**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, 2006, 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.)**75
                Broad Street, 31st Floor**
              **New
                York, New York 10004**
            **10004**(Address
                of principal executive offices)
            (Zip
                code)




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





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




**Title
                of Each Class**
            **Name
                of Each Exchange on**
              **Which
                the Securities are Registered**Class
                A Common Stock, par value $0.001 per share
            Nasdaq
                Capital Market




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


None.





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





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




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





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





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




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




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


Yes o No x





The
      aggregate market value of the Class A common stock held by non-affiliates
      of the Registrant based upon the closing price of the Class A common stock
      as
      reported by The Nasdaq Stock Market on June 30, 2006 was $41,439,578. 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.





The
      number of shares outstanding of the Registrant's capital stock as of March
      27,
      2007 is as follows:





**Title
                of Each Class**
            
            **Number
                of Shares Outstanding****at
                March 27, 2007**Class
                A Common Stock, $0.001 par value
            
            32,768,045




Documents
      incorporated by reference: None





**DELTATHREE, INC.**


**2006
      ANNUAL REPORT ON FORM 10-K**





**TABLE
      OF CONTENTS**




**Page****PART
                I**ITEM
                1.
            Business
            1ITEM
                1A.
            Risk
                Factors
            19ITEM
                1B.
            Unresolved
                Staff Comments
            31ITEM
                2.
            Properties
            31ITEM
                3.
            Legal
                Proceedings
            32ITEM
                4.
            Submission
                of Matters to a Vote of Security Holders
            32**PART
                II**ITEM
                5.
            Market
                for Registrant's Common Equity, Related Stockholder Matters and Issuer
                Purchases of Equity Securities
            33ITEM
                6.
            Selected
                Financial Data
            34ITEM
                7.
            Management's
                Discussion and Analysis of Financial Condition and Results of
                Operations
            35ITEM
                7A.
            Quantitative
                and Qualitative Disclosures About Market Risk
            45ITEM
                8.
            Financial
                Statements and Supplementary Data
            46ITEM
                9.
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure
            46ITEM
                9A.
            Controls
                and Procedures
            46ITEM
                9B.
            Other
                Information
            46**PART
                III**ITEM
                10.
            Directors
                and Executive Officers of the Registrant
            48ITEM
                11.
            Executive
                Compensation
            52ITEM
                12.
            Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters
            72ITEM
                13.
            Certain
                Relationships and Related Transactions
            74ITEM
                14.
            Principal
                Accounting Fees and Service
            74**PART
                IV**ITEM
                15.
            Exhibits,
                Financial Statement Schedules
            75Index
                to Consolidated Financial Statements
            F-1










**PART
      I**





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





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





**ITEM
      1.**  **BUSINESS**





**Company
      Overview**





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





Today
      we
      support hundreds of thousands of active users around the globe through our
      two
      primary distribution channels: our service provider and reseller
      channel and our
      direct-to-consumer channel. We offer a broad suite of private label VoIP
      products and services as well as a back-office platform for service providers,
      resellers, and corporate customers, such as incumbent telecommunications
      providers, Internet service providers, or ISPs, cable companies **,** licensed
      VoIP operators, and various corporate enterprises. Based on our customizable
      VoIP solutions, these customers can offer private label telecommunications
      to
      their own customer bases, under their own brand name, a white-label brand,
      our
      iConnectHere, or ICH, brand, or the deltathree brand. At the same time, our
      direct-to-consumer channel includes our iConnectHere offering which provides
      award-winning VoIP products and services **** directly
      to consumers and small businesses online using the same primary platform, and
      includes our recently established **** joip
      offering which will serve as the exclusive VoIP service provider embedded in
      the
      GLOBARANGE cordless phones of Panasonic Communications Co., Ltd., or Panasonic,
      the world leader in consumer cordless phones. We expect this joip-enabled phone
      to be available in the summer of 2007.





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




1





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 Web site. 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, SIP, an
      Internet Engineering Task Force standard that has been embraced by industry
      leaders such as Microsoft and Cisco. These efforts culminated in the launch
      of
      our state-of-the-art SIP infrastructure, and in doing so we became the first
      major VoIP service provider to deploy an end-to-end SIP network and services.
      In
      recent years, we have continued our pioneering efforts in SIP and these efforts
      have yielded significant new releases. For example, we released a next
      generation SIP-based PC-to-Phone application, certified many new devices which
      function as access points to our services, and added new features and new
      calling plans to our offerings.





In
      2004,
      we announced our first major service provider contract with Verizon
      Communications Inc. In 2005 and 2006, we remained focused on increasing the
      market penetration of our core VoIP solutions and on continuing to diversify
      and
      expand our customer base. For example, we diversified our base in 2006 by adding
      customers for our Hosted Consumer VoIP Solution in markets such as instant
      messaging and cellular telecommunications. As a result, we continued to sell
      an
      increasingly diverse set of VoIP products and services to our growing Service
      Provider and Reseller base. Our product strategy for reaching these customers
      focused on enhancing our service delivery offering suite by successfully
      launching customizable modular and comprehensive VoIP solutions, adding new
      features to our VoIP products, launching new distribution lines for our consumer
      group, and upgrading our network capacity and features.





As
      a
      complement to the initiatives we have taken to organically expand our
      businesses, we have also been evaluating opportunities for inorganic growth
      through strategic acquisitions and unique collaborations. In February 2007,
      we
      acquired the service provider and consumer business assets including the
      customer bases of Go2Call.com, Inc., a privately held U.S. based VoIP solutions
      provider, for cash and our stock valued at approximately $7 million. Moreover,
      we expect that our strategic collaboration with Panasonic including our joip
      offering will present opportunities for growth as we expand into another market
      by enabling Panasonic’s GLOBARANGE cordless phones to deliver our VoIP services
      to consumers in various countries worldwide.





Going
      forward, we expect to:





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





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





·
            devote
                a significant amount of our resources to launch, market, and support
                our
                new joip offering in connection, and in collaboration, with Panasonic
                in
                various countries worldwide; and





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




2


**Industry
      Background**





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





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





·
            improved
                quality and reliability of VoIP calls due to technological advances,
                increased network development and greater bandwidth capacity;


·
            new
                product development that allow VoIP providers to offer services not
                currently offered by traditional telephone
                companies;


·
            greatly
                improved ease of use, where the end-user essentially perceives no
                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, including
      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 looking at VoIP as a viable and more affordable
      substitute for their traditional telecommunications provider.





Accordingly,
      many of the traditional telecommunications providers are looking to deploy
      VoIP
      as a defensive strategy, while cable companies, ISPs and other broadband
      providers are looking at VoIP service offerings as a way to capture new revenue
      streams from existing and new customers. These providers have two primary
      alternative means to develop and deploy VoIP offerings: they can build them
      in-house; or they can partner with a company like deltathree and outsource
      all
      or a portion of the effort. Those seeking to offer VoIP service offerings by
      developing an in-house service must learn a vastly different set of platforms,
      and integrate several additional components with their existing systems, which
      requires the development of significant technical expertise and the deployment
      and management of substantial capital expenditures. Alternatively, a full
      service VoIP company, like deltathree, can provide these service providers
      with
      the ability to outsource their VoIP services, and thereby effectively reduce
      the
      upfront and ongoing cost of providing the service, and efficiently reduce the
      time to market and risks associated with developing and maintaining an in-house
      VoIP service.





**Our
      Products and Services**




3





***Products*** .





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





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





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





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




***Services*** .





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





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





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





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





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




4




**·**
            *network
                operations care:*we
                provide a Network Operations Center 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 79.6% of our total revenues in 2006,
      while the provision of VoIP telephony through our direct-to-consumer channel,
      or
      iConnectHere, accounted for 14.9% of our total revenues in 2006.





**Our
      Distribution Channels**





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





**Service
      Provider and Reseller Channel**





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





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





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





In
      2006,
      we expanded our target markets.  For example, our Hosted Consumer VoIP
      Solution was selected to support ICQ Inc., the industry pioneer and a leader
      in
      instant messaging, in its internet-based voice calling service offering. With
      this relationship, ICQ’s instant messaging customers throughout the world,
      outside of the United States, have access to our VoIP services and features.




In
      2006
      we also
      announced two unique initiatives that demonstrate our
      ability to expand from our traditional Hosted VoIP target
      markets, namely incumbent telephony providers, cable operators,
      and ISPs, to other markets not related to the wireline
      communications industry.  For example, we completed a transaction with
      telSPACE, a leading mobile virtual network enabler to embed our Hosted
      Consumer VoIP Solution into its infrastructure which provides us with
      a presence in the cellular wireless market.  Our strategic
      relationship with telSPACE enables all of their mobile
      virtual network operator customers and us to offer both wireless and our
      VoIP solution to our respective service providers, or other customers, who
      desire to deploy both VoIP and cellular services under a unified platform.
      This
      relationship consolidates the end user’s purchasing experience for VoIP and
      cellular service into one service under one monthly bill. We expect to begin
      development and launch of this offering during 2007. Moreover, we also completed
      a unique initiative with one of our partners and Korail Networks Inc., the
      operator of South Korea’s high speed rail system. Under this initiative, Korail
      Networks Inc. is embedding a platform with VoIP calling services and features
      into Korail Networks’s frequent rider membership program plan.  This
      offering represents another example of how our VoIP services add value
      in a non-traditional market and how our offering enhances our
      customer’s core competency.  We expect to develop and launch this offering
      during 2007.




5





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





***Convergence
      of the Hosted Consumer VoIP Solution and the Reseller Program.*** For
      several years we have offered businesses the opportunity to become resellers
      of
      our services through our global reseller program. In the early years, these
      resellers met their customers’ needs by purchasing account numbers in bulk at
      reseller specific rates, and they in turn resold these accounts to private
      individuals under the deltathree brand, their own brand, or as “white-label”
product (i.e., no brand name is indicated). As our resellers became more
      sophisticated, we introduced new features and functions that allowed them to
      develop their own unique price plans and service bundles to more closely align
      their offerings with their own customers’ unique needs. In addition, we
      developed, and continue to develop, increasingly sophisticated online toolsets
      to allow our resellers to better manage their internal processes and enable
      them
      to utilize our web-based customer care tools to provide customer service to
      their end-users through their own customer service team. Moreover, in order
      to
      attract and retain a variety of different resellers across the globe, we have
      continuously tested and certified for use with our VoIP services and network
      many different SIP devices manufactured by various vendors. We have certified
      many SIP devices that operate in different network environments, such as
      dial-up, broadband, cable, and satellite or Vsat. Based on these actions, we
      have increasingly set ourselves apart from our competitors by moving from an
      undifferentiated source of “telecom minutes” to a highly differentiated partner
      by providing these customers with a full suite of tools to manage and grow
      their
      business.





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





***Go2Call
      Acquisition.*** We
      strengthened our service provider and reseller channel and our
      direct-to-consumer channel and we expanded our presence into new regions of
      the
      world with our acquisition of the service provider and consumer business assets,
      including the customer bases, of Go2Call. In connection with this asset
      transaction which was completed in February 2007, we paid to Go2Call
      approximately $7 million in a combination of cash and our stock and we did
      not
      assume any liabilities other than the obligation to provide continued services
      to the acquired customer bases. Go2Call has been a leader in the VoIP industry
      and it has delivered turnkey VoIP solutions to a variety of service providers,
      including telecom carriers, ISPs, broadband providers and licensed VoIP
      operators. Go2Call’s customer base consisted of approximately 95% service
      providers and 5% consumers located in approximately 100 countries throughout
      the
      world and, therefore, this strengthened our own customer base in most of these
      countries. Due to Go2Call’s geographical mix of customers, this acquisition has
      also brought us an increase in market penetration in certain key countries
      such
      as Brazil and Vietnam where we traditionally have not had a strong presence.
      Based on the similarity of offerings and customer bases and the complementary
      geographical mix, we expect to be able to transition the Go2Call customers
      to
      our network in a relatively seamless manner from the end user’s perspective by
      the end of our first quarter in 2007.




6




**Direct-to-Consumer
      Channel**





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





***joip:
      deltathree and Panasonic strategic alliance.*** We
      believe that with joip, our recently established consumer brand, we have
      developed a unique, powerful, and innovative offering in both the VoIP and
      the
      cordless telephone markets. In connection with our strategic cooperation with
      Panasonic which began in 2006, we and Panasonic have created, developed and
      will
      offer joip-enabled Panasonic GLOBARANGE telephones. Our joip offering will
      be
      the exclusive VoIP service embedded in Panasonic’s GLOBARANGE series of
      innovative hybrid 2-line cordless phones which provide both landline and VoIP
      services. Because our VoIP services are embedded in this hybrid cordless
      telephone, there is no requirement for any software downloads, external adaptors
      or other complicated procedures. The customers merely plug the phone into their
      broadband connection and are able to communicate. Additionally, customers of
      the
      GLOBARANGE telephones will be able to talk to each other for free through the
      use of the joip services, and will also be able to purchase a variety of
      enhanced features and value-added services. Through our joip offering and
      extensive experience in VoIP services and Panasonic’s consumer electronics
      expertise and vast distribution channels, we and Panasonic aim to create a
      global community by providing free calling between joip-enabled GLOBARANGE
      phones in all regions of the world. We expect that this phone will be available
      in the summer of 2007. Initially, this phone will be available in 12 countries
      and six languages in every region of the world, and subsequently we expect
      to
      launch the product in additional countries.





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





·
            the
                joip-enabled GLOBARANGE phone has a dual functionality - it supports
                both
                VoIP services and traditional landline services;





·
            end
                users maintain their traditional landline
                service;





·
            the
                joip offering embedded in the phone allows all purchasers of the
                phones to
                speak to each other for free;





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





·
            because
                the joip services are embedded in the phone, there are no set-up
                installation procedures, software downloads, external adaptors, or
                service
                contracts; and





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





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





***iConnectHere.*** **** We have
      positioned iConnectHere as a powerful showcase and test facility for our current
      and future products and services, and as a leverage point for service provider
      and reseller sales. iConnectHere demonstrates our products, services and hosting
      capabilities to our reseller customers and service providers. Through
      iConnectHere, an account holder can access all of our product offerings,
      including PC-to-Phone and Broadband Phone. Our customer care and support teams
      utilize the full range of our back-end infrastructure and support in servicing
      iConnectHere customers. 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.




7





Through
      iConnectHere, consumer users can:





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




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




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




·
            send
                a PC-to-Phone call;




·
            check
                real-time billing and usage information;




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




·
            view
                answers to frequently-asked questions.




**Our
      Competitive Advantages**





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





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





***Financial
      Strength.*** We have
      a strong balance sheet, with $16.9 million in cash, restricted cash, and
      short-term and long-term investments and working capital of $12.2 million as
      of
      December 31, 2006. Furthermore, in 2006 we were able to generate $2 million
      in
      cash from operating activities and positive net income. Our full year 2006
      financial results have demonstrated our ability to simultaneously grow revenues
      and improve the bottom-line. Our financial strength allows us to pursue new,
      unique, and strategic sales opportunities in the service provider and reseller
      markets, while at the same time growing our existing core business lines in
      targeted areas. In addition, our financial strength allows us to employ a
      strategy of evaluating and pursuing appropriate acquisition targets and
      collaborations that will continue to expand and diversify our customer base.





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




8





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





**Our
      Strategy**





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





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





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





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





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





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




9





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





**Sales
      and Marketing**





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





·
            selecting,
                training, and deploying regional sales managers to sell, market and
                maintain support for our customers and potential
                partners;


·
            attending,
                presenting, and participating at local industry trade
                venues;


·
            developing,
                deploying and supporting local-specific product features and services,
                such as multiple language capabilities, different currency capabilities,
                and various payment methods;


·
            pursuing
                strategic alliances with both customers, including licensed providers,
                and
                suppliers; and


·
            using
                various on-line advertising and search strategies to target and optimize
                sales efforts.




**Service
      Provider and Reseller Channel**





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





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





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





**Direct-to-Consumer
      Channel**





***joip:
      deltathree and Panasonic strategic alliance.*** We
      are in
      the process of finalizing and refining the details of our sales and marketing
      strategy with Panasonic in connection with the summer 2007 launch of the joip
      and GLOBARANGE offering. In general, Panasonic will use its leading global
      experience and well-established product distribution channels to market and
      sell
      the product in each applicable local market. We will engage in a variety of
      targeted strategies through the use of on-line media, direct marketing and
      inbound telemarketing to market our joip offering. We and Panasonic, together,
      are planning to market the joip-enabled GLOBARANGE phone to specific key
      channels.





***iConnectHere.*** **** We
      have
      developed and will continue to develop low-cost, diversified marketing,
      advertising and promotional programs to stimulate demand for our iConnectHere
      services. Our marketing, advertising and promotional programs include:




10





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





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





**Our
      Infrastructure**





**Network**





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





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





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





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





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




11





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





**Support**




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





We
      provide customer support on various levels to different customers. With respect
      to certain of our service provider and reseller customers, we provide customer
      care and technical support directly to these customers, and they in turn provide
      their own support directly to the end user. With some of our other service
      provider and reseller customers, we provide customer care and technical support,
      on behalf of the customer, directly to the end user. Customers of iConnectHere
      receive technical support and customer care through our web-based customer
      service site, e-mail support and telephone 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 from third-party vendors the provisioning of certain of our local
      telecommunications services, including local phone numbers, access to the PSTN,
      operator assistance, directory listings and assistance, E-911 emergency services
      and local number portability. We also outsource the provisioning of our consumer
      premises equipment, such as our analog telephone adapters, IP Phones and
      gateways, and certain aspects of our customer care services. We do not rely
      on
      any one specific vendor for providing these services, except for E-911 emergency
      services and certain specific services of customer care **.** While we
      believe our relations with our suppliers are good, we believe that we could
      replace our suppliers if necessary, and believe that our ability to provide
      services to our customers may be impacted but do not expect that this would
      have
      a significantly adverse affect on our business, financial condition and results
      of operation.





**Proprietary
      Rights**





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





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




12





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





**Regulation**




***Regulatory
      Environment Overview***


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





***Federal
      Regulation***





*Regulatory
      Classification of VoIP Services*




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




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




13




VoIP
      E-911 Matters




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




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




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




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




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




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




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


*Bundling
        of DSL and Voice Services by Incumbent Telephone Companies*


14


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





*Communications
      Assistance for Law Enforcement Act, or CALEA*





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 that offer services that
      allow users to receive calls from, and make calls to, the public switched
      telecommunications network. The FCC established a deadline of May 14, 2007
      for VoIP providers to comply with the requirements of CALEA. In May 2006, the
      FCC released an order finding that broadband Internet access service providers
      and interconnected VoIP providers are required to implement the same type of
      CALEA requirements that have been applied to wireline telecommunications
      carriers, though many of the technical parameters for implementation have yet
      to
      be worked out in ongoing industry standards-setting processes. These include
      obligations to (1) ensure that communications equipment, facilities, and
      services meet interception assistance capability requirements and (2) develop
      system security policies and procedures to define employee supervision and
      record retention requirements. The FCC determined that interconnected VoIP
      providers may rely on standards developed by industry standards-setting bodies
      as a “safe harbor” for CALEA implementation and may use trusted third parties as
      a reasonable method of achieving CALEA compliance. In either case, however,
      the
      interconnected VoIP provider remains responsible for compliance with the CALEA
      requirements. While we intend to comply with the CALEA orders issued by the
      FCC
      and we continue to cooperate with law enforcement to enable authorities to
      accomplish lawful wiretaps, we may be required to expend significant resources
      to comply with CALEA. If we do not comply, the FCC may subject us to fines
      and
      penalties, and we may decide to or be required to disconnect customers.





*Universal
      Service Fund*





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




15




*Intercarrier
      Compensation*





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





*Other
      FCC Proceedings That Could Affect VoIP Services*





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





***State
      Regulation***




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





*Fees
      and Taxes*





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




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




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




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




16




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





***International***




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





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





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





As
      we
      make our services 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. Nor can we
      predict how a regulatory or policy change of a particular country might affect
      the provision of our services.




17





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 to cease providing services or
      conducting their business as conducted in that country. We cannot be certain
      that our network partners either are currently in compliance with any such
      requirements, will be able to comply with any such requirements, and/or will
      continue in compliance with any such requirements.





***Other
      Regulation Affecting the Internet***





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





**Competition**





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





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





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





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





·
            substantially
                greater financial, technical and marketing resources;




·
            larger
                networks;




·
            a
                broader portfolio of services;




·
            stronger
                name recognition and customer loyalty;




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




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




18





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





**Revenues
      and Assets by Geographic Area**





For
      the
      year ended December 31, 2006, approximately $21.1 million, or 55.5%, of our
      revenue was derived from international customers, and $16.9 million, or 44.5%,
      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 12 to our financial statements included elsewhere
      in this annual report.





**Employees**





As
      of
      December 31, 2006, we employed
      115 full-time and 29 part-time employees, of which 118 were located in Israel,
      and
      26 were located in New York. We consider our relationship with our employees
      to
      be good. None of our employees is covered by collective bargaining agreements.





