**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C.  20549**

**FORM 10-Q**

**       (MarkOne)**

**x****                             ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For thequarterly period ended July 31, 2006**

**OR**

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

**     ****                                                                              Forthe transition period from                        to                        **

**CommissionFile Number:  1-15529**

**OPTIOSOFTWARE, INC.**(Exact name of registrant as specified in its charter)
| **Georgia**                                                     |   | **58-1435435**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State of other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **3015  Windward Plaza, Fairways II, Alpharetta, GA**           |   | **30005**                             |
| (Address of  principal executive offices)                       |   | (Zip Code)                            |

 

Registrant’stelephone number, including area code: **(770) 576-3500**

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes x  No  o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act).
|  | Large accelerated filer o |   | Accelerated filer o |   | Non-accelerated filer x |
|--|---------------------------|--------|---------------------|--------|-------------------------|

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theSecurities Exchange Act): Yes o  No  x

There were22,342,273 shares of the Registrant’s common stock outstanding as of September13, 2006.

 

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**OPTIO SOFTWARE, INC.**

**FORM 10-Q**

# **For theQuarterly Period Ended July 31, 2006**

**TABLE OF CONTENTS**
| **PART I – FINANCIAL  INFORMATION** |   |                                                                                        |
|------------------------------------------|--------|---------------------------------------------------------------------------------------------|
| ** **                               |   |                                                                                        |
| Item 1.                                  |   | Financial  Statements                                                                       |   |   |
| Item 2.                                  |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |   |
| Item 3.                                  |   | Quantitative  and Qualitative Disclosures About Market Risk                                 |   |   |
| Item 4.                                  |   | Controls and  Procedures                                                                    |   |   |
|                                     |   |                                                                                        |   |   |
| **PART II – OTHER  INFORMATION**    |   |                                                                                        |
| ** **                               |   |                                                                                        |
| Item 1.                                  |   | Legal Proceedings                                                                           |   |   |
| Item  1A.                                |   | Risk  Factors                                                                               |   |   |
| Item 2.                                  |   | Unregistered  Sales of Equity Securities and Use of Proceeds                                |   |   |
| Item 3.                                  |   | Defaults Upon  Senior Securities                                                            |   |   |
| Item 4.                                  |   | Submission of  Matters to a Vote of Security Holders                                        |   |   |
| Item 5.                                  |   | Other Information                                                                           |   |   |
| Item  6.                                 |   | Exhibits                                                                                    |   |   |

 

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# **FORWARD-LOOKINGSTATEMENTS**

In addition to historical information, this QuarterlyReport on Form 10-Q for the quarter ended July 31, 2006 containsforward-looking statements that involve risks and uncertainties. Suchforward-looking statements are made pursuant to the “safe-harbor” provisions ofthe Private Securities Litigation Reform Act of 1995 and are made based onmanagement’s current expectations or beliefs as well as assumptions made by,and information currently available to, management.  These forward-looking statements include,among other things, statements regarding Optio Software, Inc.’s (“Optio”)anticipated costs and expenses, Optio’s capital needs and financing plans, productand service development, Optio’s growth strategies, integration of acquiredentities, market demand for Optio’s products and services, relationships withOptio’s strategic marketing alliances, and competition. These forward-lookingstatements include, among others, those statements including the words “expects,”“anticipates,” “intends,” “believes” and similar language. Optio’s actualresults may differ significantly from those projected in the forward-lookingstatements. Factors that might cause or contribute to such differences include,but are not limited to, risks associated with Optio’s reliance on strategicmarketing and reseller relationships, collectibility of accounts receivable andnotes receivable (specifically, the note receivable from M2 SystemsCorporation), fluctuations in operating results because of acquisitions ordispositions, failure to integrate new products and newly acquired companies,diversion of management resources relating to acquisitions, reduction in cashreserves relating to acquisitions, challenges relating to acquisitions and thepossibility that this may cause Optio to no longer be profitable, the negativeeffect on Optio’s earnings relating to the amortization or potential write-downof acquired assets or goodwill, failure to retain the business relationships with existing customers fromacquisitions, changes in competition, changes in economic conditions in theU.S. and in other countries in which Optio currently does business (bothgeneral and relative to the technology industry), delays or inability todevelop new or unique software products, market acceptance of new products, thefailure of new products to operate as anticipated, expectation of achieving andsustaining operating profits and earnings, including timing of such cash flowsand company performance, disputes regarding Optio’s intellectual property,risks relating to the delisting of Optio’s stock, possible adverse results ofpending or future litigation, or risks associated with Optio’s internationaloperations. These and additional factors are set forth in Item 1A of Optio’sAnnual Report on Form 10-K for the fiscal year ended January 31, 2006 (the “2006Annual Report”), filed with the Securities and Exchange Commission (“SEC”) onMay 1, 2006. You should carefully review the risk factors in the 2006 AnnualReport and any additional risks described in other documents that Optio filesfrom time to time with the SEC. You are cautioned not to place undue relianceon the forward-looking statements in this document, which speak only as of thedate of this Quarterly Report on Form 10-Q. Optio undertakes no obligation topublicly release any revisions to the forward-looking statements or reflectevents or circumstances after the date of this document.

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# **PART I –FINANCIAL INFORMATION**

ITEM 1.  FINANCIAL STATEMENTS

**Optio Software, Inc.**

**ConsolidatedCondensed Balance Sheets**
| ** **                                                                            | ** ** | **January 31,  2006** | ** ** | **July 31,  2006** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------|------------|-------------------------|------------|
| ** **                                                                            | ** ** | ** **                 | ** ** | **(Unaudited)**         | ** ** |
| **ASSETS**                                                                            | ** ** | ** **                 |       |                    |       |
| Current assets:                                                                       | ** ** | ** **                 | ** ** | ** **              | ** ** |
| Cash and cash  equivalents                                                            |       | $                          | 7,954,000  |                    | $          | 8,473,000 |   |
| Accounts  receivable, net                                                             |       | 4,811,000                  |       | 3,255,000               |       |
| Prepaid expenses  and other current assets                                            |       | 720,000                    |       | 836,000                 |       |
| Notes receivable  from related party                                                  |       | 5,000                      |       | 5,000                   |       |
| Current portion  of note receivable from M2                                           |       | 323,000                    |       | 298,000                 |       |
| Total current assets                                                                  |       | 13,813,000                 |       | 12,867,000              |       |
| Property and equipment,  net                                                          |       | 613,000                    |       | 2,327,000               |       |
| Other assets:                                                                         |       |                       |       |                    |       |
| Note receivable  from M2, net of impairment reserve of $900,000, less current portion |       | 1,720,000                  |       | 1,598,000               |       |
| Goodwill                                                                              |       | 1,846,000                  |       | 2,302,000               |       |
| Other intangible  assets, net                                                         |       | 1,615,000                  |       | 1,423,000               |       |
| Other                                                                                 |       | 91,000                     |       | 94,000                  |       |
| Total assets                                                                          |       | $                          | 19,698,000 |                    | $          | 20,611,000 |   |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                        |       |                       |       |                    |       |
| Current liabilities:                                                                  |       |                       |       |                    |       |
| Accounts payable                                                                      |       | $                          | 922,000    |                    | $          | 858,000 |   |
| Accrued expenses                                                                      |       | 2,218,000                  |       | 1,411,000               |       |
| Current portion of  lease incentive liability                                         |       | —                     |       | 122,000                 |       |
| Current portion  of capital lease obligations                                         |       | 1,000                      |       | 69,000                  |       |
| Deferred revenue                                                                      |       | 7,373,000                  |       | 7,206,000               |       |
| Total current  liabilities                                                            |       | 10,514,000                 |       | 9,666,000               |       |
|                                                                                  |       |                       |       |                    |       |
| Long-term portion of  lease incentive liability                                       |       | —                     |       | 878,000                 |       |
| Long-term portion of  capital lease obligations                                       |       | —                     |       | 346,000                 |       |
| Other long-term  liabilities                                                          |       | 63,000                     |       | 158,000                 |       |
| Total liabilities                                                                     |       | 10,577,000                 |       | 11,048,000              |       |
| Commitments and  contingencies                                                        |       |                       |       |                    |       |
| Shareholders’ equity:                                                            |       |                       |       |                    |       |
| Common stock                                                                          |       | 52,577,000                 |       | 53,456,000              |       |
| Accumulated  deficit                                                                  |       | (43,533,000                | )          | (44,037,000             | )          |
| Accumulated  other comprehensive income                                               |       | 77,000                     |       | 144,000                 |       |
| Total shareholders’  equity                                                      |       | 9,121,000                  |       | 9,563,000               |       |
| Total liabilities and shareholders’ equity                                       |       | $                          | 19,698,000 |                    | $          | 20,611,000 |   |

 

***Seeaccompanying notes.***

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**Optio Software, Inc.**

**ConsolidatedCondensed Statements of Operations and Comprehensive Income (Loss)(Unaudited)**
| ** **                                                                             | ** ** | **Three Months Ended July 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** |
| **Revenue:**                                                                           |       |                                                |       |   |   |
| License fees                                                                           |       | $                                                   | 2,544,000  |   | $ | 1,643,000 |   |
| Subscription  fees                                                                     |       | 526,000                                             |       | 560,000 |   |
| Services,  maintenance, and other                                                      |       | 4,309,000                                           |       | 4,565,000 |   |
|                                                                                   |       | 7,379,000                                           |       | 6,768,000 |   |
| Costs of revenue  (exclusive of depreciation and amortization shown separately below): |       |                                                |       |   |   |
| License fees                                                                           |       | 175,000                                             |       | 146,000 |   |
| Services,  maintenance, and other                                                      |       | 1,561,000                                           |       | 1,644,000 |   |
|                                                                                   |       | 1,736,000                                           |       | 1,790,000 |   |
|                                                                                   |       | 5,643,000                                           |       | 4,978,000 |   |
| Operating expenses:                                                                    |       |                                                |       |   |   |
| Sales and  marketing                                                                   |       | 2,748,000                                           |       | 2,543,000 |   |
| Research and  development                                                              |       | 1,316,000                                           |       | 1,375,000 |   |
| General and  administrative                                                            |       | 1,127,000                                           |       | 1,380,000 |   |
| Depreciation and  amortization                                                         |       | 243,000                                             |       | 200,000 |   |
|                                                                                   |       | 5,434,000                                           |       | 5,498,000 |   |
| Income (loss) from  operations                                                         |       | 209,000                                             |       | (520,000 | ) |
| Other income (expense):                                                                |       |                                                |       |   |   |
| Interest income                                                                        |       | 60,000                                              |       | 113,000 |   |
| Interest expense                                                                       |       | (2,000                                              | )          | (2,000 | ) |
| Other                                                                                  |       | (13,000                                             | )          | (5,000 | ) |
|                                                                                   |       | 45,000                                              |       | 106,000 |   |
|                                                                                   |       |                                                |       |   |   |
| Income (loss) before  income taxes                                                     |       | 254,000                                             |       | (414,000 | ) |
| Income tax expense                                                                     |       | 10,000                                              |       | 36,000 |   |
| Net income (loss)                                                                      |       | $                                                   | 244,000    |   | $ | (450,000 | ) |
| Net income (loss) per  share – basic and diluted                                  |       | $                                                   | 0.01       |   | $ | (0.02 | ) |
| Weighted average common  shares outstanding – basic                               |       | 20,880,334                                          |       | 22,223,643 |   |
| Weighted average common  shares outstanding – diluted                             |       | 23,935,173                                          |       | 22,223,643 |   |
| Comprehensive income  (loss):                                                          |       |                                                |       |   |   |
| Net income  (loss)                                                                     |       | $                                                   | 244,000    |   | $ | (450,000 | ) |
| Foreign currency  translation adjustment                                               |       | (175,000                                            | )          | 18,000 |   |
| Comprehensive income  (loss)                                                           |       | $                                                   | 69,000     |   | $ | (432,000 | ) |

