction and (ii) a warrant, exercisable for ten years, to purchase up to an
additional 30,000,000 shares of our common stock at an exercise price of $0.04
per share.  D4 Holdings is a private investment fund whose ownership
includes owners of ACN, Inc., or ACN, a direct seller of telecommunications
services.  As a result of the investment in our company by D4
Holdings, we expect to seek opportunities to provide services to ACN and enter
into other commercial transactions that give us access to ACN’s international
marketing and distribution capabilities.


3
 Table of Contents




We have
sustained significant operating losses in recent periods, which has led to a
significant reduction in our cash reserves.  As a result, in 2008 we
effected a restructuring that helped us reduce our operating costs significantly
and better align our operations with our current business model.  As
part of this restructuring, we initiated a series of reductions in force,
which  resulted in a decrease in the number of our employees from 148
as of December 31, 2007, to 43 as of December 31, 2008, as discussed below in “
– Employees”.  In addition, as discussed below in “ - Properties”, we
subleased our principal executive offices, following which we entered into an
agreement with the landlord pursuant to which we paid a termination fee equal to
$450,000, our lease agreement for the offices was terminated, and the landlord
returned to us the letter of credit in the approximate amount of $1.0 million we
had provided to secure our obligations under the lease.  We also
secured the release of letters of credit we had previously provided to
other suppliers.  From an operational standpoint, we shifted the focus
of our efforts and resources away from our service provider and consumer
divisions towards our reseller business.  Within the reseller business
itself we made a decision to focus on servicing fewer, larger resellers rather
than more, smaller resellers.  Finally, we began seeking additional
financing, which culminated in the transaction with D4 Holdings described below
in “ – Transaction with D4 Holdings”.


Going
forward, we expect to:





·
            continue
      to devote significant resources to develop and expand our reseller base,
      as we expect our revenue from this key channel will represent a
      significant percentage of our total revenue in the foreseeable
      future;·
            actively
      market our products and services to licensed VoIP operators and corporate
      enterprises, specifically small and medium-sized business;
    and·
            pursue
      a targeted strategy of identifying and evaluating appropriate strategic
      collaborations, such as potentially engaging in commercial transactions
      with ACN, that we hope will continue to expand and diversify our customer
      base.





Transaction
with D4 Holdings





On
February 10, 2009, we entered into a Securities Purchase Agreement with D4
Holdings pursuant to which we issued to D4 Holdings (i) 39,000,000 shares of our
common stock, representing approximately 54.3% of the total number of issued and
outstanding shares of common stock following the transaction, for an aggregate
purchase price of $1,170,000, paid in cash, and (ii) a warrant, exercisable for
ten years, to purchase up to an additional 30,000,000 shares of our common stock
at an exercise price of $0.04 per share. The transaction closed on February 12,
2009.





Upon the
closing of the transaction and pursuant to the terms of the Purchase Agreement,
Noam Bardin resigned as a director and the board of directors appointed Robert
Stevanovski and Anthony Cassara to serve on the board.  In addition,
Lior Samuelson resigned as Chairman of the Board and remained a director, and
Robert Stevanovski was appointed to serve as Chairman.  Following the
closing of the transaction, our Board of Directors appointed three additional
directors to serve on the Board. The appointments of the three new directors
became effective on March 28, 2009.





In
connection with the transaction, the parties also entered into an Investor
Rights Agreement, pursuant to which we have agreed to file, upon the request of
D4 Holdings, a registration statement covering the resale of any shares of our
common stock held by D4 Holdings (including the shares of common stock
underlying the warrant issued to D4 Holdings). Subject to our ability to suspend
the effectiveness of the registration statement for a limited period of time
under certain circumstances, we are required to maintain the effectiveness of
any such registration statement until the earlier of (i) the date on which all
shares of common stock covered by the registration statement have been sold
thereunder or (ii) the date on which all such shares of common stock can be sold
without registration pursuant to Rule 144 or another similar exemption under the
Securities Act of 1933.  Subject to certain limitations, D4 Holdings
will also be entitled to “piggy-back” registration rights on all future
registrations by and any registrations initiated by our other
stockholders.





Industry
Background





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.





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.





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.  As
broadband connectivity has become more available and less expensive around the
world, it is now possible for providers like us to offer voice as well as video
services to businesses and residential consumers.





4
 Table of Contents




Our
Products and Services




Products





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





Broadband Phone. Our
Broadband Phone product is a phone replacement solution available to business
and consumer customers over the "last mile" through broadband connections via
cable modem, DSL or fixed wireless. 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.




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.





Services





We
provide a robust set of value-added services that enables us to 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; 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.





The
provision of VoIP telephony products and services through our service provider
and reseller sales channel accounted for 84.7% of our total revenues in 2008,
while the provision of VoIP telephony through our direct-to-consumer channel
accounted for 13.8% of our total revenues in 2008.





Our
Distribution Channels





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





Service
Provider and Reseller Channel





We have
developed 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.





Our
Hosted Consumer VoIP Solution leverages our VoIP experience and delivers to our
service providers, resellers, and various corporate customers a customizable,
private-label suite of VoIP products and services. Using our infrastructure, we
enable these enterprises to offer their customers different combinations of our
basic products and services, accessible through a single account.




Direct-to-Consumer
Channel





Our
direct-to-consumer channel includes our iConnectHere offering, which provides
VoIP products and services directly to consumers and small businesses online,
and our joip offering, which serves as the exclusive VoIP service provider
embedded in the Globarange cordless phones of Panasonic.




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 Broadband Phone and PC-to-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 Broadband Phone and
      PC-to-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.






5
 Table of Contents





joip. In
connection with our strategic cooperation with Panasonic, Panasonic and we have
created, developed and are offering joip-enabled Panasonic Globarange
telephones. Our joip offering is the exclusive VoIP service embedded in these
hybrid two-line cordless phones, which provide both landline and VoIP
services.





Our Strategy





Our
strategy is to become a leading worldwide provider of VoIP telephony products
and services. 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
markets.  We plan to focus our efforts and resources on growing our
reseller business while simultaneously seeking out selective opportunities for
our service provider unit.





Target Small to
Medium-sized Businesses.We intend to leverage our experience in the deployment of sophisticated
VoIP solutions to target small to medium-sized business in the U.S. and
worldwide. We believe that such entities may want to utilize a VoIP solution but
may not have the significant technical and financial resources (such as the
personnel to support network operations, engineering, support and project
management) required to develop an internal VoIP telephony solution. We believe
that our service will reduce their costs and risks associated with developing
and maintaining an in-house VoIP service.





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 desired 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.




Strategic
Relationships. In addition
to our strategy and actions to grow organically as described above, we also
actively evaluate and pursue appropriate strategic relationships that we believe
will continue to expand our customer base and grow our revenues. As discussed
above under “ - Transaction with D4 Holdings”, we recently consummated a
transaction with D4 Holdings pursuant to which we sold 39,000,000 shares of our
common stock and a warrant to purchase up to an additional 30,000,000 shares of
our common stock.  D4 Holdings is a private investment fund whose
ownership includes owners of ACN, a direct seller of telecommunications
services.  As a result of the investment in our company by D4
Holdings, we expect to seek opportunities to provide services to ACN and enter
into other commercial transactions that give us access to ACN’s international
marketing and distribution capabilities  Sales
and Marketing





We sell
and market our products and services through our service provider and reseller
channel and our direct-to-consumer channel. In general, our sales and marketing
activities include:




·
                  developing,
      deploying and supporting local-specific product features and services,
      such as multiple language capabilities, different currency capabilities,
      and various payment methods;·
                  engaging
      in strategic relationships with customers (including licensed providers);
      and·
                  using
      various on-line advertising and search strategies to target and optimize
      sales efforts.




6
 Table of Contents




Service
Provider and Reseller Channel





Service Provider Sales.  Our
experience in deploying sophisticated solutions provides us with leverage as we
introduce these services to other service providers.





Reseller Program.Through our
reseller program, we contract with smaller service providers and resellers
around the world, which in turn sell our products and services under their own
brand, a white-label brand 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.





Direct-to-Consumer
Channel





iConnectHere.  iConnectHere
provides VoIP products and services directly to consumers and small businesses
online. Through iConnectHere, an account holder can access all of our product
offerings, including Broadband Phone and PC-to-Phone.


joip. We
launched our joip service and Globarange offering with Panasonic in August
2007.  The Globarange phone is currently available in different
international locations.





Our
Infrastructure





Network





In order
to deliver our VoIP products and services, we operate a privately-managed IP
telephony network. By managing our own 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 all of our offerings.In recent years, we have
continued our pioneering efforts in SIP and these efforts have yielded
significant new releases. For example, in 2007 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.





Our
network is built around a high availability backbone that connects New Jersey,
Atlanta, London and Frankfurt. 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 a high level of
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.





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.





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


We are a
party to service agreements with several telecommunications providers, including
competitive local exchange carriers, foreign telephone 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.





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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 that identifies
the malfunction so that proper measures can be taken to restore service in a
timely fashion. Our NOC utilizes a combination of 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 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 users. Customers of iConnectHere and joip 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 public
switched telephone network, or 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 material 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”, “deltathree making VoIP work for you”, “the IP Communications
Network”, “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”. 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.




To
further safeguard our intellectual property, we have a policy that requires our
employees and contractors to execute confidentiality and assignment of
inventions 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. In addition, several foreign governments have
adopted or proposed regulations that could restrict or prohibit the provision of
VoIP 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. In
addition, to the extent we become required to contribute to regulatory funds and
collect and remit regulatory fees, taxes and surcharges this will increases our
costs, which may result in either our increasing the retail price of our service
offerings or reducing our profitability.





Federal
Regulation





Regulatory
Classification of VoIP Services




Although
there are several regulatory proceedings currently pending before federal
authorities, VoIP telephony is lightly regulated compared to more traditional
telecommunications services. 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. The rulemaking is ongoing
and we cannot predict the outcome of this proceeding. In November 2004, the FCC
determined that certain interconnected VoIP services (meaning VoIP services that
can be used to send and receive calls to or from the PSTN), including some
services that are similar to ours, should be considered interstate services
subject to federal rather than state jurisdiction.  Although this
ruling was appealed by several states, on March 21, 2007, the United States
Court of Appeals for the Eighth Circuit affirmed the FCC’s
determination.





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The FCC’s
generic rulemaking proceeding could result in the FCC determining, for instance,
that certain types of Internet telephony should be regulated like basic
telecommunications services. Thus, Internet telephony would no longer be exempt
from more onerous telecommunications-related regulatory obligations, or other
economic regulations typically imposed on traditional telecommunications
carriers.





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. The order applies to
our iConnectHere and joip customers, or our “consumer 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. 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 consumer 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 consumer 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
interconnected VoIP providers, like us, that have received affirmative
acknowledgement from at least 90% of their subscribers. We received affirmative
acknowledgment from more than 95% of our customers that they understand the
nature of the emergency services available through our service, and thus we
believe we are substantially in compliance with the first aspect of the FCC's
June 3 order.




Second,
the order required us to provide enhanced emergency dialing capabilities, or
E-911, to all of our consumer 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.




Almost
all of our consumer customers currently receive E-911 service in conformity with
the FCC’s order, but (as is the case with customers for other interconnected
VoIP providers) some customers who were receiving service prior to the FCC’s
deadline for compliance with the E-911 regulations may not receive such service.
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 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.





The FCC
is considering enhancing its VoIP E-911 rules.  In June, 2007, the FCC
released a Notice of Proposed Rulemaking to consider whether it should impose
additional obligations on interconnected VoIP
providers.  Specifically, the FCC included a proposal that
interconnected VoIP providers be required to automatically determine the
location of their customers for purposes of E-911 rather than require customers
to update their existing location (as is the case under the current
regulations).  Moreover, the Notice included a tentative conclusion
that interconnected VoIP providers that allow their service to be used in more
than one location, like us, be required to meet the same customer location
accuracy standards applicable to providers of mobile telecommunications
services.  We cannot predict the outcome of this proceeding or its
potential impact on our business.





See
“ - State and Local Regulation” below for a discussion of fees we may collect in
the future in connection with providing E-911.





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. 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. As
a result of the steps we have taken, we believe that we comply with the
CALEA.




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. 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) a
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
FCC suggested that its preemption of state regulation of such services may 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. Furthermore, some states may
attempt to impose state universal service contribution requirements on
interconnected VoIP providers such as deltathree. At this time, various states –
including Nebraska and New Mexico – claim that they have the right to require
interconnected VoIP providers to contribute to their respective USF funds. The
attempts of the Nebraska and New Mexico authorities to impose state USF
obligations on interconnected VoIP providers are currently subject to
litigation, and we cannot predict how the courts, the FCC, and states may rule
on these matters.





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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. 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.  As a result of the steps we have taken, we believe that
we comply with the FCC’s order regarding CPNI.





Access
for People with Disabilities





On June
15, 2007, and effective October 5, 2007, interconnected VoIP providers, like us,
became required to make certain that their equipment and service is accessible
to and usable by individuals with disabilities, if readily achievable, which we
did. In addition, interconnected VoIP providers like us became obligated to
contribute to the Telecommunications Relay Services, or TRS, fund and to offer
711 abbreviated dialing for access to relay services. Following March 31, 2009,
interconnected VoIP providers are required to route such 711 calls to the
appropriate TRS center based upon the registered location provided by such
customers.  Although we experienced a delay in providing 711
abbreviated dialing for access to relay services and routing such services to
the appropriate relay center, we are in the final stages of implementing such
requirements and expect to provide such services in the immediate
future.





Regulatory
Fees





On August
6, 2007 and effective November 2007, the FCC adopted an Order concerning the
collection of regulatory fees for Fiscal Year 2007 requiring the collection of
such fees from interconnected VoIP providers like us. Interconnected VoIP
providers pay regulatory fees based on interstate and international revenues.
The Regulatory Fees Order became effective in November 2007.





Local
Number Portability





On
November 8, 2007, the FCC released an Order relating to local number portability
imposing local number portability and related obligations on interconnected VoIP
Providers like us. The Order requires interconnected VoIP providers to
contribute to shared numbering administration costs. Additionally, the Order
mandates that we port telephone numbers within certain timeframes.  As
a result of the steps we have taken, we believe that we comply with the FCC’s
order regarding local number portability.





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.





State
and Local Regulation





Some
state and local regulatory authorities believe they retain jurisdiction to
regulate the provision of, and impose taxes, fees and surcharges on, intrastate
Internet and VoIP telephony services, and have attempted to impose such taxes,
fees and surcharges, such as a fee for providing E-911 service. 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.





We are in
the process of examining the applicability of such state and other local taxes
and other fees. We have recently completed an initial study of state and local
taxes and other fees and have accrued approximately $500,000 of estimated taxes
and fees due through the year ended December 31, 2008.  We have also
determined that we need to collect and remit sales and excise taxes in certain
states and local jurisdictions and will begin collecting and remitting such
sales and excise taxes in the immediate 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 over traditional telecommunications companies.





In
addition, it is possible that we will be required to collect and remit taxes,
fees and surcharges in other states and local jurisdictions and which such
authorities may take the position that we should have collected. If so, they may
seek to collect those past taxes, fees and surcharges from us and impose fines,
penalties or interest charges on us. Our payment of these past taxes, fees and
surcharges, as well as penalties and interest charges, could have a material
adverse effect on us.





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International
Regulation




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, 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. 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 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.  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.




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, and specifically in
the VoIP reseller market. 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.In addition, many
companies provide, or are planning to provide, some of the services we offer,
including Net2Phone and MediaRing.





Revenues
and Assets by Geographic Area





For the
year ended December 31, 2008, approximately $11.0 million, or 54.5%, of our
revenue was derived from international customers, and $9.2 million, or
45.5%,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 16 to our financial statements included elsewhere in this
Annual Report.





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Employees





As of
December 31, 2008, we had 43 employees, of which 36 were located in Israel
(ten of whom were part-time employees) and eight were located in the United
States (of which one was a part-time employee). This was a significant reduction
from the number of employees we had as of December 31, 2007, at which time we
had 148 employees, of which 124 were located in Israel (20 of whom were
part-time employees) and 24 were located in New York. This reduction was due to
the restructuring that we implemented in 2008, which included reductions in
force.  We consider our relationship with our employees to be good.
None of our employees is covered by collective bargaining
agreements.
 Customers
 
 In 2008,
one customer accounted for approximately 16.5% of our annual gross revenues; in
the fourth quarter of 2008 this customer accounted for approximately 21.0% of
our gross revenues for that quarter.  We have no long-term agreements
with this customer, and we have no assurance that it will continue to purchase
services from us in the future.  Any significant decline in our sales
to this customer could have a material adverse effect on our
revenues.
 
 In
addition, during 2008 Verizon accounted for approximately 10.9% of our gross
revenues; in the fourth quarter of 2008 Verizon accounted for approximately 9.7%
of our gross revenues.  As discussed above under “Company Overview”,
on January 15, 2009, we received notice from Verizon that no later than May 15,
2009, our service provider contract with Verizon would be terminated pursuant to
the terms of the agreement.  Following the termination date we will
not receive any more revenue as a result of this agreement, which could have a
material adverse effect on our financial condition and results of
operations.





Available
Information





Our
Internet address is www.deltathree.com. Through a link at the Investor Relations
section of our website 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
SEC.





ITEM1A.  
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 we reported net income of
approximately $500,000 but a net loss from operations of $52,000, we have a
history of significant, recurring losses since our inception, and we may
continue to incur significant losses for the foreseeable future. We reported net
losses of $9.3 million in 2007 and $11.9 million in 2008. As of
December 31, 2008, our accumulated deficit was approximately $172.6
million. Our revenues may not grow or even continue at their current level.
Going forward, we will need to increase our revenues and/or lower our current
cost structure to reach 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 reach profitability on a
quarterly or annual basis in the future.  These factors raise
substantial doubt about our ability to continue as a going concern.





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
service provider and reseller sales channel and our direct-to-consumer channel.
VoIP telephony from these channels generated 98.5%, 98.3% and 94.6%of our total revenues in
2008, 2007 and 2006, respectively.





We expect
that our revenues for the foreseeable future will be dependent on, among other
factors:





·
                      sales
      of our VoIP telephony products and services;·
                      the
      public’s acceptance and use of VoIP telephony;·
                      expansion
      of our service offerings;·
                      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 our services.




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The
global financial crisis may have an impact on our business and financial
condition in ways that we currently cannot predict.




The
continued financial crisis and related turmoil in the global financial system
may have an impact on our business and our financial condition, as well as
increase the risk of uncollectible accounts receivable from our customers. 
For example, our ability to seek additional financing may be severely restricted
at a time when we would like, or need, to do so, which could have an impact on
our flexibility to react to changing economic and business
conditions.





We
are substantially dependent upon a few material customers, and any significant
decline in our sales to those customers could have a material adverse effect on
our revenues.




In 2008,
one customer accounted for approximately 16.5% of our annual gross revenues; in
the fourth quarter of 2008 this customer accounted for approximately 21.0% of
our gross revenues for that quarter.  We have no long-term agreements
with this customer, and we have no assurance that it will continue to purchase
services from us in the future.  Any significant decline in our sales
to this customer could have a material adverse effect on our
revenues.  In addition, because we have recently begun focusing on
servicing fewer, larger reseller customers rather than many, smaller reseller
customers, it is probable that our dependence upon a few material customers will
increase in the future.
 
 In
addition, during 2008 Verizon accounted for approximately 10.9% of our gross
revenues; in the fourth quarter of 2008 Verizon accounted for approximately 9.7%
of our gross revenues.  As discussed above under “Company Overview”,
on January 15, 2009, we received notice from Verizon that no later than May 15,
2009, our service provider contract with Verizon would be terminated pursuant to
the terms of the agreement.  Following the termination date we will
not receive any more revenue as a result of this agreement, which could have a
material adverse effect on our financial condition and results of
operations.





A
continuing decline in telecommunications prices may cause us to lower our prices
to remain competitive, which could prevent our future
profitability.





International
and domestic telecommunications prices have decreased significantly over the
last few years in most of the markets in which we operate, and as a result our
margins have decreased materially. 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 service provider
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
believe that we will need additional capital to continue our
operations.