**Available
      Information**





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





**ITEM
      1A.**  **RISK
      FACTORS**





*Investing
      in our common stock involves a high degree of risk. Before you invest in our
      common stock, you should understand and carefully consider the risks below,
      as
      well as all of the other information contained in this annual report, including
      our financial statements and the related notes contained elsewhere in this
      report. Any of these risks could materially adversely affect our business,
      financial condition and results of operations and the trading price of our
      common stock, and you may lose all or part of your investment. 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.**





Until
      the
      year ended December 31, 2006, the Company has had a history of significant
      losses since its inception. For the year ended December 31, 2006, we reported
      net income of $0.5 million but a net loss from operations of $52,000. Although
      this is a significant improvement from prior years when we reported net losses
      of $0.9 million in 2005, approximately $3.2 million in 2004, and approximately
      $8.3 million in 2003, we cannot assure you that we will be able to obtain
      or sustain a level of profitability going forward and we may begin to incur
      significant losses again. As of December 31, 2006, our accumulated deficit
      was approximately $151.4 million. Our revenues may not increase or even continue
      at their current level. As a result, while we believe we have sufficient funds
      to meet our working capital requirements for at least the next fiscal year
      and
      although we attained profitability during 2006, we did incur a loss during
      the
      fourth quarter of 2006. Going forward, we will need to increase our revenues
      and
      maintain our current cost structure to obtain, once again, profitability. If
      our
      revenues do not increase as much as we expect or if our expenses increase at
      a
      greater pace than revenues, we may not be able to reach profitability again.
      We
      cannot assure you that we will be able to obtain, sustain or increase
      profitability on a quarterly or annual basis in the future.




19





**We
      may not be able to expand our revenue.**





Our
      business strategy is to expand our revenue sources and our distribution channels
      in order to include the provision of VoIP telephony to different customer
      groups. We can neither assure you that we will be able to accomplish this nor
      that this strategy will be profitable. Currently, our revenues are primarily
      generated by sales of our VoIP telephony products and services through our
      direct-to-consumer channel and our service provider and reseller sales channel
      (including sales of our Hosted Consumer VoIP Solution). VoIP telephony from
      these channels generated 94.6%, 96.1%, and 96.02% of our total revenues in
      2006,
      2005, and 2004, respectively.





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





·
            sales
                of our VoIP telephony products and services, including sales of our
                Hosted
                Consumer VoIP Solution;


·
            acceptance
                and use of VoIP telephony;


·
            expansion
                of our service and product offerings;


·
            traffic
                levels on our network;


·
            the
                effect of competition, regulatory environment, international long
                distance
                rates and access and transmission costs on our prices; and


·
            continued
                improvement of our global network quality.





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





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





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





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





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





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


·
            to
                compete effectively;




20




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


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





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





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





·
            introduction
                and deployment of our new, or existing, products and services, including
                our joip offering;


·
            enhancement
                and expansion of our network;


·
            unanticipated
                opportunities;


·
            strategic
                alliances, and potential acquisitions;


·
            changing
                business conditions; and


·
            unanticipated
                competitive pressures.





We
      intend
      to continue to expand our network and to introduce new products and services.
      These activities require significant marketing and promotional expenses that
      we
      often incur before we begin to receive the related revenue. While we believe
      we
      have sufficient funds to meet our working capital requirements for at least
      the
      next fiscal year, if our cash flow from operations is not sufficient to meet
      our
      capital expenditure and working capital requirements, we will need to raise
      additional capital. There can be no assurance that we will be able to raise
      such
      additional capital on favorable terms or at all. If we are unable to obtain
      additional capital, we may be required to reduce the scope of our business
      or
      our anticipated growth, which could have a material adverse effect on our
      business, financial condition, and results of operations.





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





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





·
            inability
                to successfully integrate the acquired technology and operations
                into our
                business and maintain uniform standards, controls, policies, and
                procedures;


·
            distraction
                of management’s attention away from normal business
                operations;


·
            challenges
                retaining the key employees of the acquired
                operation;


·
            insufficient
                revenue generation to offset liabilities
                assumed;


·
            expenses
                associated with the acquisition; and


·
            unidentified
                issues not discovered in our due diligence process, including product
                quality issues and legal
                contingencies.





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




21


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





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





·
            inconsistent
                quality or speed of service, including power outages;


·
            traffic
                congestion on the Internet;


·
            potentially
                inadequate development of the necessary infrastructure;


·
            lack
                of acceptable security technologies;


·
            lack
                of timely development and commercialization of performance improvements;
                and


·
            unavailability
                of cost-effective, high-speed access to the Internet.





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





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





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





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




22





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





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





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





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





·
            the
                rate at which we are able to attract users to purchase our VoIP telephony
                products and services, including our Hosted Consumer VoIP
                Solution;


·
            the
                amount and timing of expenses to enhance marketing and promotion
                efforts
                and to expand our infrastructure; and


·
            the
                timing of announcements or introductions of new or enhanced services
                by
                us.





The
      factors outside our control include:





·
            the
                timing of announcements or introductions of new or enhanced services
                by
                our competitors;


·
            regulations
                in various countries that prohibit us from providing our services
                cost-effectively or at all;


·
            technical
                difficulties or network interruptions in the Internet or our
                privately-managed network; and


·
            general
                economic and competitive conditions specific to our industry.





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





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





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





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




23





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





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





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





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





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





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





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





**Operating
      internationally exposes us to additional and unpredictable
      risks.**





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




24





·
            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.





**We
      have experienced losses as a result of fraud.**





We
      have
      experienced losses due to fraud. While in 2006 we experienced losses from fraud
      of less than 1% of our revenues, callers have obtained our services without
      rendering payment by unlawfully using our access numbers and personal
      identification numbers. While we have continued to implement anti-fraud measures
      in order to control losses relating to these practices, and these measures
      have
      proven to be effective today, these measures may not in the future be sufficient
      to effectively limit all of our exposure in the future from fraud and future
      losses could rise significantly above current levels.





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





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





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





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




25





**Third
      parties might infringe upon our proprietary technology.**





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





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





Third
      parties may assert claims that we have violated a patent or infringed a
      copyright, trademark or other proprietary right belonging to them. We
      incorporate licensed third-party technology in some of our products and
      services. In these license agreements, the licensors have agreed to indemnify
      us
      with respect to any claim by a third party that the licensed software infringes
      any patent or other proprietary right so long as we have not made changes to
      the
      licensed software. We cannot assure you that these provisions will be adequate
      to protect us from infringement claims. Any infringement claims, even if not
      meritorious, could result in substantial monetary liability or may materially
      disrupt the conduct of our business. In a recent federal court ruling, a
      permanent injunction was issued against Vonage, one of the largest independent
      provider of residential VoIP services, in response to a jury decision that
      Vonage had infringed on three Verizon Communications patents that concern
      interconnection of Vonage's Internet voice service to the public switched
      telephone network. The federal judge in this case has delayed the signing of
      the
      order for the permanent injunction to permit Vonage to seek an appeal. We have
      no way of assessing what effect, if any, this may have on 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 any jurisdiction. Based on specific
      regulatory classifications and recent regulatory decisions, we believe we should
      not be regulated as a telecommunications common carrier in any of our markets.
      However, the growth of IP telephony has led to close examination of its
      regulatory treatment in many jurisdictions making the legal status of our
      services uncertain and subject to change as a result of future regulatory
      action, judicial decisions or legislation in any of the jurisdictions in which
      we operate. Established regulated telecommunications carriers have sought and
      may continue to seek regulatory actions to restrict the ability of companies
      such as ours to provide services or to increase the cost of providing such
      services. In addition, our services may be subject to regulation if regulators
      distinguish phone-to-phone telephony service using IP technologies over
      privately-managed networks such as our services from integrated PC-to-PC and
      PC-originated voice services over the Internet. Some regulators may decide
      to
      treat the former as regulated common carrier services and the latter as
      unregulated enhanced or information services.





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




26





Our
      international operations are also subject to regulatory risks, including the
      risk that regulations in some jurisdictions will prohibit us from providing
      our
      services cost-effectively or at all, which could limit our growth. Currently,
      there are several countries where regulations prohibit us from offering service.
      These regulations have had an impact on us in 2006. We, however, cannot assure
      you that these conditions will not have a material effect on our revenues and
      growth in the future. In addition, because customers can use our services almost
      anywhere that a broadband Internet connection is available, including countries
      where providing VoIP services is illegal, the governments of those countries
      may
      attempt to assert jurisdiction over us, which could expose us to significant
      liability and regulation. For
      a
      more detailed discussion of the regulation of IP telephony, see "Regulation."





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





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





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





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





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





**If
      we fail to comply with new FCC regulations requiring us to provide E-911
      emergency calling services, we may be subject to fines or penalties, which
      could
      include disconnection of our service for certain customers or prohibitions
      on
      marketing of our services and accepting new customers in certain areas.**




On
      June
      3, 2005, the FCC released an order, which we refer to as the VoIP E-911 Order,
      that imposed an obligation on VoIP providers to offer enhanced emergency calling
      services, or E-911, to their VoIP customers by November 28, 2005. We have taken
      many significant steps to comply with the enhanced emergency service rules,
      but
      we were unable to comply with all of the requirements of the FCC's order by
      the
      November 28, 2005 deadline. Some of our iConnectHere customers currently
      receive E-911 service in conformity with the FCC’s order, but a number of
      iConnectHere customers do not receive such service. These are customers who
      were
      receiving service prior to the FCC’s deadline for compliance with the E-911
      regulations. The FCC permitted service providers to continue to provide service
      to those existing customers rather than disconnect those customers. Pursuant
      to
      the FCC’s requirement, after the implementation of the FCC E-911 requirements,
      we provide services to customers only where we can provide the FCC required
      E-911 service. We may be required to stop serving those iConnectHere customers
      to whom we cannot provide the required enhanced emergency dialing capabilities
      that were being serviced prior to the issuance of the FCC’s rules at any time,
      but this is difficult to predict at this time. See “Regulation - VoIP E-911
      Matters” for further information on the FCC’s E-911 requirements.




27




The
      VoIP
      E-911 Order also required us to notify our customers of any differences between
      our emergency calling services and those available through wireline telephone
      providers and to obtain affirmative acknowledgment from each of our customers
      of
      those notifications. We notified our customers of the differences in our
      emergency calling service and have received affirmative acknowledgement from
      substantially all of our customers.




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
      our consumer division, ICH, to accept new customers and may also have an adverse
      effect on our sales to customers who resell our service.




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




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




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




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




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




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




28




The
      FCC
      Order applying USF contributions to interconnected VoIP providers is currently
      under appeal and the FCC continues to evaluate alternative methods for assessing
      USF charges, including imposing an assessment on telephone numbers. The outcome
      of these proceedings can not be determined at this time.




**There
      may be risks associated with our ability to comply with the requirements of
      federal law enforcement agencies.**




On
      August 5, 2005, the FCC unanimously adopted an order responsive to a joint
      petition filed by the Department of Justice, the Federal Bureau of
      Investigation, and the Drug Enforcement Administration asking the FCC to declare
      that broadband Internet access services and VoIP services be covered by the
      Communications Assistance for Law Enforcement Act, or CALEA. The Order concludes
      that CALEA applies to facilities-based broadband Internet access providers
      and
      providers of interconnected VoIP service and requires these providers to be
      in
      full compliance within 18 months of the effective date of the Order, which
      is
      May 15, 2007. The FCC also stated that, in the coming months, it would release
      another order that will address separate questions regarding the assistance
      capabilities required of the providers covered by the August 5, 2005 order.
      On
      May 3, 2006, the FCC adopted a second order, which clarifies that the FCC will
      not establish standards for VoIP providers to comply with CALEA. Instead, the
      FCC directs law enforcement agencies, experts and the industry to develop the
      standards. The FCC's order clarifies that VoIP providers may use third party
      vendors to comply with the requirements of CALEA. We are currently working
      with
      a third party vendor to provide for us, and to develop with us, certain aspects
      of the requirements of CALEA. Our failure to achieve compliance with any future
      CALEA orders or any enforcement action initiated by the FCC or other agency
      or
      task force against us could have a material adverse effect on our financial
      position, results of operations or cash flows.




***Risks
      Related to our relationship with Atarey***





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





Atarey
      owns approximately 36% of the voting power and economic interest in us, and
      is
      the largest shareholder of our stock. As long as Atarey continues to
      beneficially own such a significant percentage of our capital stock and there
      are no other major shareholders, Atarey will be able to exercise a significant
      influence over decisions affecting us, including:





·
            composition
                of our board of directors and, through it, our direction and policies,
                including the appointment and removal of officers;


·
            mergers
                or other business combinations;


·
            acquisitions
                or dispositions of assets by us;


·
            future
                issuances of capital stock or other securities by us;


·
            incurrence
                of debt by us;


·
            amendments,
                waivers and modifications to any agreements between us and
                Atarey;


·
            payment
                of dividends on our capital stock; and


·
            approval
                of our business plans and general business development.





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





**A
      third party may be deterred from acquiring our company.**





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




29





***Risks
      Related to our Common Stock***





**Volatility
      of our stock price could adversely affect our
      stockholders.**





Since
      trading commenced 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:





·
            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;


·
            changes
                in financial estimates by securities analysts;


·
            conditions
                or trends in the Internet industry;


·
            changes
                in the market valuations of other Internet companies;


·
            announcements
                by us or our competitors of significant acquisitions;


·
            our
                entry into strategic partnerships or joint ventures; and


·
            sales
                of our common stock by Atarey.





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





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





**The
      liquidity of our common stock could be adversely affected by changes in our
      Nasdaq listing.**





Our
      common stock is currently listed on the Nasdaq Capital Market. The
      listing of our common stock was transferred from the Nasdaq National Market
      to
      the Nasdaq Capital Market effective on September 17, 2002.  We
      currently meet all criteria for continued inclusion in the Nasdaq Capital
      Market. However, based on the volatile nature of our stock price, we can make
      no
      assurances that we will continue to do so .  Failure
      to meet these criteria could result in our delisting from the Nasdaq Capital
      Market. If our shares were to be delisted from the Nasdaq Capital Market, our
      shares would continue to trade, if at all, on the OTC Bulletin Board, upon
      application by the requisite market makers. This would adversely impact our
      stock price, as well as the liquidity of the market for our shares which, as
      a
      result, would adversely affect the ability of our stockholders to purchase
      and
      sell their shares in an orderly manner, or at all. Furthermore, a delisting
      of
      our shares could damage our general business reputation and impair our ability
      to raise additional funds. Any of the foregoing events could have a material
      adverse effect on our business, financial condition and operating results.





**We
      do not intend to pay dividends.**





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




30





***Risks
      Related to our Israel-based Office***





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





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





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





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.





**ITEM
      1B. UNRESOLVED STAFF COMMENTS**





Not
      applicable.




**ITEM
      2.**  **PROPERTIES**





We
      lease
      our executive offices at 75 Broad Street, New York, New York at an annual cost
      of approximately $650,000, which increases annually to $815,000 for the final
      year of the lease. The term of the lease is until July 2010, with an option
      to
      extend the lease for an additional five years. In October 2003 we entered into
      a
      sub-lease agreement with a third party to sub-lease approximately 30% of the
      overall the New York office space. The annual sub-lease income was $152,235
      for
      2006, increasing annually to $168,000 for the final year of the sub-lease and
      the term extends until July 2010.





We
      lease
      a 1,290 square meter office, which houses our research and development
      facilities, in Jerusalem, Israel  at
      an
      annual cost of $199,234. In February 2003, we signed an amendment that extended
      the term of our lease through February 2006. In September 2005, we signed an
      additional amendment that extended our lease term through December 2009. We
      have
      an option to further extend the term of the lease for an additional 5 years
      through December 2014.




31




**ITEM
      3.**  **LEGAL
      PROCEEDINGS**





We,
      as
      well as certain of our former officers and directors, were named as defendants
      in a number of purported securities class actions in United States District
      Court for the Southern District of New York, arising out of our initial public
      offering in November 1999. On August 31, 2005, the United States District Court
      granted preliminary approval of an omnibus settlement of the litigation between
      the plaintiffs and issuer defendants. Final approval is pending. Under the
      terms
      of the settlement, we are not conceding any liability and we presently do not
      expect to make any payments under the pending settlement, other than legal
      fees
      we may incur (which fees are being submitted to the insurance carrier for
      reimbursement).




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





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





No
      matters were submitted to a vote of security holders during the fourth quarter
      of the year ended December 31, 2006.


32


**PART
      II**





**ITEM
                5.**
            **MARKET
                FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
                MATTERS**





**Market
      Information**





Our
      common stock is currently listed on the Nasdaq Capital Market under the symbol
      “DDDC”. The
      listing of our common stock was transferred from the Nasdaq National Market
      to
      the Nasdaq Capital Market effective on September 17, 2002. Our common stock
      had
      traded on the
      Nasdaq National Market under the symbol "DDDC" since November 22, 1999. We
      currently meet all criteria for continued inclusion in the Nasdaq Capital
      Market.





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





**High**
            
            **Low****Year
                ended December 31, 2005**First
                quarter
            
            
            6.67
            
            
            3.20Second
                quarter
            
            
            4.16
            
            
            2.84Third
                quarter
            
            
            3.44
            
            
            2.55Fourth
                quarter
            
            
            3.11
            
            
            2.43**Year
                ended December 31, 2006**First
                quarter
            
            
            3.50
            
            
            2.44Second
                quarter
            
            
            3.20
            
            
            2.10Third
                quarter
            
            
            2.30
            
            
            1.52Fourth
                quarter
            
            
            2.10
            
            
            1.20**Year
                ended December 31, 2007**First
                quarter (through March 27h,
                2007)
            
            
            1.98
            
            
            1.28





On
      March 27, 2007, the last reported sale price for our common stock on the
      Nasdaq Capital Market was $1.78 per share. The market price for our stock is
      highly volatile and fluctuates in response to a wide variety of factors.





**Holders**





As
      of
      March 27, 2007, we had approximately 136 holders of record of the
      32,768,045 outstanding shares of our common stock. This does not reflect persons
      or entities that hold their stock in nominee or "street" name through various
      brokerage firms.





**Dividend
      Policy**





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





**Recent
      Sales of Unregistered Securities**





None.




**Issuer
      Purchases of Equity Securities**





None.




33





**ITEM
      6.**  **SELECTED
      FINANCIAL DATA**




You
      should read the selected consolidated financial data together with our
      consolidated financial statements and related notes and the section of this
      annual report entitled "Management's Discussion and Analysis of Financial
      Condition and Results of Operations." Brightman Almagor & Co., a member
      firm of Deloitte Touche Tohmatsu, independent certified public accountants,
      audited our historical financial statements since inception. The selected
      financial data for each of the years in the three-year period ended December
      31,
      2006, and as of December 31, 2006 and 2005 is derived from our audited financial
      statements that have been included in this annual report. The selected financial
      data as of December 31, 2002, 2003 and 2004 and for the years ended December
      31,
      2002 and 2003 is derived from consolidated financial statements that have not
      been included in this annual report.




**Year
                Ended December 31,****2002**
            
            **2003**
            
            **2004**
            
            **2005**
            
            **2006****(In
                thousands, except per share data)****Statement
                of Operations Data:**Revenues
            
            $
            12,929
            
            $
            13,162
            
            $
            21,069
            
            $
            29,714
            
            $
            37,953Costs
                and operating expenses:Cost
                of revenues
            
            
            (8,934
            )
            
            (8,393
            )
            
            (13,791
            )
            
            (18,698
            )
            
            (24,375
            )Research
                and development expenses
            
            
            (3,435
            )
            
            (2,326
            )
            
            (2,531
            )
            
            (3,228
            )
            
            (4,043
            )Selling
                and marketing expenses
            
            
            (3,910
            )
            
            (3,325
            )
            
            (3,274
            )
            
            (4,173
            )
            
            (4,956
            )General
                and administrative expenses (exclusive of non-cash compensation expense
                shown below)
            
            
            (2,158
            )
            
            (2,062
            )
            
            (2,194
            )
            
            (2,912
            )
            
            (3,088
            )Non-cash
                compensation expense
            
            
            (270
            )
            
            —
            
            
            —
            
            
            —
            
            
            —Depreciation
                and amortization
            
            
            (6,606
            )
            
            (5,584
            )
            
            (2,731
            )
            
            (1,931
            )
            
            (1,543
            )Total
                costs and operating expenses
            
            
            (25,313
            )
            
            (21,690
            )
            
            (24,521
            )
            
            (30,942
            )
            
            (38,005
            )Loss
                from operations
            
            
            (12,384
            )
            
            (8,528
            )
            
            (3,452
            )
            
            (1,228
            )
            
            (52
            )Interest
                income, net
            
            
            448
            
            
            245
            
            
            269
            
            
            418
            
            
            620Income
                taxes
            
            
            (141
            )
            
            (57
            )
            
            (66
            )
            
            (44
            )
            
            (61
            )Net
                income (loss)
            
            $
            (12,077
            )
            $
            (8,340
            )
            $
            (3,249
            )
            $
            (854
            )
            $
            507Net
                income (loss) per share - basic
            
            $
            (0.42
            )
            $
            (0.29
            )
            $
            (0.11
            )
            $
            (0.03
            )
            $
            0.02Net
              income (loss) per share - diluted
            
            $
            (0.42
            )
            $
            (0.29
            )
            $
            (0.11
            )
            $
            (0.03
            )
            $
            0.02Weighted
                average shares outstanding - basic
            
            
            28,888
            
            
            28,989
            
            
            29,316
            
            
            29,672
            
            
            29,771Weighted
                average shares outstanding - diluted
            
            
            28,888
            
            
            28,989
            
            
            29,316
            
            
            29,672
            
            
            30,129




**December
                31,****2002**
            
            **2003**
            
            **2004**
            
            **2005**
            
            **2006****(In
                thousands)****Balance
                Sheet Data:**Cash
                and cash equivalents
            
            $
            5,681
            
            $
            1,682
            
            $
            4,856
            
            $
            3,847
            
            $
            3,790Short-term
                investments
            
            
            15,552
            
            
            16,442
            
            
            10,527
            
            
            10,648
            
            
            12,067Working
                capital
            
            
            17,675
            
            
            14,820
            
            
            10,285
            
            
            10,264
            
            
            12,182Long-term
                investments
            
            
            —
            
            
            —
            
            
            1,095
            
            
            1,216
            
            
            1,085Total
                assets
            
            
            32,197
            
            
            23,643
            
            
            22,273
            
            
            21,504
            
            
            22,395Total
                stockholder's equity
            
            
            27,114
            
            
            19,141
            
            
            16,025
            
            
            15,561
            
            
            16,618





34




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





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





**Overview**





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





Today
      we
      support hundreds of thousands of active users around the globe through our
      two
      primary distribution channels: our service provider and reseller
      channel and our
      direct-to-consumer channel. We offer a broad suite of private label VoIP
      products and services as well as a back-office platform for service providers,
      resellers, and corporate customers, such as incumbent telecommunications
      providers, Internet service providers, or ISPs, cable companies **,** licensed
      VoIP operators, and various corporate enterprises. Based on our customizable
      VoIP solutions, these customers can offer private label telecommunications
      to
      their own customer bases, under their own brand name, a white-label brand,
      our
      iConnectHere, or ICH, brand, or the deltathree brand. At the same time, our
      direct-to-consumer channel includes our iConnectHere offering which provides
      award-winning VoIP products and services **** directly
      to consumers and small businesses online using the same primary platform, and
      includes our recently established **** joip
      offering which will serve as the exclusive VoIP service provider ebedded in
      the
      GLOBARANGE cordless phones of Panasonic Communications Co., Ltd., or Panasonic,
      the world leader in consumer cordless phones. We expect this joip-enabled phone
      to be available in the summer of 2007.