 

***Seeaccompanying notes.***

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**Optio Software, Inc.**

**ConsolidatedCondensed Statements of Operations and Comprehensive Income (Loss)(Unaudited)**

** **
| ** **                                                                             | ** ** | **Six Months Ended July 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2005**                                          | ** ** | **2006** | ** ** |
| **Revenue:**                                                                           |       |                                              |       |   |   |
| License fees                                                                           |       | $                                                 | 4,755,000  |   | $ | 3,541,000 |   |
| Subscription  fees                                                                     |       | 1,035,000                                         |       | 1,115,000 |   |
| Services,  maintenance, and other                                                      |       | 8,505,000                                         |       | 8,974,000 |   |
|                                                                                   |       | 14,295,000                                        |       | 13,630,000 |   |
| Costs of revenue  (exclusive of depreciation and amortization shown separately below): |       |                                              |       |   |   |
| License fees                                                                           |       | 357,000                                           |       | 278,000 |   |
| Services,  maintenance, and other                                                      |       | 3,176,000                                         |       | 3,321,000 |   |
|                                                                                   |       | 3,533,000                                         |       | 3,599,000 |   |
|                                                                                   |       | 10,762,000                                        |       | 10,031,000 |   |
| Operating expenses:                                                                    |       |                                              |       |   |   |
| Sales and  marketing                                                                   |       | 5,609,000                                         |       | 5,082,000 |   |
| Research and  development                                                              |       | 2,594,000                                         |       | 2,697,000 |   |
| General and  administrative                                                            |       | 2,044,000                                         |       | 2,522,000 |   |
| Depreciation and  amortization                                                         |       | 431,000                                           |       | 384,000 |   |
|                                                                                   |       | 10,678,000                                        |       | 10,685,000 |   |
| Income (loss) from  operations                                                         |       | 84,000                                            |       | (654,000 | ) |
| Other income (expense):                                                                |       |                                              |       |   |   |
| Interest income                                                                        |       | 116,000                                           |       | 209,000 |   |
| Interest expense                                                                       |       | (4,000                                            | )          | (3,000 | ) |
| Other                                                                                  |       | (14,000                                           | )          | (4,000 | ) |
|                                                                                   |       | 98,000                                            |       | 202,000 |   |
|                                                                                   |       |                                              |       |   |   |
| Income (loss) before  income taxes                                                     |       | 182,000                                           |       | (452,000 | ) |
| Income tax expense                                                                     |       | 28,000                                            |       | 52,000 |   |
| Net income (loss)                                                                      |       | $                                                 | 154,000    |   | $ | (504,000 | ) |
| Net income (loss) per  share – basic and diluted                                  |       | $                                                 | 0.01       |   | $ | (0.02 | ) |
| Weighted average common  shares outstanding – basic                               |       | 20,870,480                                        |       | 22,036,310 |   |
| Weighted average common  shares outstanding – diluted                             |       | 24,188,430                                        |       | 22,036,310 |   |
| Comprehensive income  (loss):                                                          |       |                                              |       |   |   |
| Net income  (loss)                                                                     |       | $                                                 | 154,000    |   | $ | (504,000 | ) |
| Foreign currency  translation adjustment                                               |       | (43,000                                           | )          | 67,000 |   |
| Comprehensive income  (loss)                                                           |       | $                                                 | 111,000    |   | $ | (437,000 | ) |

 

***Seeaccompanying notes.***

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**Optio Software, Inc.**

**Consolidated Condensed Statementof Shareholders’ Equity**

**(Unaudited)**
| ** **                                     | ** ** | **Common Stock** | ** ** | **Accumulated** | ** ** | **Accumulated Other  Comprehensive** | ** ** | **Total Shareholders’** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|-----------------|------------|-------------------------------------------|------------|-----------------------------------|------------|
| ** **                                     | ** ** | **Shares**            | ** ** | **Amount**      | ** ** | **Deficit**                               | ** ** | **Income**                        | ** ** | **Equity** | ** ** |
|                                           |       |                  |       |            |       |                                      |       |                              |       |   |   |
| Balance at February 1,  2006                   |       | 21,435,826            |       | $               | 52,577,000 |                                      | $          | (43,533,000                       | )          | $ | 77,000 |   | $ | 9,121,000 |   |
| Comprehensive  loss, net of tax:               |       |                  |       |            |       |                                      |       |                              |       |   |   |
| Net  loss                                      |       | —                |       | —          |       | (504,000                                  | )          | —                            |       | (504,000 | ) |
| Foreign  currency translation adjustment       |       | —                |       | —          |       | —                                    |       | 67,000                            |       | 67,000 |   |
| Comprehensive  loss                            |       |                  |       |            |       |                                      |       |                              |       | (437,000 | ) |
| Exercise  of stock options                     |       | 563,947               |       | 300,000         |       | —                                    |       | —                            |       | 300,000 |   |
| VertiSoft  Shares released from escrow         |       | 310,000               |       | 381,000         |       | —                                    |       | —                            |       | 381,000 |   |
| Compensation  expense related to stock options |       | —                |       | 198,000         |       | —                                    |       | —                            |       | 198,000 |   |
| Balance at July 31, 2006                       |       | 22,309,773            |       | $               | 53,456,000 |                                      | $          | (44,037,000                       | )          | $ | 144,000 |   | $ | 9,563,000 |   |

 

***Seeaccompanying notes****.*

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**Optio Software, Inc.**

**Consolidated Condensed Statementsof Cash Flows**

**(Unaudited)**
| ** **                                                                                | ** ** | **Six Months Ended July 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                                          | ** ** | **2006** | ** ** |
|                                                                                      | ** ** | ** **                                        |       |   |   |
| Cash flows from  operating activities:                                                    | ** ** | ** **                                        |       |   |   |
| Net income  (loss)                                                                        |       | $                                                 | 154,000    |   | $ | (504,000 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                                              |       |   |   |
| Depreciation and  amortization                                                            |       | 211,000                                           |       | 192,000 |   |
| Amortization of  intangibles                                                              |       | 220,000                                           |       | 192,000 |   |
| Non-cash stock  compensation                                                              |       | —                                            |       | 198,000 |   |
| Loss on disposal  of assets                                                               |       | —                                            |       | 2,000 |   |
| Provision for  doubtful accounts                                                          |       | —                                            |       | 20,000 |   |
| Provision for  deferred taxes                                                             |       | 20,000                                            |       | 50,000 |   |
| Changes in  operating assets and liabilities, exclusive of effects from acquisition:      |       |                                              |       |   |   |
| Accounts  receivable                                                                      |       | (392,000                                          | )          | 1,607,000 |   |
| Prepaid expenses  and other assets                                                        |       | (205,000                                          | )          | (141,000 | ) |
| Accounts payable                                                                          |       | 90,000                                            |       | (75,000 | ) |
| Accrued expenses                                                                          |       | (359,000                                          | )          | (704,000 | ) |
| Income taxes  payable                                                                     |       | 45,000                                            |       | (53,000 | ) |
| Deferred revenue                                                                          |       | 282,000                                           |       | (238,000 | ) |
| Net cash provided by  operating activities                                                |       | 66,000                                            |       | 546,000 |   |
|                                                                                      |       |                                              |       |   |   |
| Cash flows from  investing activities:                                                    |       |                                              |       |   |   |
| Purchases of  property and equipment                                                      |       | (190,000                                          | )          | (482,000 | ) |
| Purchase of  VertiSoft                                                                    |       | —                                            |       | (75,000 | ) |
| Repayment of  note receivable from M2 Systems                                             |       | 159,000                                           |       | 147,000 |   |
| Net cash used in  investing activities                                                    |       | (31,000                                           | )          | (410,000 | ) |
|                                                                                      |       |                                              |       |   |   |
| Cash flows from  financing activities:                                                    |       |                                              |       |   |   |
| Payments of  notes payable and capital lease obligations                                  |       | (44,000                                           | )          | (3,000 | ) |
| Proceeds from  exercise of stock options                                                  |       | 100,000                                           |       | 300,000 |   |
| Net cash provided by  financing activities                                                |       | 56,000                                            |       | 297,000 |   |
|                                                                                      |       |                                              |       |   |   |
| Impact of foreign  currency rate fluctuations on cash                                     |       | (63,000                                           | )          | 86,000 |   |
| Net increase in cash  and cash equivalents                                                |       | 28,000                                            |       | 519,000 |   |
|                                                                                      |       |                                              |       |   |   |
| Cash and cash  equivalents at beginning of period                                         |       | 5,433,000                                         |       | 7,954,000 |   |
| Cash and cash  equivalents at end of period                                               |       | $                                                 | 5,461,000  |   | $ | 8,473,000 |   |
|                                                                                      | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Supplemental  disclosures of cash flow information:                                       | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Cash paid during  the period for:                                                         | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Interest paid                                                                             |       | $                                                 | 3,000      |   | $ | 3,000 |   |
| Income taxes paid                                                                         |       | $                                                 | 8,000      |   | $ | 6,000 |   |

 

***Seeaccompanying notes.***

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**Optio Software, Inc.**

**Notes to the ConsolidatedCondensed Financial Statements**

**(Unaudited)**

**1.Description of Business**

OptioSoftware, Inc. (the “Company” or “Optio”), provides document automation andelectronic health record solutions that enable organizations to achieveunprecedented speed, accuracy, functionality and quality in their inbound andoutbound documents. The Company’s infrastructure software and services enhancethe form, content, distribution and availability of business criticalinformation. The Company markets primarily to companies located principally inthe United States and Europe.  Theindustry in which the Company operates is subject to rapid change due todevelopment of new technologies and products.

**2. Basisof Presentation**

#### ***Interim FinancialInformation***

The accompanying interim consolidated condensedfinancial statements of the Company have been prepared in accordance with theinstructions for Quarterly Reports on Form 10-Q. Accordingly, certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America have been condensed or omitted. In the opinion ofmanagement, all adjustments, consisting of normal recurring adjustments unlessotherwise disclosed in a separate note, considered necessary for a fairpresentation of the financial information for the interim period reported havebeen made.

The accompanying financial statements should be readin conjunction with the Company’s audited consolidated financial statements forthe year ended January 31, 2006, included in the Company’s Annual Report onForm 10-K for the year ended January 31, 2006 (the “2006 Annual Report”), filedwith the Securities and Exchange Commission on May 1, 2006. Results ofoperations for the three and six months ended July 31, 2006 are not necessarilyindicative of the results for the year ending January 31, 2007.

