UNITED
STATESSECURITIESAND
EXCHANGE COMMISSION


Washington,
D.C. 20549









FORM
10-K







(Mark
      One)ý
                                ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
      OF
      THE SECURITIES EXCHANGE ACT OF 1934For
      the fiscal year ended December 31, 2008
      orr
                                TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
  For
the transition period from __________ to _____________
 Commission
file number 000-51384




InterMetro
Communications, Inc.


(Exact Name of
Registrant as Specified in its Charter)


Nevada
                  88-0476779(State
      ofIncorporation)
                  (IRS
      EmployerIdentification
      No.)




2685
Park Center Drive, Building A


Simi
Valley, California 93065


(Address
of principal executive offices) (Zip Code)




(805)
433-8000


(Registrant’s
telephone number, including area code)




______________




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




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




Common
Stock, $0.001 par value




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




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




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




Indicate
by check mark whether the registrant is a large accelerated file, an accelerated
file, a non-accelerated filer, or a smaller reporting company.  See
the definition of “large accelerated filer”, “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.




Large
accelerated filer       □                Accelerated
Filer       □            Non-accelerated
filer    □            Smaller
reporting company    x




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes   ̈  No  ý




The
aggregate market value of voting stock held by non-affiliates of the registrant,
based upon the average of the bid and ask prices reported by the OTC Bulletin
Board on March 31, 2009, was approximately $361,000.




There
were 65,643,901 shares outstanding of the registrant’s Common Stock as
of  March 31, 2009.




Table of Contents




CAUTIONARY
STATEMENT PURSUANT TO SAFE HARBOR PROVISIONS OF THE PRIVATE


SECURITIES
LITIGATION REFORM ACT OF 1995




THIS
ANNUAL REPORT ON FORM 10-KSB AND THE INFORMATION INCORPORATED BY REFERENCE MAY
INCLUDE “FORWARD-LOOKING STATEMENTS” WITHIN THE MEANING OF SECTION 27A OF THE
SECURITIES ACT AND SECTION 21E OF THE EXCHANGE ACT. THE COMPANY INTENDS THE
FORWARD-LOOKING STATEMENTS TO BE COVERED BY THE SAFE HARBOR PROVISIONS FOR
FORWARD-LOOKING STATEMENTS. ALL STATEMENTS REGARDING THE COMPANY’S EXPECTED
FINANCIAL POSITION AND OPERATING RESULTS, ITS BUSINESS STRATEGY, ITS FINANCING
PLANS AND THE OUTCOME OF ANY CONTINGENCIES ARE FORWARD-LOOKING STATEMENTS. THE
FORWARD-LOOKING STATEMENTS ARE BASED ON CURRENT ESTIMATES AND PROJECTIONS ABOUT
OUR INDUSTRY AND OUR BUSINESS. WORDS SUCH AS “ANTICIPATES,” “EXPECTS,”
“INTENDS,” “PLANS,” “BELIEVES,” “SEEKS,” “ESTIMATES,” VARIATIONS OF SUCH WORDS
AND SIMILAR EXPRESSIONS ARE INTENDED TO IDENTIFY SUCH FORWARD-LOOKING
STATEMENTS. THE FORWARD-LOOKING STATEMENTS ARE SUBJECT TO RISKS AND
UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE
SET FORTH OR IMPLIED BY ANY FORWARD LOOKING STATEMENTS. THE COMPANY ASSUMES NO
OBLIGATION TO UPDATE PUBLICLY THE FORWARD-LOOKING STATEMENTS CONTAINED HEREIN,
WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OR OTHERWISE, EXCEPT AS
MAY BE REQUIRED BY LAW.







Table of Contents







TABLEOF CONTENTS





PagePART
      IItem
      1.
                  Description of Business
                  
                  1Item
      1A.
                  Risk Factors
                  
                  7Item
      2.
                  Description of Property
                  
                  17Item
      3.
                  Legal Proceedings
                  
                  17Item
      4.
                  Submission of Matters to a Vote of Security
      Holders
                  
                  18PART
      IIItem
      5.
                  Market for Common Equity and Related Shareholder
      Matters
                  
                  19Item
      6.
                  Management’s Discussion and Analysis of Results of Operations
      and Financial Condition
                  
                  21Item
      7.
                  Financial Statements of InterMetro Communications,
      Inc.
                  