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




35





Within
      the new Service Provider and Reseller Channel in 2006, we
      announced two unique initiatives that demonstrate our
      ability to expand from our traditional Hosted VoIP target
      markets, namely incumbent telephony providers, cable operators,
      and ISP's, to other markets not related to the wireline
      communications industry.  For example, we completed a transaction with
      telSPACE, a leading mobile virtual network enabler to embed our Hosted
      Consumer VoIP Solution into its infrastructure which provides us with
      a presence in the cellular wireless market.  Our strategic
      relationship with telSPACE enables all of their mobile
      virtual network operator customers and us to offer both wireless and our
      VoIP solution to our respective service providers, or other customers, who
      desire to deploy both VoIP and cellular services under a unified platform.
      This
      relationship consolidates the end user’s purchasing experience for VoIP and
      cellular service into one service under one monthly bill. We expect to begin
      development and launch of this offering during 2007. Moreover, we also completed
      a unique initiative with one of our partners and Korail Networks Inc., the
      operator of South Korea’s high speed rail system. Under this initiative, Korail
      is embedding a platform with VoIP calling services and features into the Korail
      frequent rider membership program plan.  This
      offering represents another example of how our VoIP services add value
      in a non-traditional market and how our offering enhances our
      customer’s core competency.  We expect to develop and launch this offering
      in 2007.





Our
      direct-to-consumer channel includes our recently established **** joip
      offering which will serve as the exclusive VoIP service provider embedded in
      the
      GLOBARANGE cordless phones of Panasonic, the world leader in consumer cordless
      phones, and includes our iConnectHere offering which provides VoIP products
      and
      services **** directly
      to consumers and small businesses online. Prior to the recently established
      joip
      offering, ICH was traditionally our direct-to-consumer channel. We
      have
      positioned iConnectHere as a powerful showcase and test facility for our current
      and future products and services, and as a leverage point for service provider
      and reseller sales. iConnectHere demonstrates our products, services and hosting
      capabilities to our reseller customers and service providers. Through
      iConnectHere, an account holder can access all of our product offerings,
      including PC-to-Phone and Broadband Phone. Our customer care and support teams
      utilize the full range of our back-end infrastructure and support in servicing
      iConnectHere customers. Additionally, iConnectHere permits us to collect usage
      information on our products and services and enables us to provide our service
      provider and reseller customers with key information and recommendations
      regarding implementation of our products and services. As for
      our joip offering, we and Panasonic have created, developed and will offer
      joip-enabled Panasonic GLOBARANGE telephones pursuant to our strategic
      cooperation which began in 2006. Our joip offering will be the exclusive VoIP
      service embedded in Panasonic’s GLOBARANGE series of innovative hybrid 2-line
      cordless phones which provide both landline and VoIP services. Because our
      VoIP
      services are embedded in this hybrid cordless telephone, there is no requirement
      for any software downloads, external adaptors or other complicated procedures.
      Additionally, customers of the GLOBARANGE telephones will be able to talk to
      each other for free through the use of the joip services, and will also be
      able
      to purchase a variety of enhanced features and value-added services. We expect
      that this phone will be available in the summer of 2007. Through our joip
      offering and extensive experience in VoIP services and Panasonic’s consumer
      electronics expertise and vast distribution channels, we and Panasonic aim
      to
      create a global community by providing free calling between joip-enabled
      GLOBARANGE phones in all regions of the world as we expand our reach in our
      direct to consumer channel.





As
      a
      complement to the initiatives we plan to take to organically expand our
      businesses, we have also been evaluating opportunities for inorganic growth
      through strategic acquisitions and unique collaborations. In February 2007,
      we
      acquired the service provider and consumer businesses, including the customer
      bases, of Go2Call.com, Inc., a privately held U.S. based VoIP solution provider,
      for cash and our stock valued at approximately $7 million.





Going
      forward, we expect to:





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




36




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





·
            devote
                a significant amount of our resources to launch, market, and support
                our
                new joip offering in connection, and in collaboration, with Panasonic
                in
                various countries worldwide; and





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





**Trends
      in Our Industry and Business**





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





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





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





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





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





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




37





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





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





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





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





**Revenue** ***s***





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 79.6% and 73.7% of our total revenues in 2006 and 2005,
      respectively, while the provision of VoIP telephony (primarily PC-to-Phone)
      through iConnectHere accounted for 14.9% and 22.4% of our total revenues in
      2006
      and 2005, respectively.





**Costs
      and Operating Expenses**





Costs
      and
      operating expenses consist of cost of revenues, research and development
      expenses, selling and marketing expenses, general and administrative expense,
      depreciation and amortization of goodwill, non-cash stock compensation,
      write-down of fixed assets, expenses due to cancellation of agreement with
      a
      supplier and impairment of goodwill related expenses.





·
            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.




38




·
            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. We
                anticipate that as we add new paid users we will be able to spread
                these
                costs over a larger revenue base and accordingly improve our operating
                margins.




·
            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.





We
      have
      not recorded any income tax benefit for net losses and credits incurred for
      any
      period from inception to December 31, 2006. The utilization of these losses
      and
      credits depends on our ability to generate taxable income in the future. Because
      of the uncertainty of our generating taxable income going forward, we have
      recorded a full valuation allowance with respect to these deferred assets.





**Critical
      Accounting Policies**





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





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





*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.





39




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 are reported at the lower of carrying amount
      or fair value less costs to sell.





40


**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,****2006**
            
            **2005**
            
            **2004**Revenues:Total
                revenues
            
            
            100.0
            
            
            100.0
            
            
            100.0Costs
                and operating expenses:Cost
                of revenues
            
            
            64.2
            
            
            62.9
            
            
            65.5Research
                and development expenses
            
            
            10.7
            
            
            10.9
            
            
            12.0Selling
                and marketing expenses
            
            
            13.1
            
            
            14.0
            
            
            15.5General
                and administrative expenses (exclusive of non-cashcompensation
                expense)
            
            
            8.1
            
            
            9.8
            
            
            10.4Depreciation
                and amortization
            
            
            4.1
            
            
            6.5
            
            
            13.0Total
                costs and operating expenses
            
            
            100.1
            
            
            104.1
            
            
            116.4Loss
                from operations
            
            
            (0.1
            )
            
            (4.1
            )
            
            (16.4
            )Interest
                income, net
            
            
            1.6
            
            
            1.4
            
            
            1.3Income
                taxes
            
            
            (0.2
            )
            
            (0.1
            )
            
            (0.3
            )Net income
                (loss)
            
            
            1.3
            %
            
            (2.9
            )%
            
            (15.4
            )%




**Comparison
      of 2006 and 2005**





**Revenues**





Revenues
      increased approximately $8.3 million or 27.9% to approximately $38.0 million
      in
      2006 from approximately $29.7 million in 2005. Revenues from VoIP telephony
      through our service provider and reseller sales increased approximately $9.4
      million or 37.9% to approximately $30.2 million in 2006 from approximately
      $21.9
      million in 2005, due primarily to a greater number of PC-to-Phone and Broadband
      Phone calls being placed by an increasing user base. Revenues from VoIP
      telephony (primarily PC-to-Phone) through iConnectHere decreased approximately
      $0.9 million or 13.6% to approximately $5.7 million in 2006 from approximately
      $6.6 million in 2005 due primarily to a lower number of PC-to-Phone and
      Broadband Phone calls being placed by a decreasing user base. No customer
      accounted for 10% or more of our sales during 2006.





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




**Costs
      and Operating Expenses**





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




41





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





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





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





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





**Loss
      from Operations**





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





**Interest
      Income, Net**





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





**Income
      Taxes, Net**





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





**Net
      Income/Loss**





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





**Comparison
      of 2005 and 2004**





**Revenues**





Revenues
      increased approximately $8.6 million or 41% to approximately $29.7 million
      in
      2005 from approximately $21.1 million in 2004. Revenues from VoIP telephony
      through our service provider and reseller sales efforts (including sales of
      our
      Hosted Consumer VoIP Solution) increased approximately $9.3 million or 68%
      to
      approximately $23 million in 2005 from approximately $12.9 million in 2004,
      due
      primarily to a greater number of PC-to-Phone and Broadband Phone calls being
      placed by an increasing user base. Revenues from VoIP telephony (primarily
      PC-to-Phone) through iConnectHere decreased approximately $0.5 million or 7%
      to
      approximately $6.6 million in 2005 from approximately $7.1 million in 2004
      due
      primarily to a lower number of PC-to-Phone and Broadband Phone calls being
      placed by a decreasing user base. No customer accounted for 10% or more of
      our
      sales during 2005.





**Costs
      and Operating Expenses**





***Cost
      of revenues.*** Cost of
      revenues increased by $4.9 million or 35% to $18.7 million in 2005 from
      $13.8 million in 2004, due primarily to an increase in the amount of traffic
      being terminated.




42





***Research
      and development expenses.*** Research
      and development expenses increased by $0.7 million or 28% to
      $3.2 million in 2005 from $2.5 million in 2004, due to increased
      personnel costs associated with the development of new services and enhancements
      to our existing services.





***Selling
      and marketing expenses.*** Selling
      and marketing expenses decreased by $0.9 million or 27% to
      $4.2 million in 2005 from $3.3 million in 2004, due to a decrease in
      branding and promotional activities.





***General
      and administrative expenses.*** General
      and administrative expenses increased by $0.7 million or 32% to
      $2.9 million in 2005 from $2.2 million in 2004, primarily due to
      increased personnel and occupancy costs.





***Depreciation
      and amortization.*** Depreciation and amortization decreased by $0.8 million or 30% to
      $1.9 million in 2005 from $2.7 million in 2004, due to a lower
      relative level of capital expenditures in 2005 compared to prior years.





**Loss
      from Operations**





Loss
      from
      operations decreased by $2.3 million or 66% to $1.2 million in 2005 from
      $3.5 million in 2004, due primarily to the decrease in costs and operating
      expenses, including selling and marketing expenses.





**Interest
      Income, Net**





We
      earned
      interest income of $0.4 million
      in 2005 compared to $0.3 million in 2004 due primarily to moderately higher
      interest rates earned on the moderately reduced balance of the remaining
      proceeds from our initial public offering.





**Income
      Taxes, Net**





We
      paid
      net income taxes of $0.1 million in 2005 compared to $0.1 million in
      2004.





**Net
      Loss**





Net
      loss
      decreased $2.2 million or 69% to $1.0 million in 2005 from $3.2 million in
      2004, due to the foregoing factors.





**Liquidity
      and Capital Resources**





Since
      our
      inception in June 1996, we have incurred significant operating and net
      losses due in large part to the start-up and development of our operations.
      For
      the year ended December 31, 2006, our net loss from operations decreased by $1.1
      million or 95.8% to $0.1 million in 2006 from $1.2 million in 2005 and we were
      able to show net income of $0.5 million, an increase
      of $1.4 million or 155.6% in 2006 from a loss of $0.9 million in 2005. Although
      management believes that our five year trend is favorable and we believe that
      we
      are emerging out of the start-up phase, we are uncertain that we will be able
      to
      continue to have net income nor are we able to ensure that we will be able
      to
      show income from operations for the year ended December 31, 2007. At December
      31, 2006, we had an accumulated
      deficit of approximately $151.4 million.





As
      of
      December 31, 2006, we had cash and cash equivalents of approximately $3.8
      million, restricted cash and short-term investments of approximately $12.0
      million, long-term investments of approximately $1.1 million or a total of
      cash,
      cash equivalents, restricted cash and investments of $16.9 million, an increase
      of $1.2 million from December 31, 2005, and working capital of approximately
      $12.2 million. The increase in our cash is largely attributable to the $1.8
      million we received from Panasonic during the second quarter of 2006.





Cash
      provided by operating activities is net income adjusted for certain non-cash
      items and changes in assets and liabilities. We generated positive cash flow
      from operating activities of approximately $2.0 million during 2006 compared
      with positive cash flow from operating activities of $0.2 million during
      2005. In 2006 compared to 2005, we were able to increase our cash from
      operations based on our significant change from a net loss of $0.9 million
      to
      innet income of $0.5 million or a change of approximately $1.4 million or 155.6%
      , the addition of approximately $0.5 million in deferred compensation with
      the
      adoption of FASB 123R and a net change in operating assets and liabilities
      of
      approximately $0.3 million. This was offset by the net changes we experienced
      in
      depreciation, amortization and miscellaneous adjustments. The changes that
      we
      experienced in our current assets and liabilities were driven by our strong
      growth in revenue, the $2.0 million received from Panasonic during the second
      quarter and our ability to continue to slow our cash burn and pay down some
      of
      our current liabilities.




43





Net
      cash
      used in investing activities is generally driven by our annual capital
      expenditures and changes in our short and long term investments. In 2006, we
      spent $0.9 million on capital expenditures and increased our investments by
      $1.3
      million, for a net increase use of $2.2 million. During 2005, net cash used
      by
      investing activities was $1.6 million, primarily due to $1.4 million used for
      purchase of property and equipment.





Financing
      cash flows consist primarily of proceeds from exercise of employee options.
      During 2006 and 2005, our employees exercised options of $0.1 million, and
      $0.4
      million, respectively.





We
      obtained our funding from our utilization of the remaining proceeds from our
      initial public offering, offset by positive or negative cash flow from our
      operations. These proceeds are maintained as cash, restricted cash, and short
      and long term investments. Based on current trends in our operations, these
      funds will be sufficient to meet our working capital requirements, including
      operating losses, and capital expenditure requirements for at least the next
      fiscal year, assuming that our business plan is implemented successfully, and
      that:





·
            our
                recent revenue trends continue to increase or
                stabilize;





·
            our
                expense trends remain at or near the rates of 2006 rates, which were
                somewhat reduced compared to the previous the year, as a percentage
                of
                revenues, through a continuous focus on maximizing our personnel
                utilization, curtailment of discretionary expenditures, and optimized
                network rent and termination rates from our carriers;





·
            the
                cash that we estimate to spend on the purchase and integration of
                Go2Call,
                of approximately $3.0 million ($2.5 cash paid upon purchase and $0.5
                million estimated costs of the transaction and integration), is accurate
                and that we do not need to incur any additional costs to integrate
                the
                newly acquired Go2Call customers to our existing platform;





·
            the
                amount budgeted to complete the development and launch of our joip
                offering during 2007 is accurate and obtainable; and





·
            our
                net cash-burn rate remains similar as in 2006, when we saw a minimal
                use
                of cash of less than $0.1 million.





To
      the
      extent that these trends do not continue or, if in the longer-term, we are
      not
      able to successfully implement our business strategy we may be required to
      raise
      additional funds for our ongoing operations. Additional financing may not be
      available when needed or, if available, such financing may not be on terms
      favorable to us. If additional funds are raised through the issuance of equity
      securities, our existing stockholders may experience significant dilution.
      If
      additional funds are raised through the issuance of debt securities, we may
      not
      be able to obtain additional subsequent financing, if necessary, if the debt
      security contains certain covenants restricting our ability to obtain additional
      financing while such debt security is outstanding. We cannot assure you that
      any
      third party will be willing or able to provide additional capital on favorable
      terms or at all.





**Contractual
      Obligations and Commercial Commitments**





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





44




**Payments
                  due by period (in thousands of dollars)****Contractual
                  obligations**
              
              
              **Total**
              
              
              **Less
                  than 1 year**
              
              
              **1-3
                  years**
              
              
              **3-5
                  years**
              
              
              **More
                  than 5 years**Real
                  Estate Leases
              
              
              4,855
              
              
              1,054
              
              
              2,170
              
              
              1,182
              
              
              449Auto
                  Leases
              
              
              396
              
              
              234
              
              
              162
              
              
              —
              
              
              —Other
                  Operating Leases
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —Purchase
                  Obligations
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —**Total**
              
              
              5,251
              
              
              1,288
              
              
              2,332
              
              
              1,182
              
              
              449





**Off-Balance
      Sheet Arrangements**





None.





**Certain
      Factors That May Affect Future Results of Operations**





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





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





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





**ITEM
      7A.**  **QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS**





The
      SEC's
      rule related to market risk disclosure requires that we describe and quantify
      our potential losses from market risk sensitive instruments attributable to
      reasonably possible market changes. Market risk sensitive instruments include
      all financial or commodity instruments and other financial instruments (such
      as
      investments and debt) that are sensitive to future changes in interest rates,
      currency exchange rates, commodity prices or other market factors. We believe
      our exposure to market risk is immaterial.





45





**ITEM
      8.**  **FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA**





The
      Company's Consolidated Financial Statements required by this Item are set forth
      in Item 15 beginning on page F-1 of this report.





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





None.




**ITEM
      9A.**  **CONTROLS
      AND PROCEDURES**





(a)*Evaluation
                of Disclosure Controls and Procedures*.
                Our principal executive officer and principal financial officer,
                after
                evaluating the effectiveness of our disclosure controls and procedures
                (as
                defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the
                end of
                the period covered by this Annual Report on Form 10-K, have concluded
                that, based on such evaluation, our disclosure controls and procedures
                were adequate and effective to ensure that material information relating
                to us, including our consolidated subsidiaries, was made known to
                them by
                others within those entities, particularly during the period in which
                this
                Annual Report on Form 10-K was being prepared.  (b)  *Changes
              in Internal Controls*.  There
              were no changes in our internal control over financial reporting,
              identified in connection with the evaluation of such internal control
              that
              occurred during the fourth quarter of our last fiscal year that have
              materially affected, or are reasonably likely to materially affect,
              our
              internal control over financial
              reporting.





**ITEM
      9B.**  **OTHER INFORMATION**





Listed
      below for our named executive officers are the salaries that were awarded during
      fiscal 2006, the bonuses that were earned for performance during 2006 but
      awarded in 2007 **,** and
      the
      salaries that have been established for fiscal 2007. Bonuses for fiscal 2007
      have not yet been determined.




46








**Executive
                Officer**
            
            **2006
                Salary**
              **$**
            
            **2006
                Bonus****(2)**
              **$**
            
            **2007
                Salary**
              **$**Shimmy
                Zimels
              *Chief
                Executive Officer*
              *and President*
            
            
            258,000
            (1)
            
            35,000
            
            
            264,000
            (1)Paul
                C. White(3)
              *Chief
                Financial Officer*
            
            
            129,216
            (4)
            
            --
            (5)
            
            ---Guy
                Gussarsky(6)
              *Executive
                VP Sales and Business Development*
            
            
            231,627
            
            
            8,000
            
            
            10,928
            (7)Richard
                Grant
              *Senior
                VP of Finance and Treasurer*
            
            
            153,333
            (8)
            
            13,000
            
            
            175,000
            (9)




(1)
            Salary
                is pursuant to Mr. Zimels’ employment
                agreement.


(2)
            Bonus
                shown is the aggregate amount of bonuses earned by the executive
                in 2006,
                under our Amended and Restated 1999 Performance Incentive Plan, for
                his
                performance during 2006.


(3)
            Mr.
                White resigned effective as of February 28,
                2006.


(4)
            The
                amount includes Mr. White’s salary pursuant to his employment agreement
                for the period up to his resignation date, and (ii) a severance payment
                in
                the amount of $90,000.


(5)
            In
                connection with Mr. White’s resignation, Mr. White received certain
                severance and benefits in lieu of any bonuses for his performance
                during
                2005. For additional information about the severance and benefits,
                please
                see the information under “Executive Compensation - Termination of
                Employment and Change-in-Control
                Arrangements.”


(6)
            Mr.
                Gussarsky resigned effective as of February 14, 2007.


(7)
            This
                amount represents Mr. Gussarsky’s salary through the date of his
                resignation on February 14, 2007. This amount does not include Mr.
                Gussarsky’s commissions through the date of his resignation, which have
                not yet been determined by us.  (8)
            The amount represents salary earned from January
              23,
              2006, the date Mr. Grant joined the Company, through the end of fiscal
              2006. This amount is based on an annual salary of
              $162,500.


(9)
            Salary
                increase for 2007 was based on offer upon joining the
                Company in January 2006.




47


**PART
      III**





**ITEM
      10.**  **DIRECTORS,
      EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE**





**The
      Board of Directors**





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





***Noam
      Bardin*** ,
      35,
      Chairman of the Board. Mr. Bardin has served as Chairman of the Board since
      April 2002.  Since January 2007, Mr. Bardin has been the Chief Executive
      Officer of Arootz, Inc., a private broadband TV content enabler and network
      provider.  Mr. Bardin co-founded deltathree and served as Chief Executive
      Officer and President of deltathree from July 2000 through June 2002.  Mr.
      Bardin served as Vice President of Technology and Chief Technology Officer
      of
      deltathree since June 1997, before being named President and Chief Executive
      Officer in April 2000.  He served as Global Network Director of deltathree
      from November 1996 to May 1997. Prior to founding deltathree, he served as
      Director of Operations at Ambient Corporation.  Mr. Bardin earned a B.A. in
      Economics from the Hebrew University (Jerusalem) and an M.P.A. from the Harvard
      University Kennedy School of Government.