We have
sustained significant operating losses in recent periods, which have led to a
significant reduction in our cash reserves.  At this time, we believe
that, unless we are able to increase our revenues, we will not have sufficient
funds to continue our current operations over the foreseeable future if we do
not receive additional financing.  There can be no assurance that we
will be able to raise such additional capital on favorable terms or at
all.  In addition, as a result of D4 Holdings’ controlling interest in
our company, D4 Holdings will be able to exercise a controlling influence over
future issuances of capital stock or other securities by us and a third party
may be deterred from investing in us.





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. If any or all of these factors fail to occur, our business
may not be successful.




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





The
market for VoIP telephony is extremely competitive. Our competitors include
companies in the Internet and telecommunications industries. 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, our Internet competitors use the Internet instead of a
private network to transmit traffic, and the operating and capital costs of
these providers may be less than ours.





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 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.





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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;·
              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.





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.





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 Jersey, Atlanta, London and
Frankfurt. 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.





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
operate in many international markets. In addition to the uncertainty regarding
our ability to generate revenue from foreign operations, 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.





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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 whom we rely upon to run our
operations; this is particularly true following the significant reduction in the
number of employees that occurred as a result of the reductions in force during
2008. Except for Mr. Effi Baruch, our interim Chief Executive Officer and
President, and Senior Vice President of Technology and Operations, none of our
officers or key employees is subject to an employment agreement for any specific
term. The loss of the services of any of these officers or key employees could
impact our ability to run our operations and delay the development and
introduction of, and negatively impact our ability to sell, our products, either
of which could adversely affect our financial results. We currently do not
maintain key person life insurance policies on any of our
employees.





Our
ability to provide our service is dependent in part 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 may 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 trademarks
and 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.





Third parties may claim that our
services infringe upon their intellectual property rights.





Third
parties may assert claims that we have violated a patent or infringed a
copyright, trademark or other proprietary right belonging to them and subject us
to expensive and disruptive litigation.  For example, a complaint was
filed in the United States District Court for the Eastern District of
Texas-Tyler Division by Centre One alleging,inter alia, that we and
Verizon are offering for sale a VoIP service that infringes a patent held by
Centre One.  In addition, 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 and lawsuits, even if not meritorious, could be
expensive and time consuming to defend; divert management’s attention and
resources; require us to redesign our products, if feasible; require us to
pay royalties or enter into licensing agreements in order to obtain the right to
use necessary technologies; and/or may materially disrupt the conduct of our
business.





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 many jurisdictions based on specific
regulatory classifications and recent regulatory decisions. 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.





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. Furthermore, 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.
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.





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





Our
industry is subject to rapid technological change, and we cannot predict the
effect of technological changes on our business. 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
and/or 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
iConnectHere to accept new customers and may also have an adverse effect on our
sales to customers who resell our service.





Various
U.S. state and local fees, taxes and surcharges may increase our costs and our
customers' cost of using our services.




Some
state and local regulatory authorities claim that they retain jurisdiction to
regulate the provision of, and impose taxes, fees and surcharges on, intrastate
Internet and VoIP telephony services, and have attempted to impose such taxes,
fees and surcharges, such as a fee for providing E-911 service. 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.





We have
recently completed an initial study of state and local taxes and other fees and
have accrued approximately $500,000 of estimated taxes and fees due through the
year ended December 31, 2008.  We have also determined that we need to
collect and remit sales and excise taxes in certain states and local
jurisdictions and will begin collecting and remitting such sales and excise
taxes in the immediate 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 over traditional
telecommunications companies.





In
addition, it is possible that we will be required to collect and remit taxes,
fees and surcharges in other states and local jurisdictions, and which such
authorities may take the position that we should have collected. If so, they may
seek to collect those past taxes, fees and surcharges from us and impose fines,
penalties or interest charges on us. Our payment of these past taxes, fees and
surcharges, as well as penalties and interest 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 as well as other FCC-mandated funding
requirements or that our customers will cancel service due to the impact of
these or other price increases to their service.




We
began contributing to the USF during the fourth fiscal quarter of 2006 and began
charging our customers a USF surcharge fee.  In addition, we are
required to collect and remit other FCC-related fees, such as the TRS fund and
contributions towards local number portability.  We have recently
completed an initial study of FCC-related fees that are due and have accrued
approximately $200,000 of estimated fees due through December 31, 2008. The
impact of this price increase on our customers or our inability to recoup the
costs or liabilities in remitting such fees could have a material adverse effect
on our financial position, results of operations and cash flows, or could cause
some customers to cancel our service due to the loss of any price advantage we
may have over traditional telecommunications companies..




Future
legislation or regulation of our service offerings may increase our costs, which
may result in either our increasing the retail price of our service offerings or
reducing our profitability.





The FCC
has several ongoing proceedings that could negatively impact
us.  Specifically, the FCC may reform the system of payments between
companies that connect telephone companies.  Such reforms may increase
the charges we pay to other companies for handling our calls.  The FCC
may adopt more stringent E-911 obligations.  This could result in us
having to deploy new technologies or engage a third party to provide services in
compliance with the new regulations, increasing our costs.  The FCC
may determine that some or all of our offerings are properly classified as
“telecommunications” services subjecting our offerings to state and federal
regulations, thereby increasing our compliance costs.  The U.S.
Congress, state legislatures, state regulatory commissions and foreign
regulatory commissions could attempt to impose additional obligations on us at
any time.  We cannot predict the outcome of the pending FCC
proceedings or what actions such other governmental and regulatory bodies may
take that may affect us.







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Risks Related to our Relationship
with D4 Holdings




D4
Holdings controls a majority of our common stock and has the ability to exercise
control over all matters submitted to a stockholder vote.





D4
Holdings owns approximately 54.3% of the issued and outstanding shares of our
common stock and, in the event it exercises in full the warrant that we issued
to it to purchase up to an additional 30,000,000 shares of our common stock at
an exercise price of $0.04 per share, it will own approximately 67.7% of the
issued and outstanding shares of our common stock.  As long as D4
Holdings continues to beneficially own more than 50% of the voting power of our
company, D4 Holdings will be able to exercise a controlling 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 our officers;·
                        potential
      mergers, acquisitions, sales of assets and other significant corporate
      transactions;·
                        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 D4
      Holdings;·
                        payment
      of dividends on our capital stock; and·
                        approval
      of our business plans and general business
  development.





In
addition, this concentration of ownership may discourage, delay or prevent a
change in control of our company, which could deprive our stockholders of an
opportunity to receive a premium for their common stock as part of a sale of our
company or result in strategic decisions that could negatively impact the value
and liquidity of our outstanding stock. D4 Holdings also has sufficient voting
power to amend our organizational documents. Furthermore, conflicts of interest
could arise in the future between us and D4 Holdings concerning, among other
things, potential competitive business activities or business opportunities. D4
Holdings is not restricted from competitive activities or investments. We cannot
provide assurance that the interests of D4 Holdings will coincide with the
interests of other holders of our common stock.  Also, four of our
seven directors are affiliated with D4 Holdings. 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.





The
ownership of D4 Holdings includes owners of ACN, and we may engage in commercial
transactions with ACN in the future.




D4
Holdings is a private investment fund whose ownership includes owners of ACN.
Several of the members of our board of directors currently serve as officers
and/or directors of ACN. Because ACN is a direct seller of telecommunications
services, we may seek to engage in commercial transactions to provide services
to ACN in the future.  Although we expect that the terms of any such
transactions will be established based upon negotiations between employees of
ACN and us and, when appropriate, subject to the approval of the independent
directors on our board or a committee of disinterested directors, there can be
no assurance the terms of any such transactions will be as favorable to us as
might otherwise be obtained in arm’s length negotiations.




As
a result of D4 Holding’s controlling interest in deltathree a third party may be
deterred from attempting to acquire our company.





D4
Holding’s controlling interest in deltathree 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.




Our
stockholders may suffer dilution in the future in the event that D4 Holdings
exercises its warrant.





On
February 12, 2009, we issued to D4 Holdings 39,000,000 shares of our common
stock for an aggregate purchase price of $1,170,000 and a warrant, exercisable
for up to ten years, to purchase up to an additional 30,000,000 shares of our
common stock for a purchase price of $0.04 per share.  In the event
that D4 Holdings exercises the warrant, in full or in part, our existing
stockholders may experience significant and immediate dilution.





Our
ability to utilize our historical net operating losses is substantially limited
as a result of our transaction with D4 Holdings.





As of
December 31, 2008, we had net operating loss carryforwards, or NOLs, generated
in the U.S. of approximately $80.0 million. Our issuance of common stock to D4
Holdings in February 2009 may constitute an “ownership change” as defined in
Section 382 of the Internal Revenue Code, which may result in a loss of a
substantial amount of the NOLs we have accrued and our ability to offset income
that we may generate in the future.  Our ability to use our remaining
NOLs could be additionally reduced if we experience any further “ownership
change,” as defined under Section 382.





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 Table of Contents




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;·
            announcements
      by us or our competitors of significant acquisitions;·
            our
      entry into strategic partnerships or joint ventures;
and·
            purchases
      and sales of our common stock by D4Holdings.





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.





Our
common stock is quoted on the OTC Bulletin Board, which may increase the
volatility of our stock and make it harder to sell shares of our
stock.




Our
common stock is quoted on the OTC Bulletin Board, which tends to be a highly
illiquid market.  There is a greater chance of market volatility for
securities that trade on the OTC Bulletin Board (as opposed to a national
exchange or quotation system), as a result of which stockholders may experience
wide fluctuations and a depressed price in the market price of our securities.
Thus, stockholders may be required to either sell our securities at a market
price which is lower than their purchase price or to hold our securities for a
longer period of time than they planned.  Because our common stock
falls under the definition of “penny stock,” trading in our common stock may be
limited because broker-dealers are required to provide their customers with
disclosure documents prior to allowing them to participate in transactions
involving our common stock. These rules impose additional sales practice
requirements on broker-dealers that sell low-priced securities to persons other
than established customers and institutional accredited investors; and require
the delivery of a disclosure schedule explaining the nature and risks of the
penny stock market. As a result, the ability or willingness of broker-dealers to
sell or make a market in our common stock might decline, and stockholders could
find it more difficult to sell their stock.




Risks
Related to our Israel Operations





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.




18
 Table of Contents




ITEM2.  
PROPERTIES





Until
July 15, 2008,we
leased our executive offices on the 31st and
32nd
floors at 75 Broad Street, New York, New York. The term of the lease was until
July 2010. In October 2003 we entered into a sub-lease agreement with eMarketer,
Inc., or eMarketer, to sub-lease our office space on the 32nd
floor.  The term of the sublease was until July 2010.





As of
July 15, 2008, eMarketer subleased from us our offices located on the 31st floor,
and effective August 1, 2010, eMarketer was to be substituted in place of us as
the tenant under the lease between us and the landlord.  On November
20, 2008, upon receipt of a termination fee equal to $450,000 payable by us and
a letter of credit provided by eMarketer in the amount of $850,000 to the
landlord, the landlord substituted eMarketer for us as the tenant under the
lease and returned to us the original letter of credit in the approximate amount
of $1.0 million we had provided to secure our obligations under the
lease.





We are
currently renting office space at 419 Lafayette Street, New York, N.Y. on an
interim basis while we seek long-term facilities.





We lease
a 1,290 square meter office, which houses our research and development
facilities, in Jerusalem, Israel, at an annual cost of approximately
$265,900; in 2008, we also received approximately $31,200 from a subtenant that
was subleasing part of our office space.  The term of our lease extends
through December 2014. We have an option to terminate the lease, effective
December 31, 2009, by providing written notice thereof prior to June 1, 2009,
and paying a termination fee equal to approximately $40,000.




ITEM3.  
LEGAL
PROCEEDINGS





On
December 5, 2008, a complaint for patent infringement was filed in the United
States District Court for the Eastern District of Texas (Tyler Division) by
Centre One naming us, Verizon Communications Inc., Vonage Holdings Corp. and
Vonage America Inc. as defendants.  The complaint alleges,inter alia, that we and
Verizon are offering for sale “a VoIP service, including, but not limited to, a
service under the name Verizon VoiceWing” that infringes United States Patent
No. 7,068,668, or Patent ’668, entitled “Method and Apparatus for
Interfacing a Public Switched Telephone Network and an Internet Protocol Network
for Multi-Media Communication.”





On
February 23, 2009, defendants Vonage Holdings and Vonage America filed a motion
to transfer the action from the United States District Court for the Eastern
District of Texas (Tyler Division) to the United States District Court for the
District of New Jersey.  The transfer motion argued that none of the
parties have meaningful contacts with the Eastern District of Texas and that
most of the defendants’ evidence and fact witnesses are located in or near New
Jersey.  On March 6, 2009, we filed an Answer and Counterclaim, in
which we denied that we have infringed Patent ’668 and sought declaratory
judgments that: we have not infringed Patent ’668; any alleged infringement
would not be actionable due to one or more of our affirmative defenses; and
Patent ’668 is invalid and unenforceable due to inequitable conduct and a
failure to meet the requirements of patentability.  Also on March 6,
we joined the Vonage defendants in moving to transfer the action to the United
States District Court for the District of New Jersey. The transfer motions
remain pending.





On April
7, 2009, the court held a status conference and assigned May 6, 2010, and
December 6, 2010, as the dates for the pretrial hearing to interpret the
construction of Centre One’s claims and the commencement of the trial,
respectively.





Our
initial examination of the allegations set forth in the Complaint lead us to
firmly believe that we do not infringe any valid claim of Patent ’668. We are
continuing our examination into the allegations set forth in the complaint and
the validity of Patent ’668, and cannot predict with any degree of certainty the
results of our examination and/or the outcome of the suit or determine the
extent of any potential liability or damages.





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 the 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. The case is currently
being litigated against a small number of focus issuers (which does not include
us) selected by the district court. A confidential global settlement is
presently being negotiated between the plaintiffs, issuers, underwriters and
insurers, which ultimately will be subject to the approval of 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 pending
legal proceedings, other than ordinary routine litigation incidental to the
business, to which we are a party or of which any of our property is the
subject.




ITEM4.   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, 2008.





19
 Table of Contents




PART
II




ITEM5.   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.OB”. 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 on September 17, 2002, and from The Nasdaq Capital Market to the
OTC Bulletin Board on March 28, 2008.





The
following table sets forth the high and low sales prices of our common stock for
such time as our common stock was traded on the Nasdaq Capital Market and the
high and low bid prices for such time as our shares have been listed on the OTC
Bulletin Board for the periods indicated:




Year
      ended December 31, 2007
                                            
                                            High
                                            
                                            
                                            LowFirst
      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
                                            
                                            
                                            0.53
                                            
                                            
                                            
                                            0.12Second
      quarter
                                            
                                            
                                            0.22
                                            
                                            
                                            
                                            0.11Third
      Quarter
                                            
                                            
                                            0.17
                                            
                                            
                                            
                                            0.06Fourth
      Quarter
                                            
                                            
                                            0.13
                                            
                                            
                                            
                                            0.01Year
      ending December 31, 2009First
      Quarter
                                            
                                            
                                            0.20
                                            
                                            
                                            
                                            0.01Second
      Quarter (through April 12)
                                            
                                            
                                            0.12
                                            
                                            
                                            
                                            0.16




Holders





As of
April 6, 2009, we had 163 holders of record of the 71,932,405 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, and 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.





Purchases
of Equity Securities by the Issuer and Affiliated Purchasers





None.





20
 Table of Contents




ITEM6.   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, have
audited our historical financial statements since inception. The selected
financial data for each of the years in the three-year period ended December 31,
2008, and as of December 31, 2007 and 2008 is derived from our audited financial
statements that have been included in this Annual Report. The selected financial
data as of December 31, 2004, 2005 and 2006 and for the years ended December 31,
2004 and 2005 is derived from consolidated financial statements that have not
been included in this Annual Report.


Year
      Ended December 31,2004
                      
                      
                      2005
                      
                      
                      2006
                      
                      
                      2007
                      
                      
                      2008(In
      thousands)Statement
      of Operations Data:Revenues
                      
                      $
                      21,069
                      
                      
                      $
                      29,714
                      
                      
                      $
                      37,953
                      
                      
                      $
                      29,477
                      
                      
                      $
                      20,226Costs
      and operating expenses:Cost
      of revenues
                      
                      
                      (13,791
                      )
                      
                      
                      (18,698
                      )
                      
                      
                      (24,375
                      )
                      
                      
                      (21,107
                      )
                      
                      
                      (14,744)Research
      and development expenses
                      
                      
                      (2,531
                      )
                      
                      
                      (3,228
                      )
                      
                      
                      (4,043
                      )
                      
                      
                      (4,669
                      )
                      
                      
                      (3,356)Selling
      and marketing expenses
                      
                      
                      (3,274
                      )
                      
                      
                      (4,173
                      )
                      
                      
                      (4,956
                      )
                      
                      
                      (5,068
                      )
                      
                      
                      (3,636)General
      and administrative expenses
                      
                      
                      (2,194
                      )
                      
                      
                      (2,912
                      )
                      
                      
                      (3,088
                      )
                      
                      
                      (2,952
                      )
                      
                      
                      (3,130)Depreciation
      and amortization
                      
                      
                      (2,731
                      )
                      
                      
                      (1,931
                      )
                      
                      
                      (1,543
                      )
                      
                      
                      (2,644
                      )
                      
                      
                      (1,836)Write-off
      of goodwill
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      2,002Write-off
      of intangible assets
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (2,680
                      )
                      
                      
                      1,564Restructuring
      costs
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      
                      -
                      
                      
                      (1,223)Deferred
      revenue restatement
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      
                      -
                      
                      
                      (596)Total
      costs and operating expenses
                      
                      
                      (24,521
                      )
                      
                      
                      (30,942
                      )
                      
                      
                      (38,005
                      )
                      
                      
                      (39,120
                      )
                      
                      
                      (32,087)Loss
      from operations
                      
                      
                      (3,452
                      )
                      
                      
                      (1,228
                      )
                      
                      
                      (52
                      )
                      
                      
                      (9,643
                      )
                      
                      
                      (11,861)Capital
      gain
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      39Other
      non-operating income
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      13
                      
                      
                      
                      19Interest
      income, net
                      
                      
                      269
                      
                      
                      
                      418
                      
                      
                      
                      620
                      
                      
                      
                      442
                      
                      
                      
                      (35)Income
      taxes
                      
                      
                      (66
                      )
                      
                      
                      (44
                      )
                      
                      
                      (61
                      )
                      
                      
                      (126
                      )
                      
                      
                      (28)Net
      income (loss)
                      
                      $
                      (3,249
                      )
                      
                      $
                      (854
                      )
                      
                      $
                      507
                      
                      
                      $
                      (9,314
                      )
                      
                      $
                      (11,866)Net
      income (loss) per share – basic and diluted
                      
                      $
                      (0.11
                      )
                      
                      $
                      (0.03
                      )
                      
                      $
                      0.02
                      
                      
                      $
                      (0.29
                      )
                      
                      $
                      (0.36)Weighted
      average shares outstanding  – basic and diluted
                      
                      
                      29,316
                      
                      
                      
                      29,672
                      
                      
                      
                      29,771
                      
                      
                      
                      32,427
                      
                      
                      
                      32,870







December
      31,2004
                    
                    
                    2005
                    
                    
                    2006
                    
                    
                    2007
                    
                    
                    2008(In
      thousands)Balance
      Sheet Data:Cash
      and cash equivalents
                    
                    $
                    4,856
                    
                    
                    $
                    3,847
                    
                    
                    $
                    3,790
                    
                    
                    $
                    1,649
                    
                    
                    $
                    1,788Short-term
      investments
                    
                    
                    10,527
                    
                    
                    
                    10,648
                    
                    
                    
                    12,067
                    
                    
                    
                    5,883
                    
                    
                    
                    317Working
      capital
                    
                    
                    10,285
                    
                    
                    
                    10,264
                    
                    
                    
                    12,182
                    
                    
                    
                    4,522
                    
                    
                    
                    723Long
      –term investments
                    
                    
                    1,095
                    
                    
                    
                    1,216
                    
                    
                    
                    1,085
                    
                    
                    
                    1,085
                    
                    
                    
                    -Total
      assets
                    
                    
                    22,273
                    
                    
                    
                    21,504
                    
                    
                    
                    22,395
                    
                    
                    
                    17,299
                    
                    
                    
                    4,854Total
      stockholders’ equity
                    
                    
                    16,025
                    
                    
                    
                    15,561
                    
                    
                    
                    16,618
                    
                    
                    
                    12,024
                    
                    
                    
                    548






21
 Table of Contents




ITEM7.   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
well-known 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, or
VoIP telephony.  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 a
well-known provider of next generation communication services.