***Share-Based Compensation Plans***

Prior to February 1, 2006, the Company accounted forits stock-based employee compensation arrangements under the intrinsic valuemethod prescribed by Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees* (“APBNo. 25”), as allowed by Statement of Financial Accounting Standards (“SFAS”)No. 123, *Accounting for Stock-BasedCompensation*, as amended by SFAS No. 148, *Accounting for Stock-Based Compensation-Transition and Disclosure*.As a result, no expense was recognized for options that were granted with anexercise price equal to quoted market price at the date of grant. In December2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123R, *Share-Based Payment*, which amended SFASNo. 123 and supersedes APB No. 25. SFAS No. 123R requires measurement of thecost of share-based payments to employees, including grants of employee stock options,to be recognized in the financial statements based on their fair valuesbeginning with the first interim or annual period after June 15, 2005.Subsequent to the effective date, the pro forma disclosures previouslypermitted under SFAS No. 123 are no longer an alternative to financialstatement recognition. Effective February 1, 2006, the Company has adopted SFASNo. 123R using the modified prospective method. Under this method, compensationcost recognized during the three and six-month periods ended July 31, 2006includes: (a) compensation cost for all share-based payments granted prior to,but not yet vested as of February 1, 2006, based on the grant date fair valueestimated in accordance with the original provisions of SFAS No. 123 amortizedover the employees’

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serviceperiod (typically the options’ vesting period) and (b) compensation cost forall share-based payments granted subsequent to February 1, 2006, based on thegrant-date fair value estimated in accordance with the provisions of SFAS No.123R amortized ratably over the options’ vesting period.

For periods prior to adoption of SFAS No. 123R,companies were required to calculate the estimated fair value of options andcould elect to either include the estimated cost in earnings or disclose thepro forma effect in the footnotes to their financial statements. The Companychose to disclose the pro forma effect.

The fair value of the options used for the applicationof SFAS No. 123R disclosures is estimated at the date of grant using the Black- Scholes option pricing model. In determining the fair value of options usingthe Black-Scholes option pricing model, various assumptions such as expectedlife, volatility, risk-free interest rate, dividend yield and forfeiture ratesare used.  The expected life of awardsgranted represents the period of time that they are expected to be outstanding.The Company determines the expected life using the “simplified method” inaccordance with Staff Accounting Bulletin No. 107. Using the Black-Scholesoption valuation model, the Company estimates the volatility of our commonstock at the date of grant based on the historical volatility of our commonstock. Optio bases the risk-free interest rate used in the Black-Scholes optionvaluation model on the implied yield currently available on U.S. Treasuryzero-coupon issues with an equivalent remaining term equal to the expected lifeof the award. Optio has not paid any cash dividends on our common stock in thelast ten years and we do not anticipate paying any cash dividends in theforeseeable future. Consequently, the Company used an expected dividend yieldof zero in the Black-Scholes option valuation model. Finally, the Company useshistorical data to estimate pre-vesting option forfeitures. Stock-basedcompensation is recorded for only those awards that are expected to vest. Thefollowing weighted-average assumptions were used for the three and six monthsended July 31, 2006: risk-free interest rate of 5.03% and 5.0%, respectively;no dividend yield; volatility of 123% and 123% respectively; a forfeiture rateof 20.6% and 20.6% respectively; and an expected life of the options of 5.3 and5.3 years, respectively.

For purposes of pro forma disclosures, the estimatedfair value of the options is amortized to expense over the service period,which is generally the options’ vesting period. The following table illustratesthe effect on net income and net income per share had the Company applied thefair value recognition provisions of SFAS No. 123 to account for our employeestock option plan for the three and six-month periods ended July 31, 2005,because stock-based employee compensation was not accounted for using the fairvalue recognition method during that period (in thousands, except per sharedata):
|                                                            | ** ** | **Three Months  Ended July 31,  2005** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------------------|------------|
|                                                       |       |                                                  |       |
| Net income as  reported                                    |       | $                                                     | 244,000    |   |
| Deduct:  Compensation cost using the fair value method     |       | $                                                     | (114,000   | ) |
| Pro forma net  income                                      |       | $                                                     | 130,000    |   |
| Net income per  share as reported – basic and diluted |       | $                                                     | 0.01       |   |
| Pro forma net income  per share – basic and diluted   |       | $                                                     | 0.01       |   |

 

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|                                                            | ** ** | **Six Months  Ended July 31,  2005** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------------|------------|
|                                                       |       |                                                |       |
| Net income as  reported                                    |       | $                                                   | 154,000    |   |
| Deduct:  Compensation cost using the fair value method     |       | $                                                   | (213,000   | ) |
| Pro forma net  loss                                        |       | $                                                   | (59,000    | ) |
| Net income per  share as reported – basic and diluted |       | $                                                   | 0.01       |   |
| Pro forma net loss per  share – basic and diluted     |       | $                                                   | 0.00       |   |

 

The historical pro forma impact of applying the fairvalue method prescribed by SFAS No. 123 is not representative of the impactthat may be expected in the future due to changes resulting from additionalgrants in future years and changes in assumptions such as volatility, interestrates and expected life used to estimate fair value of the grants in futureyears.

Note that the above pro forma disclosure was notpresented for the three and six-month periods ended July 31, 2006 becausestock-based employee compensation has been accounted for using the fair valuerecognition method under SFAS No. 123R for this period. Implementation of SFASNo. 123R resulted in $117,000 and $198,000 of share-based compensation expensein the three and six months ended July 31, 2006, respectively, reflectedentirely within the general and administrative line item of the ConsolidatedCondensed Statement of Operations and Comprehensive Income (Loss). No deferredtax asset was recognized during the three and six months ended July 31, 2006due to the valuation allowance placed on the Company’s deferred tax assets. Theadoption of SFAS No. 123R had no impact on cash flows from operations orfinancing activities.

***Goodwill and Other IntangibleAssets***

TheCompany acquired goodwill and other intangible assets in connection with theacquisition of VertiSoft Corporation (“VertiSoft”) in August 2004. Under thepurchase method of accounting pursuant to Statement of Financial AccountingStandards (“SFAS”) No. 141, *BusinessCombinations*, the total purchase price was allocated to the acquiredentity’s net tangible and intangible assets based on their estimated fair valuesas of the date of the acquisition. The excess of the purchase price over thefair value of the net tangible assets/liabilities and identifiable intangibleassets acquired was recorded as goodwill. In accordance with SFAS 142, *Goodwill and Other Intangibles*, goodwill and intangibleassets with indefinite lives resulting from business combinations have not beenamortized but instead will be tested for impairment at least annually (morefrequently if certain indicators are present) while identifiable intangibleassets with finite lives are being amortized over their estimated useful lives.In the event that the Company’s management determines that the value ofgoodwill or intangible assets has become impaired, the Company will incur anaccounting charge for the amount of impairment during the fiscal quarter inwhich the determination is made. The Company has selected August 1 as itsannual impairment testing date for its goodwill. The Company performed ananalysis comparing the fair value of the reporting units with the carryingvalue of such reporting units, including goodwill, and determined that noimpairment of its goodwill existed.

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Asof July 31, 2006, the gross carrying amount and the accumulated amortization bymajor intangible asset class is as follows:
| **Intangible Asset** | ** ** | **Useful Life**     | ** ** | **Gross Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Value** | ** ** |
|---------------------------|------------|--------------------------|------------|--------------------------------|------------|-------------------------------|------------|------------------------------|------------|
| Customer  relationships   |       | 11.5  years              |       | $                              | 1,260,000  |                          | $          | 337,000                      |       | $ | 923,000 |   |
| Technology                |       | 3  months – 5 years |       | 893,000                        |       | 444,000                       |       | 449,000                      |       |
| Non-compete agreement     |       | 5 years                  |       | 85,000                         |       | 34,000                        |       | 51,000                       |       |
|                           |            |                          |            |                                |            |                               |            |                              |            |  |  |  |

 

***Non-Cash Transactions***

Duringthe three months ended July 31, 2006, Optio entered into a capital lease fortelephone equipment in the amount of $422,000. In addition, Optio renegotiatedthe lease for its headquarter facilities. As part of the new lease agreement,the landlord contributed $1.0 million towards the improvements of the space.This $1.0 million in leasehold improvements is reflected as a fixed asset withan offsetting lease incentive liability of $1.0 million, which will reducefuture rent expense, has been recorded as a liability on Optio’s condensedconsolidated balance sheet.

***New Accounting Pronouncements***

In June 2006, theFASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes-an interpretation of SFAS No. 109” (“FIN 48”). FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in financial statementsin accordance with SFAS No. 109, and recommends a recognition threshold andmeasurement characteristic for financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return. Thedifferences between a tax position taken in a tax return and amounts recognizedin the financial statements may result in an increase in a liability for incometaxes payable, a reduction of an income tax refund receivable, a reduction in adeferred tax asset or an increase in a deferred tax liability. FIN 48 alsoprovides guidance on classification, interest and penalties, accounting ininterim periods, disclosure, and transition. FIN 48 is effective for fiscalyears beginning after December 16, 2006, with early adoption encouraged. TheCompany intends to adopt FIN 48 on February 1, 2008. The Company does notexpect that the adoption of FIN 48 will have a material impact on its resultsof operations or financial position.

**3. Net Income (Loss) per Share**

Netincome (loss) per share has been computed in accordance with SFAS 128, *Earnings per Share*, which requiresdisclosure of basic and diluted earnings per share. Basic earnings per shareexcludes any dilutive effects of stock options. Diluted earnings per shareincludes the impact of potentially dilutive securities.

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Thefollowing table sets forth the computation of net income (loss) per share:
|                                                                                                                         | ** ** | **Three months ended July 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2005**                                            | ** ** | **2006** | ** ** |
|                                                                                                                    |       |                                                |       |   |   |
| Net income (loss)                                                                                                       |       | $                                                   | 244,000    |   | $ | (450,000 | ) |
| Weighted average shares  outstanding – basic                                                                       |       | 20,880,334                                          |       | 22,223,643 |   |
| Dilutive securities                                                                                                     |       | 3,054,839                                           |       | — |   |
| Weighted average shares  outstanding – diluted                                                                     |       | 23,935,173                                          |       | 22,223,643 |   |
| Net income (loss) per  share – basic and diluted                                                                   |       | $                                                   | 0.01       |   | $ | (0.02 | ) |
| Potentially dilutive  stock options, excluded from diluted weighted average shares outstanding                          |       | 1,722,937                                           |       | 4,394,084 |   |
| Potentially dilutive  VertiSoft shares held in escrow excluded from diluted weighted average common  shares outstanding |       | 310,000                                             |       | — |   |

 
|                                                                                                                        | ** ** | **Six months ended July 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2005**                                          | ** ** | **2006** | ** ** |
|                                                                                                                   |       |                                              |       |   |   |
| Net income (loss)                                                                                                      |       | $                                                 | 154,000    |   | $ | (504,000 | ) |
| Weighted average shares  outstanding – basic                                                                      |       | 20,870,480                                        |       | 22,036,310 |   |
| Dilutive securities                                                                                                    |       | 3,317,950                                         |       | — |   |
| Weighted average shares  outstanding – diluted                                                                    |       | 24,188,430                                        |       | 22,036,310 |   |
| Net income (loss) per  share – basic and diluted                                                                  |       | $                                                 | 0.01       |   | $ | (0.02 | ) |
| Potentially dilutive  stock options, excluded from diluted weighted average shares outstanding                         |       | 980,637                                           |       | 4,405,201 |   |
| Potentially dilutive VertiSoft shares held in escrow excluded from  diluted weighted average common shares outstanding |       | 310,000                                           |       | — |   |

 

**4. Segment and Geographic Information**

The Company’s business is organized around geographicareas. Optio’s U.S. operations and European operations represent Optio’s tworeportable segments. The foreign locations principally function as distributorsof products developed by the Company in the United States. The accountingpolicies described in the summary of significant accounting policies areapplied consistently across the segments. Intersegment sales are based onintercompany transfer prices to achieve a reasonable margin upon distribution.Revenues are attributable to each segment based on the location of thesubsidiary originating the sale, which is typically the geographic locationwhere the software is installed.