                  30Item
      8.
                  Changes in and Disagreements with Accountants on Accounting and
      Financial Disclosure
                  
                  30Item
      8a.
                  Controls and Procedures
                  
                  30Item
      8b.
                  Other Information
                  
                  31PART
      IIIItem
      9.
                  Directors,
      Executive Officers, Promoters and Control Persons; Compliance withSection
      16(a) of Exchange Act
                  
                  32Item
      10.
                  Executive Compensation
                  
                  35Item
      11.
                  Security
      Ownership of Certain Beneficial Owners and Management and RelatedStockholder
      Matters
                  
                  37Item
      12.
                  Certain Relationships and Related Transactions, and Director
      Independence
                  
                  39Item
      13.
                  Exhibits
                  
                  40Item
      14.
                  Principal Accountant Fees and Services
                  
                  41SIGNATURES
                  
                  42









i
 Table of Contents




PART
I




Item1. Description of Business




General




We have
built a national, private, proprietary voice-over Internet Protocol, or VoIP,
network infrastructure offering an alternative to traditional long distance
network providers. We use our network infrastructure to deliver voice calling
services to traditional long distance carriers, broadband phone companies, VoIP
service providers, wireless providers, other communications companies and end
users. Our VoIP network utilizes proprietary software, configurations and
processes, advanced Internet Protocol, or IP, switching equipment and
fiber-optic lines to deliver carrier-quality VoIP services that can be
substituted transparently for traditional long distance services. Based on the
ability to compress data transported across VoIP infrastructures and lower
capital cost per equivalent equipment capacity, we believe that VoIP technology
is generally more cost efficient than the circuit-based technologies
predominately used in existing long distance networks. In addition, traditional
circuit based switches typically use proprietary embedded call control systems.
In contrast, we believe VoIP technology, which uses software specifically
developed to facilitate the sharing of data across different systems, makes it
easier to integrate with enhanced IP communications services such as web-enabled
phone call dialing, unified messaging and video conferencing
services.




We focus
on providing the national transport component of voice services over our private
VoIP infrastructure. This entails connecting phone calls of carriers or end
users, such as wireless subscribers, residential customers and broadband phone
users, in one metropolitan market to carriers or end users in a second
metropolitan market by carrying them over our VoIP infrastructure. We compress
the phone calls on our network allowing us to carry up to approximately eight
times the number of calls carried by a traditional long distance company over an
equivalent amount of bandwidth. In addition, we believe our VoIP equipment costs
significantly less than traditional long distance equipment based on the cost
per equivalent voice port capacity and is less expensive to operate and maintain
based on lower electricity needs, smaller space requirements and fewer engineers
to operate. Our proprietary software and hardware configuration enables us to
quickly, without modifying the existing network, add equipment that increases
our geographic coverage and calling capacity.




During
2006, we enhanced our network’s functionality by implementing Signaling System
7, or SS-7, technology. SS-7 allows access to customers of the local telephone
companies, as well as customers of wireless carriers. SS-7 is the established
industry standard for reliable call completion, and it also provides
interoperability between our VoIP infrastructure and traditional telephone
company networks.




Historically,
VoIP services have been hampered by poor sound quality and by lack of
interoperability with traditional circuit-based phone devices. Our private,
managed network design, as opposed to use of the unmanaged public Internet,
gives us a high level of control of sound quality and we have designed internal
software that provides access to our infrastructure from traditional phone
devices. Our network services allow our customers to reduce costs while taking
advantage of access to useful information about their voice traffic and can be
easily accessed with both traditional phone devices and new IP-based devices,
such as broadband IP phones, IP videophones and wireless IP phones.




Our VoIP
infrastructure delivers significant benefits to our customers,
including:




·
            increasing
      the margins earned from existing retail voice services or reducing the
      costs of using voice services;




·
            improving
      customer service through access to real-time information about network
      performance and billing;




·
            reducing
      the administrative burden of managing end users for our carrier
      customers;




·
            increasing
      the investment return on customer owned traditional circuit-based
      equipment; and




·
            enabling
      the creation of value-added enhanced voice
  services.