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 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 (in which no brand name is indicated and
different customers can offer the same product), 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 joip
offering (which serves as the exclusive VoIP service provider embedded in the
Globarange cordless phones of Panasonic Communications).





We have
built a privately-managed, state-of-the-art global telecommunications platform
using IP technology and offer our customers a suite of IP telephony products,
including PC-to-Phone and Broadband Phone products. We provide a robust set of
value-added services and features that enable us to 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, in 2007we 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.





In 2004,
we announced our first major service provider contract with Verizon
Communications to provide the Verizon VoiceWing VoIP service.  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 Starpower
Internet Phone Service.  On January 15, 2009, we received notice from
Verizon that no later than May 15, 2009, our service provider contract with
Verizon would be terminated pursuant to the terms of the
agreement.  Verizon is not required to pay us any termination
penalties or fees in connection with its termination of the agreement, and
following the termination date we will not receive any more revenues as a result
of this agreement.  In addition, on February 5, 2009, we entered into
a Termination, Settlement Agreement and Mutual Release with RCN, pursuant to
which the service agreement between us and RCN was terminated and RCN
transferred to us some of the subscribers to the VoIP service we had been
providing to RCN under the agreement. In addition, RCN paid us a termination fee
of $230,000.





As a
complement to the initiatives we have taken to attempt to organically expand our
businesses, we have also evaluated opportunities for growth through acquisitions
and strategic 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. However, in 2008
we wrote-off approximately $2.0 million in goodwill and approximately $1.6
million in intangible assets acquired in the Go2Call transaction. Through our
joip offering we attempted to expand into other product and geographic consumer
markets, but in 2008 we recognized only $119,000in revenues from our
service agreement with Panasonic and we do not expect that this will be a
significant source of revenue in the future. In addition, as discussed above, on
February 12, 2009, we consummated a transaction with D4 Holdings LLC, or D4
Holdings, a Delaware limited liability company, pursuant to which, among other
things, D4 Holdings acquired (i) 39,000,000 shares of our common stock,
representing approximately 54.3% of the total number of issued and outstanding
shares of common stock following the transaction and (ii) a warrant, exercisable
for ten years, to purchase up to an additional 30,000,000 shares of our common
stock at an exercise price of $0.04 per share.  D4 Holdings is a
private investment fund whose ownership includes owners of ACN, Inc., or
ACN, a direct seller of telecommunications services.  As a result
of the investment in our company by D4 Holdings, we expect to seek opportunities
to provide services to ACN and enter into other commercial transactions that
give us access to ACN’s international marketing and distribution
capabilities.


We have
sustained significant operating losses in recent periods, which has led to a
significant reduction in our cash reserves.  As a result, in 2008 we
effected a restructuring that helped us reduce our operating costs significantly
and better align our operations with our current business model.  As
part of this restructuring, we initiated a series of reductions in force,
which  resulted in a decrease in the number of our employees from 148
as of December 31, 2007, to 43 as of December 31, 2008.  In addition,
we subleased our principal executive offices, following which we entered into an
agreement with the landlord pursuant to which we paid a termination fee equal to
$450,000, our lease agreement for the offices was terminated, and the landlord
returned to us the letter of credit in the approximate amount of $1.0 million we
had provided to secure our obligations under the lease.  We also
secured the release of letters of credit we had previously provided to
other suppliers.  From an operational standpoint, we shifted the focus
of our efforts and resources away from our service provider and consumer
divisions towards our reseller business. Finally, we began seeking additional
financing, which culminated in the transaction with D4 Holdings described
above.





22
 Table of Contents




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. 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 increase 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: telecommunications regulations;
war, terrorism and other international conflicts; restrictions on production,
imports and exports; price controls; tax increases and retroactive tax claims;
expropriation of property; and cancellation of contract rights. 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 Factors:
  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 to begin instituting such regulation,
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,
access to relay services for people with disabilities, 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 over traditional telecommunications
companies.





We have
recently completed an initial study of FCC-related fees that are due and have
accrued approximately $200,000 of estimated fees due through December 31,
2008.  In addition, we have recently completed an initial study of
state and local taxes and other fees and have accrued approximately $500,000 of
estimated taxes and fees due through December 31, 2008.  We have also
determined that we need to collect and remit such FCC-related fees and sales and
excise taxes in certain states and local jurisdictions and will begin collecting
and remitting such FCC-related fees and sales and excise taxes in the immediate
future.





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 “Item 1A.
Risk Factors” for a discussion of the impact of market risks, financial risks
and other uncertainties.




23
 Table of Contents




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 84.7% and 85.2% of our total revenues in 2008 and 2007,
respectively, while the provision of VoIP telephony (primarily PC-to-Phone)
through iConnectHere accounted for 13.8% and 13.4% of our total revenues in 2008
and 2007, respectively.




Costs
and Operating Expenses




Costs and
operating expenses consist of the following: 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.




Depreciation
and amortization consists of the depreciation calculated on our fixed assets for
the fiscal year ended December 31, 2008, and the amortization of the intangible
assets acquired by us 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, 2008.  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.




Net
Operating Losses
 
 As of December 31, 2008, we had NOLs
generated in the U.S. of approximately $80.0 million. Our issuance of common
stock to D4 Holdings in February 2009 may constitute an “ownership change” as
defined in Section 382 of the Internal Revenue Code, which may result in a loss
of a substantial amount of the NOLs we have accrued and our ability to offset
income that we may generate in the future.  Our ability to use our
remaining NOLs could be additionally reduced if we experience any further
“ownership change,” as defined under Section
382.




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:




Use of
estimates:  Our consolidated financial statements are prepared
in conformity with accounting principles generally accepted in the United
States, which require management to make estimates and assumptions that affect
the amounts reported and disclosed in the consolidated financial statements and
the accompanying notes. Actual results could differ materially from these
estimates.




On an
ongoing basis, we evaluate our estimates, including the following:


·
                      the
      useful lives of property and equipment and intangible
    assets;·
                      commitments
      and contingencies, based on the information available at the time we are
      making such estimates.  For 2008, we reserved an accrual for
      estimated regulatory, state and local fees and taxes based upon the
      information available at the time we made such estimate;
    and·
                      the
      assumptions used for the purpose of determining share-based compensation
      using the Black-Scholes option model and various other assumptions that we
      believe to be
reasonable.


24
 Table of Contents




We base
our estimates on historical experience, available market information,
appropriate valuation methodologies and various other assumptions that we
believe to be reasonable, the results of which form the basis for making
judgments about the carrying values of assets and liabilities.





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.





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 31,2008
                              
                              
                              2007
                              
                              
                              2006Revenues:Total
      revenues
                              
                              
                              100.0
                              %
                              
                              
                              100.0
                              %
                              
                              
                              100.0
                              %Costs
      and operating expenses:Cost
      of revenues
                              
                              
                              72.9
                              
                              
                              
                              71.6
                              
                              
                              
                              64.2Research
      and development expenses
                              
                              
                              16.6
                              
                              
                              
                              15.8
                              
                              
                              
                              10.7Selling
      and marketing expenses
                              
                              
                              18.0
                              
                              
                              
                              17.2
                              
                              
                              
                              13.1General
      and administrative expenses (exclusive of non-cash compensation
      expense)
                              
                              
                              15.4
                              
                              
                              
                              10.0
                              
                              
                              
                              8.1Write
      down of intangible asset
                              
                              
                              17.6
                              
                              
                              
                              9.1
                              
                              
                              
                              -Deferred
      revenue restatement
                              
                              
                              2.9
                              
                              
                              
                              -
                              
                              
                              
                              -Restructuring
      costs
                              
                              
                              6.0
                              
                              
                              
                              -
                              
                              
                              
                              -Depreciation
      and amortization
                              
                              
                              9.1
                              
                              
                              
                              9.0
                              
                              
                              
                              4.1Total
      costs and operating expenses
                              
                              
                              158.6
                              
                              
                              
                              132.7
                              
                              
                              
                              100.1Loss
      from operations
                              
                              
                              (58.6
                              )
                              
                              
                              (32.7
                              )
                              
                              
                              (0.1
                              )Capital
      gain
                              
                              
                              0.2
                              
                              
                              
                              -
                              
                              
                              
                              -Other
      non-operating income
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -Interest
      income, net
                              
                              
                              (0.2
                              )
                              
                              
                              1.5
                              
                              
                              
                              1.6Income
      taxes
                              
                              
                              (0.1
                              )
                              
                              
                              (0.4
                              )
                              
                              
                              (0.2
                              )Net
      income (loss)
                              
                              
                              (58.6
                              )%
                              
                              
                              (31.6
                              )%
                              
                              
                              (1.3
                              )%


25
 Table of Contents




Comparison
of 2007 and 2008




Revenues





Revenues
overall decreased approximately $9.3 million or 31.5% to approximately $20.2
million in 2008 from approximately $29.5 million in 2007.  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 $8.0 million or 31.9% from approximately $25.1 million in 2007 to
approximately $17.1 million in 2008.  In addition, revenues from VoIP
telephony (primarily PC-to-Phone) through iConnectHere decreased approximately
$1.0 million or 27% from approximately $3.8 million in 2007 to approximately
$2.8 million in 2008.





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.  Some of the other factors included the
following:


·
                        our
      ongoing financial challenges have caused us to lose certain
      customers;·
                        we
      temporarily were cut off from certain key termination routes during 2008,
      causing a drop in the number of calls being placed over our network into
      such key markets; and·
                        a
      decline in sales in our service provider and consumer businesses resulting
      from our de-emphasis on those units as a result of the
      restructuring.


As a
result, the number of minutes on our network utilized by our resellers and
end-users dropped by approximately 17% from 380 million in 2007 to 315 million
in 2008.





Furthermore,
our reseller revenues, which made up approximately 66% of our overall revenues
in both 2007 and 2008, 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 $1.1 million or 7% of our reseller revenues in 2008,
down by $1.9 million or 62% from $3.0 million for  2007.





Revenues
from our Hosted Consumer VoIP Solution division decreased by approximately $2.0
million or 36% from $5.6 million in 2007 to $3.6 million in 2008, largely due to
the expiration of our service agreements with SBC Communications and Bezek
International, together with the expiration of our development agreement with
Panasonic.





In
addition, during 2008 Verizon accounted for approximately 10.9% of our gross
revenues; in the fourth quarter of 2008 Verizon accounted for approximately 9.7%
of our gross revenues. As discussed above under “Item 1. Company Overview”, on
January 15, 2009, we received notice from Verizon that no later than May 15,
2009, our service provider contract with Verizon would be terminated pursuant to
the terms of the agreement.  Following the termination date we will
not receive any more revenue as a result of this agreement, which could have a
material adverse effect on our financial condition and results of
operations.


Costs
and Operating Expenses




Cost of
revenues.  Cost of revenues decreased by $6.4 million or 30.3%
from $21.1 million in 2007 to $14.7 million in 2008.  Although
our network rent cost increased by 36.3% from $1.1 million in 2007 to $1.5
million in 2008, our termination cost decreased by 30.2% from $15.9 million
in 2007 to $11.1 million in 2008. The main reason for the decrease in cost
of revenues was a reduction in the amount of traffic being terminated over
our network. In addition, there have been significant pricing pressures put on
the market, as a result of which we have generally dropped our
rates.





Research and
development expenses.  Research and development expenses
decreased by $1.3 million or 27.7% from $4.7 million in 2007 to
$3.4 million in 2008. The primary reason for the decline was the decrease
in overall personnel costs as a result of the restructuring of 25.7% to $2.6
million in 2008 from $3.5 million in 2007.





Selling and
marketing expenses.  Selling and marketing expenses decreased
by $1.5 million or 29.4% to $3.6 million in 2008 from $5.1 million in 2007. The
cost of our selling and marketing personnel decreased by approximately 34.6% to
$1.7 million in 2008 from $2.6 million in 2007 as a result of the reduction in
force discussed above.  The balance was caused by an increase in
promotional and branding activities.





General and administrative
expenses.  General
and administrative expenses increased by $0.1 million or 3% to $3.1 million in
2008 from $3.0 million in 2007, due primarily to $0.7 million we recorded as a
tax liability. Excluding such tax liability our general and administrative
expenses decreased by approximately $0.6 million during 2008 as a result of the
restructuring.





Restructuring
costs. We recorded reorganization expenses totaling approximately $1.2
million. No such expenses were recorded in the year ended December 31, 2007. The
reorganization expenses are one-time costs related to (i) changes to the
structure of our work force, including reductions in force, that totaled
approximately $0.3 million, (ii) the sublease of our New York office for the
remaining term of the lease, for which we have accrued the shortfall between the
rental amounts we will be receiving from the subtenant and the rental amount we
need to pay to the landlord and legal costs associated with the sublease, legal
costs and broker fees associated with the sublease, or approximately $0.6
million, (iii) severance costs we paid to our former Chief Executive Officer of
approximately $0.1 million and (iv) costs associated with the final termination
of the lease for our principal executive offices of approximately $0.2
million.





Write-off of
Go2Call goodwill.As part of
our acquisition of Go2Call, we recognized goodwill of approximately $2.0 million
relating to our reseller division.  During the third quarter of 2008,
we assessed the value of our reseller division and determined that based on our
general current financial condition and the specific state of our reseller
division it would be appropriate to write-off the entire value of the goodwill
acquired in the Go2Call acquisition, or $2.0 million.




26
 Table of Contents




Write-off of
Go2Call intangible assets.  As part of our assessment of our
current financial situation and operations, in 2008 we wrote off the balance of
the intangible assets associated with the Go2Call transaction.  During
the second quarter of 2008, we reached the conclusion that we will not invest
significant resources into a segment of the business that we purchased as part
of the Go2Call transaction.  As a result, we decided to write off
$475,000, representing the entire amount of the asset allocated to that portion
of the business, in the second quarter to properly adjust the value of the
intangible asset associated with that portion of the business.  In
addition, during the third quarter we assessed the life of the remaining
intangible assets associated with the purchase of certain assets from Go2Call
and reached the conclusion that the carrying amount of the assets exceeded the
fair value attributable to those assets as a result of our current financial
situation.  Consequently, we decided to write off the remaining value
of these assets, or approximately $3.1 million, since we believe that these
assets can no longer sustain their value.




Change in
deferred revenue relating to previous years.  During the first
half of 2008, we restated our deferred revenue to include $0.6 million in
deferred revenue liability.





Depreciation and
amortization.  Depreciation
and amortization decreased by $0.8 million or 30.7% from $2.6 million in 2007 to
$1.8 million in 2008 due to a lower expense level of periodic amortizations of
intangible assets, which were fully amortized in the second quarter of
2008.





Loss
from Operations





Loss from
operations increased by $2.3 million or 24% from $9.6 million in 2007 to $11.9
million in 2008, due primarily to the decrease in revenues, increase in costs
and operating expenses (including selling and marketing expenses) and a one-time
amortization charge.





Interest
Income, Net




We
recorded interest expense of $0.01 million in 2008 compared to interest earned
of $0.4 million in 2007.  This was due to both the drop in our overall
cash and cash equivalents of approximately $6.5 million and the drop in our
overall interest rate achieved on our investments.





Income
Taxes, Net




We paid
net income taxes of $28,000 in 2008 compared to $126,000 in 2007.




Net
Loss




Net Loss
increased by $2.6 million or 28% from $9.3 million in 2007 to $11.9 million in
2008, due to the foregoing factors.





Comparison
of 2006 and 2007




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 iConnectHere 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.




27
 Table of Contents




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.





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.





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 and
our recent losses from operations. For the year ended December 31, 2008,
our net loss from operations increased by $2.3 million or 24.0% from $9.6
million in 2007 to $11.9 million in 2008.  To date, we have an
accumulated deficit of approximately $172.6 million.





As of
December 31, 2008, we had cash and cash equivalents of approximately $1.8
million and restricted cash and short-term investments of approximately $0.3
million. or a total of cash, cash equivalents and restricted cash of $2.1
million, a decrease of $6.5 million from December 31, 2007.  In
addition, we had negative working capital of approximately $0.7 million, down
from $4.5 million in 2007 or a net change of ($5.2) million.  The
decrease in cash, restricted cash, and short and long term investments was
primarily caused by the net cash used in operating activities of approximately
$6.2 million.  During 2008, our average monthly cash burn was approximately
$0.53 million (including cash used in our operations and cash used in to pay
capital leases).  In the first quarter of 2008 our average monthly
cash burn was approximately $0.8 million, or approximately $2.4 million for the
quarter, following which we were able to decrease our cash burn as a result of
the steps we took during the restructuring.  Looking forward, we
estimate that the average monthly cash burn rate for the first quarter of 2009
will be approximately $0.1 million on a monthly basis without one-time
items.




28
 Table of Contents




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 $6.2 million during 2008 compared
with negative cash flow from operating activities of approximately
$5.1 million during 2007.  The decrease in our cash generated
from operating activities was primarily driven by our net loss of $11.9 million
plus changes in working capital of approximately $1.7 million, depreciation and
amortization of approximately $1.5 million and write-offs for the Go2call
intangible asset of approximately $3.6 million.




Net cash
used in investing activities is generally driven by our annual capital
expenditures and changes in our short and long term investments.  In
2008, we spent $0.3 million on capital expenditures and decreased our
investments by $6.7 million, for a net decrease of $6.4 million. 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.




Financing
cash flows consist primarily of payments of capital leases and of proceeds from
exercise of employee options. During 2008 we paid $0.1 million for capital lease
and $0.01 million during 2007. During 2007 our employees exercised options of
$0.03 million. No options were exercised during 2008 due to the drop in the
market price of our common stock.





As
discussed above under “Business – Transaction with D4 Holdings”, on February 12,
2009, we consummated the transaction with D4 Holdings pursuant to which we
issued to D4 Holdings (i) 39,000,000 shares of our common stock, representing
approximately 54.3% of the total number of issued and outstanding shares of
common stock following the transaction, for an aggregate purchase price of
$1,170,000, paid in cash, and (ii) a warrant, exercisable for ten years, to
purchase up to an additional 30,000,000 shares of our common stock at an
exercise price of $0.04 per share.





We
obtained our funding from our utilization of the remaining proceeds from our
IPO, offset by positive or negative cash flow from our operations, and most
recently from the sale of shares of our common stock to D4 Holdings. These
proceeds are maintained as cash, restricted cash, and short and long term
investments. We have sustained significant operating losses in recent periods,
which has led to a significant reduction in our cash
reserves.   In 2008 we initiated a restructuring plan that helped
us cut  operating costs significantly and better align our operations
with our current business model, but there are no assurances that these
reductions in costs will be sufficient to return us to positive cash
flow.  Based on current trends in our operations we believe that we
will not have sufficient funds to meet our working capital requirements,
including operating losses, and capital expenditure requirements for the next
fiscal year future if we do not receive additional financing.  There
can be no assurance that we will be able to raise such additional capital on
favorable terms or at all.  If additional funds are raised through the
issuance of equity securities, our existing stockholders will experience
significant further dilution. As a result of the foregoing factors, there is
substantial doubt about our ability to continue as a going
concern.


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 5 yearsReal
      estate leases
                    
                    
                    1,346
                    
                    
                    
                    224
                    
                    
                    
                    449
                    
                    
                    
                    673
                    
                    
                    
                    -Auto
      leases
                    
                    
                    324
                    
                    
                    
                    183
                    
                    
                    
                    141
                    
                    
                    
                    -
                    
                    
                    
                    -Capital
      leases
                    
                    
                    295
                    
                    
                    
                    148
                    
                    
                    
                    147
                    
                    
                    
                    -
                    
                    
                    
                    -Purchase
      obligations
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Total
                    
                    
                    1,965
                    
                    
                    
                    555
                    
                    
                    
                    737
                    
                    
                    
                    673
                    
                    
                    
                    -




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 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.