***Ilan
      Biran*** *,* 60,
      Director. Mr. Biran has served as a director of deltathree since December 2003.
      Mr. Biran brings a wealth of business and management experience from the telecom
      and defense industries. From January 2004
      through June 2006, Mr. Biran has served as the Chairman of YES Satellite
      Television, one of the leading satellite television companies in Israel. From
      1999 to 2003, Mr. Biran served as the President and Chief Executive Officer
      of
      Bezeq Ltd. - the Israeli PTT, with annual sales of over $2 billion and
      approximately 16,000 employees. Mr. Biran holds the rank of Major General (res.)
      in the Israeli Defense Force where, as Commander of the IDF's Central Command,
      he played an active role in reaching the peace agreements with Jordan. From
      1996
      to 1999, he served as the Director General of the Israeli Ministry of Defense,
      and prior to that command, he held a wide variety of senior-level positions
      in
      other Israeli units, since 1964. Mr. Biran holds a B.A. in Economics and
      Business Administration from Bar-Ilan University, and holds an Associate Diploma
      in Strategy and Political Economic Research from Georgetown University. He
      is
      also a graduate of the U.S. Marine Corps Command and Staff College. In addition,
      Mr. Biran's public activities include: serving as the Israeli Prime Minister's
      Special Coordinator for POWs and MIAs, and since 1996, has served as the
      Chairman of the Board of Directors of the Israeli Oil Refineries,
      Ltd.





***Benjamin
      Broder*** ,
      43,
      Director. Mr. Broder has served as a director of deltathree since July 24,
      2005.
      As of 2002, Mr. Broder has served as the Finance Director of Atarey. From 1996
      to 2001, Mr. Broder worked as the chief financial officer of a telecom start-up
      company and a bio-tech start-up company. Previously, Mr. Broder also held
      various positions with several leading banks, including HSBC, Bank Hapoalim,
      and
      Bank of Israel. Mr. Broder earned a B.S. degree in Economics from University
      of
      London. Mr. Broder is a Chartered Accountant in the U.K. and a C.P.A. in
      Israel.





***Lior
      Samuelson*** ,
      56,
      Director. Mr. Samuelson 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. Mr. Samuelson earned B.S. and
      M.S. degrees in Economics from Virginia Polytechnic University.




48





***Shimmy
      Zimels*** ,
      41,
      Chief Executive Officer and President and Director. Mr. Zimels has served as
      Chief Executive Office and President since June 2002, and served as Vice
      President of Operations and Chief Operating Officer of deltathree since June
      1997, before being named President and Chief Executive Officer in June 2002.
      Prior to joining deltathree, Mr. Zimels was the Controller and Vice President
      of
      Finance at Net Media Ltd., a leading Israel based Internet Service Provider,
      from June 1995 to June 1997. From April 1991 to May 1995, Mr. Zimels was a
      senior tax auditor for the Income Tax Bureau of the State of Israel. Mr. Zimels
      graduated with distinction from Hebrew University with a degree in Economics
      and
      Accounting and holds a Masters in Economics from Hebrew University.





Our
      Board
      has determined that the following members of the Board qualify as independent
      under the definition promulgated by the Nasdaq Stock Market: Noam Bardin, Ilan
      Biran, Benjamin Broder, and Lior Samuelson.





**Executive
      Officers**





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





**Richard
      Grant** , 43,
      Senior Vice President of Finance and Treasurer. Mr. Grant joined deltathree
      on
      January 23, 2006. Mr. Grant is a Certified Public Accountant. Prior to his
      employment with deltathree, Mr. Grant was a co-founder and Chief Financial
      Officer of Tel2Net, Inc., a technology infrastructure service company. From
      2001
      through 2003, Mr. Grant served as a Senior Manager for Marotta, Gund, Budd
      and
      Dzera LLP, a business restructuring consulting company. Prior to Marotta, Gund,
      Mr. Grant was a Senior Manager at KPMG LLP in the Audit Division, and a Senior
      Manager at Arthur Andersen LLP in the Transaction Advisory Services Group.
      Mr.
      Grant earned a B.A. in Business Administration-Accounting at Adelphi
      University.





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





**Eugene
      Serban** ,
      38,
      General Counsel and Secretary. In January 2007, Mr. Serban became our General
      Counsel. Mr. Serban joined deltathree in 2005 as our corporate counsel. Mr.
      Serban’s experience is in the areas of securities offerings and reporting,
      mergers and acquisitions, corporate governance, venture capital financing,
      technology licensing, joint ventures, and general corporate matters. Before
      joining deltathree, Mr. Serban served as Corporate Counsel - Securities and
      Mergers/Acquisitions Group and Assistant Secretary of Lucent Technologies Inc.
      Prior to that, Mr. Serban was associated with the international law firms of
      Clifford Chance LLP and Greenberg Traurig LLP. Mr. Serban holds a B.A. from
      McGill University, a J.D. from Seton Hall University School of Law, and an
      LL.M.
      from New York University School of Law.





**Board
      of Directors and Committees of the Board**





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




49





The
      Board
      had eight regular and no special meetings during the fiscal year ended December
      31, 2006. During the fiscal year ended December 31, 2006, each member of the
      Board participated in at least 75% of all Board and applicable committee
      meetings held during the period for which he was a director. Except for Mr.
      Zimels, none of our other directors attended our 2006 Annual Stockholder
      Meeting. The Board 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 2007 Annual Meeting
      of Stockholders using the procedures set forth in the Company's By-laws, it
      must
      follow the procedures described under "Nomination of Directors" in our By-laws.
      If a stockholder wishes simply to propose a candidate for consideration as
      a
      nominee by our Board, it should submit any pertinent information regarding
      the
      candidate to the Chairman of the Board by mail at 75 Broad Street, New York,
      New
      York 10004.





The
      Compensation Committee is responsible for:





·
            evaluating
                our compensation policies;


·
            determining
                executive compensation, and establishing executive compensation policies
                and guidelines; and


·
            administering
                our stock option and compensation
                plans.





As
      part
      of these responsibilities, the Compensation Committee determines the
      compensation of our Chief Executive Officer, and conducts its decision making
      process with respect to this issue without the presence of the Chief Executive
      Officer. All
      members of the Compensation Committee qualify as independent under the
      definition promulgated by the Nasdaq Stock Market. The Compensation Committee
      had ten meetings during 2006. Benjamin Broder (Chairman) and Ilan Biran are
      the
      current members of the Compensation Committee. Please also see the report of
      the
      Compensation Committee set forth elsewhere in this annual report.





The
      Audit
      Committee is responsible for:





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






50


·
              reviewing
                  and approving the scope of the annual audit and evaluates 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.


Ilan
      Biran (Chairman), Noam Bardin and Lior Samuelson are the current members of
      the
      Audit Committee. All members of the Audit Committee satisfy the current
      independence standards promulgated by the SEC and by the Nasdaq Stock Market,
      as
      such standards apply specifically to members of audit committees. The Board
      has
      determined that each of Mr. Bardin, Mr. Biran, and Mr. Samuelson are “audit
      committee financial experts,” as the SEC has defined that term in Item 401
      of Regulation S-K. The Audit Committee had five meetings during 2006.





**Section
      16(a) Beneficial Ownership Reporting Compliance**





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





To
      our
      knowledge, based solely upon our review of the copies of such reports furnished
      to us, we believe that all of our directors, officers and greater than 10%
      stockholders have complied with the applicable Section 16(a) reporting
      requirements except that: one report of change in beneficial ownership, covering
      one transaction, was filed late by Benjamin Broder; and one report of change
      in
      beneficial ownership, covering one transaction, was filed late by Richard Grant.





**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 2006. 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
      Corporate Secretary at 75 Broad Street, New York, New York 10004. We intend
      to
      post on our website and include in a Current Report on Form 8-K filed with
      the
      SEC any amendments to, or waivers from, our Code of Conduct and Ethics that
      apply to our principal executive officer, principal financial and accounting
      officer and controller. We have all of our new employees certify that they
      have
      read and understand our Corporate Code of Conduct and Ethics, and, periodically,
      we also ask our existing employees to certify that they have reviewed our
      Corporate Code of Conduct and Ethics.




51




**ITEM
      11.**  **EXECUTIVE
      COMPENSATION**




**Compensation
      Discussion and Analysis**





*Overview*





Our
      Board
      of Directors appoints the members of its Compensation Committee and delegates
      to
      the Compensation Committee the direct responsibility for overseeing the design
      and administration of our executive compensation program, including the ongoing
      monitoring of the compensation strategy’s implementation. The Compensation
      Committee is also responsible for recommending new incentive compensation plans
      and implementing changes and improvements to existing compensation plans. The
      Compensation Committee makes its compensation determinations based upon its
      own
      analysis of information it compiles and the business experience of its
      members.





The
      Compensation Committee makes decisions based upon management's request and
      recommendations provided to it by our Chief Executive Officer. Our Compensation
      Committee, and as appropriate from time to time in consultation with our Board
      of Directors, considers and approves matters regarding the compensation of
      our
      named executive officers, including any severance terms if applicable. Our
      Compensation Committee negotiated the employment agreement with our Chief
      Executive Officer. Our Chief Executive Officer negotiated the employment terms
      with our other named executive officers. The goal in negotiating these
      employment terms was to secure and retain talented executives and to ensure
      stability and structure during our growth stage. The Compensation Committee
      negotiated the employment agreement with our Chief Executive Officer with these
      same goals in mind.





*Overall
      Policy, Objectives and Philosophy*




In
      general, the objectives of our executive compensation program are to:




·
            attract,
                motivate and retain talented and dedicated executive officers;




·
            provide
                our executive officers with both cash and equity incentives to promote
                strong performance and the attainment of goals set for them by the
                Compensation Committee and our Board of Directors;




·
            provide
                our executive officers with long-term incentives in order to retain
                their
                services;




·
            provide
                stability during our growth stage; and




·
            align
                the interests of our executive officers with those of our stockholders.




The
      Compensation Committee believes that the stability of our management team,
      as
      well as our ability to continue to incentivize management and to attract and
      retain highly qualified executives for our expanding operations, will be a
      contributing factor to our continued growth and success. In order to promote
      stability, growth and performance, and to attract new executives, our strategy
      is to compensate our executive officers with an overall package that we believe
      is competitive with those offered by similarly situated companies. The principal
      elements of our executive compensation program consist of: (i) a stable base
      salary set at a sufficiently competitive level as compared to our peer group
      comparables to retain and motivate these officers, (ii) an annual bonus linked
      to our overall performance each year and to the individual executive’s
      performance each year and (iii) equity-related compensation which aligns the
      financial interests of our executive officers with those of our stockholders
      by
      promoting stock ownership and stock performance through the grant of stock
      options and stock appreciation rights, restricted stock and other equity and
      equity-based interests under our various plans.





In
      December of each year, our Compensation Committee meets to set recommendations
      for base salaries to be paid to our named executive officers. In February or
      immediately following our release of our annual financial results each year,
      our
      Compensation Committee meets to set recommendations for the bonus and long-term
      incentive compensation awards to be paid to our named executive officers with
      respect to performance for the prior year. In setting annual recommendations
      for
      salaries and bonuses and long-term incentive compensation awards, the
      Compensation Committee reviews the individual contributions of each executive
      officer and the achievement of predetermined corporate, departmental and
      individual performance goals, and in accordance with our Amended and Restated
      1999 Performance Incentive Plan.




52




*Executive
      Compensation Components*





The
      components of our compensation package are as follows:





*Base
      Salary*





Base
      salary is used to compensate our executive officers based on their experience,
      skills, training, knowledge and responsibilities, taking into account
      competitive market salaries paid by our peer companies for similar positions.
      We
      believe that executive base salaries should be targeted at a competitive level
      within the range of salaries for executives in similar positions with similar
      responsibilities at our peer companies. Salaries for our named executive
      officers are reviewed by our Chief Executive Officer with the Compensation
      Committee, other than his own, which is reviewed by the Compensation Committee,
      on an annual basis, as well as at the time of promotion or other changes in
      responsibilities. As part of this annual salary review, the Compensation
      Committee compiles information and performs benchmarking analysis in order
      to
      compare salaries of our executives against salaries of similarly situated
      executives in peer companies.





The
      base
      salary for our Chief Executive Officer is pursuant to his employment agreement
      with us and for 2007 is $264,000. For 2007, Mr. Gussarsky received as part
      of
      his base salary $10,928 through the date of his resignation in February 2007,
      not including his commissions which have not yet been determined by us. Mr.
      Grant’s annual salary for 2007 is $175,000. The base salaries for Mr. Gussarsky
      and Mr. Grant were set at a level
      that is commensurate with each of their responsibilities and competitive with
      similar positions at other comparable companies.





*Annual
      Incentive Bonuses*




On
      July
      5, 2006, our Board of Directors approved our Amended and Restated 1999
      Performance Incentive Plan, or Performance Incentive Plan. The Board amended
      and
      restated our Performance Incentive Plan to enable our company and its
      subsidiaries to continue to attract, retain, motivate and reward the best
      qualified executive officers and key employees by providing them with the
      opportunity to earn competitive compensation directly linked to our performance.





The
      Plan
      is administered by the Compensation Committee. Each year the Compensation
      Committee determines the performance objectives and targets, including each
      such
      objective’s relative weight percentage, for the Chief Executive Officer and for
      the other participants in the Plan in consultation with the Chief Executive
      Officer. The performance objectives are based on the following general
      categories with respect to the Company: (i) financial; (ii) strategic; and
      (iii)
      discretionary. In connection with establishing the performance objectives and
      targets, the Compensation Committee is responsible for:




·
            determining
                the relative weight of each of the three categories of performance
                objectives, expressed in percentage out of a total of
                100%;





·
            determining
                the specific performance measures within each of the categories of
                performance objectives;




53




·
            determining
                the targets for each performance objective, expressed in a percentage
                out
                of a total of 100%;





·
            determining
                the range of the minimum and the maximum achievement figure/criteria
                for
                each target; and





·
            making
                any other determination as it deems necessary.





The
      maximum amount payable in a specific category is determined based upon (i)
      the
      achievement of the targets within such category of performance objectives and
      (ii) the product of the total maximum amount payable for a participant
      multiplied by the relative weight assigned to such category. In the event a
      participant is not eligible for payment under one or two out of the three
      categories of performance objectives, this does not automatically preclude
      the
      participant from being eligible to earn a payment under the other remaining
      category (or categories), subject to achieving the applicable performance
      objectives and targets. Performance equal to or below the minimum achievement
      figure/criteria for a target results in no payment for such target, but
      performance above the minimum achievement figure/criteria is pro-rated in
      proportion to the achievement above the minimum, up to the maximum achievement
      figure/criteria.





The
      Compensation Committee determines whether the performance objectives and targets
      are achieved. If the performance objectives and targets are achieved, the
      participants are awarded a bonus, payable in cash (or subject to agreement
      between the participant and the Compensation Committee, payable in our stock).
      The maximum potential bonus that the Chief Executive Officer is eligible to
      receive each year under the Plan is up to 45% of the annual base salary. The
      maximum number of shares for which options or stock appreciation rights may
      be
      granted to any one participant in a calendar year is 500,000, pursuant to our
      Stock Incentive Plan.




On
      March 25, 2007, the Compensation Committee approved our executives' cash
      bonus awards for 2006 performance pursuant to the Amended and Restated 1999
      Performance Incentive Plan, including the following awards to our Chief
      Executive Officer and other named executive officers:




**Name**
            
            **Bonus
                ($)******Shimmy
                Zimels
            
            
            35,000Guy
                Gussarsky
            
            
            8,000Richard
                Grant
            
            
            13,000




The
      Chief Executive Officer's cash bonus equaled approximately 13% of his base
      salary and the other named officers were awarded cash bonus amounts equaling
      3%
      to 8% of their respective base salaries.




Pursuant
      to the terms of the Amended and Restated 1999 Performance Incentive Plan, awards
      for the current year are to be paid by February 28 or within 60 days after
      determination of the financial results for 2006, whichever occurs later.





*Long-Term
      Incentive Compensation*





We
      reinforce the importance of producing satisfactory returns to stockholders
      over
      the long-term through the operation of the 2004 Stock Incentive Plan and the
      2006 Non-Employee Director Stock Plan. For a discussion relating to the Director
      Plan, refer to the section entitled “2006 Non-Employee Director Stock Plan” in
      this annual report. Grants of stock, restricted stock, stock options, stock
      unit
      awards and stock appreciation rights under such plans provide executives with
      the opportunity to acquire an equity interest in us and align the executive’s
      interest with that of the stockholders to create stockholder value as reflected
      in growth in the market price of the Common Stock.





2004
      Stock Incentive Plan




54





The
      purposes of the 2004 Stock Incentive Plan, as amended, are to foster and promote
      our long-term financial success and materially increase stockholder value by
      (i)
      motivating superior performance by means of performance-related incentives,
      (ii)
      encouraging and providing for the acquisition of an ownership interest in us
      by
      executive officers and other key employees and (iii) enabling us to attract
      and
      retain the services of an outstanding management team upon whose judgment,
      interest and special effort the successful conduct of its operations is largely
      dependent.





Under
      the
      2004 Stock Incentive Plan, the Compensation Committee is authorized to grant
      options for 2,759,732 shares of Common Stock, plus (b) such additional shares
      of
      Common Stock as are represented by awards previously granted under the 1999
      Stock Incentive Plan which are cancelled or without delivery of shares of stock.
      Options granted under the 2004 Stock Incentive Plan are to be granted to certain
      of our officers and to our other employees and consultants. Directors who are
      non-employees are prohibited from participating in the 2004 Stock Incentive
      Plan.





The
      2004 Stock Incentive Plan is administered by the Compensation Committee and
      provides for the grant of (i) incentive and non-incentive stock options to
      purchase Common Stock; (ii) stock appreciation rights, which may be granted
      in
      tandem with or independently of stock options; (iii) restricted stock and
      restricted units; (iv) incentive stock and incentive units; (v) deferred stock
      units; and (vi) stock in lieu of cash. The maximum number of shares for which
      options or stock appreciation rights may be granted to any one participant
      in a
      calendar year is 500,000. As of December 31, 2006, the Company has outstanding
      options to acquire an aggregate of 2,330,835 shares of Common Stock, of which
      1,673,835 were granted under the expired 1999 Stock Incentive Plan and the
      expired 1999 Directors’ Plan and 657,000 were granted under the 2004 Stock
      Incentive Plan and the terminated 2004 Non-Employee Director Stock Option
      Plan.





In
      the
      third fiscal quarter of 2006, our Compensation Committee, in consultation with
      the other members of our Board, decided that going forward it would grant
      restricted shares of our common stock instead of stock options to key employees
      who are critical to the future success of the company. The Compensation
      Committee believes that restricted share grants provide long-term incentive
      for
      such key employees to build stockholder value. Because the restricted share
      grants have a defined value at the time the restricted share grants are made,
      the Compensation Committee believes that restricted share grants are perceived
      as having more immediate value than stock options, which have a less calculable
      value when granted. However, we generally will grant fewer restricted shares
      of
      our common stock than the number of stock options we would grant for a similar
      purpose.





The
      restricted share grants are made in order to reward contributions that have
      been
      made by certain individuals and in anticipation of future contributions that
      will create value in the company. The restricted share grants are subject to
      certain forfeiture provisions over a period of time and, therefore, are
      restricted as to transferability until such forfeiture restrictions have lapsed.
      The restrictions relate to continued service with us. The vesting period for
      such restricted shares of common stock is typically three years. In 2006, we
      granted a total of 224,500 restricted shares of our common stock to our
      employees, which included a grant of 30,000 restricted shares to Mr. Zimels
      and
      25,000 restricted shares to Mr. Gussarsky as recommended by our Compensation
      Committee and approved by our Board. Because Mr. Gussarsky resigned effective
      as
      of February 14, 2007, all of the 25,000 restricted shares granted to Mr.
      Gussarsky have been forfeited and cancelled. The restricted shares of our common
      stock were granted pursuant to the 2004 Stock Incentive Plan.





The
      Compensation Committee’s plan is to make grants of restricted shares of our
      common stock as part of our overall performance management program. The
      Compensation Committee intends to make such grants on a periodical-basis, in
      recognition or in anticipation of certain contributions. As is the case when
      the
      amounts of base salary and the other components of compensation are determined,
      a review of all components of the executive’s compensation is conducted when
      determining equity grants to ensure that an executive’s total compensation
      conforms to our overall philosophy and objectives.





*Other
      Executive Benefits and Perquisites*





Executive
      officers are also entitled to customary benefits generally available to all
      of
      our employees, including health insurance, life and disability insurance, dental
      insurance, and a 401(k) plan. Base salary, bonuses and benefits are paid by
      the
      Company and its subsidiaries.




55





*Federal
      Income Tax Deductibility of Executive Compensation*





Section
      162(m) of the Internal Revenue Code of 1986, as amended (the “Code”), limits the
      amount of compensation a publicly held corporation may deduct as a business
      expense for Federal income tax purposes. The limit, which applies to a company’s
      chief executive officer and the four other most highly compensated executive
      officers, is $1 million (the “Deductibility Limit”), subject to certain
      exceptions. The exceptions include the general exclusion of performance-based
      compensation from the calculation of an executive officer’s compensation for
      purposes of determining whether his or her compensation exceeds the
      Deductibility Limit. The Compensation Committee has determined that compensation
      payable to the executive officers should generally meet the conditions required
      for full deductibility under section 162(m) of the Code. While the Company
      does
      not expect to pay its executive officers compensation in excess of the
      Deductibility Limit, the Compensation Committee also recognizes that in certain
      instances it may be in our best interest to provide compensation that is not
      fully deductible.