Our goal
is to displace the current long distance carriers as the presumed choice for
voice transport services. We also intend to become a significant provider of
VoIP infrastructure services for traditional phone companies and wireless
carriers, as well as new high growth entrants in the consumer voice services
market such as broadband phone companies and cable operators. We also package
our VoIP services into calling cards and prepaid services. We have developed
plug-and-play technology designed to enable IP devices, such as broadband phones
and videophones, to be plugged directly into end users’ broadband internet
routers, allowing for instant use of our services without having to configure
the device or install any software to interoperate with our network. These
technologies are expected to be sold under private label third-party
arrangements.  We sell our services through our direct sales force and
independent sales agents. Our calling cards and prepaid services are primarily
sold by our retail distribution partners. We believe that our proprietary
technology and management experience in the communications industry, and in
particular with VoIP, will enable us to benefit from the adoption of VoIP
technologies by traditional phone companies. The wide-spread adoption of VoIP in
the telecommunications industry may not materialize, however, and our business
may not benefit from any adoption that does occur




1
 Table of Contents




Company
Background




InterMetro
Communications, Inc. (hereinafter, “we,” “us,”  “InterMetro” or the
“Company”) is a Nevada corporation which, through its wholly owned subsidiary,
InterMetro Communications, Inc. (Delaware) (hereinafter, “InterMetro Delaware”),
is engaged in the business of providing voice over Internet Protocol (“VoIP”)
communications services. On December 29, 2006, InterMetro, a public “shell”
company, completed a Business Combination with InterMetro Delaware whereby
InterMetro Delaware became our wholly-owned subsidiary.  On the
closing of the Business Combination, we authorized the issuance of 27,490,194
shares of common stock and 3,652,842 common stock purchase warrants to the
InterMetro Delaware security holders. On May 31, 2007, the Company filed Amended
and Restated Articles of Incorporation increasing the Company’s authorized
shares of common stock to 150,000,000, par value $0.001 per share, at
which time the second phase of 14,049,580 shares of common stock and 2,983,335
common stock purchase warrants were effectively issued in exchange for all of
the remaining InterMetro Delaware common stock and warrants held by InterMetro
Delaware security holders. All InterMetro Delaware securities were effectively
cancelled except 100 shares of InterMetro Delaware common stock which represent
100% of the outstanding stock of the wholly-owned subsidiary.




InterMetro
Delaware was originally incorporated in the State of California on July 22,
2003 to build a communications business based on VoIP technology and was
reincorporated in Delaware on May 10, 2006.




Material
Acquisitions, Private Placements of Securities and Agreements





Acquisition of
Advanced Tel, Inc.  In March 2006, we acquired
all of the outstanding stock of Advanced Tel, Inc. (“ATI”), a switchless
reseller of wholesale long-distance services, for a combination of stock and
cash. ATI was acquired to increase our customer base, to add minutes to our
network and to access new sales channels. The initial purchase price included
308,079 shares of our common stock, as adjusted for the Business Combination, a
promissory note payable of $250,000 to be paid over the six-month period
following the closing and a two-year unsecured promissory note in an amount tied
to ATI’s working capital of $150,000. The amount of common stock consideration
paid to the selling shareholder of ATI is subject (or the payment of additional
cash in lieu thereof at our option) to an adjustment during the two years
following the closing date. The value of this guarantee has been included in our
determination of the purchase price of the ATI acquisition. ATI’s selling
shareholder may earn an additional 308,079 shares of our common stock, as
adjusted for the Business Combination, and additional cash amounts during the
two-year period following the closing upon meeting certain performance targets
tied to revenue and profitability.In December 2008, the
Company issued 4,089,930 shares of common stock to the President of ATI as a
result of an earn-out evaluation performed by the Company.  This
valuation ascribed a value to the common stock of $611,043.