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Segmentinformation for the three and six months ended July 31, 2006 and 2005 issummarized below.
| **Three Months ended  July 31, 2005** | ** ** | **United  States** | ** ** | **Europe** | ** ** | **Combined** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------|------------|--------------------|------------|------------|------------|--------------|------------|------------------|------------|------------------|------------|
| Revenue from external  customers:                         |       |               |       |       |       |         |       |             |       |             |       |
| License fees                                              |       | $                  | 1,932,000  |       | $          | 612,000      |       | $                | 2,544,000  |             | $          | — |   | $ | 2,544,000 |   |
| Subscription  revenue                                     |       | 526,000            |       | —     |       | 526,000      |       | —           |       | 526,000          |       |
| Services,  maintenance and other                          |       | 3,589,000          |       | 720,000    |       | 4,309,000    |       | —           |       | 4,309,000        |       |
| Inter-segment  revenue                                    |       | 127,000            |       | 10,000     |       | 137,000      |       | (137,000         | )          | —           |       |
| Total revenue                                             |       | 6,174,000          |       | 1,342,000  |       | 7,516,000    |       | (137,000         | )          | 7,379,000        |       |
| Interest income                                           |       | 60,000             |       | —     |       | 60,000       |       | —           |       | 60,000           |       |
| Interest expense                                          |       | 2,000              |       | —     |       | 2,000        |       | —           |       | 2,000            |       |
| Depreciation and  amortization                            |       | 235,000            |       | 8,000      |       | 243,000      |       | —           |       | 243,000          |       |
| Income tax expense                                        |       | 10,000             |       | —     |       | 10,000       |       | —           |       | 10,000           |       |
| Segment income before  income taxes                       |       | 214,000            |       | 40,000     |       | 254,000      |       | —           |       | 254,000          |       |
| Segment net income                                        |       | 204,000            |       | 40,000     |       | 244,000      |       | —           |       | 244,000          |       |
| Total segment assets                                      |       | 17,702,000         |       | 3,171,000  |       | 20,873,000   |       | (3,252,000       | )          | 17,621,000       |       |
| Expenditures for long-lived  assets                       |       | 55,000             |       | 1,000      |       | 56,000       |       | —           |       | 56,000           |       |
|                                                           |            |                    |            |            |            |              |            |                  |            |                  |            |  |  |  |  |  |

 
| **Three Months  ended  July 31, 2006**     | ** ** | **United  States** | ** ** | **Europe** | ** ** | **Combined** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------|------------|--------------------|------------|------------|------------|--------------|------------|------------------|------------|------------------|------------|
| Revenue from external  customers:          |       |               |       |       |       |         |       |             |       |             |       |
| License fees                               |       | $                  | 1,305,000  |       | $          | 338,000      |       | $                | 1,643,000  |             | $          | — |   | $ | 1,643,000 |   |
| Subscription  revenue                      |       | 550,000            |       | 10,000     |       | 560,000      |       | —           |       | 560,000          |       |
| Services,  maintenance and other           |       | 3,753,000          |       | 812,000    |       | 4,565,000    |       | —           |       | 4,565,000        |       |
| Inter-segment  revenue                     |       | 28,000             |       | 17,000     |       | 45,000       |       | (45,000          | )          | —           |       |
| Total revenue                              |       | 5,636,000          |       | 1,177,000  |       | 6,813,000    |       | (45,000          | )          | 6,768,000        |       |
| Interest income                            |       | 113,000            |       | —     |       | 113,000      |       | —           |       | 113,000          |       |
| Interest expense                           |       | 2,000              |       | —     |       | 2,000        |       | —           |       | 2,000            |       |
| Depreciation and  amortization             |       | 192,000            |       | 8,000      |       | 200,000      |       | —           |       | 200,000          |       |
| Income tax expense  (benefit)              |       | 40,000             |       | (4,000     | )          | 36,000       |       | —           |       | 36,000           |       |
| Segment income (loss)  before income taxes |       | (447,000           | )          | 33,000     |       | (414,000     | )          | —           |       | (414,000         | )          |
| Segment net income  (loss)                 |       | (487,000           | )          | 37,000     |       | (450,000     | )          | —           |       | (450,000         | )          |
| Total segment assets                       |       | 20,561,000         |       | 3,598,000  |       | 24,159,000   |       | (3,548,000       | )          | 20,611,000       |       |
| Expenditures for long-lived assets         |       | 301,000            |       | 8,000      |       | 309,000      |       | —           |       | 309,000          |       |
|                                            |            |                    |            |            |            |              |            |                  |            |                  |            |  |  |  |  |  |

 

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| Six Months ended  July 31, 2005 | ** ** | **United  States** | ** ** | **Europe** | ** ** | **Combined** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------|------------|--------------------|------------|------------|------------|--------------|------------|------------------|------------|------------------|------------|
| Revenue from external  customers:                   |       |               |       |       |       |         |       |             |       |             |       |
| License fees                                        |       | $                  | 3,870,000  |       | $          | 885,000      |       | $                | 4,755,000  |             | $          | — |   | $ | 4,755,000 |   |
| Subscription  revenue                               |       | 1,035,000          |       | —     |       | 1,035,000    |       | —           |       | 1,035,000        |       |
| Services,  maintenance and other                    |       | 7,191,000          |       | 1,314,000  |       | 8,505,000    |       | —           |       | 8,505,000        |       |
| Inter-segment  revenue                              |       | 180,000            |       | 55,000     |       | 235,000      |       | (235,000         | )          | —           |       |
| Total revenue                                       |       | 12,276,000         |       | 2,254,000  |       | 14,530,000   |       | (235,000         | )          | 14,295,000       |       |
| Interest income                                     |       | 116,000            |       | —     |       | 116,000      |       | —           |       | 116,000          |       |
| Interest expense                                    |       | 4,000              |       | —     |       | 4,000        |       | —           |       | 4,000            |       |
| Depreciation and  amortization                      |       | 412,000            |       | 19,000     |       | 431,000      |       | —           |       | 431,000          |       |
| Income tax expense                                  |       | 28,000             |       | —     |       | 28,000       |       | —           |       | 28,000           |       |
| Segment income (loss)  before income taxes          |       | 482,000            |       | (300,000   | )          | 182,000      |       | —           |       | 182,000          |       |
| Segment net income  (loss)                          |       | 454,000            |       | (300,000   | )          | 154,000      |       | —           |       | 154,000          |       |
| Total segment assets                                |       | 17,702,000         |       | 3,171,000  |       | 20,873,000   |       | (3,252,000       | )          | 17,621,000       |       |
| Expenditures for  long-lived assets                 |       | 172,000            |       | 18,000     |       | 190,000      |       | —           |       | 190,000          |       |
|                                                     |            |                    |            |            |            |              |            |                  |            |                  |            |  |  |  |  |  |

 
| Six Months ended  July 31, 2006    | ** ** | **United  States** | ** ** | **Europe** | ** ** | **Combined** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------|------------|--------------------|------------|------------|------------|--------------|------------|------------------|------------|------------------|------------|
| Revenue from external  customers:  |       |               |       |       |       |         |       |             |       |             |       |
| License fees                       |       | $                  | 2,782,000  |       | $          | 759,000      |       | $                | 3,541,000  |             | $          | — |   | $ | 3,541,000 |   |
| Subscription  revenue              |       | 1,095,000          |       | 20,000     |       | 1,115,000    |       | —           |       | 1,115,000        |       |
| Services,  maintenance and other   |       | 7,491,000          |       | 1,483,000  |       | 8,974,000    |       | —           |       | 8,974,000        |       |
| Inter-segment  revenue             |       | 125,000            |       | 49,000     |       | 174,000      |       | (174,000         | )          | —           |       |
| Total revenue                      |       | 11,493,000         |       | 2,311,000  |       | 13,804,000   |       | (174,000         | )          | 13,630,000       |       |
| Interest income                    |       | 209,000            |       | —     |       | 209,000      |       | —           |       | 209,000          |       |
| Interest expense                   |       | 2,000              |       | 1,000      |       | 3,000        |       | —           |       | 3,000            |       |
| Depreciation and  amortization     |       | 369,000            |       | 15,000     |       | 384,000      |       | —           |       | 384,000          |       |
| Income tax expense  (benefit)      |       | 56,000             |       | (4,000     | )          | 52,000       |       | —           |       | 52,000           |       |
| Segment loss before  income taxes  |       | (370,000           | )          | (82,000    | )          | (452,000     | )          | —           |       | (452,000         | )          |
| Segment net loss                   |       | (426,000           | )          | (78,000    | )          | (504,000     | )          | —           |       | (504,000         | )          |
| Total segment assets               |       | 20,561,000         |       | 3,598,000  |       | 24,159,000   |       | (3,548,000       | )          | 20,611,000       |       |
| Expenditures for long-lived assets |       | 472,000            |       | 10,000     |       | 482,000      |       | —           |       | 482,000          |       |
|                                    |            |                    |            |            |            |              |            |                  |            |                  |            |  |  |  |  |  |

 

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**5.Note Receivable**

As furtherexplained in Note 3 of the Notes to Consolidated Financial Statements includedin Optio’s 2006 Annual Report, Optio holds a note receivable from M2 SystemsCorporation (“M2 Systems”) as partial consideration for the sale by Optio ofits Muscato Corporation (“Muscato”) and Translink Solutions Corporationbusiness units. Under the terms of the note, M2 Systems was required to makepayments of $100,000 each on September 1, 2003 and December 1, 2003 and apayment of $115,000 on June 1, 2004. M2 Systems failed to make these paymentson their respective due dates; however, payment was made prior to an event of default.All scheduled payments subsequent to June 1, 2004 have been appropriately madeon their respective due dates.

During the thirdquarter of fiscal 2004, as a result of M2 Systems’ failure to make timelypayments in the prior quarters, management determined that this was anindication that it was probable that Optio would be unable to collect allamounts due according to the contractual terms of the note.  At that time, the loan was consideredimpaired and was written down to the assessed fair value of the collateral. Asof October 31, 2003, the collateral, including technology, accounts receivable,fixed assets and the discounted net cash flows of maintenance contracts wasestimated to have an approximate fair value of $2.8 million, substantially lessthan the $3.7 million note receivable balance as of October 31, 2003. ThusOptio recorded an impairment charge of $900,000 during the year ended January31, 2004. Optio continues to reassess the value of the collateral on an ongoingbasis. The amount of the note receivable recorded could be materially differentunder different conditions or using different assumptions, including, withoutlimitation, the varying assumptions regarding the fair value of the collateral.If M2 Systems defaults on the note and the collateral proves to be of no valueto the Company, the Company would incur an additional loss of approximately$1.9 million.