*Severance
      and Change in Control Benefits*





We
      provide protections for our Chief Executive Officer by including severance
      and
      change of control provisions in his employment agreement. We provide these
      protections in order to attract and retain a highly skilled and experienced
      individual in this position, as well as to align the interests of this executive
      with those of our stockholders. In addition, we believe that the difficulty
      of
      finding comparable employment opportunities at the level of chief executive
      officer or president requires that companies provide severance payments in
      order
      to attract and retain highly skilled and experienced individuals for these
      positions.





In
      the
      event of a change of control, certain provisions of our Chief Executive
      Officer’s employment agreement allow for acceleration of equity awards and for
      the payment of certain amounts and benefits in the event the executive
      terminates his employment for good reason. We believe that this type of
      arrangement incentivizes our Chief Executive Officer to achieve corporate goals
      and rewards him for increasing our value, even during a change of control period
      of time. As of December 31, 2006, none of our other executive officers had
      any
      severance arrangements with us.  For
      more
      details regarding severance, change of control and termination, see the
      subsection below entitled “Employment Agreements, Termination of Employment and
      Change-in-Control Arrangements” in this annual report.





*Conclusion*





We
      believe that to attract, motivate and retain high-performing executives a
      competitive base salary and stock award package are necessary for top
      performance and attainment of long-term goals. We believe that our compensation
      policies are designed to accomplish these goals and to ultimately reward our
      key
      personnel for outstanding individual and corporate performance.




56





**Compensation
      Committee Report**





The
      compensation committee of our Board of Directors has reviewed and discussed
      the
      Compensation Discussion and Analysis required by Item 402(b) of Regulation
      S-K,
      which appears elsewhere in this annual report on Form 10-K, with our management.
      Based on this review and discussion, the Compensation Committee has recommended
      to the Board of Directors that the Compensation Discussion and Analysis be
      included in our annual report.





Members
      of the Compensation Committee:


Benjamin
      Broder


Ilan
      Biran




57


**Summary
      Compensation Table**





The
      following table shows the total compensation paid or accrued during the fiscal
      year ended 2006 **** to
      (1)
      our Chief Executive Officer (principal
      executive officer, principal financial officer, and principal accounting
      officer) ,
      and (2)
      our two next most highly compensated executive officers who earned more than
      $100,000 during the fiscal year ended 2006. The table includes one additional
      former executive who would have been among the three most highly compensated
      executive officers except for the fact that he was not serving as executive
      officers of the Company as of the end of 2006 **.** ****




These
      executive officers are referred to in this report as “named executive
      officers”.


**Name
                  and Principal Position**
              
              **Year**
              
              **Salary**
                **($)**
              
              **Bonus**
                **($)**
              
              **Stock
                  Awards**
                **($)**
              
              **Option
                  Awards**
                **($)**
              
              **All
                  Other Compensation ($)**
              
              **Total
                  ($)**Shimmy
                  Zimels
                Chief
                  Executive Officer and President (principal executive officer, principal
                  financial officer, and principal accounting officer)
              
              
              2006
              
              
              258,000
              
              
              35,000
              (1)
              
              3,991
              (2)
              
              0
              
              
              0
              
              
              296,991Paul
                  C. White (3)
                Former
                  Chief Financial Officer
              
              
              2006
              
              
              39,216
              (4)
              
              
              
              
              
              
              
              0
              
              
              90,000
              (5)
              
              129,216Guy
                  Gussarsky (6)
                Former
                  Executive Vice President of
                Sales
                  and Business Development
              
              
              2006
              
              
              231,627
              (7)
              
              8,000
              (1)
              
              3,326
              (8)
              
              0
              
              
              10,000
              (9)
              
              252,953Richard
                  Grant
                Senior
                  Vice President of Finance and Treasurer
              
              
              2006
              
              
              153,333
              (10)
              
              13,000
              (1)
              
              
              
              
              35,092
              (11)
              
              
              
              
              201,425
 (1)
                Earned
                    for performance during 2006, but award approved on March 25,
                    2007. The
                    bonuswas
                    made pursuant to ourAmended
                    and Restated 1999 Performance Incentive
                    Plan.
 58




(2)
            Represents
                the compensation expense incurred by us in 2006 in connection with
                a grant
                of 30,000 restricted shares of our common stock to Mr. Zimels on
                July 31,
                2006. See Note 9 and Note 2 (p) to our Condensed Consolidated
                Financial Statements contained in this annual report for details
                as to the
                assumptions used to determine the fair value of the stock awards.




(3)
            Mr.
                White resigned effective as of February 28,
                2006.




(4)
            The
                amount includes Mr. White’s salary pursuant to his employment agreement
                for the period up to his resignation
                date.





(5)
            Represents
                the severance payment received by Mr. White in connection with his
                resignation. For additional information about the severance and benefits,
                see the information under “Executive Compensation - Employment Agreements,
                Termination of Employment and Change-in-Control
                Arrangements.”





(6)
            Mr.
                Gussarsky resigned effective as of February 14, 2007.




(7)
            Includes
                both base and commission components of Mr. Gussarsky’s
                salary.





(8)
            Represents
                the compensation expense incurred by us in 2006 in connection with
                a grant
                of 25,000 restricted shares of our common stock to Mr. Gussarsky
                on July
                31, 2006. Because Mr. Gussarsky resigned effective as of February
                14,
                2007, all of the 25,000 restricted shares granted to Mr. Gussarsky
                have
                been forfeited and cancelled. See Note 9 and Note 2 (p) to our
                Condensed Consolidated Financial Statements contained in this annual
                report for details as to the assumptions used to determine the fair
                value
                of the stock awards.





(9)
            Represents
                payment for severance in connection with his resignation, which was
                approved on March 25, 2007.


(10)
              Amount
                    represents salary earned from January 23, 2006, the date Mr.
                    Grant joined
                    the Company, through the end of fiscal 2006. This amount is based
                    on an
                    annual salary of $162,500.
 (11)
                Represents
                      the compensation expense incurred by us in 2006 in connection
                      with a grant
                      of options to purchase 50,000 shares of our common stock. See
                      Notes 2 (o)
                      and 9 to our Condensed Consolidated Financial Statements contained
                      in this
                      annual report for details as to the assumptions used to determine
                      the fair
                      value of the option awards.


**Grants
      Of Plan-Based Awards**




The
      following table shows information regarding grants of equity awards that we
      made
      during the fiscal year ended 2006 to each of the executive officers named in
      the
      Summary Compensation Table. All such grants were made under our 2004 Stock
      Incentive Plan.


**Name**
              
              **Grant
                  Date**
              
              **Approval**
                **Date**
              
              **All
                  Other Stock Awards: Number of Shares of Stock or
                  Units**
                **(#)**
              
              **All
                  Other Option Awards: Number of Securities Underlying
                  Options**
                **(#)**
              
              **Exercise
                  or Base Price of Option Awards ($/Sh)**
              
              **Grant
                  Date Fair Value of Stock and Option Awards**
                **($)**Shimmy
                  Zimels
                Chief
                  Executive Officer and President (principal executive officer, principal
                  financial officer, and principal accounting officer)
              
              
              7/31/06
              (1)
              
              6/29/06
              
              
              30,000
              
              
              0
              
              
              
              
              
              44,400Paul
                  C. White
                Chief
                  Financial Officer
              
              
              
              
              
              
              
              
              
              
              
              0Guy
                  Gussarsky
                Former
                  Executive Vice President of Sales and Business
                  Development
              
              
              7/31/06
              (1)
              
              6/29/06
              
              
              25,000
              
              
              0
              
              
              
              
              
              37,000Richard
                  Grant
                Senior
                  Vice President of Finance and Treasurer
              
              
              1/23/06
              
              
              1/23/06
              
              
              0
              
              
              50,000
              
              
              3.02
              
              
              112,355




59





(1)  Approved
      for granting on June 29, 2006, but granted on July 31, 2006 immediately after
      the end of the Company’s self-imposed trading black-out period for the quarter
      ended June 30, 2006.





*Employment
      Agreement with Mr. Shimmy Zimels*





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





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





·
            Pursuant
                to the agreement, Mr. Zimels was entitled to receive a base salary
                of
                $258,800 during 2006. Such base salary is increased on each January
                1,
                commencing January 1, 2005, by an amount equal to the base salary
                then in
                effect, multiplied by the applicable cost of living index during
                the prior
                year. The employee’s base salary, as adjusted for cost of living
                increases, may be further increased at the option and in the discretion
                of
                our Board. In 2007, Mr. Zimels base salary was increased to $264,000
                reflecting the adjustment for cost of living increases.





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





In
      2006,
      Mr. Zimels received a grant of 30,000 restriced shares of our common stock
      pursuant to our 2004 Stock Incentive Plan. The
      restricted share grants are subject to certain forfeiture provisions over a
      period of time based on continued service with the company. As a result, Mr.
      Zimels restricted shares will not be forfeitable and vest as follows: 8,400
      shares will vest on July 31, 2007, 9,900 shares will vest on July 31, 2008,
      and
      11,700 shares will vest on July 31, 2009. In addition, the Compensation
      Committee approved on March 25, 2007 a bonus in the amount of $35,000 for Mr.
      Zimels’ performance in 2006. This bonus was made pursuant to our Amended and
      Restated 1999 Performance Incentive Plan. Pursuant to the Amended and Restated
      1999 Incentive Plan, this cash bonus was set based on the achievement of certain
      pre-determined targets based on the Company’s performance, individual
      performance, and discretion.





60




**Outstanding
      Equity Awards At Fiscal Year-End**





The
      following table shows grants of stock options and grants of unvested stock
      awards outstanding on the last day of the fiscal year ended 2006 **** to
      each
      of the executive officers named in the Summary Compensation Table.


**Option
                  Awards**
              
              **Stock
                  Awards****Name**
              
              **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**
                **($)**Shimmy
                  Zimels
                Chief
                  Executive Officer and President (principal executive officer, principal
                  financial officer, and principal accounting officer)
              
              
              12/31/2000
                3/16/2001
                3/12/2002
                11/4/2003
              
              
              130,000
                39,000
                100,000
                85,000
              
              
              
              
              
              1.38
                1.13
                1.02
                1.76
              
              
              12/31/2007
                3/16/2008
                3/12/2009
                11/4/201012/22/2004
              
              
              53,334
              
              
              26,666(2
              )
              
              2.86
              
              
              12/22/20147/31/2006
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              30,000(3
              )
              
              37,800(4
              )Paul
                  C. White
                Former
                  Chief Financial Officer(5)
              
              
              12/31/2000
                3/12/2002
                11/4/2003
                12/22/2004
              
              
              103,402
                100,000
                65,000
                25,000
              
              
              
              
              
              1.38
                1.02
                1.75
                2.85
              
              
              2/29/2008
                2/29/2008
                2/29/2008
                2/29/2008Guy
                  Gussarsky
                Former
                  Executive Vice President of
                Sales
                  and Business Development(5)
              
              
              12/31/2000
                3/12/2002
                11/4/2003
                12/22/2004
              
              
              15,000
                13,334
                26,667
                33,334
              
              
              16,666(2
              )
              
              1.38
                1.02
                1.75
                2.85
              
              
              12/31/2007
                2/14/2008
                2/14/2008
                2/14/20087/31/2006
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              25,000
              
              
              31,500(6
              )Richard
                  Grant
                Senior
                  Vice President of Finance and Treasurer
              
              
              1/23/2006
              
              
              0
              
              
              50,000(7
              )
              
              3.02
              
              
              1/23/2016




61




(1)  For
      better understanding of this table, we have included an additional column
      showing the grant date of the stock options and the restricted shares of common
      stock.





(2)  Options
      will vest on December 22, 2007.





(3)  Restricted
      shares of our common stock were granted on July 31, 2006 and vest as follows:
      8,400 on the first anniversary of the grant date, 9,900 on the second
      anniversary of the grant date, and 11,700 on the third anniversary of the grant
      date, provided the individual remains an employee of the Company on such
      date.





(4)  The
      market value of the stock awards is determined by multiplying the number of
      shares times $1.26, the closing price of our common stock on the NASDAQ Capital
      Market on December 31, 2006, the last day of our fiscal year.





(5)  Mr.
      White resigned
      effective as of February 28, 2006. Mr. Gussarsky resigned effective as of
      February 14, 2007.





(6)  Although
      the restricted shares had a market value on December 31, 2006, b ecause
      Mr. Gussarsky resigned effective as of February 14, 2007, all of the 25,000
      restricted shares granted to Mr. Gussarsky have been forfeited and cancelled,
      and the current market value is $0.





(7)  One-third
      of the options vested on January 23, 2007. 16,666 options will vest on January
      23, 2008, and the remaining options will vest on January 23, 2009.




**Option
      Exercises and Stock Vested**





There
      were no exercises of stock options or vesting of restricted shares of our common
      stock held by the executive officers named in the Summary Compensation Table
      during the fiscal year ended December 31, 2006.





**Pension
      Benefits**





We
      do not
      have any qualified or non-qualified defined benefit plans.





**Nonqualified
      Deferred Compensation**





We
      do not
      have any non-qualified defined contribution plans or other deferred compensation
      plans.





**Termination
      of Employment and Change-in-Control Arrangements**




62





With
      regard to Mr. Zimels employment agreement, below are the principal terms
      regarding termination and change of control:





·
            The
                employee’s options are immediately exercisable in full upon a change of
                control. The employee’s options, following any termination of the
                employee’s employment, other than for cause, remain exercisable for the
                lesser of two years and the remaining term of the
                options.





·
            If
                employee’s employment is terminated by us without cause or by the employee
                for good reason (which includes, without limitation, a reduction
                in salary
                and/or bonus opportunity, a change of control and a material reduction
                in
                duties and responsibilities), the employee is entitled to receive
                previously earned, but unpaid salary, vested benefits and a payment
                equal
                to his annual base salary as in effect immediately prior to the
                termination date.





·
            If
                employee dies or is unable to perform his duties, he or his
                representative, estate or beneficiary will be paid, in addition to
                any
                previously earned but unpaid salary and vested benefits, 12 months’ total
                base salary reduced, in the case of disability, by any disability
                benefits
                they receive.




The
      tables below reflect the acceleration of options and the lapsing of repurchase
      rights/forfeiture for unvested restricted shares of common stock outstanding
      as
      of December 31, 2006.





**Shimmy
      Zimels, Chief Executive Officer and President**


Executive
                  Benefits and Payments Upon Termination
              
              Termination
                  Without Cause by the Company or by Employee for Good Reason (including
                  a
                  Change of Control) (2)Base
                  Salary
              
              $
              516,000Acceleration
                  of Vesting of Equity
              
              
              100
              %Number
                  of Stock Options and Value upon Termination(1)
              
              $
              407,334
                  shares
                29,070Number
                  of Shares of Vested Stock Received and Value upon Termination(1)
              
              $
              0
                  shares
                0*Total:*
              
              $
              545,070





(1)
            Assumes
                the price per share of our common stock of $1.26, which is the closing
                price of our stock on the NASDAQ Capital Market on December 31, 2006,
                the
                last day of our fiscal year.





(2)
            Termination
                by employee for “good reason” includes a reduction in employee’s base
                salary and/or bonus opportunity, a material reduction in employee’s duties
                and responsibilities, a change of control, a material change in employee’s
                work location, and a material breach of the employment agreement
                by the
                Company.





63





In
      connection with Paul White's resignation from our company, a Separation and
      Release Agreement was approved by the Compensation Committee of our Board and
      executed by us and Mr. White on February 13, 2006. The Separation Agreement
      provides that Mr. White's resignation as an employee of the Company is effective
      as of February 28, 2006, or the separation date, and that Mr. White will
      continue to be available to us in order to ensure a smooth transition for a
      reasonable time period after the separation date. In addition, the Separation
      Agreement provides that Mr. White: (i) will continue to receive his base salary
      until the separation date; (ii) will receive a lump sum separation payment
      of
      $90,000; (iii) will continue to participate in our benefit plans at his current
      levels until the earlier of the date he enrolls in a comparable benefits plan
      with another employer or a period of six (6) months after the separation date;
      (iv) will have his unvested stock options for 21,667 shares of our common stock
      at the exercise price of $1.75 accelerated to vest on the separation date;
      and
      (v) will be entitled to expense reimbursement due through the separation date.
      Mr. White will not be entitled to any other payments, bonuses, severance,
      vacation pay or any other amounts that are, or may be, due to him under his
      employment agreement with us, as amended, or any other agreement. Mr. White
      will
      not be eligible for any bonus for 2005 under our 1999 Performance Incentive
      Plan
      or under any other plan. Under the terms of the Separation Agreement, neither
      we
      nor Mr. White have any further obligations under his employment agreement with
      us other than the parties' obligations in connection with non-competition and
      non-solicitation, confidentiality, company property, no disparagement, our
      obligation of indemnification, and any additional items specifically provided
      in
      the Separation Agreement. In addition, we have agreed that in the event of
      Mr.
      White's death after the date of the Separation Agreement, his surviving spouse
      shall be entitled to certain unpaid payment amounts, as long as he did not
      breach of the Separation Agreement prior to his death. Pursuant to the
      Separation Agreement, Mr. White has provided us with a general liability release
      of all claims arising out of his employment and separation from our
      Company.




64




**Director
      Compensation**





The
      following table shows the total compensation paid or accrued during the fiscal
      year ended 2006 **** to
      each
      of our directors.


**Name**
              
              **Fees
                  Earned or**
                **Paid
                  in**
                **Cash**
                **($)**
              
              **Stock**
                **Awards**
                **($)(1)**
              
              **Option**
                **Awards**
                **($)(2)**
              
              **All
                  Other**
                **Compensation**
                **($)**
              
              **Total**
                **($)**Noam
                  Bardin
              
              
              10,000
              
              
              17,760(3
              )
              
              22,751(4
              )
              
              53,725(5
              )
              
              104,236Ilan
                  Biran
              
              
              10,000
              
              
              14,800(6
              )
              
              34,127(7
              )
              
              0
              
              
              58,927Benjamin
                  Broder
              
              
              13,850(12
              )
              
              11,840(8
              )
              
              0
              
              
              0
              
              
              25,690Lior
                  Samuelson
              
              
              20,000(12
              )
              
              11,840(9
              )
              
              22,751(10
              )
              
              0
              
              
              54,591Shimmy
                  Zimels (11)
              
              
              0
              
              
              0
              
              
              0
              
              
              0
              
              
              0




(1)  See
      Note
      2 (p) and Note 9 to our audited consolidated financial statements included
      elsewhere in this annual report for details as to the assumptions used to
      determine the fair value of the stock awards.





(2)  See Note
      2 (o) and Note 9 to our audited consolidated financial statements included
      elsewhere in this annual report for details as to the assumptions used to
      determine the fair value of the option awards. See also our discussion of
      stock-based compensation under “Management’s Discussion and Analysis of
      Financial Condition and Results of Operations - Critical Accounting Policies
      and
      Estimates.” Our non-employee directors will not realize the value of these
      awards in cash until these awards are exercised and the underlying shares are
      subsequently sold.





(3)  Consists
      of $11,840 and $5,920, representing (A) the compensation expense incurred by
      us
      in fiscal year 2006 in connection with the issuance of 8,000 restricted shares
      of our common stock on September 11, 2006 as the form of payment for board
      and
      chairman services for the period from the 2006 annual stockholders’ meeting
      though and until the company’s next annual stockholders’ meeting in 2007,
      calculated in accordance with SFAS 123R, all of which fully vest on September
      11, 2007, and (B) the compensation expense incurred by us in fiscal year 2006
      in
      connection with the issuance of 4,000 restricted shares of our common stock
      on
      November 8, 2006 as the form of payment for services as a member of the audit
      committee of our board for the period from the 2006 annual stockholders’ meeting
      though and until the company’s next annual stockholders’ meeting in 2007,
      calculated in accordance with SFAS 123R, all of which fully vest on November
      8,
      2007. The restricted share grants were made pursuant to the 2006 Non-Employee
      Director Stock Plan.





(4)  Represents
      the compensation expense incurred by us in fiscal year 2006 in connection with
      an option grant to Mr. Bardin to purchase 10,000 shares of our common stock
      on
      January 10, 2006 at an exercise price of $3.20 per share, calculated in
      accordance with SFAS 123R. The grant of options was made in connection with
      board chairman services pursuant to the 2004 Non-Employee Director Stock Option
      Plan.




65





(5)  Represents
      fees for consulting services pursuant to our consulting letter agreement with
      Mr. Bardin.




(6)  Representing
      the compensation expense incurred by us in fiscal year 2006 in connection with
      the issuance of 10,000 restricted shares of our common stock on September 11,
      2006 as the form of payment for board and committee chairman services for the
      period from the 2006 annual stockholders’ meeting though and until the company’s
      next annual stockholders’ meeting in 2007, calculated in accordance with SFAS
      123R, all of which fully vest on September 11, 2007. The restricted share grants
      were made pursuant to the 2006 Non-Employee Director Stock Plan.





(7)  Represents
      the compensation expense incurred by us in fiscal year 2006 in connection with
      an option grant to Mr. Biran to purchase 15,000 shares of our common stock
      on
      January 10, 2006 at an exercise price of $3.20 per share, calculated in
      accordance with SFAS 123R. The grant of options was made in connection with
      board and audit committee chair services pursuant to the 2004 Non-Employee
      Director Stock Option Plan.