Private Placement
of Securities – November 2007 to June 2008.In November and December
2007, the Company received $600,000 pursuant to the sale of secured notes with
individual investors for general working capital. These funds were received
prior to the closing of the sale of the secured notes, which occurred on January
16, 2008.  The Company sold an additional amount of the same secured
notes totaling $1,320,000 in the period between January and June 2008, and can
continue to sell similar secured notes up to a maximum offering of $3 million.
The secured notes mature 13 to 18 months after issuance and bear interest at a
rate of 13% per annum due at the maturity date.  The secured notes are
secured by substantially all of the assets of the Company.  In connection
with the notes, the Company issued two common stock purchase warrants for
every dollar received or 3.84 million common stock purchase warrants with an
exercise price of $1.00, 1.92 million of which expire on January 16, 2013 (the
“Initial Warrants”) and 1.92 million of which expire on February 1, 2014 (the
“Additional Warrants”).  With respect to 1.92 million Initial Warrants
issued in this financing, if such warrants are still held by the lenders at
February 1, 2009, the lenders will be entitled to receive a payment (the
“Reference Payment”) to the extent that the volume weighted average price per
share for the 30 trading days ending January 30, 2009 (the “Reference Price”) is
less than $1.00.  The Reference Payment will be equal to the difference
between $1.00 and the Reference Price.  The Company, in its sole
discretion, will have the right, but not the obligation, to make this payment by
issuing Common Stock, in lieu of cash, but in no event will the amount of stock
issued be more than one share per dollar invested by the lenders.With respect to the
remaining 1.92 million Additional Warrants issued in this financing, if
such warrants are still held by the lenders at February 10, 2009, the lenders
will be entitled to receive a payment (the “Second Reference Payment”) to the
extent that the volume weighted average price per share for the 30 trading days
ending January 30, 2009 (the “Second Reference Price”) is less than $2.00. 
The Second Reference Payment will be equal to the difference between $2.00 and
the Second Reference Price up to a maximum value of $1.00.  The Company, in
its sole discretion, will have the right, but not the obligation, to make this
payment by issuing Common Stock, in lieu of cash, but in no event will the
amount of stock issued be more than one share per dollar invested by the
lenders.




Private Placement
of Securities – April 2008.In April 2008 the Company
entered into a revolving credit agreement, effective as of April 30, 2008 (see
Note 11 to the Consolidated Financial Statements), pursuant to which the Company
originally could access funds up to $1,500,000. Such access increased to
$2,000,000 per Amendment No. 1 to the agreement in September 2008 and to
$2,400,000 per Amendment no. 2 to the agreement in November 2008.  As
part of the original transaction, the lender received warrants to purchase
2,000,000 shares of the Company’s common stock with an exercise price of $1.00
which expire on April 30, 2015.  As part of the 2 amendments the
lender received warrants to purchase an additional 4,000,000 shares of the
Company’s common stock under the same terms as the original 2,000,000
warrants.




Private Placement
of Securities –July 2008.In July 2008, the Company
issued 200,000 shares of stock pursuant to an agency agreement for services
related to potential financing activities, which had a fair value of
$100,000.




Our
Service Offerings




We use
our network backbone to deliver voice calling services to traditional long
distance carriers, broadband phone companies, VoIP service providers, wireless
providers, other communications companies and end users.




Carrier Services . Carrier
services consist of origination and termination services. Such services are
provided over our VoIP network constructed as a nationwide system of regional IP
nodes known as points-of-presence, or PoPs, connected by a fiber-optic backbone
and other bandwidth segments utilizing a secure packet technology called
asynchronous transfer mode, or ATM. Our PoPs are typically located in major
metropolitan cities and allow us to connect to a majority of the personal and
business telephones within a metropolitan geographic region.




Because
the network is based on IP technology, the network enables a significant amount
of information to be passed to our customers. This allows us to differentiate
our service from traditional wholesale voice providers by providing unique
real-time information along with enhanced voice services. Important uses for
this functionality include the ability to quickly identify misuse or fraud that
is occurring with a customer’s user base or to react more quickly to marketing
opportunities based on identifiable trends in traffic patterns.




2
 Table of Contents




We
believe our services offer our carrier customers a competitive advantage
by:




·
            providing
      an alternative to the large traditional network service providers that
      have influenced price and service
levels;




·
            increasing
      margins transparently by reducing direct network costs while maintaining
      or improving the quality of service received by their end
      users;




·
            providing
      access to our VoIP infrastructure without altering the physical connection
      process to a voice network and without any required investment in new
      equipment or software; and




·
            providing
      new functionality to reduce the cost of customer care and improve fraud
      detection.