In light
of these assumptions, risks and uncertainties, the results and events discussed
in the forward-looking statements contained in this Annual Report 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. 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.




29
 Table of Contents




ITEM8.  
FINANCIAL STATEMENTS AND
SUPPLEMENTARY DATA





The
Company's Consolidated Financial Statements required by this Item are set forth
in Item 15 beginning on page 40 of this Annual Report.





ITEM9.
CHANGES IN AND DISAGREEMENTS
WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE




None.




ITEM9A(T).
  CONTROLS AND
PROCEDURES




(a)  
Evaluation of Disclosure
Controls and Procedures. Each of 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, has concluded that, based on such evaluation, and as a
result of the material weaknesses described below, our disclosure controls and
procedures were not adequate and effective to ensure that material information
required to be disclosed by us in the reports that we file and submit under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the SEC’s rules and forms.




(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 assessed the
effectiveness of our internal control over financial reporting as of
December 31, 2008. During the course of this assessment, management
identified material weaknesses relating primarily to:


·
                          recording
      of revenues and deferred revenues, primarily in the authorization,
      monitoring and segregation of duties over our billing system;
      and·
                          recording
      of cost of revenues, primarily in the authorization, monitoring and
      segregation of duties over our route purchasing
    system.


Based on
management's assessment, management concluded that internal controls over
financial reporting were not effective, as of December 31, 2008, due to the
material weaknesses described above. In discussion with our outside auditors we
are currently actively attempting to determine how we will remediate these
material weaknesses and prevent their reoccurrence, although we have not yet
identified a specific course of action. This Annual Report does not include an
attestation report of our registered public accounting firm regarding internal
control over financial reporting. Management's report was not subject to
attestation by our registered public accounting firm pursuant to temporary rules
of the SEC that permit us to provide only management's report in this Annual
Report.
  (c)  Changes in Internal
Controls.  As discussed above under “Item 1. Employees”, in
2008 we effected a series of reductions in force that caused the number of our
employees to drop from 148 as of December 31, 2007, to 43 as of December 31,
2008. As a result of this sharp decline our ability to ensure a proper
segregation of duties amongst different employees was severely
curtailed.  This had a material effect on our internal controls over
financial reporting, and resulted in the material weaknesses set forth
above.





ITEM9B.  
OTHER
INFORMATION





None.




30
 Table of Contents




PART
III





ITEM10.  
DIRECTORS, EXECUTIVE OFFICERS
AND CORPORATE GOVERNANCE





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. Set forth below are
the name, age and the positions and offices held by each of our current
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.





Upon the
closing of the transaction with D4 Holdings and pursuant to the terms of the
Purchase Agreement, Noam Bardin resigned as a director and the board of
directors appointed Robert Stevanovski and Anthony Cassara to serve on the
board.  In addition, Lior Samuelson resigned as Chairman of the Board
and remained a director, and Robert Stevanovski was appointed to serve as
Chairman.  Following the closing of the private placement, our Board
of Directors appointed Gregory Provenzano, Lyle Patrick and David Stevanovski to
serve on the Board, effective on March 28, 2009.





Robert
Stevanovski,45.  Mr.
Stevanovski was appointed as a director and Chairman of the Board on February
12, 2009.  He is one of the co-founders of ACN, and has served as
Chairman of ACN since its founding in 1993. Mr. Stevanovski has served as
Chairman of the Board of WorldGate Communications, Inc., a provider of video
phone products, since April 6, 2009.  Mr. Stevanovski is the
brother of David Stevanovski.





Anthony
Cassara,54.  Mr.
Cassara was appointed as a director on February 12, 2009. Mr. Cassara currently
serves as President of Cassara Management Group, Inc., a privately held business
counseling practice focused on the telecommunications industry. Prior to
founding Cassara Management Group, Mr. Cassara was President of the Carrier
Services division at Frontier Corporation and later at Global Crossing. Mr.
Cassara has served as a director of WorldGate Communications since April 9,
2009.





Lior
Samuelson, 60.  Mr. Samuelson served as Chairman of the Board
from January 2008 until February 2009, and has served as a director of
deltathree since August 2001. 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.





Benjamin
Broder, 45. Mr. Broder has served as a director of deltathree since July
24, 2005. Since 2002, Mr. Broder has served as the Finance Director of Atarey
Hasharon Chevra Lepituach Vehashkaot Benadlan (1991) Ltd. 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 is a Chartered Accountant in the U.K. and a C.P.A. in
Israel.





David
Stevanovski,42.  Mr.
Stevanovski was appointed to serve on the board effective March 28, 2009, ten
days following the date of the transmittal of the Information Statement to our
stockholders.  He has served in a number of positions at ACN, and
currently serves as Chief Operating Officer of ACN North America. Mr.
Stevanovski has served as a director of WorldGate Communications since April 9,
2009. Mr. Stevanovski is the brother of Robert Stevanovski.





Gregory
Provenzano,49.  Mr.
Provenzano was appointed to serve on the board effective March 28, 2009,
ten days following the date of the transmittal of the Information Statement to
our stockholders.  Mr. Provenzano is one of the co-founders of ACN,
Inc. and has served as President of ACN since its founding in 1993. Mr.
Provenzano has served as a director of WorldGate Communications since April 9,
2009.





J.
Lyle Patrick,56.  Mr. Patrickwas appointed to serve on the board
effective March 28, 2009, ten days following the date of the transmittal of the
Information Statement to our stockholders.  Mr. Patrick has served as
chief financial officer of a number of telecommunications companies, including,
most recently, US LEC, a competitive telecommunications company, from June 2005
to March 2007, and MetroPCS, a wireless communications provider, from
May 2004 to March 2005.  Mr. Patrick is a Certified Public
Accountant.





Benjamin
Broder and J. Lyle Patrick qualify as “independent” as defined in Rule
4200(a)(15) of the Nasdaq listing standards.





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.





Efraim
Baruch, 33, interim Chief Executive Officer and President, Senior Vice
President of Operations and Technology. In December 2008 Mr. Baruch became our
interim Chief Executive Officer and President; 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 Operations Center (NOC), and soon after specialized in
the management of data networks and security in our 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.





Richard
Grant, 45, Chief Financial Officer and Treasurer. Mr. Grant joined
deltathree on January 23, 2006 as our Senior Vice President of Finance and
Treasurer and has served as our Chief Financial Officer since May 2008. 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.





31
 Table of Contents




Dan
Antebi, 38, Chief Commercial Officer and Senior Vice President of Sales
and Marketing.  Mr. Antebi has served as our Chief Commercial Officer
and Senior Vice President of Sales and Marketing since May 2008. Mr. Antebi
brings more than 13 years of experience in management and international and
domestic sales and marketing.  In his most recent position, Mr. Antebi
headed an independent consultancy firm assisting international companies in the
European telecom domain. Prior to that, Mr. Antebi served as a Senior Director
and Region Manager for Comverse Ltd., a provider of software and systems
enabling network based multimedia communications services.





Peter
Friedman, 38, 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.





Board
of Directors and Committees of the Board





Our
Amended and Restated Certificate of Incorporation provides that the number of
members of our Board of Directors shall be not less than three and not more than
thirteen. There are currently seven 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.





The Board
had five regular meetings and four special meetings during the fiscal year ended
December 31, 2008. During the fiscal year ended December 31, 2008, 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. None of our other
directors attended our 2008 Annual Stockholder Meeting with the exception of Mr.
Gonen, who at the time of the meeting served as a member of the Board of
Directors. 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.





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 2009 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 Amended and Restated 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 care of our Secretary at 419 Lafayette Street, New York, New York
10003.





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.




32
 Table of Contents




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 three meetings during 2008. Benjamin
Broder is currently the sole current member of the Compensation
Committee.  The Compensation Committee has a charter, a copy of which
is available to our stockholders at the Corporate Governance section of our
website located at www.deltathree.com.





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.
 During
the course of the 2008 fiscal year, Noam Bardin and (until his resignation from
the board on November 2, 2008) Ilan Biran and (until such time as he was
appointed Chairman of the Board) Lior Samuelson served on the Audit Committee.
Following the resignation of Noam Bardin on February 12, 2009, there were no
members of the Audit Committee. Mr. Patrick was appointed by the Board to serve
as the Chairman and, until such time as we are able to appoint additional
independent directors,  the sole member of the Audit Committee
effective March 28, 2009, the effective time of his appointment to the
board.  The Board of Directors has determined that Mr. Patrick meets
the requirements of the applicable Securities and Exchange Commission rules for
membership on the Audit Committee, including Rule 10A-3(b) under the Exchange
Act, is “independent” as defined in Rule 4200(a)(15) of the Nasdaq listing
standards, and qualifies as an “audit committee financial expert” as defined in
Item 407 of Regulation S-K.  The Audit Committee had four
meetings during 2008.  The Audit Committee has a charter, a copy of
which is available to our stockholders at the Corporate Governance section of
our website located at www.deltathree.com.


Section
16(a) Beneficial Ownership Reporting Compliance





Section
16(a) of the Exchange Act requires that the Company’s directors, executive
officers and persons who own more than 10% of the outstanding common stock of
the Company file initial reports of ownership and reports of changes in
ownership in such common stock with the SEC. Officers, directors and
stockholders who own more than 10% of the outstanding common stock are required
by the SEC to furnish the Company with copies of all Section 16(a) reports 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 each of Ilan
Biran (a former member of our Board of Directors), Benjamin Broder and Noam
Bardin (a former member of our Board of Directors).





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 2008. 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 419 Lafayette Street, New York, New York 10003. We intend to post
on our website 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.






33
 Table of Contents




ITEM11.  
EXECUTIVE
COMPENSATION




Summary
Compensation Table





The
following table shows the total compensation accrued during the fiscal years
ended December 31, 2007 and 2008 to (1) all individuals who served as our Chief
Executive Officer during any part of 2008 and (2) our two next most highly
compensated executive officers whose total compensation exceeded $100,000 during
the fiscal year ended December 31, 2008. These executive officers are referred
to in this Annual Report as our “named executive officers”.




Name
      and Principal Position
                                                                                                                          
                                                                                                                          Year
                                                                                                                          
                                                                                                                          Salary
                                                                                                                            ($)
                                                                                                                          
                                                                                                                          Bonus
                                                                                                                            ($)
                                                                                                                          
                                                                                                                          Stock
      Awards
                                                                                                                            ($)(1)
                                                                                                                          
                                                                                                                          Option
      Awards
                                                                                                                            ($)(1)
                                                                                                                          
                                                                                                                          All
      Other
                                                                                                                            Compensation
                                                                                                                            ($)
                                                                                                                          
                                                                                                                          Total
                                                                                                                            ($)Shimmy
      Zimels,Former
      Chief Executive Officer, President and Chief Financial
    Officer(former
      principal executive officer, principal financial officer and
                                                                                                                          
                                                                                                                          2008
                                                                                                                          
                                                                                                                          50,000
                                                                                                                          (2)
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          100,000
                                                                                                                          (3)
                                                                                                                          150,000principal
      accounting officer)
                                                                                                                          
                                                                                                                          2007
                                                                                                                          
                                                                                                                          258,005
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          34,690
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          292,695Dror
      Gonen,Former Chief Executive Officer
      and President (former principal
                                                                                                                          
                                                                                                                          2008
                                                                                                                          
                                                                                                                          170,416
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          67,060
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          237,476executive
      officer)(4)
                                                                                                                          
                                                                                                                          2007
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -Effi Baruch,Chief
      Executive Officer, President and Senior Vice
                                                                                                                          
                                                                                                                          2008
                                                                                                                          
                                                                                                                          106,257
                                                                                                                          (5)
                                                                                                                          30,407
                                                                                                                          
                                                                                                                          971
                                                                                                                          
                                                                                                                          18,179
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          155,814President
      of Operations and Technology (principal executive
      officer)
                                                                                                                          
                                                                                                                          2007
                                                                                                                          
                                                                                                                          85,574
                                                                                                                          
                                                                                                                          7,000
                                                                                                                          
                                                                                                                          7,326
                                                                                                                          
                                                                                                                          10.564
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          110,644Richard
      Grant,Chief
      Financial Officer and Treasurer
                                                                                                                          
                                                                                                                          2008
                                                                                                                          
                                                                                                                          175,000
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          777
                                                                                                                          
                                                                                                                          44,168
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          219,945(principal
      financial officer and principal accounting officer)
                                                                                                                          
                                                                                                                          2007
                                                                                                                          
                                                                                                                          175,000
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          36,896
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          211,896Dan
      Antebi,Chief
      Commercial Officer and Senior Vice President of Sales and
                                                                                                                          
                                                                                                                          2008
                                                                                                                          
                                                                                                                          115,500
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          9,695
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          125,195Marketing(6)
                                                                                                                          
                                                                                                                          2007
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -
                                                                                                                          
                                                                                                                          -




(1)
            Represents the
      compensation expense accrued by us in the applicable fiscal year for
      financial statement reporting purposes in accordance with SFAS 123R in
      connection with the issuance of the applicable restricted stock or
      restricted unit award or option award.  For a detailed
      discussion of the assumptions made in the valuation of stock awards,
      please see the Notes to the Consolidated Financial Statements included in
      this Annual Report. 11,666 restricted shares of common stock that were
      held by Shimmy Zimels were forfeited and terminated when Mr. Zimels ceased
      being an employee of the Company on May 14, 2008. Options to purchase
      1,000,000 shares of common stock that were held by Dror Gonen were
      forfeited and terminated when Mr. Gonen ceased being an employee of the
      Company on January 15, 2009.(2)
            Mr.
      Zimels resigned as Chief Executive Officer, President and Chief Financial
      Officer effective as of May 14,
2008.


(3)
            Represents
      severance pay paid to Mr. Zimels pursuant to his severance arrangement
      with the Company.(4)
            Mr.
      Gonen joined the Company on April 18, 2008, and served as Chief Executive
      Officer and President from May 14, 2008, until December 9, 2008, and as an
      employee thereafter until January 15,
2009.


(5)
            Represents
      the aggregate salary paid to Mr. Baruch as the Senior Vice President of
      Operations and Technology from January 1, 2008 to December 9, 2008 and as
      the interim Chief Executive Officer and President, and Senior Vice
      President of Operations and Technology from December 9, 2008 to December
      31, 2008.(6)
            Mr.
      Antebi joined the Company on May 12,
2008.




Employment
Agreement with Mr. Effi Baruch




We
currently have an employment agreement with Mr. Baruch, our interim Chief
Executive Officer and President, and Senior Vice President of Operations and
Technology.  The agreement became effective on December 9, 2008, and
was amended as of March 17, 2009, and will continue indefinitely
thereafter.  Mr. Baruch receives a base salary of $186,000 per year,
which is adjusted as of January 15 each year (beginning 2010) by the percentage
change in the Cost of Price Index during the preceding year. Mr. Baruch is
entitled to receive an annual bonus under our then-applicable bonus plan equal
to up to three (3) months’ salary based on performance criteria that shall be
jointly agreed upon by him and the Board of Directors.  Mr. Baruch is
also entitled to an award of non-qualified stock options under our Amended and
Restated 2004 Stock Incentive Plan, as set forth in the option agreement to be
entered into between him and us.  In the event of termination of the
agreement, the terminating party is required to provide the other party 90 days’
written notice unless the Company terminates the agreement for cause, in which
case the Company is required to provide such written notice required by
applicable law.





Employment
Agreement with Mr. Lior Samuelson




We were a
party to an employment agreement with Mr. Samuelson, our former Chairman of the
Board, from February 1, 2008, until February 12, 2009, at which time Mr.
Samuelson resigned as Chairman pursuant to the terms of the transaction with D4
Holdings described above under “Business – Transaction with D4
Holdings”.  Under the terms of the agreement, Mr. Samuelson received a
salary of $125,000 per year.  Mr. Samuelson also received an award of
non-qualified stock options to purchase 300,000 shares of our common stock under
our Amended and Restated 2004 Stock Incentive Plan.  The options have
an exercise price of $0.39 per share, and terminate on February 1,
2018.  Immediately upon the consummation of the transactions with D4
Holdings, which constituted a change of control under Mr. Samuelson’s employment
agreement, all unvested options became vested and immediately
exercisable.





34
 Table of Contents




Outstanding
Equity Awards at Fiscal Year-End





The
following table shows certain information with respect to stock options and
unvested stock awards outstanding as of December 31, 2008, for each of the named
executive officers.





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
                                                                                                                  Stock
      That Have Not
                                                                                                                  Vested
      ($)(2)Shimmy
      Zimels
                                                                                                                
                                                                                                                4/1/1999
                                                                                                                
                                                                                                                
                                                                                                                58,707
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                -
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                5.11
                                                                                                                
                                                                                                                4/1/20093/12/2002
                                                                                                                
                                                                                                                
                                                                                                                100,000
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                -
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1.02
                                                                                                                
                                                                                                                3/12/200911/4/2003
                                                                                                                
                                                                                                                
                                                                                                                85,000
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                -
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1.75
                                                                                                                
                                                                                                                5/4/201012/22/2004
                                                                                                                
                                                                                                                
                                                                                                                80,000
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                -
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                2.85
                                                                                                                
                                                                                                                5/4/2010Dror
      Gonen
                                                                                                                
                                                                                                                4/18/2008
                                                                                                                
                                                                                                                
                                                                                                                -
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1,000,000
                                                                                                                (3)
                                                                                                                
                                                                                                                
                                                                                                                0.14
                                                                                                                
                                                                                                                4/18/2015Effi
      Baruch
                                                                                                                
                                                                                                                3/12/2002
                                                                                                                
                                                                                                                
                                                                                                                15,000
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                -
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1.02
                                                                                                                
                                                                                                                3/12/200911/4/2003
                                                                                                                
                                                                                                                
                                                                                                                15,000
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                -
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                1.75
                                                                                                                
                                                                                                                11/4/201012/22/2004
                                                                                                                
                                                                                                                
                                                                                                                25,000
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                -
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                2.85
                                                                                                                
                                                                                                                11/22/20113/30/2008
                                                                                                                
                                                                                                                
                                                                                                                -
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                250,000
                                                                                                                (4)
                                                                                                                
                                                                                                                
                                                                                                                0.15
                                                                                                                
                                                                                                                3/30/20187/31/2006
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                5,850
                                                                                                                (5)
                                                                                                                
                                                                                                                
                                                                                                                9.361/1/2008
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                18,000
                                                                                                                (6)
                                                                                                                
                                                                                                                
                                                                                                                288.00Richard
      Grant
                                                                                                                
                                                                                                                1/23/2006
                                                                                                                
                                                                                                                
                                                                                                                33,334
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                16,333
                                                                                                                (7)
                                                                                                                
                                                                                                                
                                                                                                                3.02
                                                                                                                
                                                                                                                1/23/20133/30/2008
                                                                                                                
                                                                                                                
                                                                                                                -
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                100,000
                                                                                                                (8)
                                                                                                                
                                                                                                                
                                                                                                                0.15
                                                                                                                
                                                                                                                3/30/20181/1/2008
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                14,400
                                                                                                                (9)
                                                                                                                
                                                                                                                
                                                                                                                230.40Dan
      Antebi
                                                                                                                
                                                                                                                5/12/2008
                                                                                                                
                                                                                                                
                                                                                                                -
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                200,000
                                                                                                                (10)
                                                                                                                
                                                                                                                
                                                                                                                0.162
                                                                                                                
                                                                                                                5/12/2018





(1)
            For
      a better understanding of this table, we have included an additional
      column showing the grant date of the stock options, the restricted shares
      and the restricted stock units.  Subject to the terms and
      conditions contained in any award agreement between the Company and the
      holder of any such award, in the event of a change of control of the
      Company the Compensation Committee determines the effect that such change
      of control has on the vesting and forfeiture of the stock options,
      restricted shares and restricted stock units granted to our employees
      under our Amended and Restated 2004 Stock Incentive
  Plan.(2)
            The
      market value of the stock awards is determined by multiplying the number
      of shares times $0.016, the closing price of our common stock on The OTC
      Bulletin Board on December 31, 2008.(3)
            Options
      to purchase 250,000 shares of common stock were due to vest on April 18,
      2009, and options to purchase 62,500 were due to vest on a quarterly basis
      over the three year period thereafter.  All such options were
      forfeited and terminated when Mr. Gonen ceased being an employee of the
      Company on January 15, 2009.(4)
            Options
      to purchase 125,000 shares of common stock vested on March 30, 2009, and
      options to purchase 125,000 shares of common stock vest on March 30,
      2010.  In the event of a change of control, as defined in the
      Option Agreement dated as of March 30, 2008, between the Company and Mr.
      Baruch, as amended as of July 1, 2008, all such options immediately vest
      and become exercisable.(5)
            Restricted
      shares of common stock were granted on July 31, 2006 and vest as follows:
      4,200 shares vested on July 31, 2007, 5,000 shares vested on July 31,
      2008, and 5,850 shares vest on July 31, 2009.(6)
            Restricted
      units to purchase 25,000 shares of our common stock were granted on
      February 3, 2008 and vest as follows: units to purchase 7,000 shares
      vested on January 1, 2009, units to purchase 8,250 shares vest on January
      1, 2010, and units to purchase 9,750 shares vest on January 1,
      2011.(7)
            Options
      to purchase 16,333 shares of common stock vested on January 23,
      2009.(8)
            Options
      to purchase 50,000 shares of common stock vested on March 30, 2009, and
      options to purchase 50,000 shares of common stock vest on March 30, 2010.
      In the event of a change of control, as defined in the Option Agreement
      dated as of March 30, 2008, between the Company and Mr. Grant, as amended
      as of July 1, 2008, all such options immediately vest and become
      exercisable.(9)
            Restricted
      units to purchase 20,000 shares of common stock were granted on February
      3, 2008 and vest as follows: units to purchase 5,600 shares vested on
      January 1, 2009, units to purchase 6,600 shares vest on January 1, 2010,
      and units to purchase 7,800 shares vest on January 1,
  2011.(10)
            Options
      to purchase 100,000 shares of common stock vest on May 12, 2009, and
      options to purchase 25,000 shares of common stock vest on each of August
      12, 2009, November 12, 2009, February 12, 2010, and May 12,
      2010.