(8)  Representing
      the compensation expense incurred by us in fiscal year 2006 in connection with
      the issuance of 8,000 restricted shares of our common stock on September 11,
      2006 as the form of payment for board and committee chairman services for the
      period from the 2006 annual stockholders’ meeting though and until the company’s
      next annual stockholders’ meeting in 2007, calculated in accordance with SFAS
      123R, all of which fully vest on September 11, 2007. The restricted share grants
      were made pursuant to the 2006 Non-Employee Director Stock Plan.





(9)  Representing
      the compensation expense incurred by us in fiscal year 2006 in connection with
      the issuance of 8,000 restricted shares of our common stock on September 11,
      2006 as the form of payment for board and audit committee services for the
      period from the 2006 annual stockholders’ meeting though and until the company’s
      next annual stockholders’ meeting in 2007, calculated in accordance with SFAS
      123R, all of which fully vest on September 11, 2007. The restricted share grants
      were made pursuant to the 2006 Non-Employee Director Stock Plan.





(10)  Represents
      the compensation expense incurred by us in fiscal year 2006 in connection with
      an option grant to Mr. Samuelson to purchase 10,000 shares of our common stock
      on January 10, 2006 at an exercise price of $3.20 per share, calculated in
      accordance with SFAS 123R. The grant of options was made in connection with
      audit committee services pursuant to the 2004 Non-Employee Director Stock Option
      Plan.





(11)  Mr.
      Zimels is a management director, who is not entitled to any fees or awards
      other
      than the compensation he receives as our Chief Executive Officer and President.
      See “Executive Compensation - Summary Compensation Table” in this annual report
      for further information.





(12)  Represents
      fees for service in 2005 and 2006. Mr. Broder’s fees for 2005 were pro-rated as
      of the date he joined the Board in July 2005.




*Director
      Compensation Policy*




At
      our
      Annual Meeting on September 8, 2006, each of our non-employee directors (Noam
      Bardin, Ilan Biran, Benjamin Broder, and Lior Samuelson) became eligible to
      receive $10,000 for their services as directors through the date of our next
      Annual Meeting. In this regard, we paid $10,000 to each non-employee director
      in
      2006. In 2006, we also paid two of our non-employee directors for their service
      as directors for the period from our 2005 Annual Meeting through our 2006 Annual
      Meeting. Directors are reimbursed for the expenses they incur in attending
      meetings of the Board and Board committees.




66





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





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





*2004
      Non-Employee Director Stock Option Plan*





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





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





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





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





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





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




67





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




*2006
      Non-Employee Director Stock Plan*





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





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





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





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





*Non-Discretionary
      Grants*





*Initial
      Restricted Stock Awards* .
      Each
      director who is not an employee of the Company will be granted 4,000 shares
      of
      restricted stock on the date he or she joins the Board.





*Subsequent
      Restricted Stock Awards* .
      On the
      first business day after each annual meeting of stockholders of the Company
      occurring during the term of the Plan commencing with the Meeting, each
      non-employee director who meets the guidelines for Board service and who
      continues to be a non-employee director following such annual meeting shall
      automatically be granted 4,000 shares of restricted stock; provided that no
      Subsequent Restricted Stock Award shall be made to any non-employee director
      who
      has not served as a director of the Company, as of the time of such annual
      meeting, for at least six months.




68





*Committee
      Chairman Awards* .
      Each
      non-employee director who is appointed as chairman of a standing committee
      of
      the Board (and has not served as the chairman of such committee immediately
      prior to the appointment) shall be automatically granted 4,000 shares of
      restricted stock on the date of such appointment. Each non-employee director
      who
      serves as a chairman of the full Board or of a standing committee of the Board
      other than the audit committee, and who meets the guidelines for Board service,
      immediately following each annual meeting of the Company’s stockholders,
      commencing with the Meeting, shall be granted an additional 4,000 shares of
      restricted stock; provided that no Committee Chairman Award shall be made to:
      any non-employee director who has not served as a director of the Company,
      as of
      the time of such annual meeting, for at least six months, and no Committee
      Chairman Award shall be made to any Eligible Director who has received a
      Committee Chairman award for such service on the same committee within the
      past
      six months.





*Audit
      Committee Service Awards* .
      Each
      non-employee director who is appointed as a member of the audit committee of
      the
      Board (and has not served as a member of such committee immediately prior to
      that appointment) shall be automatically granted 4,000 shares of restricted
      stock on the date of such appointment. Each non-employee director who serves
      as
      a member of the audit committee of the Board, and who meets the guidelines
      for
      Board service, immediately following each annual meeting of the Company’s
      stockholders, commencing with the Meeting, shall be granted an additional 4,000
      shares of restricted stock; provided that: no Audit Committee Service Award
      shall be made to any non-employee director who has not served as a director
      of
      the Company, as of the time of such annual meeting, for at least six months,
      and
      no Audit Committee Award shall be made to any Eligible Director who has received
      an Audit Committee award for such service within the past six months. In
      addition, the chairman of the audit committee of the Board shall be granted
      an
      additional 2,000 shares of restricted stock.





*Annual
      Limitation* .
      Notwithstanding the foregoing, a non-employee director shall receive a maximum
      of 12,000 shares of restricted stock during any single calendar
      year.





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





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





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





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





(iii)
      Any
“Person” (as such term is used in Sections 13(d) and 14(d) of the Securities
      Exchange Act of 1934, as amended) other than a Person who is an affiliate as
      of
      the effective date of the Plan becomes the “Beneficial Owner” (as defined in
      Rule 13d-3 under said Act), directly or indirectly, of securities of the Company
      representing 50% or more of the total voting power represented by the Company’s
      then outstanding voting securities (excluding for this purpose the Company
      or
      its Affiliates or any employee benefit plan of the Company) pursuant to a
      transaction or a series of related transactions which the Board of Directors
      does not approve.




69





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





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





*Consulting
      Agreement with Mr. Noam Bardin*





On
      January 24, 2006, we entered into a consulting letter agreement with Mr. Noam
      Bardin, our Chairman of the Board, pursuant to which Mr. Bardin provided
      consulting services as mutually determined by us and Mr. Bardin from time to
      time. Prior to entering into this consulting agreement, all of the members
      of
      our Board of Directors, excluding Mr. Bardin, were of the opinion that Mr.
      Bardin's service as a consultant to us would not interfere with his exercise
      of
      independent judgment in carrying out his current responsibilities as a member
      and Chairman of the Board of Directors. Under the terms of the agreement, we
      provided compensation to Mr. Bardin at a rate of $100 per hour. The consulting
      services performed by Mr. Bardin were completed by November 1, 2006, at which
      time we and Mr. Bardin mutually terminated the consulting agreement. We paid
      Mr.
      Bardin a total of $53,725 for all of his consulting services.




70








**STOCK
      PERFORMANCE CHART**




The
      graph
      depicted below shows a comparison of cumulative total shareholder returns for
      our common stock over our company’s past five fiscal years as compared with the
      cumulative total return on The Nasdaq Stock Market (U.S.) Index and the Nasdaq
      Telecommunications Index. Shareholder returns over the indicated period are
      based on historical data and should not be considered indicative of future
      shareholder returns.




**COMPARISON
      OF 5 YEAR CUMULATIVE TOTAL RETURN***




AMONG
      DELTATHREE, INC. THE NASDAQ STOCK MARKET (U.S.) INDEX


AND
      THE
      NASDAQ TELECOMMUNICATIONS INDEX











*
      $100
      invested in 12/31/00 in our stock and the indicated indexes, including
      reinvestment of all dividends. This graph covers the period of time from
      December 31, 2001 through the end of fiscal 2006.


**Cumulative
                Total Returns****12/01**
            
            **12/02**
            
            **12/03**
            
            **12/04**
            
            **12/05**
            
            **12/06**deltathree,
                Inc.
            
            $
            100.00
            
            $
            52.78
            
            $
            324.50
            
            $
            368.95
            
            $
            323.35
            
            $
            140.04Nasdaq
                Stock Market (U.S.) Index
            
            $
            100.00
            
            $
            68.76
            
            $
            103.68
            
            $
            113.18
            
            $
            115.57
            
            $
            127.58Nasdaq
                Telecommunications Index
            
            $
            100.00
            
            $
            46.04
            
            $
            76.57
            
            $
            81.64
            
            $
            77.57
            
            $
            102.00




71




**Compensation
      Committee Interlocks and Insider Participation**





Executive
      compensation decisions in 2006 were made by the Compensation Committee. During
      2006, no interlocking relationship existed between our Board and the board
      of
      directors or compensation committee of any other company.





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





The
      following table sets forth information with respect to the beneficial ownership
      of shares of our common stock as of March 27, 2007 by:





·
            each
                person who we know owns beneficially more than 5% of our common
                stock;





·
            each
                of our directors individually;





·
            each
                of our named executive officers individually;
                and





·
            all
                of our executive officers and directors 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 27, 2007
      pursuant to the exercise of options are deemed to be outstanding for the purpose
      of computing the percentage ownership of such person or group, but are not
      deemed outstanding for the purpose of calculating the percentage owned by any
      other person listed.





**Number**
            
            **Percentage(1)****Shares
                of deltathree Class A Common****Stock
                Beneficially Owned****Principal
                Stockholder:**Atarey
                Hasharon Chevra Lepituach Vehashkaot Benadlan (1991) Ltd.
            
            
            11,927,677
            
            
            36
            %7
                Giborey Israel St., P.O. Box 8468.South
                Netanya Industrial Zone 42504, Israel.**Executive
                Officers and Directors:**Noam
                Bardin(2)(3)(12)
            
            
            564,366
            
            
            1.7
            %Shimmy
                Zimels(2)(4)(13)
            
            
            528,469
            
            
            1.6
            %Paul
                C. White(5)(11)
            
            
            293,402
            
            
            *Guy
                Gussarsky(5)(11)
            
            
            88,335
            
            
            *Noam
                Ben-Ozer (5)(10)
            
            
            44,848
            
            
            *Ilan
                Biran (2)(6)(12)
            
            
            99,849
            
            
            *Benjamin
                Broder (2)(7)(12)
            
            
            28,000
            
            
            *Joshua
                Maor (8)(10)
            
            
            90,999
            
            
            *Lior
                Samuelson (2)(9)(12)
            
            
            68,000
            
            
            *Richard
                Grant (5)
            
            
            50,000
            
            
            *All
                Directors and Executive Officers as a group
                (6 persons)(14)
            
            
            1,288,684
            
            
            3.9
            %








*
            Less
                than 1%.




72




(1)
            Percentage
                of beneficial ownership is based on 32,768,045 shares of common stock
                outstanding as of March 27, 2007.




(2)
            The
                address for the director or executive officer listed is c/o the Company.




(3)
            Includes
                (a) 187,366 shares of common stock, (b) options to purchase
                365,000 shares of common stock, and (c) 12,000 restricted shares
                of common
                stock .




(4)
            Includes
                (a) 64,469 shares of common stock, (b) options to purchase
                434,000 shares of common stock, and (c) 30,000 restricted shares
                of common
                stock.


(5)
              Represents
                  options to purchase shares of Common Stock. Does not include 25,000
                  restricted shares of common stock for Mr. Gussarsky because he
                  forfeited
                  all of them upon his resignation.


(6)
            Includes
                (a) 89,849 options to purchase shares of common stock, and (b) 10,000
                restricted shares of common stock.




(7)
            Includes
                (a) 20,000 options to purchase shares of common stock, and (b) 8,000
                restricted shares of common stock.




(8)
            Includes
                (a) 16,151 shares of Common Stock and (b) options to purchase
                74,848 shares of Common Stock.




(9)
            Includes
                (a) 60,000 options to purchase shares of common stock, and (b) 8,000
                restricted shares of common stock.




(10)
            Mr.
                Maor and Mr. Ben-Ozer did not stand for re-election to the Company’s Board
                of Directors at the 2006 Annual Stockholders’ Meeting held on September 8,
                2006.




(11)
            Mr.
                Whiteresigned
                effective as of February 28, 2006. Mr. Gussarsky resigned effective
                as of
                February 14, 2007.




(12)
            All
                restricted share grants to our non-employee directors fully vest
                and are
                not subject to forfeiture upon the first anniversary of the date
                of grant,
                provided the individual is serving as a director upon such date.
                The
                grants are subject to partial vesting in the event the director no
                longer
                serves as a director upon the first anniversary
                date.




(13)
            Restricted
                shares of our common stock were granted on July 31, 2006 and vest
                as
                follows: 8,400 on the first anniversary of the grant date, 9,900
                on the
                second anniversary of the grant date, and 11,700 on the third anniversary
                of the grant date, provided the individual remains an employee of
                the
                Company on such date.




(14)
            Includes (a)
                251,835 shares of common stock, (b) options to purchase 968,849 shares
                of
                common stock, and (c) 68,000 restricted shares of our common stock.
                Due to the resignations of Messrs. White and Mr. Gussarsky and due
                to
                Messrs. Maor and Ben-Ozer no longer being members of the Company’s Board
                of Directors, these individuals are not included in this 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, 2006.




Plan
                Category
            
            Number
                of Securities to be Issued Upon Exercise of Outstanding Options,
                Warrants
                and Rights
            
            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 (1)
            
            
            2,330,835
            
            $
            2.06
            
            
            3,215,319Equity
                Compensation Plans not Approved by Security Holders
            
            
            N/A
            
            
            N/A
            
            
            N/ATotal
            
            
            2,330,835
            
            $
            2.06
            
            
            3,215,319





(1)
            These
                plans consist of****our
                2004 Stock Incentive Plan and 2006 Non-Employee Director Stock Plan.
                The
                table also includes information for equity compensation plans that
                have
                expired. Our 1999 Directors’ Plan and our 1999 Employee Stock Incentive
                Plan have expired. Additionally,
                our 2004 Non-Employee Director Stock Option Plan was terminated,
                except
                with respect to outstanding options previously granted
                thereunder.





73




**ITEM
      13.**  **CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS**





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





**ITEM
      14.**  **PRINCIPAL
      ACCOUNTING FEES AND SERVICES**




The
      following table presents fees for professional audit services rendered by
      Brightman Almagor & Co. for the audit of the Company's annual financial
      statements for the years ended December 31, 2006, and December 31, 2005, and
      fees billed for other services rendered by Brightman Almagor & Co. during
      those periods.




**2006**
            
            **2005****Audit
                fees**
            
            $
            62,500
            
            $
            62,000**Audit
                related fees**
            
            
            −
            
            
            −**Tax
                fees**
            
            
            18,500
            
            
            9,000**All
                Other Fees**
            
            
            -
            
            
            −**Total**
            
            $
            81,000
            
            $
            71,000





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





74




**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. ***Other
      Fees*** 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.




**PART
      IV**




**ITEM
                15.**
            **EXHIBITS,
                FINANCIAL STATEMENT
                SCHEDULES**





(a)(1)
      Financial Statements.





The
      Consolidated Financial Statements filed as part of this Annual Report on
      Form 10-K 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.




75





(a)(3)
      Exhibits.





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





**Exhibit**
              **Number**
            
            **Description**2.1
            
            Asset
                Transfer Agreement dated February 17, 2007 by and between deltathree,
                Inc.
                and Go2Call.com, Inc. (Incorporated by reference to Exhibit 2.1 of
                our
                Current Report on Form 8-K, filed on February 20,
                2007).3.1.1
            
            Form
                of Restated Certificate of Incorporation of deltathree, Inc. (Incorporated
                by reference from our registration statement on Form S-1
                (Registration No. 333-122242)).3.1.2
            
            Form
                of Amendment to Restated Certificate of Incorporation of deltathree,
                Inc.
                (Incorporated by reference to our annual report on Form 10-K/A, filed
                on April 30, 2001).3.2
            
            Form
                of Amended and Restated By-laws of deltathree, Inc. (Incorporated
                by
                reference from our registration statement on Form S-1 (Registration
                No. 333-122242)).4.1
            
            Specimen
                Certificate of Common Stock (Incorporated by reference from our
                registration statement on Form S-1 (Registration
                No. 333-122242)).4.2
            
            Specimen
                Certificate of Class B Common Stock (Incorporated by reference from
                our
                registration statement on Form S-1 (Registration
                No. 333-122242)).10.1
            
            Form
                of deltathree, Inc. 1999 Stock Incentive Plan (Incorporated by reference
                from our registration statement on Form S-1 (Registration
                No. 333-122242)).+10.2
            
            Form
                of deltathree, Inc. 1999 Employee Stock Purchase Plan (Incorporated
                by
                reference from our registration statement on Form S-1 (Registration
                No. 333-122242)).10.3
            
            Form
                of deltathree, Inc. 1999 Performance Incentive Plan (Incorporated
                by
                reference from our registration statement on Form S-1 (Registration
                No. 333-122242)).+10.4
            
            Form
                of deltathree, Inc. 1999 Directors’ Plan (Incorporated by reference from
                our registration statement on Form S-1 (Registration
                No. 333-122242)).+10.5
            
            Employment
                Agreement, effective as of April 26, 2004, between Shimmy Zimels
                and
                deltathree, Inc. (Incorporated by reference to our annual report
                on
                Form 10-K/A, filed on April 29, 2004).+10.6
            
            Employment
                Agreement, effective as of April 26, 2004, between Paul White and
                deltathree, Inc. (Incorporated by reference to our annual report
                on
                Form 10-K/A, filed on April 29,
                2004).+


76




10.7
            
            2004
                Stock Incentive Plan (Incorporated
                by reference to our registration statement on Form S-8 (Registration
                No. 333-86503)).+10.8
            
            2004
                Non-Employee Director Stock Option Plan (Incorporated
                by reference to our registration statement on Form S-8 (Registration
                No. 333-86503)).+10.9
            
            Form
                of Option Agreement Pursuant to 2004 Stock Incentive Plan (Incorporated
                by reference to our annual report on Form 10-K, filed on March 31,
                2005).+10.10
            
            Form
                of Option Agreement Pursuant to 2004 Non-Employee Director Stock
                Option
                Plan (Incorporated
                by reference to our annual report on Form 10-K, filed on March 31,
                2005).+10.11
            
            Executive
                and Director Compensation Arrangements (Incorporated
                by reference to our annual report on Form 10-K, filed on March 31,
                2005).+10.12
            
            Separation
                and Release Agreement, dated February 13, 2006 between deltathree,
                Inc.
                and Paul C. White (Incorporated
                by reference to Exhibit 10.1 of our Current Report on Form 8-K, filed
                on
                February 15, 2006).+10.13
            
            First
                Amendment to the deltathree, Inc. 2004 Stock Incentive Plan, dated
                as of
                December 20, 2005 (Incorporated
                by reference to Exhibit 10.1 to our Current Report on Form 8-K, filed
                on
                December 21, 2005).+10.14
            
            First
                Amendment to the deltathree, Inc. 2004 Non-Employee Director Stock
                Option
                Plan, dated as of December 20, 2005 (Incorporated
                by reference to Exhibit 10.2 of our Current Report on Form 8-K, filed
                on
                December 21, 2005).+10.15
            
            Registration
                Rights Agreement dated February 19, 2007 by and between deltathree,
                Inc.
                and Go2Call.com, Inc. (Incorporated
                by reference to Exhibit 2.1 of our Current Report on Form 8-K, filed
                on
                February 20, 2007).10.16
            
            Consulting
                Letter Agreement dated January 24, 2006 by and between deltathree,
                Inc.
                and Noam Bardin (Incorporated by reference to Exhibit 10.1 of our
                Current
                Report on Form 8-K, filed on January 25, 2006).+10.17
            
            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).+10.18
            
            Deltathree,
                Inc. 2006 Non-Employee Director Stock Plan (Incorporated by reference
                to
                Exhibit 10.1 of our Current Report on Form 8-K, filed on September
                8,
                2006).+14.1
            
            deltathree,
                Inc. Corporate Code of Conduct and Ethics (Incorporated
                by reference to our annual report on Form 10-K, filed on March 30,
                2004).21.1*
            
            Subsidiaries
                of deltathree, Inc.23.1*
            
            Consent
                ofBrightman
                Almagor & Co.31.1*
            
            Certification
                of the Chief Executive Officer, as adopted pursuant to Section 302
                of the
                Sarbanes-Oxley Act of 2002.31.2*
            
            Certification
                of the Chief Financial Officer, as adopted pursuant to Section 302
                of the
                Sarbanes-Oxley Act of 2002.32*
            
            Certifications
                of the Chief Executive Officer and Chief Financial Officer pursuant
                to 18
                U.S.C. Section 1350, as adopted pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002.







*  Filed
      herewith.




+  Management
      contract or compensatory plan.




77




Report
                of Independent Registered Accounting Firm
            
            
            F-2Consolidated
                Balance Sheets as of December 31, 2006 and 2005
            
            
            F-3Consolidated
                Statements of Operations for the years ended December 31, 2006, 2005,
                and
                2004
            
            
            F-4Statements
                of Stockholders’ Equity for the years ended December 31, 2006, 2005, and
                2004
            
            
            F-5Consolidated
                Statements of Cash Flows for the years ended December 31, 2006, 2005,
                and
                2004
            
            
            F-6Notes
                to Consolidated Financial Statements
            
            
            F-7




F-1





**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**




To
      the
      Stockholders of


Deltathree,
      Inc.





We
      have
      audited the accompanying consolidated balance sheets of Deltathree, Inc. ("the
      Company") and its subsidiary as of December 31, 2006 and 2005 and the related
      consolidated statements of operations, stockholders' equity and cash flows
      for
      each of the three years in the period ended December 31, 2006. These
      consolidated financial statements are the responsibility of the Company's
      management. Our responsibility is to express an opinion on these
      consolidated financial statements based on our audits.




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





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the consolidated financial position of the Company
      and
      its subsidiary as of December 31, 2006 and 2005, and the consolidated results
      of
      its operations and its consolidated cash flows for each of the three years
      in
      the period ended December 31, 2006 in conformity with U.S. generally accepted
      accounting principles.








/s/
      Brightman Almagor & Co.