On September 15,2004, Optio notified M2 System’s of certain non-monetary defaults under the M2Systems’ note.  M2 Systems disputed thesedefaults.  Optio did not accelerate theindebtedness under the M2 Systems’ note, but the parties agreed to modify theloan documents to address the alleged defaults by M2 Systems to give Optioadditional collateral.  On May 18, 2005,the parties executed modified and additional security documents granting Optioa security interest in the assets of certain of M2 Systems’ affiliates andplacing greater restrictions on the use of the collateral.

Based on thetimely payments by M2 Systems over the previous six fiscal quarters and theabsence of any impairment indications, the Company has concluded that noadditional impairment charge is warranted at this time.

**6.Acquisition of VertiSoft Corporation**

OnAugust 10, 2004, Optio consummated the merger of VertiSoft, a privately heldGeorgia corporation, and Optio Software II, Inc., a wholly owned subsidiary ofOptio, whereby VertiSoft became the surviving wholly owned subsidiary of Optio.Subsequently, on September 15, 2004, VertiSoft was merged with and into Optio,with Optio remaining the surviving corporation. The consideration paid for allof the common stock of VertiSoft included $348,000 in cash, the issuance of 1.5million shares of Optio common stock, of which 310,000 shares were held inescrow for a period of 18 months to secure the indemnification obligations ofthe shareholders of VertiSoft, the issuance of options for the purchase of340,000 shares of common stock and future conditional cash payments of $225,000to be paid out in various installments over the following two years, contingentupon the achievement of certain customer retention and product developmentgoals, which are included in goodwill when the uncertainties associated withits contingencies are recorded. A cash payment of $75,000 was paid on August30, 2005. Additional cash payments of $75,000 were paid in May 2006. The cashcomponent of the consideration given was paid from funds generated from 

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the on-goingoperations of Optio.  The purchase pricefor VertiSoft consisted of the following:

| Cash paid in initial  transaction       |   | $         | 348,000   |   |
|-----------------------------------------|--------|-----------|-----------|--------|
| Cash paid in  contingent payment        |   | 150,000   |      |
| Common stock  issued (1,500,000 shares) |   | 1,690,000 |      |
| Stock options  issued                   |   | 361,000   |      |
| Acquisition  costs                      |   | 339,000   |      |
|                                    |   | $         | 2,888,000 |   |

                                                                                                

Thevalue of the common stock issued above was based on the market price of Optio’scommon stock for a reasonable period before and after the date the merger wasannounced. The 310,000 shares held in escrow were released at the end of the 18month period, the value of the shares based on the market value of Optio’scommon stock on that date was added to goodwill.

Theacquired assets consisted primarily of accounts receivable, software,machinery, equipment, furniture and fixtures, cash, and all of the interests,rights and benefits accruing to VertiSoft under any sales orders, salescontracts, service agreements, and purchase orders. In connection with theacquisition, Optio also assumed the liabilities of VertiSoft, consistingprimarily of promissory notes payable (totaling approximately $1,100,000),accounts payable, accrued payroll, and service agreements.

Thepurchase price was allocated to the assets and liabilities assumed based ontheir respective fair values on the date of acquisitions as follows:

| Tangible assets acquired |   | $          | 280,000   |   |
|--------------------------|--------|------------|-----------|--------|
| Liabilities  assumed     |   | (1,932,000 | )         |
| Technology               |   | 893,000    |      |
| Customer  relationships  |   | 1,260,000  |      |
| Non-compete  agreement   |   | 85,000     |      |
| Goodwill                 |   | 2,302,000  |      |
|                     |   | $          | 2,888,000 |   |

 

Theacquired technology is being amortized over periods ranging from three monthsto five years, the customer relationships are being amortized over 11.5 yearsand the non-compete agreement with the shareholders of VertiSoft is beingamortized over five years.

Theresults of operations of VertiSoft have been included in Optio’s consolidatedcondensed financial statements from the date of acquisition.

ITEM 2. MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

#### **OVERVIEW**

Optio is engaged primarily in the development, sale and support ofinfrastructure software that enhances the form, content, distribution andavailability of business information. Optio’s primary business consists ofproviding software and services that address organizations’ needs for customizedinformation delivered via print, fax and e-mail to users of enterpriseand healthcare applications.

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Optio markets and sells its software and services throughout the UnitedStates, Europe and the Asia Pacific region, through its direct sales force andcertified resellers. Optio has offices in the United States, France, the UnitedKingdom and Germany. Optio also offers consulting services, which providecustomers with implementation assistance and training. No single customeraccounted for 10% or more of Optio’s revenue for the three and six months endedJuly 31, 2006 or 2005.

**CriticalAccounting Policies and Use of Estimates**

Optio has identifiedsignificant accounting policies and estimates that are critical to theunderstanding of its financial statements.

*Revenue Recognition*

*Overview*

TheCompany’s revenue consists of perpetual fees derived from the Company’ssoftware products, maintenance, consulting services, customer training andsubscription fees received from the licensing of the Company’s softwareproducts and maintenance. The Company generally charges fees for licenses ofits software products either based on the number of Central Processing Units (“CPUs”)on which the product is installed or, to a lesser extent, based on the numberof persons or hospital beds registered to use the product. The Company’srevenue recognition policies are in accordance with Statement of Position (“SOP”)No. 97-2, *Software Revenue Recognition*,as amended by SOP No. 98-9, *SoftwareRevenue Recognition With Respect to Certain Transactions* and theSecurities and Exchange Commission’s Staff Accounting Bulletin (“SAB”)No. 101, *Revenue Recognition inFinancial Statements,* as amended by SAB 104, *Revenue Recognition*.

*LicenseFees*

TheCompany licenses its products through its direct sales force and indirectlythrough resellers. In general, software license revenues are recognized when anon-cancelable license agreement has been signed and the customer acknowledgesan unconditional obligation to pay, the software product has been delivered,there are no significant uncertainties surrounding product acceptance, the feesare fixed or determinable, collection is considered probable, the remainingelements such as future services are not considered essential to thefunctionality of the software and the Company has a legally enforceable claimnot subject to refund or forfeiture if future services are not rendered.Delivery is considered to have occurred when title and risk of loss have beentransferred to the customer, which generally occurs when media containing thelicensed programs is provided to a common carrier. In case of electronicdelivery, delivery occurs when the customer is given access to the licensedprograms. If collectibility is not considered probable, revenue is recognizedwhen the fee is collected. The Company enters into reseller arrangements thattypically provide for sublicense fees payable based upon a percentage of listprice. The Company does not grant its resellers the right of return.

TheCompany recognizes revenue using the residual method pursuant to therequirements of SOP No. 97-2, as amended by SOP No. 98-9.Revenues recognized from multiple-element software arrangements are allocatedto each element of the arrangement based on the fair values of the elements,such as licenses for software products, maintenance, consulting services orcustomer training. The determination of fair value is based on objectiveevidence, which is specific to the Company and can differ from amountscontained in the customer arrangement. The Company limits its assessment ofobjective evidence for each element to either the price charged when the sameelement is sold separately or the price established by management having therelevant authority to do so, for an element not yet sold separately. Ifevidence of fair value of all undelivered elements exists but evidence does notexist for one or more delivered elements, then revenue is

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recognized usingthe residual method. Under the residual method, the fair value of theundelivered elements is deferred and the remaining portion of the arrangementfee is allocated to the delivered elements and recognized as revenue when theaforementioned criteria is met.

TheCompany records deferred revenue for software license agreements when cash hasbeen received from the customer and the agreement does not qualify for revenuerecognition under the Company’s revenue recognition policy. The Company recordsaccounts receivable for software license agreements when the agreementqualifies for revenue recognition but cash or other consideration has not beenreceived from the customer.

*SubscriptionRevenue*

TheCompany**also licenses certain of its productsin the form of a subscription service contract, with terms typically rangingfrom three to five years.  Subscriptionrevenue, which includes a license of the software product, technical supportand future unspecified enhancements to the software product, is recognized on adaily basis over the term of the agreement. Unlike license fee revenue,subscription service agreements include licenses that are not perpetual induration.

*Services,Maintenance and Other Revenue*

Consultingservices revenue and customer training revenue are recognized as such servicesare performed because they are incidental to the functionality of the Company’ssoftware.  Maintenance revenues, whichinclude revenues bundled with software license agreements that entitle thecustomers to technical support and future unspecified enhancements to theCompany’s products, are deferred and recognized ratably over the related termof the maintenance agreement, which is generally twelve months. In accordancewith Emerging Issues Task Force release 01-14, *IncomeStatement Characterization of Reimbursements Received for Out of PocketExpenses Incurred*, the Company recognizes reimbursable expenses asrevenue and as an expense in cost of revenue in all periods presented.

*NoteReceivable*

Optio holds a note from M2 Systems as partialconsideration for the sale of Muscato and TransLink. Under the terms ofthis note, M2 Systems was required to make payments of $100,000 on September 1,2003 and December 1, 2003 and a payment of $115,000 on June 1, 2004. M2 Systemsfailed to make these payments on their respective due dates; however, eachpayment was made prior to an event of default under the terms of the note. Allpayments subsequent to June 1, 2004 have been made on their respective duedates.

During the third quarter of 2004, as a result of M2 System’s failure tomake timely payments, management determined that this was an indication that itwas probable that Optio would be unable to collect all amounts due according tothe contractual terms of the note.  Atthat time, the loan was considered impaired and was written down to theassessed fair value of the collateral. As of October 31, 2003, the collateral,including technology, accounts receivable, fixed assets and the discounted netcash flows of maintenance contracts was estimated to have an approximate fairvalue of $2.8 million, substantially less than the $3.7 million note receivablebalance as of October 31, 2003. Thus Optio recorded an impairment charge of$900,000 during the year ended January 31, 2004. Optio continues to reassessthe value of the collateral on an ongoing basis. The amount of the note receivablerecorded could be materially different under different conditions or usingdifferent assumptions, including the varying assumptions regarding the fairvalue of the collateral. In Optio’s initial assessment of the collateral,varying assumptions, including the length of time of which customers wouldcontinue on maintenance, resulted in estimates of the value of the collateralranging 

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from $1.8 million to $3.5 million, which could haveresulted in an impairment charge ranging from $200,000 to $1.9 million. Optio’scontinued assessment of the collateral has resulted in varying estimates of thevalue of the collateral ranging from $1.9 million to $2.5 million, which couldcurrently result in an additional impairment charge of $100,000 or a reversalof the previously recorded impairment charge of $500,000.  If M2 Systems defaults on the note and thecollateral proves to be of no value to Optio, Optio would incur an additionalloss of approximately $1.9 million. TheCompany periodically assesses the value of the collateral and the note, asreflected on the Company’s consolidated financial statements.

On September 15, 2004, Optio notified M2 Systemsof certain non-monetary defaults under the note.  M2 Systems disputed these defaults. Optio didnot accelerate the indebtedness under the note, but the parties agreed to modify the loan documentsto address the alleged defaults by M2 Systems giving Optio additionalcollateral.  On May 18, 2005, the partiesexecuted modified and additional security documents granting Optio a securityinterest in the assets of certain M2 Systems’ affiliates and placing greaterrestrictions on the use of the collateral.

Based on thetimely payments by M2 Systems over the previous six fiscal quarters and theabsence of any impairment indications, the Company has concluded that noadditional impairment charge is warranted at this time.