35
 Table of Contents




Director
Compensation




The
following table shows the total compensation earned for services performed for
us by each member of our Board of Directors, other than directors who were also
named executive officers, during the fiscal year ended December 31,
2008.




Name
                    
                    Fees
      Earned or
                      Paid
      in
                      Cash
                      ($)
                    
                    
                    Stock
                      Awards
                      ($)(1)
                    
                    
                    All
      Other
                      Compensation
                      ($)
                    
                    
                    Total
                      ($)Noam
      Bardin
                    
                    
                    15,000
                    
                    
                    
                    11,989
                    (2)
                    
                    
                    0
                    
                    
                    
                    26,989Ilan
      Biran
                    
                    
                    15,000
                    
                    
                    
                    7,992
                    (3)
                    
                    
                    0
                    
                    
                    
                    22,992Benjamin
      Broder
                    
                    
                    15,000
                    
                    
                    
                    6,992
                    (4)
                    
                    
                    0
                    
                    
                    
                    21,992Lior
      Samuelson
                    
                    
                    115,833
                    (5)
                    
                    
                    67,946
                    (6)
                    
                    
                    0
                    
                    
                    
                    183,779




(1)
            Represents
      the aggregate compensation expense accrued by us in 2008 for financial
      statement reporting purposes in accordance with SFAS 123R for restricted
      stock awards and stock options granted to our non-employee directors. The
      restricted share grants were made pursuant to the Amended and Restated
      2006 Non-Employee Director Stock Plan.  For a detailed
      discussion of the assumptions made in the valuation of stock awards,
      please see the Notes to the Consolidated Financial Statements included in
      this Annual Report.(2)
            Represents the
      compensation expense accrued by us in 2008 in connection with the issuance
      of 24,000 restricted shares of common stock on September 4,
      2007, for services as the Chairman of the Board and as a member of the
      audit committee until the Company's next annual stockholders'
      meeting.  As of December 31, 2008, Mr. Bardin held options to
      purchase 50,000 shares of common stock and 42,666 restricted shares of
      common stock.(3)
            Represents the
      compensation expense accrued by us in 2008 in connection with the issuance
      of 16,000 restricted shares of common stock on September 4,
      2007, for services as a member of the board and as the chairman of the
      audit committee until the Company's next annual stockholders'
      meeting.  Mr. Biran resigned as a member of the Board of
      Directors effective November 2, 2008. As a result of his resignation,
      13,500 restricted shares of our common stock that were held by Mr. Biran
      were forfeited and terminated as of November 2, 2008. As of December 31,
      2008, Mr. Biran held options to purchase 83,848 shares of common stock and
      20,500 restricted shares of common stock.(4)
            Represents the
      compensation expense accrued by us in 2008 in connection with the issuance
      of 14,000 restricted shares of common stock on September 4,
      2007, for services as a member of the board and as the chairman of the
      compensation committee until the Company's next annual stockholders'
      meeting.  As of December 31, 2008, Mr. Broder held 29,500
      restricted shares of common stock.(5)
            Represents
      $1,250 paid to Mr. Samuelson in exchange for services as a member of the
      board for January 2008 and $114,583 paid to Mr. Samuelson in exchange for
      his services as Chairman of the Board from February 2008 through December
      2008 pursuant to his Employment Agreement with the
  Company.(6)
            Represents the
      compensation expense accrued by us in 2008 in connection with the issuance
      of 14,000 restricted shares of common stock on September 4, 2007, for
      services as a member of the board and as a member of the audit committee
      until the Company's next annual stockholders' meeting, calculated in
      accordance with SFAS 123R, and options to purchase 300,000 shares of
      Common Stock issued over the course of 2008 for services as the Chairman
      of the Board pursuant to Mr. Samuelson’s Employment Agreement with the
      Company. As of December 31, 2008, Mr. Samuelson held options to purchase
      350,000 shares of common stock and 22,000 restricted shares of common
      stock.





Director
Compensation Policy





At our
Annual Meeting on July 28, 2008, each of our then-non-employee directors (Noam
Bardin, Ilan Biran and Benjamin Broder) became eligible to receive $15,000 for
their services as a member of the board through the date of our next annual
stockholders' meeting. At a meeting of the Board of Directors on March 4, 2009,
the board decided to increase the annual cash compensation that a non-employee
director is eligible to receive for serving as a member of the board to
$20,000.  In addition, the board decided that, on an annual basis, (i)
the chairman of the audit committee will be eligible to receive an annual
retainer of $20,000, (ii) the chairman of the compensation committee will be
eligible to receive an annual retainer of $5,000, and (iii) a member of a
committee (other than a chairperson) will be eligible to receive an annual
retainer of $5,000.We reimburse each member
of our Board of Directors for reasonable travel and other expenses in connection
with attending meetings of the Board of Directors.





Each of
our directors has the right to elect to convert the total cash compensation that
such director is eligible to receive into shares of our common stock at the
then-applicable market price.  Directors have the right to make this
election only during such times as the employees and directors of the Company
are not in a black-out period in trading in securities of the Company and such
director is not in possession of material, non-public information about the
Company.  Any such shares so acquired by a director are restricted and
vest only after a period of one year from the date of grant, following which the
director is able to sell such shares in accordance with Rule 144 under the
Securities Act of 1933.





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. 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.  Under the Amended and Restated
2006 Non-Employee Director Stock Plan, non-employee directors are entitled to
receive an automatic grant of 10,000 shares of restricted stock upon their
appointment to the board and on an annual basis for serving on the
board.  In addition, any director appointed to serve as (i) chairman
of a board committee (other than the audit committee) is entitled to receive a
grant of 8,000 shares of restricted stock upon such appointment and on an annual
basis for serving as chairman of such board committee and (ii) a member of the
audit committee is entitled to receive a grant of 8,000 shares of restricted
stock upon such appointment and on an annual basis for serving as a member of
the audit committee (provided that any director appointed to serve as chairman
of the audit committee is entitled to receive an additional grant of 4,000
shares of restricted stock upon such appointment and on an annual basis for
serving as the chairman of the audit  committee).




36
 Table of Contents





ITEM12.  
SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS





As of
March 13, 2009, there were 71,932,405 shares of our common stock issued and
outstanding.  Each share of common stock entitles the holder thereof
to one vote with respect to each item to be voted on by holders of the shares of
common stock. We have no other securities, voting or nonvoting,
outstanding.





The
following table sets forth information with respect to the beneficial ownership
of shares of our common stock as of March 13, 2009by:


·
                                each
      person whom we know beneficially owns more than 5% of the common
      stock;·
                                each
      of our directors individually;·
                                each
      of our named executive officers individually; and·
                                all
      of our current 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 March 13, 2009
pursuant to the exercise of options or restricted stock 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
      Stockholders:D4
      Holdings, LLC (2)
                        
                        
                        69,000,000
                        
                        67.7
                        %349-L
      Copperfield Blvd., #407Concord,
      NC 28025Abraham
      Ziv-Tal (3)
                        
                        
                        10,347,677
                        
                        14.4
                        %P.O.
      Box 514
                          Rishon,
      Israel 46915Executive
      Officers and Directors:Shimmy
      Zimels (4)
                        
                        
                        306,476
                        
                        *Dror
      Gonen (5)
                        
                        
                        9,000
                        
                        *Effi
      Baruch (6)
                        
                        
                        181,200
                        
                        *Richard
      Grant (7)
                        
                        
                        105,600
                        
                        *Dan
      Antebi (8)
                        
                        
                        100,000
                        
                        *Robert
      Stevanovski (2)
                        
                        
                        69,000,000
                        
                        67.7
                        %Anthony
      Cassara (9)
                        
                        
                        69,000,000
                        
                        67.7
                        %Lior
      Samuelson (10)
                        
                        
                        592,000
                        
                        *Benjamin
      Broder (11)
                        
                        
                        52,000
                        
                        *David
      Stevanovski (9)(12)
                        
                        
                        69,000,000
                        
                        67.7
                        %Gregory
      Provenzano (9)(12)
                        
                        
                        69,000,000
                        
                        67.7
                        %J.
      Lyle Patrick (12)
                        
                        
                        0
                        
                        
                        *All
      directors and executive officers as a group (10 persons)
    (13)
                        
                        
                        70,030,800
                        
                        68.7
                        %__________________*   Less than
    1%.






37
 Table of Contents




(1)
            Percentage
      of beneficial ownership is based on 71,932,405 shares of common stock
      outstanding as of March 13, 2009.(2)
            Ownership
      is based on a Schedule 13D filed February 23, 2009 by D4 Holdings, Manna
      Holdings, LLC (“Manna Holdings”), Praescient, LLC (“Praescient”) and
      Robert Stevanovski and includes 30,000,000 shares of common stock issuable
      under a warrant held by D4 Holdings.  Robert Stevanovski is the
      manager of Praescient, which serves as the sole manager of D4 Holdings and
      as the managing member of Manna Holdings.  Manna Holdings is the
      sole member of D4 Holdings.  As such, Mr. Stevanovski,
      Praescient and Manna Holdings may be deemed to beneficially own the
      securities reported in the table.  Each of Mr. Stevanovski,
      Praescient and Manna Holdings disclaims beneficial ownership of such
      securities, and the information reported herein shall not be deemed an
      admission that such reporting person is the beneficial owner of the
      securities for any purpose, except to the extent of such person’s
      pecuniary interest therein.(3)
            Ownership
      is based on a Schedule 13D/A filed December 24, 2008.(4)
            Includes
      (a) 82,769 shares of common stock and (b) options to
      purchase 223,707 shares of common stock.  Mr. Zimels
      resigned as Chief Executive Officer, President and Chief Financial Officer
      effective as of May 14, 2008.(5)
            Includes
      9,000 shares of common stock. Mr. Gonen served as Chief Executive Officer
      and President from May 14, 2008, to December 9, 2008.(6)
            Includes
      (a) options to purchase 165,000 shares of common stock, (b) 9,200
      restricted shares of common stock and (c) restricted units to purchase
      7,000 shares of common stock.(7)
            Includes (a)
      options to purchase 100,000 shares of common stock and (b) restricted
      units to purchase 5,600 shares of common stock.(8)
            Includes
      options to purchase 100,000 shares of common stock.(9)
            The
      securities reported in the table are held directly by D4 Holdings and
      include the warrant to purchase 30,000,000 shares of common stock held by
      D4 Holdings.  Each of Anthony Cassara, David Stevanovski and
      Gregory Provenzano beneficially
      owns a membership interest inManna Holdings, which is the sole
      member of D4 Holdings. As such, each of Messrs. Cassara, Stevanovski and
      Provenzano may be deemed to beneficially own the securities reported
      herein and owned directly by D4 Holdings.  Each of Messrs.
      Cassara, Stevanovski and Provenzano disclaims beneficial ownership of such
      securities, and the information reported herein shall not be deemed an
      admission that such reporting person is the beneficial owner of the
      securities for any purpose, except to the extent of his pecuniary interest
      therein.(10)
            Includes
      (a) 220,000 shares of common stock, (b) options to
      purchase 350,000 shares of common stock and (c) 22,000 restricted
      shares of common stock.(11)
            Includes
      (a) options to purchase 20,000 shares of common stock and
      (b) 32,000 restricted shares of common
  stock.


(12)
              Appointed
      by the board to serve as a director effective on March 28,
      2009.(13)
              Includes (a) 39,220,000
      shares of common stock, (b) options to purchase 735,000 shares of
      common stock, (c) 63,200 restricted shares of common stock, (d)
      restricted units to purchase 12,600 shares of common stock and (e) a
      warrant to purchase 30,000,000 shares of common stock held directly (or
      deemed to be beneficially owned) by the executive officers and directors
      as a group.




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, 2008.




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)Equity
      compensation plans approved by security holders (2)
                      
                      2,353,541
                      
                      $
                      0.85
                      
                      
                      2,454,834Equity
      compensation plans not approved by security holders
                      
                      N/A
                      
                      
                      N/A
                      
                      
                      
                      N/ATotal
                      
                      2,353,541
                      
                      $
                      0.85
                      
                      
                      2,454,834




(1)
            Does
      not include 288,120 restricted shares of our common stock and
      restricted units to purchase 89,520 shares of our common stock that had
      been granted under our equity compensation plans as of December 31,
      2008.


(2)
            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.





ITEM13.  
CERTAIN RELATIONSHIPS AND
RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE





Certain
Relationships and Related Transactions





Robert
Stevanovski, Anthony Cassara and David Stevanovski were each appointed to serve
on the Company’s Board of Directors pursuant to the terms of the Purchase
Agreement.  Each of these directors, as well as Gregory Provenzano, is
a principal of D4 Holdings, and Robert Stevanovski serves as manager of
Praescient, LLC, the sole manager of D4 Holdings.  As a result of
their relationship with D4 Holdings, each of these individuals may be deemed to
have a direct or indirect interest in the transactions contemplated by the
Purchase Agreement and the Investor Rights Agreement described above under “Item
1. Transaction with D4 Holdings”.  As described above under “Security
Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters”, D4 Holdings beneficially owns an aggregate of 67.7% of our common
stock (which includes 39,000,000 shares of common stock and a warrant to
purchase 30,000,000 shares of our common stock).





Other
than the foregoing, since the beginning of our 2007 fiscal year until the date
hereof there has not been any transaction, and there is not currently proposed
any transaction, in which we were or will be a participant and the amount
involved exceeds $120,000 and in which any related person had or will have a
direct or indirect material interest.  All transactions between us and
our officers, directors, principal stockholders and affiliates must be reviewed
and approved in advance by the Audit Committee.





38
 Table of Contents




Director
Independence





Our
common stock is currently quoted on the OTC Bulletin Board and is not listed on
the Nasdaq Stock Market or any other national securities exchange. Accordingly,
we are not currently subject to the Nasdaq continued listing requirements or the
requirements of any other national securities exchange. Nevertheless, in
determining whether a director or nominee for director should be considered
“independent” the board utilizes the definition of independence set forth in
Rule 4200(a)(15) of the Nasdaq Marketplace Rules.  Benjamin Broder and
J. Lyle Patrick qualify as “independent” under this rule.





Our
company qualifies as a “controlled company” under Rule 4350(c)(5) of the Nasdaq
Marketplace Rules because D4 Holdings holds more than 50% of the voting power of
our company. Accordingly, we have the option to be exempt from the requirements
under Rule 4350(c) to have:





·
            a
      majority of independent directors;


·
            a
      compensation committee composed solely of independent
      directors;


·
            compensation
      of our executive officers determined by a majority of independent
      directors or a compensation committee composed solely of independent
      directors;


·
            a
      nominating committee composed solely of independent directors;
      and


·
            director
      nominees selected, or recommended for the Board's selection, either by a
      majority of the independent directors or a nominating committee composed
      solely of independent directors.





We have
not yet determined to what extent we will rely on the “controlled company”
exemption from any of the foregoing requirements.





ITEM14.  
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, 2008, and
fees billed for other services rendered by Brightman Almagor & Co. during
those periods.




2008
                    
                    
                    2007Audit
      fees
                    
                    $
                    72,000
                    
                    
                    $
                    65,000Audit
      related fees
                    
                    
                    −
                    
                    
                    
                    −Tax
      fees
                    
                    
                    -
                    
                    
                    
                    16,500All
      other fees
                    
                    
                    -
                    
                    
                    
                    −Total
                    
                    $
                    72,000
                    
                    
                    $
                    81,500




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.




39
 Table of Contents




PART
IV




ITEM15.   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.





We
hereby file, as exhibits to this Annual Report, those exhibits listed on the
Exhibit Index immediately following the signature page hereto.






40
 Table of Contents




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, on April 15,
2009.