Certified
      Public Accountants


A
      member
      firm of Deloitte Touche Tohmatsu





Tel
      Aviv,
      Israel


March
      10,
      2007


F-2




**DELTATHREE,
      INC.**


**CONSOLIDATED
      BALANCE SHEETS**





**December
                31,****2006**
            
            **2005****($ in
                thousands)****ASSETS****Current
                assets:**Cash
                and cash equivalents
            
            $
            3,790
            
            $
            3,847Restricted
                cash and short-term investments (Note 3)
            
            
            12,067
            
            
            10,648Accounts
                receivable, net (Note 4)
            
            
            1,286
            
            
            703Prepaid
                expenses and other current assets (Note 5)
            
            
            444
            
            
            612Inventory
            
            
            155
            
            
            242Total
                current assets
            
            
            17,742
            
            
            16,052**Restricted
                cash and long -term investments (Note 3)**
            
            
            1,085
            
            
            1,216**Property
                and equipment:**Telecommunications
                equipment
            
            
            18,147
            
            
            18,028Furniture,
                fixtures and other
            
            
            639
            
            
            583Leasehold
                improvements
            
            
            4,677
            
            
            4,653Computers
                hardware & software
            
            
            8,474
            
            
            8,01931,937
            
            
            31,283Less
                accumulated depreciation
            
            
            (28,479
            )
            
            (27,152
            )Property
                and equipment, net
            
            
            3,458
            
            
            4,131**Deposits**
            
            
            110
            
            
            105Total
                assets
            
            $
            22,395
            
            $
            21,504**LIABILITIES
                AND STOCKHOLDERS’ EQUITY****Current
                liabilities:**Accounts
                payable
            
            $
            2,916
            
            $
            3,904Deferred
                revenues
            
            
            1,099
            
            
            344Other
                current liabilities (Note 6)
            
            
            1,545
            
            
            1,540Total
                current liabilities
            
            
            5,560
            
            
            5,788**Long-term
                liabilities:**Severance
                pay obligations (Note 7)
            
            
            217
            
            
            155Total
                liabilities
            
            
            5,777
            
            
            5,943**Commitments
                and contingencies (Note 8)****Stockholders’
                equity (Note 9):**Share
                capital:Class
                A Common stock, - par value $0.001; authorized 75,000,000
                shares;issued
                and outstanding: 29,808,214 at December 31, 2006;29,739,232
                at December 31, 2005
            
            
            30
            
            
            30Class
                B Common stock - par value $0.001; authorized 1,000;
              issued
                and outstanding: no shares at December 31, 2006 and 2005
            
            
            —
            
            
            —Preferred
                stock, par value $0.001; authorized 25,000,000 shares;issued
                and outstanding: no shares at December 31, 2006 and 2005
            
            
            —
            
            
            —Additional
                paid-in capital
            
            
            168,030
            
            
            167,690Accumulated
                deficit
            
            
            (151,442
            )
            
            (151,949
            )16,618
            
            
            15,771Treasury
                stock at cost: 257,600 shares of Class A Common Stock as of
              December
                31, 2005
            
            
            —
            
            
            (210
            )Total
                stockholders' equity
            
            
            16,618
            
            
            15,561Total
                liabilities and stockholder's equity
            
            $
            22,395
            
            $
            21,504




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


F-3




**DELTATHREE,
      INC.**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**





**Year
                ended December 31,****2006**
            
            **2005**
            
            **2004****($ in
                thousands, except share data)**Revenues
                (Note 11):
            
            $
            37,953
            
            $
            29,714
            
            $
            21,069Costs
                and operating expenses:Cost
                of revenues (exclusive of $615, $822 and $1,218 depreciation included
                in a
                separate line below, respectively)
            
            
            24,375
            
            
            18,698
            
            
            13,791Research
                and development expenses (Note 10)
            
            
            4,043
            
            
            3,228
            
            
            2,531Selling
                and marketing expenses
            
            
            4,956
            
            
            4,173
            
            
            3,274General
                and administrative expenses
            
            
            3,088
            
            
            2,912
            
            
            2,194Depreciation
                and amortization
            
            
            1,543
            
            
            1,931
            
            
            2,731Total
                costs and operating expenses
            
            
            38,005
            
            
            30,942
            
            
            24,521Loss
                from operations
            
            
            (52
            )
            
            (1,228
            )
            
            (3,452
            )Interest
                income, net
            
            
            620
            
            
            418
            
            
            269Income
                (loss) before taxes
            
            
            568
            
            
            (810
            )
            
            (3,183
            )Income
                taxes (Note 11)
            
            
            61
            
            
            44
            
            
            66Net
                income (loss)
            
            $
            507
            
            $
            (854
            )
            $
            (3,249
            )Net
                loss per share - basic and diluted
            
            $
            0.02
            
            $
            (0.03
            )
            $
            (0.11
            )Basic
                weighted average number of shares outstanding
            
            
            29,771,470
            
            
            29,671,820
            
            
            29,315,857Diluted
                weighted average number of shares outstanding
            
            
            30,129,011
            
            
            29,671,820
            
            
            29,315,857




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


F-4




**DELTATHREE,
      INC.**


**STATEMENTS
      OF STOCKHOLDER'S EQUITY**


**($ in
      thousands, except share data)**




**Class
                A****Common
                stock****Number
                of Outstanding****Shares**
            
            **Number
                of Treasury**
              **Shares**
            
            **Amount**
            
            **Additional****Paid-in
                Capital**
            
            **Deferred****Compensation**
            
            **Treasury
                Stock****(at Cost)**
            
            **Accumulated****Deficit**
            
            **Total****Stockholders'**
              **Equity**Balance
                at January 1, 2004
            
            
            29,381,313
            
            
            257,600
            
            
            29
            
            
            167,301
            
            
            -
            
            
            (210
            )
            
            151,095
            )
            
            16,025Exercise
                of employee options
            
            
            148,117
            
            
            
            
            
            -
            *
            
            133
            
            
            
            
            
            
            
            
            
            
            
            133Loss
                for the year
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (3,249
            )
            
            (3,249
            )Balance
                at December 31, 2004
            
            
            29,381,313
            
            
            257,600
            
            
            29
            
            
            167,301
            
            
            -
            
            
            (210
            )
            
            151,095
            )
            
            16,025Exercise
                of employee options
            
            
            357,919
            
            
            
            
            
            1
            
            
            389
            
            
            
            
            
            
            
            
            
            
            
            389Loss
                for the year
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (854
            )
            
            (854
            )Balance
                at December 31, 2005
            
            
            29,739,232
            
            
            257,600
            
            
            30
            
            
            167,690
            
            
            -
            
            
            (210
            )
            
            (151,949
            )
            
            15,561Cancellation
                of treasury stock
            
            
            
            
            
            
            
            
            
            
            
            (210
            )
            
            
            
            
            210
            
            
            
            
            
            -Share
                based compensation
            
            
            
            
            
            
            
            
            
            
            
            480
            
            
            
            
            
            
            
            
            
            
            
            480Exercise
                of employee options
            
            
            68,982
            
            
            
            
            
            -
            *
            
            70
            
            
            
            
            
            
            
            
            
            
            
            70Income
                for the year
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            507
            
            
            507Balance
                at December 31, 2006
            
            
            29,808,214
            
            
            257,600
            
            $
            30
            
            $
            168,030
            
            $
            -
            
            $
            -
            
            $
            (151,442
            )
            $
            16,618





*
      - Less
      than $ 1 thousand.





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


F-5





**DELTATHREE,
      INC.**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**




**Year
                ended December 31,****2006**
            
            **2005**
            
            **2004****($ in
                thousands)****Cash
                flows from operating activities:**Net
                income (loss)
            
            $
            507
            
            $
            (854
            )
            $
            (3,249
            )Adjustments
                to reconcile net income (loss) to net cash provided by operating
                activitiesDepreciation
                and amortization
            
            
            1,543
            
            
            1,931
            
            
            2,731Amortization
                of deferred compensation
            
            
            480
            
            
            -
            
            
            -Capital
                gain, net
            
            
            (1
            )
            
            -
            
            
            (2
            )Liability
                for severance pay, net
            
            
            62
            
            
            51
            
            
            13Provision
                for losses on accounts receivable
            
            
            25
            
            
            -
            
            
            -Changes
                in operating assets and liabilities;Increase
                decrease in accounts receivable
            
            
            (608
            )
            
            (378
            )
            
            38Decrease
                (increase) in other current assets
            
            
            168
            
            
            (84
            )
            
            156Decrease
                (increase) in inventory
            
            
            87
            
            
            (49
            )
            
            (133
            )(Decrease)
                increase in accounts payable
            
            
            (988
            )
            
            203
            
            
            765Increase
                (decrease) in deferred revenues
            
            
            755
            
            
            (109
            )
            
            281Increase
                (decrease) in current liabilities
            
            
            5
            
            
            (494
            )
            
            (66
            )1,528
            
            
            1,071
            
            
            3,783Net
                cash provided by operating activities
            
            
            2,035
            
            
            217
            
            
            534**Cash
                flows from investing activities:**Purchase
                of property and equipment
            
            
            (883
            )
            
            (1,376
            )
            
            (2,315
            )Proceeds
                from sale of property and equipment
            
            
            14
            
            
            -
            
            
            4Long-term
                investments, net
            
            
            131
            
            
            (121
            )
            
            (61
            )Short-term
                investments, net
            
            
            (1,419
            )
            
            (121
            )
            
            4,881Net
                change in deposits
            
            
            (5
            )
            
            2
            
            
            (2
            )Net
                cash (used in) provided by investing activities
            
            
            (2,162
            )
            
            (1,616
            )
            
            2,507**Cash
                flows from financing activities:**Proceeds
                from exercise of employee options
            
            
            70
            
            
            390
            
            
            133Net
                cash provided by financing activities
            
            
            70
            
            
            390
            
            
            133(Decrease)
                increase in cash and cash equivalents
            
            
            (57
            )
            
            (1,009
            )
            
            3,174Cash
                and cash equivalents at beginning of year
            
            
            3,847
            
            
            4,856
            
            
            1,682**Cash
                and cash equivalents at end of year**
            
            $
            3,790
            
            $
            3,847
            
            $
            4,856**Supplemental
                disclosures of cash flow information:**Cash
                paid for:Taxes
            
            $
            68
            
            $
            21
            
            $
            23**Supplemental
                schedule of non cash investing and financing
                activities:**Acquisition
                of fixed assets on credit
            
            $
            0
            
            $
            44
            
            $
            753Cancellation
                of shares
            
            $
            210
            
            $
            0
            
            $
            0





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


F-6




**DELTATHREE,
      INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      1 -****The
      Company**





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




**Note
      2 -****Summary
      of significant accounting policies**





**a.** **Basis
          of presentation**





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





**b.** **Principles
        of consolidation**





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




**c.** **Financial
          statements in U.S. dollars**





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





**d.**  **Use
      of estimates**





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





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




**e.**  **Cash
      and cash equivalents**





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





**f** .   **Restricted
      Cash**




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





**g.**  **Marketable
      securities**





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




F-7


**DELTATHREE,
        INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**


**h.**  **Inventory**





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





**i.**   **Property
      and equipment**





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





**j.**   **Long
      lived assets**





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





**k.**   **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.





**l.**   **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.





**m.**   **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.





**n.**   **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




**DELTATHREE,
      INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      2 -****Summary
      of significant accounting policies** **(Cont.)**




**o.**   **Stock-based
      compensation**





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





Had
                compensation cost for the Company's option plans been determined
                on the
                basis of the fair value at the grant dates in accordance with the
                provisions of SFAS No. 123 “Accounting for Stock-Based Compensation,” as
                amended by SFAS No. 148, the Company's pro forma net loss and pro
                forma
                basic and diluted net loss per share for 2005 and 2004 would have
                been as
                follows:




**Year
                ended December 31,****2005**
            
            **2004**Pro
                forma net loss:Net
                loss for the year, as reported
            
            $
            (854
            )
            $
            (3,249
            )Add:
                stock-based compensation determined under SFAS 123
            
            
            (367
            )
            
            (202
            )Pro
                forma net loss
            
            $
            (1,221
            )
            $
            (3,451
            )Net
                loss per share - basic and diluted:As
                reported
            
            $
            (0.03
            )
            $
            (0.11
            )Pro
                forma
            
            $
            (0.04
            )
            $
            (0.12
            )




The
      following assumptions were used for the years 200 5 and
      200 4 :
      dividend yield of 0.00% for all periods; risk-free interest rate of 4.0% and
      3.2% respectively; an expected life of 3-years for all periods; a volatility
      rate of 78% and 87% respectively.





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





**p.**   **Restricted
      shares**





During
      three months ended on September 30, 2006, the Company has granted restricted
      shares to retain reward and motivate selected high potential employees, who
      are
      critical to the future success. The restricted share plan has been approved
      by
      the Board of Directors. We
      record
      compensation expense associated with non-vested restricted shares which has
      been
      granted in accordance with SFAS No. 123(R). In accordance with the
      aforementioned statement, we calculate compensation expense on the date of
      grant
      (number of shares granted multiplied by the fair value of our common stock
      on
      the date of grant) and recognize this expense, adjusted for forfeitures, ratably
      over the applicable vesting period.


F-9


**DELTATHREE,
        INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      2 -****Summary
      of significant accounting policies** **(Cont.)**





**q.**   **Net
      Income (loss) per share**





Basic
      and
      diluted net income (loss) per share have been computed in accordance with SFAS
      No. 128, "Earnings Per Share", using the weighted average number of common
      stock
      outstanding. Diluted earnings per share give effect to all potential dilutive
      issuances of ordinary shares that were outstanding during the period. A total
      of
      1,061,427 and 957,369 incremental shares were excluded from the calculation
      of
      diluted net loss per ordinary share for 2005 and 2004 respectively.





**r.**   **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.




**s.**   **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.




**t.**   **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.





**u.**  **Reclassification**





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





**v.**   **Recently
      issued accounting standards**





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




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




F-10


**DELTATHREE,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      2 -****Summary
      of significant accounting policies** **(Cont.)**





**v.**   **Recently
      issued accounting standards (Cont.)**




In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No. 158, Employers’ Accounting for Defined Benefit Pension and Other
      Postretirement Plans (an amendment of FASB Statements No. 87, 88, 106, and
      132R) (FAS 158), requires an employer to: (a) Recognize in its statement of
      financial position an asset for a plan’s overfunded status or a liability for a
      plan’s underfunded status; (b) measure a plan’s assets and its obligations
      that determine its funded status as of the end of the employer’s fiscal year
      (with limited exceptions); and (c) recognize changes in the funded status
      of a defined benefit postretirement plan in the year in which the changes
      occur.  Those changes will be reported in comprehensive income of a
      business entity and in changes in net assets of a not-for-profit organization.
      The requirement by FAS 158 to recognize the funded status of a benefit plan
      and
      the disclosure requirements of FAS 158 are effective as of the end of the fiscal
      year ending after December 15, 2006 for entities with publicly traded
      equity securities. The requirement to measure plan assets and benefit
      obligations as of the date of the employer’s fiscal year-end statement of
      financial position is effective for fiscal years ending after December 15,
      2008. The Company does not expect the adoption of FAS 158 to have a
      material effect on the financial position of the company at December 31,
      2006




In
      September 2006, the Securities and Exchange Commission issued Staff Accounting
      Bulletin No. 108, “Considering the Effects of Prior Year Misstatements
      when Quantifying Misstatements in Current Year Financial Statements”
(SAB 108). SAB 108 provides guidance on the consideration of the
      effects of prior year misstatements in quantifying current year misstatements
      for the purpose of a materiality assessment. SAB 108 establishes an
      approach that requires quantification of financial statement errors based on
      the
      effects of each of the company’s balance sheet and statement of operations and
      the related financial statement disclosures. Early application of the guidance
      in SAB 108 is encouraged in any report for an interim period of the first
      fiscal year ending after November 15, 2006, and will be adopted by the
      Company in the first quarter of fiscal 2007. The Company does not expect the
      adoption of SAB 108 to have a material impact on its consolidated results
      of operations and financial condition




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




F-11




**DELTATHREE,
      INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      3 -****Investment
      in marketable securities and deposits**





As
      previously noted under Marketable Securities in Note 2, the Company concluded
      that it was appropriate to classify investments in Auction Rate Securities
      as
      short-term investments. Auction Rate Securities generally have long-term stated
      maturities; however, these investments have characteristics similar to
      short-term investments because at pre-determined intervals, generally every
      7 to
      90 days, there is a new auction process at which these securities are reset
      to
      current interest rates. Previously, such investments had been classified as
      long-term investments based on the Company’s assessment of their underlying
      long-term maturities. Accordingly, as of December 31, 2005, the Company revised
      the classification to report these securities as short-term investments within
      our classification of Restricted cash and short-term investments in the
      Consolidated Balance Sheets. The Company classifies all of its short-term
      investments as available-for-sale securities. The following is a summary of
      our
      restricted cash and available-for-sale securities as of December 31, 2006 and
      2005.





**a.**  **Restricted
      cash and short-term** **** **investments** ****





Comprised
                as follows:





**December
                31,****2006**
            
            **2005****($ in
                thousands)**Restricted
                cash (money market funds)*
            
            $
            283
            
            $
            206Auction
                rate securities
            
            
            10,725
            
            
            10,100Bank
                deposits
            
            
            1,059
            
            
            342$
            12,067
            
            $
            10,648





**b.**  **Restricted
      cash and long-term** **** **investments** ****





Comprised
                as follows:





**December
                31,****2006**
            
            **2005****($ in
                thousands)**Restricted
                cash (money market funds)*
            
            $
            1,085
            
            $
            1,216$
            1,085
            
            $
            1,216




*
      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.




**Note
      4 -****Accounts
      receivable, net**





Accounts
                receivable are stated net of an allowance for doubtful accounts of
                $
                25,000 and $ $0 at December 31, 2006 and 2005,
                respectively.





Allowance
                for doubtful accounts activity during the years ended December 31,
                2006
                and 2005 was as follows:





**December
                31,****200****6**
            
            **200****5****($ in
                thousands)**Beginning
                balance
            
            $
            0
            
            $
            40Bad
                debt provisions
            
            
            28
            
            
            7Account
                write offs
            
            
            -
            
            
            (47
            )Recoveries
            
            
            (3
            )
            
            -Ending
                balance
            
            $
            25
            
            $
            0




F-12


**DELTATHREE,
        INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      5 -****Prepaid
      expenses and other current assets**





Prepaid
                expenses and other current assets consist of the
                following:





**December
                31,****200****6**
            
            **200****5****($ in
                thousands)**Government
                of Israel (VAT refund and other)
            
            $
            39
            
            $
            45Deposits
                with suppliers
            
            
            60
            
            
            128Prepaid
                expenses
            
            
            274
            
            
            317Other
            
            
            71
            
            
            122Total
                prepaid expenses and other current assets
            
            $
            444
            
            $
            612




**Note
      6 -****Other
      current liabilities**





Other
      current liabilities consist of the following:





**December
                31,****2006**
            
            **2005****($ in
                thousands)**Accrued
                expenses
            
            $
            867
            
            $
            904Employees
                and related expenses
            
            
            616
            
            
            535Other
            
            
            62
            
            
            101Total
                other current liabilities
            
            $
            1,545
            
            $
            1,540





**Note
      7 -****Severance
      pay obligations**





Deltathree
                Ltd., the Company's Israeli subsidiary, is subject to certain Israeli
                law
                and labor agreements that determine the obligations of Deltathree
                Ltd. to
                make severance payments to dismissed employees and to employees leaving
                the Company under certain other circumstances. The obligation for
                severance pay benefits, as determined by Israeli law, is based upon
                length
                of service and the employee's most recent salary. This obligation
                is
                partially funded through regular deposits made by Deltathree Ltd.
                into
                unaffiliated companies for managers' insurance policies. Amounts
                funded
                are controlled by the fund trustees and insurance companies and are
                not
                under the control and management of Deltathree
                Ltd.





Expenses
                (income) relating to employee termination benefits were $11,860;
                $ 62,368
                and $ 12,338 for the years ended December 31, 2006, 2005 and 2004,
                respectively.





The
      aggregate value of the insurance policies as of December 31, 2006 and 2005
      was
      $920,843 and $665,000 respectively




**Note
      8 -****Commitments
      and contingencies**





**a.**  **Lease
      commitments**





The
      Company leases offices in New York City for the headquarters of its United
      States operation with an initial cost of approximately $650,000, increasing
      annually to $815,000 during the final year of the lease. The lease extends
      until
      July 2010 with an option to extend the lease for an additional five years.




F-13




**DELTATHREE,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 On
      October 2003 the company entered into a sub-lease agreement with a third party
      to sub-lease approximately 30% of the overall the New York office space. The
      annual sub-lease income in 2006 was $152,235, increasing annually to $168,000
      during the final year of the lease. The sub-lease extends until July
      2010.


Rent
      expense, net was $650,000; $ 653,202 and 611,000 for the years ended December
      31, 2006, 2005 and 2004, respectively.





The
      Company leases a 1,290 square meter office, which houses its research and
      development facilities, in Jerusalem, Israel. In February 2003, the Company
      signed an amendment that extended the term of our lease through February 2006.
      In September 2005, the Company signed an additional amendment that extended
      the
      lease term through December 2009. The Company has the option to further extend
      the term of the lease for an additional 5 years ending in December
      2014.





Rent
      expense, net was $200,000; $ 209,000 and $209,000 for the years ended December
      31, 2006, 2005 and 2004, respectively





**b.**  **Legal
      proceedings**





The
      Company and certain of its former officers and directors, were named as
      defendants in a number of purported securities class actions in United States
      District Court for the Southern District of New York, arising out of our initial
      public offering in November 1999. On August 31, 2005, the United States District
      Court granted preliminary approval of an omnibus settlement of the litigation
      between the plaintiffs and issuer defendants. Final approval is pending. Under
      the terms of the settlement, the Company is not conceding any liability and
      presently does not expect to make any payments under the pending settlement,
      other than legal fees it may incur (which fees are being submitted to the
      insurance carrier for reimbursement).