*AccountsReceivable*

Optio maintains allowances fordoubtful accounts for estimated losses resulting from customers’ inability tomake payments required under their contracts. The amount of Optio’s reserve is based on historical experience and Optio’s specific review and analysis of thereceivables outstanding. Management reviews its accounts receivable on aregular basis to determine if any such amounts may be potentiallyuncollectible. The Company includes any balances that are determined to beuncollectible, along with a general reserve at varying percentages of 3%, forbalances less than 30 days old, to 50% for international accounts more than 90days old, in its overall allowance for doubtful accounts. Based on management’sbest estimate, it believes the Company’s allowance for doubtful accounts isadequate as presented; however, the amount of the reserve could be differentunder different conditions or using varying assumptions. If the percentage ofthe general reserve were to increase by 1%, an additional $25,000 reserve wouldbe required. If the financial condition of Optio’s customers were to deteriorate, resulting in their inability to makepayments, additional reserves would be required, increasing Optio’s bad debt expense included in general andadministrative expenses.

*ImpairmentAssessments*

Optio adopted Statement ofFinancial Accounting Standards (“SFAS”) No. 142, *Goodwill and Other Intangible Assets,* on February 1, 2002.This standard requires that goodwill no longer be amortized and instead betested for impairment on a periodic basis.

Pursuant to SFAS 142, Optio isrequired to test goodwill for impairment upon adoption and annually or moreoften if events or changes in circumstances indicate that the asset might beimpaired. SFAS 142 provides for a two-stage approach to determining whether andby how much goodwill has been impaired. The first stage requires a comparisonof the fair value of the reporting unit, in our case, the former VertiSoftbusiness, to its net book value. If the fair value is greater than book value,no impairment is deemed to have occurred. If the fair value is less than bookvalue, then the second stage must be completed to determine the amount, if any,of actual impairment. Optio has selected August 1 as its annual impairmenttesting date for its goodwill. The Company performed an analysis as of August 1,2005, comparing the fair value of the reporting units with the carrying valueof such reporting units, including goodwill, and determined that no impairmentof 

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its goodwill existed. While no impairment charge was determined to benecessary in the current year, the Company’s future assessments could leadmanagement to determine that the goodwill is completely or partially impaired,which would require the Company to record an impairment charge of up to $2.3million.

The process of evaluating the potentialimpairment of goodwill is highly subjective and requires significant judgmentdecisions. In estimating our fair value, we will make estimates and judgmentsabout future revenues and cash flows. Our forecasts will be based uponassumptions that are consistent with the plans and estimates we are using tomanage our business. Changes in these estimates could change our conclusionregarding impairment of goodwill and potentially result in a non-cash goodwillimpairment charge for all or a portion of the goodwill balance. For long-livedassets, accounting standards dictate that assets become impaired when theundiscounted future cash flows expected to be generated by them are less thantheir carrying amounts. In such cases, the affected assets are written down totheir estimated fair value.

*Foreign Currencies*

The financial positionand results of operations of the Company’s foreign subsidiaries are generallymeasured using local currencies as the functional currencies, including theBritish pound and the Euro. Assets and liabilities of these subsidiaries aretranslated into U.S. dollars at the exchange rate in effect at each reportingperiod. Income and expense items are translated at average exchange rates forthe period. The resulting translation adjustments are recorded in the foreigncurrency translation adjustment account. Optio and its subsidiaries conducttheir business locally, thus the effects of changes in foreign currencyexchange rates have had a minimal effect on the Company’s results of operationsto date.

**RESULTSOF OPERATIONS**

***ThreeMonths Ended July 31, 2006 Compared to Three Months Ended July 31, 2005***

## **Revenues**

The followingtable sets forth certain items from Optio’s condensed consolidated statementsof operations as a percentage of total revenue for the periods indicated.

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| ** **                                                                   | ** ** | **Three Months  Ended July 31,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                                        | ** ** | **2006** | ** ** |
| Revenue:                                                                     |       |                                            |       |   |   |
| License fees                                                                 |       | 35                                              | %          | 24 | % |
| Subscription  fees                                                           |       | 7                                               |       | 8 |   |
| Services,  maintenance and other                                             |       | 58                                              |       | 68 |   |
| Total revenue                                                                |       | 100                                             |       | 100 |   |
| Costs of revenue  (excluding depreciation and amortization, included below): |       |                                            |       |   |   |
| License fees                                                                 |       | 2                                               |       | 2 |   |
| Services, maintenance  and other                                             |       | 21                                              |       | 24 |   |
| Total cost of  revenue                                                       |       | 23                                              |       | 26 |   |
|                                                                         |       | 77                                              |       | 74 |   |
| Operating expenses:                                                          |       |                                            |       |   |   |
| Sales and  marketing                                                         |       | 37                                              |       | 38 |   |
| Research and  development                                                    |       | 18                                              |       | 21 |   |
| General and  administrative                                                  |       | 15                                              |       | 20 |   |
| Depreciation and  amortization                                               |       | 4                                               |       | 3 |   |
| Total operating  expenses                                                    |       | 74                                              |       | 82 |   |
| Income (loss) from  operations                                               |       | 3                                               |       | (8 | ) |
| Interest and other  income                                                   |       | —                                          |       | 2 |   |
| Income tax expense                                                           |       | —                                          |       | (1 | ) |
| Net income (loss)                                                            |       | 3                                               | %          | (7 | )% |

 

***Revenues***

Totalrevenues declined to $6.8 million in the three months ended July 31, 2006 from$7.4 million in the three months ended July 31, 2005.

*License fees*

Revenuesfrom software licenses decreased to $1.6 million in the three months ended July31, 2006 from $2.5 million for the three months ended July 31, 2005.  Optio has continued to see a decline in softwarelicense revenue from its document output management business. We anticipated anincrease in revenues from our business process management solutions; however,these products, while contributing to the quarter, have not generated revenueas quickly as we anticipated. Sales of Optio’s newer products, including OptioImaging Solutions, require a longer sales cycle than our traditional outputsolutions products. In addition, Optio had two significant contracts totalingover $700,000, that failed to close during the three months ended July 31,2006, but closed shortly after quarter end. Finally, Optio’s senior salesmanagement position experienced turnover, causing some disruption in the salescycle of select deals. The failure to close the two significant contracts,coupled with the slow revenue generating from our business process managementsolutions and sales management turnover, resulted in a significant decline insoftware license revenue between the three months ended July 31, 2006 and 2005.

Approximately$587,000 of Optio’s software license revenue during the three months ended July31, 2006 was derived from partners, such as resellers, value-added distributorsor OEM relationships, representing 

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36% of licenserevenue for Optio. During the three months ended July 31, 2005, Optio generated$630,000 of its software license revenue through partners, representing 24% ofOptio’s license revenue.

*Subscriptionfees*

Subscriptionrevenue increased to $560,000 in the three months ended July 31, 2006 from$526,000 in the three months ended July 31, 2005. Optio has signed additionalcontracts and additional modules for existing contracts, increasing the monthlyamount recognized on a subscription basis.

*Services, maintenance and other*

Revenues from services, maintenance and otherincreased to $4.6 million from $4.3 million during   the three months ended July 31, 2006 and2005, respectively. Services revenue decreased to $1.3 million from $1.5million for the three months ended July 31, 2006 and 2005, respectively.  A decline in software license revenuecontributed to a decline in associated consulting services revenue. Maintenancerevenue increased $500,000 to $3.3 million in the three months ended July 31,2006 from $2.8 million in the three months ended July 31, 2005. Maintenancerevenue continues to increase as Optio adds to its customer base and increasesthe price of its annual maintenance fees.

*Revenue Mix*

Revenue from licenses represented 24% of total revenuein the three months ended July 31, 2006 and 35% of total revenue in the threemonths ended July 31, 2005. Subscription revenue represented 8% and 7% of totalrevenue in the three months ended July 31, 2006 and 2005, respectively.   Services, maintenance and other revenueconstituted 68% and 58% of total revenue in the three months ended July 31,2006 and 2005, respectively. Revenue from licenses declined between the threemonths ended July 31, 2006 and 2005, thus causing the percentage of revenue toshift towards services, maintenance and other, which increased during thosesame periods.

 **Costs of Revenues**

Total costs of revenuesincreased slightly to  $1.8 million inthe three months ended July 31, 2006 from $1.7 million in the three monthsended July 31, 2005.

*Licenses*

Costs of revenues from licensesconsist of costs related to the packaging and distribution of the products,fees paid for integration of third-party software products and fees paid toreferral partners. Costs of revenues from licenses decreased to $146,000 in thethree months ended July 31, 2006 from $175,000 in the three months ended July31, 2005. Fees paid for the integration of third-party software productsdeclined approximately $20,000. Fewer products which include third-partysoftware were sold during the three months ended July 31, 2006, as compared tothe three months ended July 31, 2005, further reducing the costs of revenuefrom licenses.

*Services, Maintenance and Other*

Costs of revenues from services,maintenance and other consist of personnel, subcontracting and other expensesrelating to the cost of providing customer support, education and consultingand implementation services. Costs of revenues from services, maintenance andother remained consistent at $1.6 million for both 

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the three months ended July 31,2006 and 2005. Optio continued to keep a reduced number of internalimplementation staff and, as a result, Optio relied more heavily on externaloutsourcers. This resulted in a $114,000 increase in the cost of outsourcers inthe three months ended July 31, 2006 as compared to the three months ended July31, 2005. Alternatively, the cost of internal staff and their associated costsdecreased $31,000 between the periods July 31, 2006 and 2005.

**Operating Expenses**

*Sales and Marketing*

Sales and marketing expensesconsist primarily of salaries, commissions, bonuses and benefits earned bysales and marketing personnel, direct expenditures such as travel,communication and occupancy and marketing expenditures related to direct mail,trade shows and other advertising.

Sales and marketing expensesdecreased 7% to $2.5 million from $2.7 million for the three months ended July31, 2006 and 2005, respectively. Sales and marketing expenses were 38%and 37%, respectively, of total revenue for the same periods. Direct marketingexpenditures decreased $20,000 between the three months ended July 31, 2006 andthe three months ended July 31, 2005. In addition, commissions and bonusesdecreased approximately $170,000 between the two quarters. This decrease wasthe result of a decline in software license revenue and a modification to theCompany’s compensation plans, providing for lower commission rates until acertain level of productivity is achieved.

*Research and Development*

Research and development expense consists primarily ofsalaries, benefits and equipment for software developers, quality assurancepersonnel, and product managers.

Research and development expenses increased 4% to $1.4million for the three months ended July 31, 2006 from $1.3 million in the threemonths ended July 31, 2005.  Research anddevelopment salaries and associated benefits increased $70,000 between theperiods, primarily due to salary increases and not due to additional staff.

 *General and Administrative*

General and administrative expenses consist primarilyof salaries, benefits and related costs for executive, finance, human resourcesand information services personnel. General and administrative expenses alsoinclude legal, accounting, insurance and other professional services.

General and administrative expenses increased to $1.4million from $1.1 million in the three months ended July 31, 2006 and 2005,respectively. General and administrative expenses increased due to thefollowing: (i) $120,000 of compensation expense related to stock options withthe adoption of SFAS No. 123R, (ii) an increase of $45,000 in recruiting feesrelated to sales staff augmentation (iii) increased salaries of approximately$40,000 related to salary raises, (iv) bonuses paid of approximately $75,000,(v) increased other expenses such as bad debt expense and expendable equipmentof $50,000, offset by (vi) a decrease in legal fees of $80,000. Optio adoptedSFAS No. 123R as of February 1, 2006. This Statement requires companies toexpense the fair value of stock options over the related service period. AsSFAS No. 123R was adopted effective for the first quarter of fiscal 2007, nosuch expense is reflected in the first quarter of fiscal 2006.