DELTATHREE,
      INC.By:
              /s/ Effi
      BaruchEffi
      Baruch
                Interim
      Chief Executive Officer and President,  Senior Vice
      President of Operations and Technology
                (Principal
      Executive Officer)




KNOW ALL
MEN BY THESE PRESENTS, that each person whose signature appears below
constitutes and appoints each of Effi Baruch and Peter Friedman 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 on Form 10-K, 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
on Form 10-K has been signed by the following persons on behalf of the
registrant and in the capacities and on the dates indicated:





Signature
                                
                                Title
                                
                                Date/s/ Effi
      Baruch
                                  Effi
      Baruch
                                
                                Interim
      Chief Executive Officer and President, Senior Vice President of Operations
      and Technology (Principal Executive Officer)
                                
                                April
      15, 2009/s/ Richard B.
      Grant
                                  Richard
      B. Grant
                                
                                Chief
      Financial Officer and Treasurer (Principal Financial Officer and Principal
      Accounting Officer)
                                
                                April
      15, 2009/s/ Robert
      Stevanovski
                                  Robert
      Stevanovski
                                
                                Chairman
      of the Board of Directors
                                
                                April
      15, 2009/s/ Benjamin
      Broder
                                  Benjamin
      Broder
                                
                                Director
                                
                                April
      15, 2009/s/ Anthony
      Cassara
                                  Anthony
      Cassara
                                
                                Director
                                
                                April
      15, 2009/s/ J. Lyle
      Patrick
                                  J.
      Lyle Patrick
                                
                                Director
                                
                                April
      15, 2009/s/ Gregory
      Provenzano
                                  Gregory
      Provenzano
                                
                                Director
                                
                                April
      15, 2009/s/ Lior
      Samuelson
                                  Lior
      Samuelson
                                
                                Director
                                
                                April
      15, 2009/s/ David
      Stevanovski
                                  David
      Stevanovski
                                
                                Director
                                
                                April
      15,
2009






41
 Table of Contents




EXHIBITINDEX





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





ExhibitNumber
                          Description3.1
                          Form
      of Amended and Restated Certificate of Incorporation of deltathree, Inc.
      (incorporated by reference from our Annual Report on Schedule 14A filed on
      April 30, 2002).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 between Shimmy Zimels and deltathree, Inc., effective as of
      April 26, 2004 (incorporated by reference from our Annual Report on
      Form 10-K/A filed on April 29, 2004). +10.6
                          2004
      Non-Employee Director Stock Option Plan (incorporated by reference from
      our registration statement on Form S-8 (Registration
      No. 333-122242)). +10.7
                          Form
      of Option Agreement Pursuant to 2004 Stock Incentive Plan (incorporated by
      reference from our Annual Report on Form 10-K filed on March 31, 2005).
      +10.8
                          Form
      of Option Agreement Pursuant to 2004 Non-Employee Director Stock Option
      Plan (incorporated by reference from our Annual Report on Form 10-K filed
      on March 31, 2005). +10.9
                          First
      Amendment to the deltathree, Inc. 2004 Non-Employee Director Stock Option
      Plan, dated as of December 20, 2005 (incorporated by reference from
      Exhibit 10.2 of our Current Report on Form 8-K filed on December 21,
      2005). +10.10
                          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). +10.11
                          Form
      of Restricted Unit Agreement Pursuant to 2004 Stock Incentive Plan
      (incorporated by reference from our Annual Report on Form 10-K filed
      on March 31, 2008). +10.12
                          Employment
      Agreement between Lior Samuelson and deltathree, Inc., dated as of
      February 1, 2008 (incorporated by reference from our Current Report on
      Form 8-K filed on February 4, 2008). +10.13
                          Employment
      Agreement between Dror Gonen and deltathree, Inc., dated as of March 26,
      2008 (incorporated by reference from our Current Report on Form 8-K
      filed on April 1, 2008). +10.14
                          Employment
      Agreement between Effi Baruch and deltathree, Inc., dated as of December
      9, 2008 (incorporated by reference from our Current Report on
      Form 8-K filed on December 10, 2008). +10.15
                          Amendment
      No. 1 to Employment Agreement between Effi Baruch and deltathree, Inc.,
      dated as of March 17, 2009 (incorporated by reference from our Current
      Report on Form 8-K filed on March 18, 2009). +10.16
                          deltathree,
      Inc. Amended and Restated 2004 Stock Incentive Plan (incorporated by
      reference from our Definitive Proxy Statement on Schedule 14A filed with
      the Commission on June 19, 2008). +10.17
                          deltathree,
      Inc. Amended and Restated 2006 Non-Employee Director Stock Plan
      (incorporated by reference from our Definitive Proxy Statement on Schedule
      14A filed with the Commission on June 19, 2008). +10.18
                          Second
      Modification to Sublease Agreement, dated as of July 15, 2008, by and
      between deltathree, Inc. and eMarketer, Inc. (incorporated by reference
      from our Current Report on Form 8-K filed on August 6,
    2008).10.19
                          Consent
      to Sublease and Lease Extension Agreement, dated as of July 15, 2008, by
      and among deltathree, Inc., 75 Broad Street, LLC and eMarketer, Inc.
      (incorporated by reference from our Current Report on Form 8-K filed on
      August 6, 2008).   42
 Table of Contents
  ExhibitNumber
                                                                                                                                Description10.20
                                                                                                                                Lease
      Termination, Attornment and Modification Agreement, dated as of November
      20, 2008, by and among deltathree, Inc., 75 Broad Street, LLC and
      eMarketer, Inc. (incorporated by reference from our Current Report on Form
      8-K filed on November 21, 2008).10.21
                                                                                                                                Securities
      Purchase Agreement, dated as of February 10, 2009, between D4 Holdings,
      LLC and deltathree, Inc. (incorporated by reference from our Current
      Report on Form 8-K filed on February 12, 2009).10.22
                                                                                                                                Investor
      Rights Agreement, dated as of February 12, 2009, between D4 Holdings, LLC
      and deltathree, Inc. (incorporated by reference from our Current Report on
      Form 8-K filed on February 12, 2009).10.23
                                                                                                                                Warrant,
      dated February 12, 2009, issued by deltathree, Inc. in favor of D4
      Holdings, LLC (incorporated by reference from our Current Report on
      Form 8-K filed on February 12, 2009).10.24
                                                                                                                                Termination,
      Settlement Agreement and Mutual Release, dated as of February 5, 2009, by
      and between the Company and RCN Digital Services, LLC (incorporated by
      reference from our Current Report on Form 8-K filed on February 10,
      2009).14.1
                                                                                                                                deltathree,
      Inc. Corporate Code of Conduct and Ethics (incorporated by reference from
      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
    2002.32.1*
                                                                                                                                Certification of the Chief Executive Officer pursuant to
      18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.32.2*
                                                                                                                                Certification of the 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.




43
 Table of Contents




Indexto
Consolidated Financial Statements




Report of
      Independent Registered Public Accounting Firm
              
              
              F-2Consolidated
      Balance Sheets as of December 31, 2008 and 2007
              
              
              F-3Consolidated
      Statements of Operations for the years ended December 31, 2008, 2007, and
      2006
              
              
              F-4Statements of
      Stockholders’ Equity for the years ended December 31, 2008, 2007, and
      2006
              
              
              F-5Consolidated
      Statements of Cash Flows for the years ended December 31, 2008, 2007, and
      2006
              
              
              F-6Notes to
      Consolidated Financial Statements
              
              
              F-7






Table of Contents





REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM




To the
Board of Directors and
 Shareholders
of Deltathree, Inc.
  We have
audited the accompanying consolidated balance sheets of Deltathree, Inc. ("the
Company") and its subsidiary as of December 31, 2008 and 2007, and the related
consolidated statements of operations, changes in stockholders' equity and cash
flows for each of the three years in the period ended December 31, 2008.
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, such consolidated financial statements, present fairly, in all material
respects, the financial position of the Company and its subsidiary as of
December 31, 2008 and 2007, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2008 in
conformity with accounting principles generally accepted in the United States of
America.
 
 The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern.  As discussed in Note 1 to the
financial statements, the Company has suffered recurring losses from operations
that raises doubt about its ability to continue as a going
concern.  The accompanying financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
 
 /s/Brightman Almagor Zohar
&
Co.
 Brightman
Almagor Zohar & Co.
 Certified
Public Accountants,
 A member
firm of Deloitte Touche Tohmatsu
 
 Tel Aviv,
Israel
 April 13,
2009





F-2
 Table of Contents




DELTATHREE, INC.


CONSOLIDATED
BALANCE SHEETS


($ in
thousands)




December
      31,2008
                                                    
                                                    
                                                    2007ASSETSCurrent
      assets:Cash
      and cash equivalents
                                                    
                                                    $
                                                    1,788
                                                    
                                                    
                                                    $
                                                    1,649Restricted
      cash and short-term investments (Note 3a)
                                                    
                                                    
                                                    317
                                                    
                                                    
                                                    
                                                    5,883Accounts
      receivable, net (Note 4)
                                                    
                                                    
                                                    760
                                                    
                                                    
                                                    
                                                    1,061Prepaid
      expenses and other current assets (Note 5)
                                                    
                                                    
                                                    398
                                                    
                                                    
                                                    
                                                    526Inventory
                                                    
                                                    
                                                    33
                                                    
                                                    
                                                    
                                                    193Total
      current assets
                                                    
                                                    
                                                    3,296
                                                    
                                                    
                                                    
                                                    9,312Restricted
      cash and long–term investments (Note 3b)
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    1,085Property
      and equipment:Telecommunications
      equipment
                                                    
                                                    
                                                    17,806
                                                    
                                                    
                                                    
                                                    18,219Furniture,
      fixtures and other
                                                    
                                                    
                                                    623
                                                    
                                                    
                                                    
                                                    679Leasehold
      improvements
                                                    
                                                    
                                                    787
                                                    
                                                    
                                                    
                                                    4,870Capital
      leases
                                                    
                                                    
                                                    422
                                                    
                                                    
                                                    
                                                    225Computers
      hardware & software
                                                    
                                                    
                                                    9,181
                                                    
                                                    
                                                    
                                                    8,94628,819
                                                    
                                                    
                                                    
                                                    32,939Less
      accumulated depreciation
                                                    
                                                    
                                                    (27,378
                                                    )
                                                    
                                                    
                                                    (30,057Property and equipment,
      net
                                                    
                                                    
                                                    1,441
                                                    
                                                    
                                                    
                                                    2,882Goodwill,
      net
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    2,002Other
      intangible assets, net
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    1,902Deposits
                                                    
                                                    
                                                    117
                                                    
                                                    
                                                    
                                                    116Total
      assets
                                                    
                                                    $
                                                    4,854
                                                    
                                                    
                                                    $
                                                    17,299LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Current
      portion of capital leases
                                                    
                                                    $
                                                    148
                                                    
                                                    
                                                    $
                                                    69Accounts
      payable
                                                    
                                                    
                                                    1,485
                                                    
                                                    
                                                    
                                                    2,505Deferred
      revenues
                                                    
                                                    
                                                    771
                                                    
                                                    
                                                    
                                                    551Other
      current liabilities (Note 6)
                                                    
                                                    
                                                    1,615
                                                    
                                                    
                                                    
                                                    1,665Total
      current liabilities
                                                    
                                                    
                                                    4,019
                                                    
                                                    
                                                    
                                                    4,790Long-term
      liabilities:Capital
      leases - net of current portion (Note 7)
                                                    
                                                    
                                                    147
                                                    
                                                    
                                                    
                                                    144Severance
      pay obligations (Note 8)
                                                    
                                                    
                                                    140
                                                    
                                                    
                                                    
                                                    341Total
      current liabilities
                                                    
                                                    
                                                    287
                                                    
                                                    
                                                    
                                                    485Total
      liabilities
                                                    
                                                    
                                                    4,306
                                                    
                                                    
                                                    
                                                    5,275Commitments
      and contingencies (Note 9)Stockholders’
      equity (Note 10):Share
      capitalClass
      A Common stock, par value $0.001 per share; authorized 75,000,000
      shares;issued
      and outstanding: 32,870,105 at December 31, 2008 andDecember
      31, 2007. On February 12, 2009 71,870,105 shares were
      outstanding.
                                                    
                                                    
                                                    33
                                                    
                                                    
                                                    
                                                    33Additional
      paid-in capital
                                                    
                                                    
                                                    173,137
                                                    
                                                    
                                                    
                                                    172,747Accumulated
      deficit
                                                    
                                                    
                                                    (172,622
                                                    )
                                                    
                                                    
                                                    (160,756Total
      stockholders’ equity
                                                    
                                                    
                                                    548
                                                    
                                                    
                                                    
                                                    12,024Total
      liabilities and stockholders’ equity
                                                    
                                                    $
                                                    4,854
                                                    
                                                    
                                                    $
                                                    17,299




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





F-3
 Table of Contents




DELTATHREE, INC.


CONSOLIDATED
STATEMENTS OF OPERATIONS


($ in
thousands, except share data)




2008
                            
                            
                            2007
                            
                            
                            2006Revenues:
                            
                            $
                            20,226
                            
                            
                            $
                            29,477
                            
                            
                            $
                            37,953Costs
      and operating expenses:Cost
      of revenues (exclusive of $584, $599 and $615depreciation
      included in a separate line below, respectively)
                            
                            
                            14,744
                            
                            
                            
                            21,107
                            
                            
                            
                            24,375Research
      and development expenses (Note 11)
                            
                            
                            3,356
                            
                            
                            
                            4,669
                            
                            
                            
                            4,043Selling
      and marketing expenses
                            
                            
                            3,636
                            
                            
                            
                            5,068
                            
                            
                            
                            4,956General and administrative expenses
                            
                            
                            3,130
                            
                            
                            
                            2,952
                            
                            
                            
                            3,088Restructuring costs (Note 12)
                            
                            
                            1,223Write-off
      of goodwill (Note 13)
                            
                            2,002Write-off
      of intangible assets (Note 14)
                            
                            
                            1,564Change
      in deferred revenue relating to previous years (Note 15)
                            
                            
                            596
                            
                            
                            
                            2,680
                            
                            
                            
                            –Depreciation
      and amortization
                            
                            
                            1,836
                            
                            
                            
                            2,644
                            
                            
                            
                            1,543Total
      costs and operating expenses
                            
                            
                            32,087
                            
                            
                            
                            39,120
                            
                            
                            
                            38,005Loss
      from operations
                            
                            
                            (11,861
                            )
                            
                            
                            (9,643
                            )
                            
                            
                            (52
                            )Capital
      gain
                            
                            
                            39Other
      non-operating income
                            
                            
                            19
                            
                            
                            
                            13
                            
                            
                            
                            –Interest
      income, net
                            
                            
                            (35
                            )
                            
                            
                            442
                            
                            
                            
                            620Loss
      before income taxes
                            
                            
                            (11,838
                            )
                            
                            
                            (9,188
                            )
                            
                            
                            568Income
      taxes (Note 16)
                            
                            
                            28
                            
                            
                            
                            126
                            
                            
                            
                            61Net
      loss
                            
                            $
                            (11,866
                            )
                            
                            $
                            (9,314
                            )
                            
                            $
                            507Net
      loss per share-basic and diluted
                            
                            $
                            (0.36
                            )
                            
                            $
                            (0.29
                            )
                            
                            $
                            0.02Basic
      weighted average number of shares outstanding
                            
                            
                            32,870,105
                            
                            
                            
                            32,427,118
                            
                            
                            
                            29,771,470Diluted weighted average number of shares outstanding
                            
                            
                            32,870,105
                            
                            
                            
                            32,427,118
                            
                            
                            
                            30,129,011









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






F-4
 Table of Contents





DELTATHREE, INC.


STATEMENTS
OF STOCKHOLDERS’ EQUITY


($ in
thousands, except share data)




Class
      A Common StockNumber
      of Outstanding Shares
                              
                              
                              Number
      of Treasury
                                Shares
                              
                              
                              Amount
                              
                              
                              Additional
      Paid-in Capital
                              
                              
                              Treasury
      Stock (at Cost)
                              
                              
                              Accumulated
      Deficit
                              
                              
                              Total
      Stockholders'
                                EquityBalance
      at January 1, 2006
                              
                              
                              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
                              )
                              
                              $
                              12,024Share
      based compensation
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              390
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              390Loss
      for the year
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (11,866)
                              
                              
                              
                              (11,866)Balance
      at December 31, 2008
                              
                              
                              32,870,105
                              
                              
                              
                              -
                              
                              
                              
                              33
                              
                              
                              
                              173,137
                              
                              
                              
                              -
                              
                              
                              
                              (172,622)
                              
                              
                              
                              548




* 
Less than $1,000.







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





F-5
 Table of Contents




DELTATHREE, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


($ in
thousands)





Year
      ended December 31,2008
                                                        
                                                        
                                                        2007
                                                        
                                                        
                                                        2006Cash
      flows from operating activities:Net
      (loss) income
                                                        
                                                        $
                                                        (11,866)
                                                        
                                                        
                                                        $
                                                        (9,314)
                                                        
                                                        
                                                        $
                                                        507Adjustments
      to reconcile net loss to net cash (used in) provided
      by   operating activitiesWrite-off
      for intangible assets
                                                        
                                                        
                                                        3,566
                                                        
                                                        
                                                        
                                                        2,680
                                                        
                                                        
                                                        
                                                        –Depreciation
      and amortization
                                                        
                                                        
                                                        1,537
                                                        
                                                        
                                                        
                                                        1,576
                                                        
                                                        
                                                        
                                                        1,543Amortization
      of intangible asset
                                                        
                                                        
                                                        338
                                                        
                                                        
                                                        
                                                        1,068
                                                        
                                                        
                                                        
                                                        –Write off of  NY office equipment
                                                        
                                                        
                                                        357Telecom tax adjustment
                                                        
                                                        
                                                        700Stock
      based compensation
                                                        
                                                        
                                                        390
                                                        
                                                        
                                                        
                                                        485
                                                        
                                                        
                                                        
                                                        480Capital
      gain, net
                                                        
                                                        
                                                        (39)
                                                        
                                                        
                                                        
                                                        –
                                                        
                                                        
                                                        
                                                        (1)Liability
      for severance pay, net
                                                        
                                                        
                                                        (201)
                                                        
                                                        
                                                        
                                                        124
                                                        
                                                        
                                                        
                                                        62Provision
      for losses on accounts receivable
                                                        
                                                        
                                                        121
                                                        
                                                        
                                                        
                                                        110
                                                        
                                                        
                                                        
                                                        25Exchange
      rates differences on deposits, net
                                                        
                                                        
                                                        (1)
                                                        
                                                        
                                                        
                                                        (6)
                                                        
                                                        
                                                        
                                                        –Change
      in deferred revenues relating to previous years
                                                        
                                                        
                                                        596Changes
      in operating assets and liabilities;Decrease
      (increase) in accounts receivable
                                                        
                                                        
                                                        180
                                                        
                                                        
                                                        
                                                        115
                                                        
                                                        
                                                        
                                                        (608Decrease
      (increase) in prepaid expenses other current assets
                                                        
                                                        
                                                        128
                                                        
                                                        
                                                        
                                                        (82
                                                        )
                                                        
                                                        
                                                        168Decrease
      (increase) in inventory
                                                        
                                                        
                                                        160
                                                        
                                                        
                                                        
                                                        (38
                                                        )
                                                        
                                                        
                                                        87Decrease
      in accounts payable
                                                        
                                                        
                                                        (1,020)
                                                        
                                                        
                                                        
                                                        (778
                                                        )
                                                        
                                                        
                                                        (988)(Decrease)
      increase in deferred revenues
                                                        
                                                        
                                                        (376)
                                                        
                                                        
                                                        
                                                        (1,172
                                                        )
                                                        
                                                        
                                                        755(Decrease)
      increase in other current liabilities
                                                        
                                                        
                                                        (750)
                                                        
                                                        
                                                        
                                                        120
                                                        
                                                        
                                                        
                                                        55,686
                                                        
                                                        
                                                        
                                                        4,202
                                                        
                                                        
                                                        
                                                        1,528Net
      cash (used in) provided by operating activities
                                                        
                                                        
                                                        (6,180)
                                                        
                                                        
                                                        
                                                        (5,112
                                                        )
                                                        
                                                        
                                                        2,035Cash
      flows from investing activities:Purchase
      of property and equipment
                                                        
                                                        
                                                        (358)
                                                        
                                                        
                                                        
                                                        (724
                                                        )
                                                        
                                                        
                                                        (883Proceeds
      from sale of property and equipment
                                                        
                                                        
                                                        141
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        14Long
      term investment, net
                                                        
                                                        
                                                        1,085
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        131Decrease
      (increase) in short-term investments
                                                        
                                                        
                                                        5,566
                                                        
                                                        
                                                        
                                                        6,184
                                                        
                                                        
                                                        
                                                        (1,419Purchase
      of Go2Call operations, net
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        (2,509)Net
      change in deposits
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        (5)Net cash provided by (used in)
      investing activities
                                                        
                                                        
                                                        6,434
                                                        
                                                        
                                                        
                                                        2,951
                                                        
                                                        
                                                        
                                                        (2,162)Cash
      flows from financing activities:Payment
      of capital leases
                                                        
                                                        
                                                        (115)
                                                        
                                                        
                                                        
                                                        (12
                                                        )
                                                        
                                                        
                                                        -Proceeds
      from exercise of employee options
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        32
                                                        
                                                        
                                                        
                                                        70Net cash provided by financing
      activities
                                                        
                                                        
                                                        (115)
                                                        
                                                        
                                                        
                                                        20
                                                        
                                                        
                                                        
                                                        70Increase
      (decrease) in cash and cash equivalents
                                                        
                                                        
                                                        139
                                                        
                                                        
                                                        
                                                        (2,141
                                                        )
                                                        
                                                        
                                                        (57Cash
      and cash equivalents at beginning of year
                                                        
                                                        
                                                        1,649
                                                        
                                                        
                                                        
                                                        3,790
                                                        
                                                        
                                                        
                                                        3,847Cash
      and cash equivalents at end of year
                                                        
                                                        
                                                        1,788
                                                        
                                                        
                                                        
                                                        1,649
                                                        
                                                        
                                                        
                                                        3,790




Supplemental
      disclosures of cash flow information:Cash
      paid for:Taxes
                  
                  
                  48
                  
                  
                  
                  108
                  
                  
                  
                  68Supplemental
      schedule of non cash investing and financing activities:Acquisition
      of fixed assets on credit
                  
                  
                  -
                  
                  
                  
                  -Acquisition
      of capital leases
                  
                  
                  197
                  
                  
                  
                  225
                  
                  
                  
                  -Cancellation
      of treasury stock
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  210


Supplemental
      schedule of acquisition of Go2CallFixed
      assets
                                
                                
                                $
                                51Goodwill
                                
                                
                                
                                2,002Intangible
      assets
                                
                                
                                
                                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
 Table of Contents




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.