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





**c.**  **Other
      marketing and cooperation agreements**





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





**d.**  **Stand-by
      letters of credit**





At
      March
      27, 2006, the company had stand-by letters of credit totaling $1.4 million,
      which were issued to guarantee certain contractual obligations, and are secured
      by certificates of deposit and money market funds at the Company’s banks. These
      amounts are recorded in the restricted cash and investments line items on the
      consolidated balance sheets.





**e.**  **Regulation**





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




F-14


**DELTATHREE,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


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




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




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




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




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




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




In
      orders
      issued in September 2006 and May 2006, the FCC also has determined that
“interconnected VoIP” providers that offer services that allow users to receive
      calls from, and make calls to, the public switched telecommunications network
      must comply with the Communications Assistance for Law Enforcement Act, or
      CALEA, which requires providers to assist law enforcement agencies in conducting
      lawfully authorized electronic surveillance. The FCC established a deadline
      of
      May 14, 2007 for VoIP providers to comply with the requirements of CALEA.
      While the Company intends to comply with the CALEA order and continues to
      cooperate with law enforcement to enable authorities to accomplish lawful
      wiretaps, the Company may be required to expend significant resources to comply
      with CALEA. If the Company do not comply, the FCC may subject us to fines and
      penalties, and we may decide to or be required to disconnect
      customers.




F-15


**DELTATHREE,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


T he
      FCC
      decided in June 2006 that interconnected VoIP service providers,
      which offer services that allow users to receive calls from, and make calls
      to,
      the public switched telecommunications network, should
      be required to contribute to the universal service fund on an interim basis.
      The
      amount of universal service contribution for interconnected VoIP service
      providers is based on a percentage of revenues earned from end user interstate
      services. Additional
      changes to the assessment and recovery rules for universal service may affect
      our financial results.




**Note
      9 -****Stockholders'
      equity**




**a.**  **Share
      capital**





Following
                the Company's initial public offering, effective December 1999, the
                Company's stock was listed on the NASDAQ National Market System.
                On
                September 17, 2002 the listing of the Company’s common stock was
                transferred from the Nasdaq National Market to the Nasdaq Capital
                Market.





**b.**  **Stock
      Options**




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


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





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





As
      of
      December 31, 2006, options to purchase 2,479,953 shares of Class A Common Stock
      were exercisable and outstanding with exercise prices ranging between $ 0.004
      and $15.00 per share.




F-16


**DELTATHREE,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


A
                summary of the status of the Company’s stock option plans as of December
                31, 2006, 2005 and 2004 and changes during the years then ended,
                is
                presented below:




**December
                  31, 2006**
              
              **December
                  31, 2005**
              
              **December
                  31, 2004****Shares**
              
              **Weighted
                  average Exercise price**
              
              **Shares**
              
              **Weighted
                  average Exercise price**
              
              **Shares**
              
              **Weighted
                  average Exercise price**Options
                  outstanding at beginning of year
              
              
              2,762,686
              
              $
              2.58
              
              
              3,066,939
              
              $
              2.50
              
              
              2,753,530
              
              $
              2.55Granted
                  during the year
              
              
              105,000
              
              
              3.17
              
              
              120,000
              
              
              3.06
              
              
              606,862
              
              
              2.82Exercised
                  during the year
              
              
              68,982
              
              
              1.04
              
              
              352,253
              
              
              1.10
              
              
              148,117
              
              
              0.90Forfeited
                  during the year
              
              
              467,869
              
              
              5.53
              
              
              72,000
              
              
              6.72
              
              
              144,936
              
              
              6.80Outstanding
                  at end of year
              
              
              2,330,835
              
              $
              2.06
              
              
              2,762,686
              
              $
              2.58
              
              
              3,066,939
              
              $
              2.50Weighted
                  average fair value of options granted during the year
              
              $
              3.17
              
              
              
              
              $
              3.06
              
              
              
              
              $
              2.82




Additional
      information regarding options outstanding as of December 31, 2006 is as
      follows:


**Options
                  Outstanding**
              
              **Options
                  Exercisable****Range
                  of**
                **Exercise
                  Prices**
              
              **Number
                  of****Outstanding**
              
              **Weighted
                  average Remaining**
                **Contractual**
                **Life
                  (Years)**
              
              **Weighted******
                **Average****Exercise
                  Price**
              
              **Number
                  of Exercisable****Options**
              
              **Weighted******
                **Average****Exercise
                  Price**$0.44
                  - $0.44
              
              
              8,001
              
              
              2.67
              
              
              0.44
              
              
              8,001
              
              
              0.44$0.74
                  - $1.02
              
              
              584,961
              
              
              2.15
              
              
              1.01
              
              
              584,961
              
              
              1.01$1.13
                  - $1.38
              
              
              646,610
              
              
              1.0
              
              
              1.36
              
              
              646,610
              
              
              1.36$1.75
                  - $2.15
              
              
              312,015
              
              
              3.82
              
              
              1.77
              
              
              312,015
              
              
              1.77$2.85
                  - $3.20
              
              
              711,848
              
              
              5.0
              
              
              2.93
              
              
              469,531
              
              
              2.93$10.25
                  - $10.25
              
              
              67,400
              
              
              0.5
              
              
              10.25
              
              
              67,400
              
              
              10.252,330,835
              
              
              4.8
              
              $
              2.06
              
              
              2,088,518
              
              $
              1.96




**c.**  **Restricted
      shares of the Company’s Common Stock**





During
      the year ended December 31, 2006, the Company granted restricted shares of
      the
      Company’s common stock to retain, reward, and motivate the employees who
      are critical to the future success of the Company. The restricted shares of
      common stock were granted pursuant to the Company’s 2004 Stock Incentive Plan
      which was approved by the Board of Directors and stockholders of the
      Company.  The
      restricted shares are subject to certain forfeiture provisions, and therefore
      are restricted as to transferability until such forfeiture restrictions have
      lapsed. The restrictions relate to continued service with the Company. The
      vesting period for such restricted shares of common stock is typically three
      years. The intrinsic value of the restricted shares of common stock issued
      to
      employees of the Company is amortized as of the date of grant to compensation
      expense over the vesting period of such grant. As of December 31, 2006, the
      Company recognized approximately $35,856 of compensation expense related to
      the
      amortization of the restricted shares of common stock. The Company granted
      during 2006 a total of 224,500 restricted shares of common stock to its
      employees, including a grant of 25,000 restricted shares of common stock
      which was forfeited in February 2007.





**d.**  **Non-employee
      restricted stock plan**





On
      July
      5, 2006, the Board approved the 2006 Non-Employee Director Stock Plan (“2006
      Stock Plan”) and it was subsequently approved by the stockholders at the annual
      meeting on September 8, 2006. The 2006 Stock Plan provides for the automatic
      grant of restricted stock. With the adoption of this plan, it terminates the
      2004 Non-employee Stock Option Plan 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 Company’s 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, 2006, 38,000 shares of
      restricted stock were awared to Non-employee directors under the plan.





F-17


**DELTATHREE,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      10 -**  **Research
      and development expenses**




Research
                and development expenses consist of the
                following:




**Year
                ended December 31,****2006**
            
            **2005**
            
            **2004****($ in
                thousands)**Salaries
                and related expenses
            
            $
            2,370
            
            $
            2,331
            
            $
            1,775Consulting
                and advisory fees
            
            
            297
            
            
            101
            
            
            88Travel
            
            
            816
            
            
            104
            
            
            65Other
            
            
            560
            
            
            692
            
            
            603Total
                research and development expenses
            
            $
            4,043
            
            $
            3,228
            
            $
            2,531




**Note
      11 -****Income
      taxes**




**a.**  **Tax
      loss carryforwards**




As
                of December 31, 2006, the Company had net operating loss carryforwards
                generated in the U.S. and Israel of approximately$60,359,265
                and $6,029,000 respectively. The Company's U.S. net operating loss
                carryforwards will expire at variousdates between 2012 and 2025 if not utilized. In addition, a portion
                of
                those net operating loss carryforwards could be subject to limitation
                due
                to changes in ownership of the Company. The Company's net operating
                losses
                generated in Israel may be carried forward indefinitely. The Israeli
                subsidiary received final tax assessments through the tax year ended
                December 31, 1999.




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




**December
                31,****2006**
            
            **2005****($ in
                thousands)**Net
                operating losses carryforwards
            
            $
            20,822
            
            $
            20,887Less
                valuation allowance
            
            
            (20,822
            )
            
            (20,887
            )Net
                deferred tax assets
            
            $
            —
            
            $
            —





As
                of December 31, 2006, and 2005, a valuation allowance of
                $20,822,000and$20,887,000 respectively, is provided as the realization of the deferred
                tax assets are not assured.





**c.**
            **Income/(Loss)
                before income taxes:**




**Year
                ended December 31,****2006**
            
            **2005**
            
            **2004****(US$ in
                thousands)**Domestic
            
            
            250
            
            $
            (782
            )
            $
            (3,145
            )Foreign
            
            
            257
            
            
            (28
            )
            
            (38
            )Total
            
            
            507
            
            $
            (
                810
            )
            $
            (3,183
            )




F-18


**DELTATHREE,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      12 -****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,****2006**
            
            **2005**
            
            **2004****($ in
                thousands)**Revenues:United
                States
            
            $
            16,855
            
            $
            9,573
            
            $
            4,224Europe
            
            
            2,758
            
            
            1,378
            
            
            1,127South
                America
            
            
            6,703
            
            
            3,603
            
            
            2,432Far
                East
            
            
            5,092
            
            
            5,009
            
            
            4,234Middle
                East
            
            
            5,238
            
            
            8,551
            
            
            7,239Other
            
            
            1,307
            
            
            1,600
            
            
            1,813Total
                revenues
            
            $
            37,953
            
            $
            29,714
            
            $
            21,069Revenues
                from major customers exceeding 10% of revenues:Master
                Reseller - A
            
            
            —
            %
            
            —
            %
            
            16
            %




**December
                31,****2006**
            
            **2005****($ in
                thousands)**Long-lived
                assets:United
                States
            
            
            3,068
            
            $
            3,880Israel
            
            
            297
            
            
            212Europe
            
            
            93
            
            
            36Other
            
            
            —
            
            
            3Total
                long-lived assets
            
            
            3,458
            
            $
            4,131




F-19


**DELTATHREE,
          INC.**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Selected
      Quarterly Financial Information (Unaudited)**




**Three
                Months Ended,****March
                31**
            
            **June
                30**
            
            **September
                30**
            
            **December
                31****($ in
                thousands, except per share data)****2006**Total
                revenues
            
            $
            10,749
            
            $
            9,966
            
            $
            8,537
            
            $
            8,701Costs
                and operating expenses:Cost
                of revenues
            
            
            7,194
            
            
            6,166
            
            
            5,331
            
            
            5,684Research
                and development expenses
            
            
            1,080
            
            
            1,044
            
            
            961
            
            
            958Selling
                and marketing expenses
            
            
            1,202
            
            
            1,271
            
            
            1,276
            
            
            1,207General
                and administrative expenses
            
            
            932
            
            
            732
            
            
            693
            
            
            731Depreciation
                and amortization
            
            
            371
            
            
            379
            
            
            389
            
            
            404Total
                costs and operating expenses
            
            
            10,779
            
            
            9,592
            
            
            8,650
            
            
            8,984Loss
                from operations
            
            
            (30
            )
            
            374
            
            
            (113
            )
            
            (283
            )Interest
                income, net
            
            
            129
            
            
            148
            
            
            162
            
            
            181Profit
                (Loss) before income taxes
            
            
            99
            
            
            522
            
            
            49
            
            
            (102
            )Income
                taxes
            
            
            11
            
            
            26
            
            
            19
            
            
            5Net
                Profit (loss)
            
            $
            88
            
            $
            496
            
            $
            30
            
            $
            (107
            )Net
                loss per share - basic and diluted
            
            $
            (0.00
            )
            $
            0.02
            
            $
            0.00
            
            $
            (0.00
            )Basic
                weighted average number of shares outstanding
            
            
            29,741,307
            
            
            29,745,897
            
            
            29,788,403
            
            
            29,807,756Diluted
                weighted average number of shares outstanding
            
            
            30,673,141
            
            
            30,604,982
            
            
            29,907,650
            
            
            29,807,756**2005**Total
                revenues
            
            $
            6,604
            
            $
            6,927
            
            $
            7,105
            
            $
            9,078Costs
                and operating expenses:Cost
                of revenues
            
            
            4,210
            
            
            4,284
            
            
            4,379
            
            
            5,825Research
                and development expenses
            
            
            814
            
            
            777
            
            
            762
            
            
            875Selling
                and marketing expenses
            
            
            864
            
            
            1,001
            
            
            1,045
            
            
            1,263General
                and administrative expenses
            
            
            610
            
            
            735
            
            
            744
            
            
            824Depreciation
                and amortization
            
            
            610
            
            
            534
            
            
            402
            
            
            385Total
                costs and operating expenses
            
            
            7,108
            
            
            7,331
            
            
            7,332
            
            
            9,172Loss
                from operations
            
            
            (504
            )
            
            (404
            )
            
            (227
            )
            
            (94
            )Interest
                income, net
            
            
            94
            
            
            10
            
            
            198
            
            
            116Loss
                before income taxes
            
            
            (410
            )
            
            (394
            )
            
            (29
            )
            
            22Income
                taxes
            
            
            17
            
            
            15
            
            
            11
            
            
            0Net
                loss
            
            $
            (427
            )
            $
            (409
            )
            $
            (40
            )
            $
            22Net
                loss per share - basic and diluted
            
            $
            (0.01
            )
            $
            (0.01
            )
            $
            (0.00
            )
            $
            0.00
            )Weighted
                average number of shares outstanding -basic
                and diluted
            
            
            29,547,177
            
            
            29,707,860
            
            
            29,719,899
            
            
            29,726,732




**Note
      13 -****Subsequent
      events**





On
      February 19, 2007, the Company completed the acquisition of certain assets
      of
      Go2Call.com, Inc. (“Go2Call”) pursuant to the Asset Transfer Agreement
      (“Agreement”) for approximately $7.0 million in a combination of cash and stock.
      Under the terms of the Agreement, the Company acquired Go2Call’s consumer and
      service provider businesses, customer base, key components of their regional
      infrastructure, the right to use Go2Call’s technology going forward and certain
      trade related registered trade marks. The Company paid Go2Call approximately
      $2.5 million in cash and issued approximately 3.0 million shares in connection
      with the Agreement. This transaction is subject to certain subsequent
      adjustments that the Company believes will be immaterial to the transaction
      and
      the Company’s management estimates that their will be approximately $0.5 million
      in related transaction costs. In accordance with the Agreement, the Company
      provided registration rights for the registration of the shares of the Company’s
      common stock issued in the transaction and pursuant to these registration
      rights, the Company is obligated to file a registration statement with the
      SEC
      within 75 days of the date of completion of this acquisition.




F-20






**SIGNATURES**




Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the registrant has duly caused this Annual Report on Form 10-K to be
      signed on its behalf by the undersigned, thereunto duly authorized, in New
      York,
      New York on March 29, 2007.


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




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





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


Signature
              
              Title
              
              Date/s/
                  Shimmy Zimels
              
              Chief
                  Executive Officer, President,
              
              March
                  29, 2007Shimmy
                Zimels
              
              and
                    Director
                  (Principal
                    Executive Officer,Principal
                  Financial Officer and PrincipalAccounting
                  Officer)/s/
                  Noam Bardin
              
              Chairman
                  of the Board of Directors
              
              March
                  29, 2007Noam
                  Bardin/s/
                  Ilan Biran
              
              Director
              
              March
                  29, 2007Ilan
                  Biran/s/
                  Benjamin Broder
              
              Director
              
              March
                  29, 2007Benjamin
                  Broder/s/
                  Lior
                  Samuelson
              
              Director
              
              March
                  29, 2007Lior
                Samuelson




**EXHIBIT
      INDEX**





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




**Exhibit**
              **Number**
            
            **Description**2.1
            
            Asset
                Transfer Agreement dated February 17, 2007 by and between deltathree,
                Inc.
                and Go2Call.com, Inc. (Incorporated by reference to Exhibit 2.1 of
                our
                Current Report on Form 8-K, filed on February 20,
                2007).3.1.1
            
            Form
                of Restated Certificate of Incorporation of deltathree, Inc. (Incorporated
                by reference from our registration statement on Form S-1
                (Registration No. 333-122242)).3.1.2
            
            Form
                of Amendment to Restated Certificate of Incorporation of deltathree,
                Inc.
                (Incorporated by reference to our annual report on Form 10-K/A, filed
                on April 30, 2001).3.2
            
            Form
                of Amended and Restated By-laws of deltathree, Inc. (Incorporated
                by
                reference from our registration statement on Form S-1 (Registration
                No. 333-122242)).4.1
            
            Specimen
                Certificate of Common Stock (Incorporated by reference from our
                registration statement on Form S-1 (Registration
                No. 333-122242)).4.2
            
            Specimen
                Certificate of Class B Common Stock (Incorporated by reference from
                our
                registration statement on Form S-1 (Registration
                No. 333-122242)).10.1
            
            Form
                of deltathree, Inc. 1999 Stock Incentive Plan (Incorporated by reference
                from our registration statement on Form S-1 (Registration
                No. 333-122242)).+10.2
            
            Form
                of deltathree, Inc. 1999 Employee Stock Purchase Plan (Incorporated
                by
                reference from our registration statement on Form S-1 (Registration
                No. 333-122242)).10.3
            
            Form
                of deltathree, Inc. 1999 Performance Incentive Plan (Incorporated
                by
                reference from our registration statement on Form S-1 (Registration
                No. 333-122242)).+10.4
            
            Form
                of deltathree, Inc. 1999 Directors' Plan (Incorporated by reference
                from
                our registration statement on Form S-1 (Registration
                No. 333-122242)).+10.5
            
            Employment
                Agreement, effective as of April 26, 2004, between Shimmy Zimels
                and
                deltathree, Inc. (Incorporated by reference to our annual report
                on
                Form 10-K/A, filed on April 29, 2004).+10.6
            
            Employment
                Agreement, effective as of April 26, 2004, between Paul White and
                deltathree, Inc. (Incorporated by reference to our annual report
                on
                Form 10-K/A, filed on April 29,
                2004).+


10.7
            
            2004
                Stock Incentive Plan (Incorporated
                by reference to our registration statement on Form S-8 (Registration
                No. 333-86503)).+10.8
            
            2004
                Non-Employee Director Stock Option Plan (Incorporated
                by reference to our registration statement on Form S-8 (Registration
                No. 333-86503)).+10.9
            
            Form
                of Option Agreement Pursuant to 2004 Stock Incentive Plan (Incorporated
                by reference to our annual report on Form 10-K, filed on March 31,
                2005).+10.10
            
            Form
                of Option Agreement Pursuant to 2004 Non-Employee Director Stock
                Option
                Plan (Incorporated
                by reference to our annual report on Form 10-K, filed on March 31,
                2005).+10.11
            
            Executive
                and Director Compensation Arrangements (Incorporated
                by reference to our annual report on Form 10-K, filed on March 31,
                2005).+10.12
            
            Separation
                and Release Agreement, dated February 13, 2006 between deltathree,
                Inc.
                and Paul C. White (Incorporated
                by reference to Exhibit 10.1 of our Current Report on Form 8-K, filed
                on
                February 15, 2006).+10.13
            
            First
                Amendment to the deltathree, Inc. 2004 Stock Incentive Plan, dated
                as of
                December 20, 2005 (Incorporated
                by reference to Exhibit 10.1 to our Current Report on Form 8-K, filed
                on
                December 21, 2005).+10.14
            
            First
                Amendment to the deltathree, Inc. 2004 Non-Employee Director Stock
                Option
                Plan, dated as of December 20, 2005 (Incorporated
                by reference to Exhibit 10.2 of our Current Report on Form 8-K, filed
                on
                December 21, 2005).+10.15
            
            Registration
                Rights Agreement dated February 19, 2007 by and between deltathree,
                Inc.
                and Go2Call.com, Inc. (Incorporated
                by reference to Exhibit 2.1 of our Current Report on Form 8-K, filed
                on
                February 20, 2007).10.16
            
            Consulting
                Letter Agreement dated January 24, 2006 by and between deltathree,
                Inc.
                and Noam Bardin (Incorporated by reference to Exhibit 10.1 of our
                Current
                Report on Form 8-K, filed on January 25,
                2006).+









10.17
            
            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).+10.18
            
            Deltathree,
                Inc. 2006 Non-Employee Director Stock Plan (Incorporated by reference
                to
                Exhibit 10.1 of our Current Report on Form 8-K, filed on September
                8,
                2006).+14.1
            
            deltathree,
                Inc. Corporate Code of Conduct and Ethics (Incorporated
                by reference to our annual report on Form 10-K, filed on March 30,
                2004).21.1*
            
            Subsidiaries
                of deltathree, Inc.23.1*
            
            Consent
                ofBrightman
                Almagor & Co.31.1*
            
            Certification
                of the Chief Executive Officer, as adopted pursuant to Section 302
                of the
                Sarbanes-Oxley Act of 2002.31.2*
            
            Certification
                of the Chief Financial Officer, as adopted pursuant to Section 302
                of the
                Sarbanes-Oxley Act of 2002.32*
            
            Certifications
                of the Chief Executive Officer and Chief Financial Officer pursuant
                to 18
                U.S.C. Section 1350, as adopted pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002.




Filed
      herewith.




+  Management
      contract or compensatory plan.