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*Depreciation and Amortization*

Depreciation and amortization expense decreased to$200,000 from $243,000 for the three months ended July 31, 2006 and 2005,respectively. This decrease was primarily the result of a decrease inamortization expense as the intangibles are amortized over the estimated usefullife of the asset using the cash flow method, which results in a greaterexpense in the earlier periods.

*Interest Income*

Interest income increased to $113,000 in the threemonths ended July 31, 2006 from $60,000 in the three months ended July 31,2005. Interest income primarily represents interest earned on the principal ofthe M2 Systems’ note receivable and has increased due to an increase in theinterest rate on the note.

*Interest Expense*

Interest expense remained consistent at $2,000 in boththe three months ended July 31, 2006 and 2005. Interest expense primarilyrepresents the interest paid on Optio’s capital leases.

***SixMonths Ended July 31, 2006 Compared to Six Months Ended July 31, 2005***

## **Revenues**

The following table sets forth certain items from Optio’s statements ofoperations as a percentage of total revenue for the periods indicated.

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| ** **                                                                   | ** ** | **Six Months Ended  July 31,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                                      | ** ** | **2006** | ** ** |
| Revenue:                                                                     |       |                                          |       |   |   |
| License fees                                                                 |       | 34                                            | %          | 26 | % |
| Subscription  fees                                                           |       | 7                                             |       | 8 |   |
| Services,  maintenance and other                                             |       | 59                                            |       | 66 |   |
| Total revenue                                                                |       | 100                                           |       | 100 |   |
| Costs of revenue  (excluding depreciation and amortization, included below): |       |                                          |       |   |   |
| License fees                                                                 |       | 3                                             |       | 2 |   |
| Services,  maintenance and other                                             |       | 22                                            |       | 24 |   |
| Total cost of  revenue                                                       |       | 25                                            |       | 26 |   |
|                                                                         |       | 75                                            |       | 74 |   |
| Operating expenses:                                                          |       |                                          |       |   |   |
| Sales and  marketing                                                         |       | 39                                            |       | 37 |   |
| Research and  development                                                    |       | 18                                            |       | 20 |   |
| General and  administrative                                                  |       | 14                                            |       | 19 |   |
| Depreciation and  amortization                                               |       | 3                                             |       | 3 |   |
| Total operating  expenses                                                    |       | 74                                            |       | 79 |   |
| Income (loss) from  operations                                               |       | 1                                             |       | (5 | ) |
| Interest and other  income                                                   |       | —                                        |       | 1 |   |
| Income tax expense                                                           |       | —                                        |       | — |   |
| Net income (loss)                                                            |       | 1                                             | %          | (4 | )% |

 

**Revenues**

Totalrevenues declined to $13.6 million in the six months ended July 31, 2006 from$14.3 million in the six months ended July 31, 2005.

*License fees*

Revenuesfrom software licenses decreased to $3.5 million in the six months ended July31, 2006 from $4.8 million for the six months ended July 31, 2005.  Optio has continued to see a decline insoftware license revenue from its document output management business. Weanticipated an increase in revenues from our business process managementsolutions; however, these products, while contributing to the quarter, have notgenerated revenue as quickly as we anticipated. Sales of Optio’s newerproducts, including Optio Imaging Solutions, require a longer sales cycle thanour traditional output solutions products. During the six months ended July 31,2005, Optio entered into a single contract with a new customer valued at over$325,000 in software license revenue and three additional contracts over$100,000 in software license revenue. Alternatively, during the six monthsended July 31, 2006, Optio’s average contract size for new customers declined50%, in large part due to the fact that there were only two contracts over$100,000. Optio’s second quarter of fiscal year 2007 was also impacted by twoother factors: (i) Optio had two significant contracts that failed to close duringthe quarter ended July 31, 2006, but closed shortly after quarter end and (ii)turnover in the senior management sales position, causing disruption in thesales cycle of select deals.

Approximately$947,000 of Optio’s software license revenue during the six months ended July31, 

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2006 was derivedfrom partners, such as resellers, value-added distributors or OEMrelationships, representing 27% of license revenue for Optio. During the sixmonths ended July 31, 2005, Optio generated $1.2 million of its softwarelicense revenue through partners, representing 25% of Optio’s license revenue.As with direct sales, Optio entered into a single significant contract duringthe six months ended July 31, 2005, while there was no comparable agreement inthe six months ended July 31, 2006.

*Subscriptionfees*

Subscriptionrevenue increased to $1.1 million in the six months ended July 31, 2006 from$1.0 million in the six months ended July 31, 2005. Optio has signed additionalcontracts and additional modules for existing contracts, increasing the monthlyamount recognized on a subscription basis.

*Services, maintenance and other*

Revenues from services,maintenance and other increased to $9.0 million from $8.5 million during   the six months ended July 31, 2006 and 2005,respectively. Services revenue decreased to $2.5 million from $2.8 million forthe three months ended July 31, 2006 and 2005, respectively.  A decline in software license revenuecontributed to a decline in associated consulting services revenue. Maintenancerevenue increased $700,000 to $6.4 million in the six months ended July 31,2006 from $5.7 million in the three months ended July 31, 2005. Maintenancerevenue continues to increase as Optio adds to its customer base and increasesthe price of its annual maintenance fees.

*Revenue Mix*

Revenue from licensesrepresented 26% of total revenue in the six months ended July 31, 2006 and 34%of total revenue in the six months ended July 31, 2005. Subscription revenuerepresented 8% and 7% of total revenue in the six months ended July 31, 2006and 2005, respectively.   Services,maintenance and other revenue constituted 66% and 59% of total revenue in thesix months ended July 31, 2006 and 2005, respectively. Revenue from licensesdeclined between the six months ended July 31, 2006 and 2005, thus causing thepercentage of revenue to shift towards services, maintenance and other, whichincreased during those same periods.

 **Costs of Revenues**

Total costs of revenuesincreased slightly to  $3.6 million inthe six months ended July 31, 2006 from $3.5 million in the six months endedJuly 31, 2005.

*Licenses*

Costs of revenues from licensesdecreased to $278,000 in the six months ended July 31, 2006 from $357,000 inthe six months ended July 31, 2005. Fees paid for the integration ofthird-party software products declined approximately $75,000. Fewer productswhich include third-party software were sold during the six months ended July31, 2006, as compared to the six months ended July 31, 2005.

*Services, Maintenance and Other*

Costs of revenues from services,maintenance and other increased to $3.3 million in the six months ended July31, 2006 from $3.2 million in the six months ended July 31, 2005. Optiocontinued to keep a reduced number of internal implementation staff and, as aresult, Optio relied more heavily on external 

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outsourcers. This resulted in a$190,000 increase in the cost of outsourcers in the six months ended July 31,2006 as compared to the six months ended July 31, 2005. Alternatively, the costof internal staff and their associated costs decreased $45,000 between theperiods July 31, 2006 and 2005.

**Operating Expenses**

*Sales and Marketing*

Sales and marketing expensesdecreased 9% to $5.1 million from $5.6 million for the six months ended July31, 2006 and 2005, respectively. Sales and marketing expenses were 37%and 39%, respectively, of total revenue for the same periods. Direct marketingexpenditures decreased $80,000 between the six months ended July 31, 2006 andthe six months ended July 31, 2005. In addition, commissions and bonusesdecreased approximately $345,000 between the two quarters. This decrease wasthe result of a decline in software license revenue and a modification to theCompany’s compensation plans, providing for lower commission rates until a certainlevel of productivity is achieved.

*Research and Development*

Research and development expenses increased 4% to $2.7million for the six months ended July 31, 2006 from $2.6 million in the sixmonths ended July 31, 2005.  Research anddevelopment salaries and associated benefits increased $80,000 between theperiods, primarily due to salary increases and not due to additional staff.

 *General and Administrative*

General and administrative expenses increased to $2.5million from $2.0 million in the six months ended July 31, 2006 and 2005,respectively. General and administrative expenses increased due to thefollowing: (i) $200,000 of compensation expense related to stock options, (ii)an increase of $145,000 in recruiting fees related to sales staff augmentation(iii) increased salaries of approximately $75,000, (v) bonuses paid of $75,000,offset by (vi) a decrease in legal fees of $90,000. Optio adopted SFAS No. 123Ras of February 1, 2006. This statement requires companies to expense the fairvalue of stock options over the related service period. As SFAS No. 123R wasadopted effective for the first quarter of fiscal 2007, no such expense isreflected in the first half of fiscal 2006.

*Depreciation and Amortization*

Depreciation and amortization expense decreased to$384,000 from $431,000 for the six months ended July 31, 2006 and 2005,respectively. This decrease was primarily the result of a decrease inamortization expense as the intangibles are amortized over the estimated usefullife of the asset using the cash flow method, which results in a greaterexpense in the earlier periods.

*Interest Income*

Interest income increased to $209,000 in the sixmonths ended July 31, 2006 from $116,000 in the six months ended July 31, 2005.Interest income primarily represents interest earned on the principal of the M2Systems’ note receivable and has increased due to an increase in the interestrate on the note.

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*Interest Expense*

Interest expense was $3,000 and $4,000 in the sixmonths ended July 31, 2006 and 2005, respectively. Interest expense primarilyrepresents the interest paid on Optio’s capital leases.

**LIQUIDITY ANDCAPITAL RESOURCES**

Optio had $8.5million and $8.0 million in cash and cash equivalents at July 31, 2006 andJanuary 31, 2006, respectively.

The followingtable sets forth certain selected statements of cash flow information for thesix months ended July 31, 2006:
| Net cash provided by  operations           |   | $        | 546,000 |   |
|--------------------------------------------|--------|----------|---------|--------|
| Net cash used in  investing activities     |   | (410,000 | )       |
| Net cash  provided by financing activities |   | 297,000  |    |
| Net increase in cash  and cash equivalents |   | 519,000  |    |

 

Cash provided by operations wasprimarily the result of a $504,000 net loss, plus a $654,000 add-back ofnon-cash depreciation and amortization expense, stock compensation, loss ondisposal of assets, provision for doubtful accounts and provision for deferredtaxes, less changes in working capital resulting in a $396,000 inflow of cash.The major component of such working capital changes was the Company’s use offunds to pay down accrued expenses and accounts payable by approximately$779,000, primarily representing the payment of Optio’s year-end commissionsand bonuses and other year-end accrued liabilities such as audit fees. Inaddition, Optio prepaid several of its renewed insurance policies and othermarketing expenses, resulting in a $141,000 cash outflow. This amount waspartially offset by a decline in accounts receivable from the collection ofseveral large receivables outstanding as of January 31, 2006, resulting inadditional cash inflow of $1.6 million. In investing activities, Optio received$147,000 in payments on the receivable from M2 Systems, purchased $482,000 ofproperty and equipment, primarily related to the remodeling of Optio’sheadquarter office space and paid $75,000 in conditional payments related tothe purchase of VertiSoft Corporation. Optio’s financing activities includedreceipts of $300,000 from the exercise of stock options.