Going
Concern




The
Company has sustained significant operating losses in recent periods, which has
led to a significant reduction in its cash reserves.  The Company
initiated a restructuring plan in 2008 that has helped the Company cut its
operating costs significantly and better align the Company’s operations with its
current business model, but there are no assurances that these actions will be
sufficient to return the Company to positive cash flow.  On February 10,
2009, the Company entered into a Securities Purchase Agreement (the “Purchase
Agreement”) with D4 Holdings, LLC (“D4 Holdings”), a Delaware limited liability
company. Pursuant to the terms of the Purchase Agreement, the Company issued to
D4 Holdings 39,000,000 shares (the “Shares”) of Class A Common Stock, par value
$0.001 per share of the Company (the “Common Stock”), representing approximately
54.3% of the total number of issued and outstanding shares of Common Stock, for
an aggregate purchase price of $1,170,000, payable in cash.  In
addition, the Company issued to D4 Holdings a warrant (the “Warrant”),
exercisable for ten years, to purchase up to an additional 30,000,000 shares of
Common Stock at an exercise price of $0.04 per share.  The Company
expects to use the proceeds from the sale of the Shares primarily for working
capital purposes.  Nevertheless, there are no assurances that the
Company will be able to return to positive cash flow before it requires
additional cash, which raises substantial doubts about the ability of the
Company to continue as a going concern.




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 Delta
Three Israel Ltd., the Company's Israeli subsidiary (the “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 its 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




Cash held
in banks, are subject to U.S. Federal Depository Insurance Corporation (“FDIC”)
limits of $250,000 and cash held in foreign accounts are
unprotected.  Due to the Company’s cash needs, management has
generally held and continues to hold its cash in U.S. banks that are insured
under the FDIC.




F-7
 Table of Contents




f .
    Restricted Cash





Restricted
cash represents amounts held in cash, money market funds and certificates of
deposit 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.  The
Company does not currently have any of its assets invested in marketable
securities, but rather all amounts are held in cash.




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.  At December 31, 2008, there were no intangible assets listed
on the Company’s balance sheet.




k.     Write-off
of goodwill and intangible assets




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.  During 2008, the Company
amortized approximately $338,000and wrote-off
approximately $2.0 million in goodwill and $1.6 million in intangible assets
associated with the acquisition of certain assets in the Go2Call transaction
discussed below


.


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.




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.




F-8
 Table of Contents




p.     Stock-based
compensation





In
January 1, 2006, the Company adopted the provisions of SFAS No. 123 (revised
2004), “Share-Based Payment” (SFAS No. 123(R)). SFAS No. 123(R) requires
employee share-based equity awards to be recognized and measured using the fair
value method. Accordingly, stock-based compensation to employees and directors
is measured at the grant date, based on the fair value of the
award.




The
following assumptions were used for the fiscal year 2008: dividend yield of
0.00% for all periods; risk-free interest rate of 4.0%; an expected life of
3-years for all periods; and a volatility rate of 75%.




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 and restricted
units




The
Company has granted restricted shares and restricted units to purchase 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 share
and restricted unit plan has been approved by the Board of Directors. The
Company records compensation expense associated with non-vested restricted
shares and restricted unitsthat have been granted
in accordance with SFAS No. 123(R). In accordance with the
aforementioned statement, the Company calculates 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 recognizes 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.





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.




F-9
 Table of Contents





w.     Recently issued accounting
      standards





SFAS
      No. 162




In May
2008, the FASB issued Statement of Financial Accounting Standards (SFAS) No.
162, “The Hierarchy of Generally Accepted Accounting Principles”. SFAS No. 162
identifies the sources of accounting principles and provides entities with a
framework for selecting the principles used in preparation of financial
statements that are presented in conformity with GAAP. The current GAAP
hierarchy has been criticized because it is directed to the auditor rather than
the entity, it is complex, and it ranks FASB Statements of Financial Accounting
Concepts, which are subject to the same level of due process as FASB Statements
of Financial Accounting Standards, below industry practices that are widely
recognized as generally accepted but that are not subject to due process. The
FASB believes the GAAP hierarchy should be directed to entities because it is
the entity (not its auditors) that is responsible for selecting accounting
principles for financial statements that are presented in conformity with GAAP.
The adoption of FASB 162 is not expected to have a material impact on the
Company's financial position.





FSP
EITF 03-6-1




In June
2008, the FASB issued FASB Staff Position No. EITF 03-6-1, “Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities” (“FSP EITF 03-6-1”). FSP EITF 03-6-1 establishes that unvested
share-based payment awards that contain nonforfeitable rights to dividends or
dividend equivalents (whether paid or unpaid) are participating securities as
defined in Emerging Issues Task Force (“EITF”) Issue No. 03-6, “Participating
Securities and the Two-Class Method under FASB Statement No. 128”, and should be
included in the computation of earnings per share pursuant to the two-class
method as described in Statement of Financial Accounting Standards No. 128,
“Earnings per Share”. FSP EITF 03-6-1 is effective for financial statements
issued for fiscal years beginning after December 15, 2008, and interim periods
within those years. All prior-period earnings per share data presented shall be
adjusted retrospectively to conform to the provisions of FSP EITF 03-6-1. Early
application is not permitted. The Company is currently evaluating the impact
that the adoption of FSP EITF 03-6-1 will have on its consolidated financial
statements but believes that its effect will be immaterial due to immaterial use
of instruments within the scope of the FSP.





Note 3
-Investment
in marketable securities and deposits





The
following is a summary of our restricted cash and available-for-sale securities
as of December 31, 2008 and 2007.




a.    
Restricted cash and short-term investments




Comprised
as follows:




December
      31,2008
                        
                        
                        2007($ in
      thousands)Restricted
      cash (money market funds)*
                        
                        $
                        160
                        
                        
                        $
                        481Auction
      rate securities
                        
                        
                        
                        
                        
                        
                        3,675Bank
      deposits
                        
                        
                        157
                        
                        
                        
                        1,727Total
      restricted cash and short-term investments
                        
                        
                        317
                        
                        
                        
                        5,883




*
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.





b.     Restricted cash and
long-term investments




Comprised
as follows:




December
      31,2008
                      
                      
                      2007($ in
      thousands)Restricted  cash
      (money market funds)*
                      
                      $
                      -
                      
                      
                      $
                      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. During the fourth quarter of 2008 the Company executed an
agreement with the landlord and subtenant of its offices at 75 Broad Street, New
York, N.Y., to release the letter of credit securing the company's obligations
under the lease, and to terminate the lease.





F-10
 Table of Contents




Note 4
-   Accounts receivable, net




Accounts
receivable are stated net of an allowance for doubtful accounts of approximately
$121,000 and $110,000 at December 31, 2008 and 2007,
respectively.




Note 5 -  Prepaid
expenses and other current assets




Prepaid
expenses and other current assets consist of the following:




December
      31,2008
                        
                        2007($ in
      thousands)Government
      of Israel (VAT refund and other)
                        
                        $
                        34
                        
                        
                        $
                        74Deposits
      with suppliers
                        
                        
                        109
                        
                        
                        
                        61Prepaid
      expenses
                        
                        
                        238
                        
                        
                        
                        308Other
                        
                        
                        17
                        
                        
                        
                        83Total
      prepaid expenses and other current assets
                        
                        $
                        398
                        
                        
                        $
                        526




Note 6 - Other current
liabilities





Other
current liabilities consist of the following:




December
      31,2008
                        
                        2007($ in
      thousands)Accrued
      expenses
                        
                        $
                        1,117
                        
                        
                        $
                        1,176Employees
      and related expenses
                        
                        
                        480
                        
                        
                        
                        427Other
                        
                        
                        18
                        
                        
                        
                        62Total
      other current liabilities
                        
                        $
                        1,615
                        
                        
                        $
                        1,665




Note 7 - Capital leases -
net of current portion




Future
minimum non-cancelable lease payments required after December 31, 2008 are as
follows




2009
                
                $
                1482010
                
                
                1402011
      and
      thereafter
                
                
                7Total
      capital
      leases
                
                $
                295




Note 8 - Severance pay
obligations




The
Subsidiary is subject to certain Israeli laws and labor agreements that
determine the obligations of the Subsidiary to make severance payments to
dismissed employees and to employees leaving the Subsidiary 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 the
Subsidiary 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 the Subsidiary.





Expenses
(income) relating to employee termination benefits were $160,026, $19,942 and
$11,860 for the years ended December 31, 2008, 2007 and 2006,
respectively.




The
aggregate value of the insurance policies as of December 31, 2008 and 2007 was
$486,632 and $910,452, respectively.




F-11
 Table of Contents




Note 9 - Commitments and
contingencies




a.     Lease commitments





Until
July 15, 2008,the
Company leased its executive offices on the 31st and
32nd
floors at 75 Broad Street, New York, New York. The term of the lease was until
July 2010. In October 2003 the Company entered into a sub-lease agreement with
eMarketer, Inc. (“eMarketer”) to sub-lease the Company’s office space on the
32nd
floor.  The term of the sublease was until July 2010.





As of
July 15, 2008, eMarketer subleased from the Company its offices located on the
31st
floor, and effective August 1, 2010, eMarketer was to be substituted in place of
the Company as the tenant under the lease between the Company and the
landlord.  On November 20, 2008, upon receipt of a termination fee
equal to $450,000 payable by the Company and a letter of credit provided by
eMarketer in the amount of $850,000 to the landlord, the landlord substituted
eMarketer for the Company as the tenant under the lease and returned to the
Company the original letter of credit in the approximate amount of $1.0 million
the Company had provided to secure its obligations under the lease.





The
Company is currently renting office space at 419 Lafayette Street, New York,
N.Y. on an interim basis while it seeks long-term facilities.





Rent
expense, net for the Company’s U.S. offices was $310,000, $650,000 and $653,202
for the years ended December 31, 2008, 2007 and 2006, respectively.





The
Subsidiary leases a 1,290 square meter office, which houses the Company’s
research and development facilities, in Jerusalem, Israel, at an annual
cost of approximately $265,900; in 2008, the Company also received approximately
$31,200 from a subtenant that was subleasing part of the Company’s office
space.  The term of the Subsidiary’s lease extends through December 2014.
The Subsidiary has an option to terminate the lease, effective December 31,
2009, by providing written notice thereof prior to June 1, 2009, and paying a
termination fee equal to approximately $40,000.





Rent
expense, net for the Subsidiary was $220,000, $200,000 and $209,000 for the
years ended December 31, 2008, 2007 and 2006, respectively




b.
    Legal
proceedings





On
December 5, 2008, a complaint for patent infringement was filed in the United
States District Court for the Eastern District of Texas (Tyler Division) by
Centre One naming the Company, Verizon Communications Inc., Vonage Holdings
Corp. and Vonage America Inc. as defendants.  The complaint alleges,inter alia, that the Company
and Verizon are offering for sale “a VoIP service, including, but not limited
to, a service under the name Verizon VoiceWing” that infringes United States
Patent No. 7,068,668, or Patent ’668, entitled “Method and Apparatus for
Interfacing a Public Switched Telephone Network and an Internet Protocol Network
for Multi-Media Communication.”





On
February 23, 2009, defendants Vonage Holdings and Vonage America filed a motion
to transfer the action from the United States District Court for the Eastern
District of Texas (Tyler Division) to the United States District Court for the
District of New Jersey.  The transfer motion argued that none of the
parties have meaningful contacts with the Eastern District of Texas and that
most of the defendants’ evidence and fact witnesses are located in or near New
Jersey.  On March 6, 2009, the Company filed an Answer and
Counterclaim, in which it denied that it has infringed Patent ’668 and sought
declaratory judgments that: it has not infringed Patent ’668; any alleged
infringement would not be actionable due to one or more of the Company’s
affirmative defenses; and Patent ’668 is invalid and unenforceable due to
inequitable conduct and a failure to meet the requirements of
patentability.  Also on March 6, the Company joined the Vonage
defendants in moving to transfer the action to the United States District Court
for the District of New Jersey. The transfer motions remain
pending.





On April
7, 2009, the court held a status conference and assigned May 6, 2010, and
December 6, 2010, as the dates for the pretrial hearing to interpret the
construction of Centre One’s claims and the commencement of the trial,
respectively.





The
Company’s initial examination of the allegations set forth in the Complaint
leads the Company to firmly believe that it does not infringe any valid claim of
Patent ’668. The Company is continuing its examination into the allegations set
forth in the complaint and the validity of Patent ’668, and cannot predict with
any degree of certainty the results of its examination and/or the outcome of the
suit or determine the extent of any potential liability or damages.





The
Company, as well as certain of its former officers and directors, was named as a
co-defendant in a number of purported securities class actions in the United
States District Court for the Southern District of New York, arising out of its
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. The case is currently
being litigated against a small number of focus issuers (which does not include
the Company) selected by the district court. A confidential global settlement is
presently being negotiated between the plaintiffs, issuers, underwriters and
insurers, which ultimately will be subject to the approval of the district
court. If the settlement does not occur, and litigation against us recommences,
the Company believes that it has meritorious defenses to the claims against the
Company and the Company and intends to defend the case vigorously.





The
Company is not a party to any other material pending legal proceedings, other
than ordinary routine litigation incidental to the business, to which the
Company is a party or of which any of its property is the subject.




F-12
 Table of Contents




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.   Regulation




Although
there are several regulatory proceedings currently pending before federal
authorities, VoIP telephony is lightly regulated compared to more traditional
telecommunications services. 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. The rulemaking is ongoing
and the Company cannot predict the outcome of this proceeding.  In
November 2004, the FCC determined that certain interconnected VoIP services
(meaning VoIP services that can be used to send and receive calls to or from the
public switched telephone network, or PSTN), including some services that are
similar to those provided by the Company, should be considered interstate
services subject to federal rather than state jurisdiction.  Although
this ruling was appealed by several states, on March 21, 2007, the United States
Court of Appeals for the Eighth Circuit affirmed the FCC’s
determination.





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 would no longer be
exempt from more onerous  telecommunications-related regulatory
obligations, or other economic regulations typically imposed on traditional
telecommunications carriers.




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". The order applies
to the Company’s iConnectHere and joip customers, or its “consumer 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 the
Company’s services for the provision of services directly to end users. 
The Company cannot predict whether it would be subject to any third-party
litigation in connection with such customers who resell its
services.




First,
the order required the Company to notify its consumer 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 its consumer 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
interconnected VoIP providers, like the Company, that have received affirmative
acknowledgement from at least 90% of their subscribers. The Company received
affirmative acknowledgment from more than 95% of its customers that they
understand the nature of the emergency services available through our service,
and thus the Company believes that 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 its consumer 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. 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.




Almost
all of the Company’s consumer customers currently receive E-911 service in
conformity with the FCC’s order, but (as is the case with customers for other
interconnected VoIP providers) some customers who were receiving service prior
to the FCC’s deadline for compliance with the E-911 regulations may not receive
such service. 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
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.





The FCC is considering enhancing its
VoIP E-911 rules.  In June, 2007, the FCC released a Notice of
Proposed Rulemaking to consider whether it should impose additional obligations
on interconnected VoIP providers.  Specifically, the FCC included a
proposal that interconnected VoIP providers be required to automatically
determine the location of their customers for purposes of E-911 rather than
require customers to update their existing location (as is the case under the
current regulations).  Moreover, the Notice included a tentative
conclusion that interconnected VoIP providers that allow their service to be
used in more than one location, like the Company, be required to meet the same
customer location accuracy standards applicable to providers of mobile
telecommunications services.  The Company cannot predict the outcome
of this proceeding or its potential impact on its business.





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.  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.  As a result of the steps the Company has taken, the
Company believes that it complies with CALEA.





F-13
 Table of Contents




The FCC
decided in June 2006 that interconnected VoIP service providers should be
required to contribute to the universal service fund, or USF. 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) a
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
FCC suggested that its preemption of state regulation of such services may 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. Furthermore, some states may
attempt to impose state universal service contribution requirements on
interconnected VoIP providers such as deltathree. At this time, various states –
including Nebraska and New Mexico – claim that they have the right to require
interconnected VoIP providers to contribute to their respective USF funds. The
attempts of the Nebraska and New Mexico authorities to impose state USF
obligations on interconnected VoIP providers are currently subject to
litigation, and the Company cannot predict how the courts, the FCC, and states
may rule on these matters.





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. 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 the Company and other
companies like it to protect customer calling and network information and to
file formal certifications with the FCC regarding procedures for protecting this
information. As a result of the steps the Company has taken, the Company
believes that it complies with the FCC’s order regarding CPNI.





On June
15, 2007, and effective October 5, 2007, interconnected VoIP providers, like the
Company, became required to make certain that their equipment and service is
accessible to and usable by individuals with disabilities, if readily
achievable, which the Company did. In addition, interconnected VoIP providers
like the Company became obligated to contribute to the Telecommunications Relay
Services, or TRS, fund and to offer 711 abbreviated dialing for access to relay
services. Following March 31, 2009, interconnected VoIP providers are required
to route such 711 calls to the appropriate TRS center based upon the registered
location provided by such customers.  Although the Company experienced
a delay in providing 711 abbreviated dialing for access to relay services and
routing such services to the appropriate relay center, it is in the final stages
of implementing such requirements and expects to provide such services in the
immediate future.





On August
6, 2007 and effective November 2007, the FCC adopted an Order concerning the
collection of regulatory fees for Fiscal Year 2007 requiring the collection of
such fees from interconnected VoIP providers like the Company. Interconnected
VoIP providers pay regulatory fees based on interstate and international
revenues. The Regulatory Fees Order became effective in November
2007.





On
November 8, 2007, the FCC released an Order relating to local number portability
imposing local number portability and related obligations on interconnected VoIP
Providers like us. The Order requires interconnected VoIP providers to
contribute to shared numbering administration costs. Additionally, the Order
mandates that the Company port telephone numbers within certain
timeframes.  As a result of the steps the Company has taken, it
believes that it complies with the FCC’s order regarding local number
portability.


There are
several other recent or ongoing regulatory proceedings initiated by various
persons that relate to VoIP and other Internet services. Although the specific
effects of any such future regulations cannot be determined, increased
regulation and the imposition of additional funding requirements may increase
the Company’s costs and adversely affect the Company’s business, financial
condition, operating results and future prospects.  The Company has
recently completed an initial study of FCC-related fees that are due and has
accrued approximately $200,000 of estimated fees due through December 31,
2008.  The Company has also determined that it needs to collect and
remit such FCC-related fees and will begin collecting and remitting such
FCC-related fees and sales and excise taxes in the immediate
future.




In
addition, some state and local regulatory authorities believe they retain
jurisdiction to regulate the provision of, and impose taxes, fees and surcharges
on, intrastate Internet and VoIP telephony services, and have attempted to
impose such taxes, fees and surcharges, such as a fee for providing E-911
service. Rulings by the state commissions on the regulatory considerations
affecting Internet and IP telephony services could affect the Company’s
operations and revenues, and the Company cannot predict whether state
commissions will be permitted to regulate the services the Company offers in the
future.





The
Company is in the process of examining the applicability of such state and other
local taxes and other fees. It has recently completed an initial study of state
and local taxes and other fees and has accrued approximately $500,000 of
estimated taxes and fees due through the year ended December 31,
2008.  It has also determined that it needs to collect and remit sales
and excise taxes in certain states and local jurisdictions and will begin
collecting and remitting such sales and excise taxes in the immediate
future.  To the extent the Company increases the cost of services to
its customers to recoup some of the costs of compliance, this will have the
effect of decreasing any price advantage the Company may have over traditional
telecommunications companies.