On April 27, 2005, Optio extended its existing line of credit throughApril 19, 2006. Subsequently, on April 21, 2006, Optio extended the line ofcredit through April 19, 2007. The line of credit bears interest at prime rate,subject to increase based on Optio’s performance relative to certain financialratios.  Optio may borrow up to $4.0million, or such lesser amount as may be determined based on the level ofeligible accounts receivable.  Currently,Optio has estimated that approximately $2.0 million would be available forborrowings based upon Optio’s historical accounts receivable balance. Accountsreceivable, equipment, general intangibles and other assets, as defined in theloan agreement, collateralize the line of credit. The loan agreement containsvarious covenants, including liquidity and earnings before interest, taxes,depreciation and amortization (“EBITDA”) requirements and restrictions on thepayment of dividends. On December 4, 2003, the line of credit was amended,effective April 30, 2003, to modify the calculation of certain financial ratiosto exclude any impairment charges related to the M2 Systems’ note receivable.As of July 31, 2006, Optio was in compliance with the required financialratios. There were no borrowings under the line of credit as of July 31, 2006.

The Company holdsa note receivable from M2 Systems as partial consideration for the sale ofMuscato and TransLink. The payment schedule of the note requires four quarterlyinstallments of $100,000, including interest calculated at the prime rate, upto a maximum of 6.75% (6.75% as of July 31, 2006), through 

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January 31, 2004,four quarterly payments of $115,000, including interest, through January 31,2005, and eleven quarterly payments of $120,000 through October 31, 2007. Thebalance of the note, plus any additional accrued interest, is to be paid in thequarter ending January 31, 2008. Should the note become uncollectible, Optio’sliquidity would be negatively impacted by the amount of the remaininginstallment payments, as reflected above.

Managementbelieves that the existing cash and cash equivalents, together with the line ofcredit, will provide adequate cash to fund its anticipated cash needs at leastthrough the next twelve months. Optio intends to expand its product line, whichmay require acquisitions of companies or products that enhance the Company’sproduct line. As a result, Optio may attempt to raise additional funds throughequity or debt financing. There can be no assurance that Optio will be able toraise additional funds on favorable terms, or at all. Although not anticipated,a dramatic decrease in demand for Optio’s products or services, or a dramaticchange in technology related to Optio’s products or services offered, couldhave a negative impact on Optio’s liquidity. This risk may include thepotential for Optio not meeting its debt covenant requirements, making anyborrowings under the line of credit unavailable.

**NewAccounting Pronouncements**

In June 2006, theFASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes-an interpretation of SFAS No. 109” (“FIN 48”). FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in financial statementsin accordance with SFAS No. 109, and recommends a recognition threshold andmeasurement characteristic for financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return. Thedifferences between a tax position taken in a tax return and amounts recognizedin the financial statements may result in an increase in a liability for incometaxes payable, a reduction of an income tax refund receivable, a reduction in adeferred tax asset or an increase in a deferred tax liability. FIN 48 alsoprovides guidance on classification, interest and penalties, accounting ininterim periods, disclosure, and transition. FIN 48 is effective for fiscalyears beginning after December 16, 2006, with early adoption encouraged. TheCompany intends to adopt FIN 48 on February 1, 2008. The Company does notexpect that the adoption of FIN 48 will have a material impact on its resultsof operations or financial position.

ITEM 3.** **QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Optio provides itsservices to customers primarily in the United States and, to a lesser extent,in Europe and elsewhere throughout the world. As a result, Optio’s financialresults could be affected by various factors, such as changes in foreigncurrency exchange rates or weak economic conditions in foreign markets. Allsales are currently made in both U.S. dollars and local currencies. A strengtheningof the U.S. dollar or the weakening of these local currencies could make Optio’sproducts less competitive in foreign markets. Based upon the relative size ofOptio’s foreign operations, Optio believes its exposure to foreign currencyfluctuations is not a material risk. Optio’s interest income and expense aresensitive to changes in the general level of U.S. interest rates. Based onOptio’s cash equivalents balance and the nature of its outstanding debt, Optiobelieves its exposure to interest rate risk is not material.

ITEM 4.  CONTROLS AND PROCEDURES.

Our ChiefExecutive Officer and Chief Financial Officer have evaluated the effectivenessof our disclosure controls and procedures (as defined in Rule 13a-15(e) of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)) as of July31, 2006, and have concluded that, as of such date, our disclosure controls andprocedures are effective in ensuring that information required to be disclosedby us in the reports 

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that we file or submit underthe Exchange Act is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms. Our Chief ExecutiveOfficer and Chief Financial Officer also concluded that, as of July 31, 2006,our disclosure controls and procedures are effective in ensuring thatinformation required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,to allow timely decisions regarding required disclosure.

*Changesin Internal Controls*

There were nochanges in our internal controls over financial reporting that occurred duringthe quarter ended July 31, 2006, that have materially affected, or arereasonably likely to materially affect, our internal controls over financialreporting.

**PART II —OTHER INFORMATION**

ITEM 1. LEGALPROCEEDINGS

On November 13, 2001, a lawsuit styled Kevin Dewey vs.Optio Software, Inc., et. al. was filed in the United States District Court forthe Southern District of New York. The complaint was filed against theunderwriters in the Company’s initial public offering as well as Optio andcertain officers and directors of Optio, by a single plaintiff purportedly onbehalf of persons purchasing Optio’s common stock between December 14, 1999 andDecember 6, 2000. The lawsuit also seeks class action status. Optio is aco-defendant with approximately 300 other issuers in this suit. The complaintincludes allegations of violations of (i) Section 11 of the Securities Act of1933, as amended (the “Securities Act”), by all named defendants, (ii) Section12(a)(2) of the Securities Act by the underwriter defendants, (iii) Section 15of the Securities Act by the individual defendants, and (iv) Section 10(b) ofthe Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgatedthereunder by the underwriter defendants. The complaint alleges that Optio’sprospectus was materially false and misleading because it failed to disclose,among other things, that: (i) the underwriters had solicited and receivedexcessive and undisclosed commissions from certain investors in exchange forwhich the underwriters allocated to those investors material portions of alimited number of Optio shares issued in connection with the Optio initialpublic offering; and (ii) the underwriters had entered into agreements withcustomers whereby the underwriters agreed to allocate Optio shares to thosecustomers in the Optio initial public offering in exchange for which thecustomers agreed to purchase additional Optio shares in the aftermarket atpre-determined prices. The complaint seeks unspecified amounts as compensatorydamages as a result of Optio’s alleged actions, as well as punitive damages andreimbursement for the plaintiffs’ attorneys’ fees and associated costs andexpenses of the lawsuit. A proposal to settle the claims against Optio andother companies and individual defendants in the litigation was conditionallyaccepted by Optio. The completion of the settlement is subject to a number ofconditions, including Court approval. The Court preliminarily approved thesettlement on February 15, 2005, subject to certain modifications which arecurrently pending approval by the defendants. Under the settlement, theplaintiffs will dismiss and release all claims against participating defendantsin exchange for a contingent payment guaranty by the insurance companiescollectively responsible for insuring the issuers in the action. Optio maystill have yet undetermined exposure to the underwriters pursuant toindemnification provisions in the underwriting agreement entered into at thetime of the initial public offering. Under the guaranty, all of the insurersfor all the issuers will be required to pay an amount equal to $1.0 billionless any amounts ultimately collected by the plaintiffs from the underwriterdefendants in all of the pending cases. A settlement fairness hearing was heldon April 24, 2001, however no ruling has been issued yet by the Court. Therecan be no assurance that this proposed settlement will be approved andimplemented in its current form, or at all. The disposition of this matter islimited to Optio’s 

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$300,000 corporateinsurance deductible. The Company has completed payment of the insurancedeductible through payment of legal fees. Optio will have no additionalexposure unless the insurance companies become insolvent or unless Optio’sliability exceeds its policy limits through this matter or other matters. Optio’sinsurance companies currently have an A or AA rating. The range of loss, ifany, cannot be estimated and thus no potential loss is reflected in Optio’scondensed consolidated financial statements.

Managementbelieves that it has meritorious defenses in the foregoing matter and intendsto pursue its position vigorously.  Whilelitigation is inherently subject to many uncertainties, management does notbelieve that the outcome of this case will have a material adverse effect onthe financial position of Optio. However, depending on the amount and timing of an unfavorable resolutionof the lawsuit, it is possible that Optio’s financial condition, results ofoperation or liquidity could be materially affected.

In addition, Optiois party to routine litigation or administrative proceedings incidental to itsbusiness, none of which is believed by the Company to be likely to have amaterial effect on the financial condition, results of operations or liquidityof the Company.

ITEM 1A. RISKFACTORS

In addition to the otherinformation set forth in this report, the factors discussed under “Item 1A.Risk Factors” in Part I of the 2006 Annual Report could materially affect ourbusiness, financial condition or future results. The risks described in our2006 Annual Report are not the only risks facing our Company. Additional risksand uncertainties not currently known to us or that we currently deem to beimmaterial also may materially adversely affect our business, financialcondition or operating results.

ITEM 2.UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

Optio held itsAnnual Meeting of Shareholders on June 16, 2006.  There were present at the Annual Meeting in personor by proxy, holders of 21,200,496 shares of common stock entitled tovote.  The following directors wereelected and qualified, with the votes for each director being reflected below:
| **Name**      | ** ** | **Term**                                                                                         | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|---------------|------------|--------------------------------------------------------------------------------------------------|------------|---------------|------------|--------------------|------------|
| C. Wayne Cape |       | Class I term to expire on the date of the annual  meeting of shareholders to be held in 2009     |       | 20,919,819    |       | 280,677            |       |
| Jay A. Wolf   |       | Class I term to expire on the date of the annual  meeting of the shareholders to be held in 2009 |       | 21,154,441    |       | 46,055             |       |

 

The directorsholding office on the date of the meeting whose term had not expired remainedin office.  Such directors were David T.Leach, F. Barron Hughes and Ronald G. Diener. The Board of Directors of Optioincreased the number of directors to six on June 16, 2006 and Jeffrey Andersonwas appointed to fill the vacancy by the Board of Directors.

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The amendment ofthe Company’s Directors’ Stock Option Plan to change the number of shares ofCommon Stock subject to options to be granted each director from 10,000 foreach year of completed service to 5,000 for each full fiscal quarter ofcompleted service was ratified with 12, 054,359 affirmative votes cast, 309,053negative votes cast and 25,794 abstentions.

The appointment ofBDO Seidman, LLP as Optio Software, Inc.’s independent registered publicaccounting firm for the fiscal year ending January 31, 2007, was ratified with21,176,392 affirmative votes cast, 13,295 negative votes cast and 10,809abstentions.

ITEM 5. OTHERINFORMATION

None.

ITEM 6. EXHIBITS

(a)          Exhibits

31.1                           Certificationof CEO pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, asamended.

31.2                           Certificationof CFO pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, asamended.

32.1                           Certificationby CEO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906of the Sarbanes-Oxley Act of 2002.

32.2                           Certificationby CFO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906of the Sarbanes-Oxley Act of 2002.

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized on the 14th day of September,2006.

 
|   | OPTIO SOFTWARE, INC. |
|--------|----------------------|
|   |                 |
|   | By:                  | /s/ | C. Wayne Cape |   |
|   |                 | C. Wayne Cape |
|   |                 | President and  Chief Executive Officer |

 

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