In
addition, it is possible that the Company will be required to collect and remit
taxes, fees and surcharges in other states and local jurisdictions where it has
not done so, and which such authorities may take the position that the Company
should have collected. If so, they may seek to collect those past taxes, fees
and surcharges from the Company and impose fines, penalties or interest charges
on the Company. Our payment of these past taxes, fees and surcharges, as well as
penalties and interest charges, could have a material adverse effect on the
Company.




Note 10
-Stockholders'
equity




a.
    Share
capital




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





F-14
 Table of Contents




b.     Change in Control





On
February 10, 2009, the Company entered into the Purchase Agreement with D4
Holdings pursuant to which the Company issued to D4 Holdings the Shares,
representing approximately 54.3% of the total number of issued and outstanding
shares of Common Stock, for an aggregate purchase price of $1,170,000, payable
in cash, and the Warrant, exercisable for ten years, to purchase up to an
additional 30,000,000 shares of Common Stock at an exercise price of $0.04 per
share.  The transaction closed on February 12, 2009.





In
connection with the closing of the transaction and pursuant to the terms of the
Purchase Agreement, Noam Bardin resigned as a director and the board of
directors appointed Robert Stevanovski and Anthony Cassara to serve on the
board.  In addition, Lior Samuelson resigned as Chairman of the Board
and remained a director, and Robert Stevanovski was appointed to serve as
Chairman.  Under the terms of the Purchase Agreement, D4 Holdings had
the right to nominate for appointment by the board one director in addition to
Messrs. Stevanovski and Cassara, and it nominated David
Stevanovski.  In addition, on March 4, 2009, the Board of Directors of
the Company increased the size of the board from five to seven members and
filled the two vacancies remaining on the board by appointing Gregory Provenzano
and J. Lyle Patrick as directors.   The appointments of the three new
directors to serve on the board became effective on March 28, 2009.





As a
result of the transaction between the Company and D4 Holdings, D4 Holdings
obtained a controlling interest in the Company.





c.     Stock Options




In
November 1999, the Company’s Board of Directors adopted the 1999 Stock Incentive
Plan. Under this plan, 4,000,000 shares of the Common Stock 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 awards, either
in the form of incentive or non-incentive stock options, restricted stock or
restricted units, for (a) 3,000,000 shares, plus (b) 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 (c) 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. 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 Common Stock 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.  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, 2008, 114,666 shares of
restricted stock had been awarded to non-employee directors under the
plan.





As of
December 31, 2008, options to purchase 693,541 shares of Common Stock
granted under the Company’s stock incentive plans were exercisable and
outstanding with exercise prices ranging between $0.15 and $10.25 per
share.




A summary
of the status of the Company’s stock incentive plans as of December 31, 2006,
2007 and 2008 and changes during the years then ended, is presented
below:




December
      31, 2006
                                
                                
                                December
      31, 2007
                                
                                
                                December
      31, 2008Number
      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
                                
                                
                                2,762,686
                                
                                
                                $
                                2.58
                                
                                
                                
                                2,330,835
                                
                                
                                $
                                2.06
                                
                                
                                
                                1,560,020
                                
                                
                                $
                                1.91Granted
      during the year
                                
                                
                                105,000
                                
                                
                                
                                3.17
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                3,910,000
                                
                                
                                
                                0.16Exercised
      during the year
                                
                                
                                68,982
                                
                                
                                
                                1.04
                                
                                
                                
                                35,000
                                
                                
                                
                                0.89
                                
                                
                                
                                -Forfeited
      during the year
                                
                                
                                467,869
                                
                                
                                
                                5.53
                                
                                
                                
                                735,815
                                
                                
                                
                                1.02
                                
                                
                                
                                3,116,479
                                
                                
                                
                                1.92Outstanding
      at end of year
                                
                                
                                2,330,835
                                
                                
                                $
                                2.06
                                
                                
                                
                                1,560,020
                                
                                
                                $
                                1.91
                                
                                
                                
                                2,353,541
                                
                                
                                $
                                0.85Weighted
      average fair value of options granted during the year
                                
                                $
                                3.17
                                
                                
                                
                                
                                
                                
                                $
                                0.00
                                
                                
                                
                                
                                
                                
                                $
                                0.16







F-15
 Table of Contents




Additional
information regarding options outstanding as of December 31, 2008 is as
follows:




Options
      Outstanding
                                  
                                  
                                  Options
      ExercisableRange
      of
                                    Exercise
      Prices
                                  
                                  
                                  Number
      of
                                    Outstanding
                                  
                                  
                                  Weighted
      average
                                    Remaining
                                    Contractual
                                    Life
      (Years)
                                  
                                  
                                  Weighted
                                    Average
                                    Exercise
      Price
                                  
                                  
                                  Number
      of
                                    Exercisable
      Options
                                  
                                  
                                  Weighted
                                    Average
                                    Exercise
      Price$
                                  0.15
      - $0.16
                                  
                                  
                                  
                                  1,360,000
                                  
                                  
                                  
                                  9.3
                                  
                                  
                                  $
                                  0.15
                                  
                                  
                                  
                                  -
                                  
                                  
                                  $
                                  -$
                                  0.39
                                  
                                  
                                  
                                  300,000
                                  
                                  
                                  
                                  9.1
                                  
                                  
                                  
                                  0.39
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -$
                                  1.02
                                  
                                  
                                  
                                  221,334
                                  
                                  
                                  
                                  0.2
                                  
                                  
                                  
                                  1.02
                                  
                                  
                                  
                                  221,334
                                  
                                  
                                  
                                  1.02$
                                  1.75
                                  
                                  
                                  
                                  114,500
                                  
                                  
                                  
                                  1.8
                                  
                                  
                                  
                                  1.75
                                  
                                  
                                  
                                  114,500
                                  
                                  
                                  
                                  1.75$
                                  2.85 – $3.20
                                  
                                  
                                  
                                  294,000
                                  
                                  
                                  
                                  4.7
                                  
                                  
                                  
                                  2.95
                                  
                                  
                                  
                                  294,000
                                  
                                  
                                  
                                  2.95$
                                  5.11
      - $10.25
                                  
                                  
                                  
                                  63,707
                                  
                                  
                                  
                                  .3
                                  
                                  
                                  
                                  5.51
                                  
                                  
                                  
                                  63,707
                                  
                                  
                                  
                                  5.512,353,541
                                  
                                  
                                  
                                  7.24
                                  
                                  
                                  $
                                  0.85
                                  
                                  
                                  
                                  693,541
                                  
                                  
                                  $
                                  2.37




c.   Restricted shares of the Company’s
Common Stock





During
the year ended December 31, 2008, the Company granted restricted shares of the
Company’s common stock and restricted units to purchase 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 and restricted units 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 and restricted units 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 and restricted units is typically three years.
The intrinsic value of the restricted shares of common stock and restricted
units 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 2008, the Company recognized
approximately $88,851 of
compensation expense related to the amortization of the restricted shares of
common stock and restricted units to purchase shares of common stock. During
2008, the Company granted a total of 240,000 restricted shares of common stock
to its employees.




Note
11 -Research
and development expenses





Research
and development expenses consist of the following:




Year ended December
      31,($ in
      thousands)2008
                      
                      2007
                      
                      2006Salaries
      and related expenses
                      
                      $
                      2,564
                      
                      
                      $
                      3,498
                      
                      
                      $
                      2,370Consulting
      and advisory fees
                      
                      
                      120
                      
                      
                      
                      235
                      
                      
                      
                      297Travel
                      
                      
                      25
                      
                      
                      
                      104
                      
                      
                      
                      816Other
                      
                      
                      647
                      
                      
                      
                      832
                      
                      
                      
                      560Total
      research and development expenses
                      
                      $
                      3,356
                      
                      
                      $
                      4,669
                      
                      
                      $
                      4,043





Note 12 - Restructuring
Costs




During
2008, we recorded reorganization expenses totaling approximately $1.2 million.
No such expenses were recorded during 2007. The reorganization expenses are
one-time costs related to: (i) changes to the structure of our work force,
including three reductions in force, that totaled approximately $0.3 million;
(ii) the termination of our sublease of our New York office for the remaining
term of the lease, for which we have accrued the shortfall between the rental
amounts we will be receiving from the subtenant and the rental amount we need to
pay to the landlord and legal costs associated with the sublease, legal costs
and broker fees associated with the sublease, or approximately $0.5 million;
(iii) write-offs of equipment from our New York office of approximately $0.3
million; and (iv) severance costs we have paid to our former Chief Executive
officer of approximately $0.1 million.




F-16
 Table of Contents




Note 13 - Write-off of
Go2Call goodwill


As part
of the Company’s acquisition of Go2Call, it recognized goodwill of approximately
$2.0 million relating to its reseller division.  During the third
quarter of 2008, the Company assessed the value of its reseller division and
determined that based on its general current financial condition and the
specific state of the reseller division it would be appropriate to write-off the
entire value of the goodwill acquired in the Go2Call acquisition, or $2.0
million.
 
 Note 14 - Write-off of
Go2Call intangible assets
  As part
of its assessment of the Company’s current financial situation and operations,
management has written-off the balance of the intangible assets associated with
the Go2Call transaction during 2008 in continuation of what the Company started
during the fourth quarter of 2007. During the second quarter of 2008, management
reached the conclusion that we will not invest significant resources into the
segment of the business that the Company purchased as part of the Go2Call
transaction. As a result, the Company decided to write off $0.5 million,
representing the entire amount of the asset allocated to that portion of the
business, in the second quarter to properly adjust the value of the intangible
asset associated with that portion of the business.  In addition,
during the third quarter our management assessed the life of the remaining
intangible assets associated with the purchase of certain assets from Go2Call
and reached the conclusion that the carrying amount of the assets exceeded the
fair value attributable to those assets as a result of the Company’s current
financial situation.  Consequently, the Company decided to write-off
entirely the remaining value of these assets, or approximately $3.1 million,
since management believed that these assets can no longer sustain their value
without additional capital contributed to the Company.
  Note 15 – Change in deferred
revenue relating to previous years
  During
the first half of 2008, the Company restated its deferred revenue to include
$0.6 million in deferred revenue liability.  Management has concluded
that the adjustment is not a result of its current operations but rather most
likely occurred during the year ended December 31, 2005 and possibly years
prior.  Although the cumulative error might have been material to the
financial statements for the fiscal year ended December 31, 2005,
management does not believe that restating the financial statements for the
fiscal year ending December 31, 2005, would have a material impact on the profit
and loss statements of the Company for the years ended December 31, 2006 and
2007.
  Note 16
-Income
taxes
  a.  
Provision for income taxes
  No
provision for income taxes was required for the years ended December 31, 2008,
2007 and 2006 due to net losses in these periods.
  b.   Net operating loss
carryforwards
  As of
December 31, 2008, the Company had net operating loss carryforwards generated in
the U.S. and Israel of approximately $80.0 million and $5.7 million
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 Subsidiary received
final tax assessments through the tax year ended December 31, 1999.
 
 On
February 12, 2009, the Company consummated the transaction with D4 Holdings
pursuant to which the Company issued to D4 Holdings the Shares, representing
approximately 54.3% of the total number of issued and outstanding shares of
Common Stock, for an aggregate purchase price of $1,170,000, payable in cash,
and the Warrant, exercisable for ten years, to purchase up to an additional
30,000,000 shares of Common Stock at an exercise price of $0.04 per
share.  The transaction closed on February 12, 2009.  Under
Section 382 of the Internal Revenue Code of 1986, as amended, the net operating
losses noted above may be limited and may be further limited if D4 Holdings
exercises the Warrant.  The Company has not yet determined the effect
the change of control will have on its net operating losses, and has not
ascribed any value to these net operating losses in the Company’s financial
statements.




c.   In accordance with SFAS No. 109, the
components of deferred income taxes are as follows:




December 31,2008
                
                2007($ in
      thousands)Net
      operating losses carryforwards
                
                $
                30,235
                
                
                $
                26,042Less
      valuation allowance
                
                
                (30,235
                )
                
                
                (26,042
                )Net
      deferred tax assets
                
                $
                —
                
                
                $
                —





As of
December 31, 2008, and 2007, a valuation allowance of $30,235,000and
$26,042,000, respectively, is provided, as the realization of the deferred tax
assets are not assured.




Year ended December 31,2008
                  
                  2007
                  
                  2006(US$ in
      thousands)Domestic
                  
                  $
                  (12,117
                  )
                  
                  $
                  (9,497
                  )
                  
                  $
                  250Foreign
                  
                  
                  251
                  
                  
                  
                  309
                  
                  
                  
                  257Total
                  
                  $
                  (11,866
                  )
                  
                  $
                  (9,188
                  )
                  
                  $
                  507






F-17
 Table of Contents




Note 17 -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.




Year
      ended December 31,2008
                          
                          
                          2007
                          
                          
                          2006($ in
      thousands)Revenues:United
      States
                          
                          $
                          9,172
                          
                          
                          $
                          12,677
                          
                          
                          $
                          16,855Europe
                          
                          
                          3,756
                          
                          
                          
                          5,682
                          
                          
                          
                          2,758South
      America
                          
                          
                          2,539
                          
                          
                          
                          3,949
                          
                          
                          
                          6,703Far
      East
                          
                          
                          1,505
                          
                          
                          
                          2,559
                          
                          
                          
                          5,092Middle
      East
                          
                          
                          2,462
                          
                          
                          
                          3,744
                          
                          
                          
                          5,238Other
                          
                          
                          792
                          
                          
                          
                          866
                          
                          
                          
                          1,307Total
      revenues
                          
                          $
                          20,226
                          
                          
                          $
                          29,477
                          
                          
                          $
                          37,953Revenues
      from  major customers exceeding 10% of revenues:Master
      Reseller - A
                          
                          
                          16.5
                          %Platform
      Partner - A
                          
                          
                          10.9
                          %
                          
                          
                          --
                          %
                          
                          
                          --
                          %




December
      31,2008
                            
                            2007($ in
      thousands)Long-lived
      assets:United
      States
                            1,107
                            
                            
                            2,363Israel
                            271
                            
                            
                            385Europe
                            44
                            
                            
                            68Other
                            20
                            
                            
                            66Total
      long-lived assets
                            1,441
                            
                            
                            2,882







F-18
 Table of Contents




Selected
Quarterly Financial Information (Unaudited)




Three
      Months Ended,March
      31
                                                                    
                                                                    
                                                                    June
      30
                                                                    
                                                                    
                                                                    September
      30
                                                                    
                                                                    
                                                                    December
      31($ in
      thousands, except per share data)2008Total
      revenues
                                                                    
                                                                    $
                                                                    5,395
                                                                    
                                                                    
                                                                    $
                                                                    5,393
                                                                    
                                                                    
                                                                    $
                                                                    4,792
                                                                    
                                                                    
                                                                    $
                                                                    4,646Costs
      and operating expenses:Cost
      of revenues
                                                                    
                                                                    
                                                                    4,029
                                                                    
                                                                    
                                                                    
                                                                    4,027
                                                                    
                                                                    
                                                                    
                                                                    3,414
                                                                    
                                                                    
                                                                    
                                                                    3,475Research
      and development expenses
                                                                    
                                                                    
                                                                    1,184
                                                                    
                                                                    
                                                                    
                                                                    1,065
                                                                    
                                                                    
                                                                    
                                                                    607
                                                                    
                                                                    
                                                                    
                                                                    499Selling
      and marketing expenses
                                                                    
                                                                    
                                                                    1,238
                                                                    
                                                                    
                                                                    
                                                                    1,178
                                                                    
                                                                    
                                                                    
                                                                    638
                                                                    
                                                                    
                                                                    
                                                                    581General
      and administrative expenses
                                                                    
                                                                    
                                                                    778
                                                                    
                                                                    
                                                                    
                                                                    427
                                                                    
                                                                    
                                                                    
                                                                    692
                                                                    
                                                                    
                                                                    
                                                                    1,233Write
      down of intangible asset
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    475
                                                                    
                                                                    
                                                                    
                                                                    3,091
                                                                    
                                                                    
                                                                    
                                                                    -One
      time item - deferred revenue amend
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    396
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    -Reorganization
      expense
                                                                    
                                                                    
                                                                    372
                                                                    
                                                                    
                                                                    
                                                                    585
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    266Depreciation
      and amortization
                                                                    
                                                                    
                                                                    617
                                                                    
                                                                    
                                                                    
                                                                    399
                                                                    
                                                                    
                                                                    
                                                                    478
                                                                    
                                                                    
                                                                    
                                                                    342Total
      costs and operating expenses
                                                                    
                                                                    
                                                                    8,218
                                                                    
                                                                    
                                                                    
                                                                    8,552
                                                                    
                                                                    
                                                                    
                                                                    8,920
                                                                    
                                                                    
                                                                    
                                                                    6,396Loss
      from operations
                                                                    
                                                                    
                                                                    (2,823
                                                                    )
                                                                    
                                                                    
                                                                    (3,159
                                                                    )
                                                                    
                                                                    
                                                                    (4,128
                                                                    )
                                                                    
                                                                    
                                                                    (1,750
                                                                    )Capital
      gain / (loss)
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    39Other
      non operating income
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    12
                                                                    
                                                                    
                                                                    
                                                                    7
                                                                    
                                                                    
                                                                    
                                                                    -Interest
      (expense) income, net
                                                                    
                                                                    
                                                                    (10
                                                                    )
                                                                    
                                                                    
                                                                    (61
                                                                    )
                                                                    
                                                                    
                                                                    93
                                                                    
                                                                    
                                                                    
                                                                    (57
                                                                    )Profit
      (Loss) before income taxes
                                                                    
                                                                    
                                                                    (2,833
                                                                    )
                                                                    
                                                                    
                                                                    (3,208
                                                                    )
                                                                    
                                                                    
                                                                    (4,028
                                                                    )
                                                                    
                                                                    
                                                                    (1,768
                                                                    )Income
      taxes
                                                                    
                                                                    
                                                                    6
                                                                    
                                                                    
                                                                    
                                                                    9
                                                                    
                                                                    
                                                                    
                                                                    12
                                                                    
                                                                    
                                                                    
                                                                    1Net
      Profit (loss)
                                                                    
                                                                    $
                                                                    (2,839
                                                                    
                                                                    
                                                                    $
                                                                    (3,217
                                                                    )
                                                                    
                                                                    $
                                                                    (4,040
                                                                    )
                                                                    
                                                                    $
                                                                    (1,769
                                                                    )Net
      loss per share - basic and diluted
                                                                    
                                                                    $
                                                                    (0.09
                                                                    )
                                                                    
                                                                    $
                                                                    (0.10
                                                                    )
                                                                    
                                                                    $
                                                                    (0.12
                                                                    )
                                                                    
                                                                    $
                                                                    (0.05
                                                                    )Basic
      weighted average number of shares outstanding
                                                                    
                                                                    
                                                                    32,870,105
                                                                    
                                                                    
                                                                    
                                                                    32,870,105
                                                                    
                                                                    
                                                                    
                                                                    32,870,105
                                                                    
                                                                    
                                                                    
                                                                    32,870,105Diluted
      weighted average number of shares outstanding
                                                                    
                                                                    
                                                                    32,870,105
                                                                    
                                                                    
                                                                    
                                                                    32,870,105
                                                                    
                                                                    
                                                                    
                                                                    32,870,105
                                                                    
                                                                    
                                                                    
                                                                    32,870,1052007Total
      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
                                                                    )Interest
      income, net
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    13Other
      non operating income
                                                                    
                                                                    
                                                                    120
                                                                    
                                                                    
                                                                    
                                                                    175
                                                                    
                                                                    
                                                                    
                                                                    97
                                                                    
                                                                    
                                                                    
                                                                    50Profit
      (Loss) before income taxes
                                                                    
                                                                    
                                                                    (387
                                                                    )
                                                                    
                                                                    
                                                                    (1,622
                                                                    )
                                                                    
                                                                    
                                                                    (2,033
                                                                    )
                                                                    
                                                                    
                                                                    (5,147
                                                                    )Income
      taxes
                                                                    
                                                                    
                                                                    10
                                                                    
                                                                    
                                                                    
                                                                    17
                                                                    
                                                                    
                                                                    
                                                                    91
                                                                    
                                                                    
                                                                    
                                                                    8Net
      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
                                                                    
                                                                    
                                                                    
                                                                    32,843,752






F-19
 Table of Contents