Retail Services . Our retail
VoIP services are sold to consumers and distributed in the form of calling cards
or through the distribution of personal identification numbers, or PINs. Our
retail services integrate the installation of voice services with billing and
customer care functionality and voice and data applications such as on-demand
conferencing and find-me/follow-me service. We primarily distribute our services
through retail distribution partners who keep a portion of the retail revenue.
We have created an automated system for activating and recharging our retail
products. We believe our automation significantly lowers costs for retail
distribution partners. For example, our automated PIN generating system replaces
the need for point of sale terminals which charge per sale transaction fees and
require initial integration and software setup.




Our VoIP
network is highly flexible and allows our retail distribution partners to design
voice products that fit the needs of their underlying end users. Our VoIP
network allows our retail distribution partners to take advantage of their brand
name recognition and customer loyalty.




We
believe our services offer end users and retail distribution partners attractive
solutions by:




·
            allowing
      for delivery of “ready-to-shelf” customized voice service products
      tailored specifically to our retail distribution partners’ end user
      demographics; and




·
            providing
      access to our VoIP network allowing retail customers to use their existing
      telephones with no requirement to purchase new equipment or software and
      without the need for broadband
access.




IP Devices . We expect to
enter into arrangements with one or more distribution partners under which they
would sell plug-and-play product devices which do not require additional
software. These devices would be purchased from manufacturers and would be
configured to work exclusively with our network. We have developed three IP
devices — the Broadband MetroFone, the VideoLine MetroFone, and the DialLine
MetroFone. We do not currently generate any revenue from these
products.




·
            Broadband MetroFone .
      The Broadband MetroFone looks and operates like a traditional phone but
      will use a customer’s broadband internet connection and our network to
      complete calls as compared to traditional phone calls which travel over
      low bandwidth copper line networks.




·
            VideoLine MetroFone .
      The VideoLine MetroFone operates in the same manner as the Broadband
      MetroFone but has the additional capability of sending and receiving
      real-time television quality video between any of our
      videophones.




·
            DialLine MetroFone .
      The DialLine MetroFone is an IP device, which connects between a retail
      customer’s phone and wall jack and automatically connects a retail
      customer with our network.




Web-Services . We are in the
process of developing a web-service offering. Web-services allow voice to be
embedded in applications so that end users can move seamlessly between voice and
data communications streams.




Technology
and Network Infrastructure




Our
state-of-the-art proprietary VoIP network is comprised of three basic
components: switching equipment, software and network facilities. Our VoIP
switching equipment is manufactured by leading telecommunications industry
equipment manufacturers, and enables us to manage voice and data traffic and the
associated billing information. Our software applications, including both third
party software and internally developed proprietary software, allow for
web-based control of our VoIP switching platform and access to data gathered by
our VoIP switches. We and our customers utilize this advanced functionality to
monitor network performance, capacity utilization and traffic patterns, among
other metrics, in real-time. Our IP-based core network facilities provide an
efficient physical transport layer for voice and data traffic, and are
supplemented by other carriers’ networks to provide extensive domestic and
international coverage.




The
geographic markets serviced by our VoIP infrastructure are connected by leased
fiber lines and private IP circuits. In many geographic markets we have leased
collocation facilities where we have installed our ATM/MPLS switching equipment
which is used to interconnect these fiber lines and IP circuits. This equipment
interconnects to the fiber lines running between markets in the network and our
VoIP gateway equipment. The VoIP gateway equipment performs analog-to-digital
conversion and compression of IP voice. The network is designed to be redundant
and self-healing, so that isolated events do not disrupt overall service. Our
proprietary software and hardware configuration enables us to quickly, without
modifying the existing network, add equipment that increases our geographic
coverage and calling capacity.




Our
network switching system is configured to connect to carrier customers by
connecting their switches with ours via traditional circuit-switched
connections, or increasingly, through private and public IP connections. We also
connect to local exchange carriers through traditional circuit-switched
connections so that retail customers can gain access to our services through
their existing telephones and telecommunications devices.




3
 Table of Contents




We
believe that our competitive advantage includes the ability to incorporate
software applications into our VoIP network. This allows us to provide enhanced
functionality and customer service tools. Our VoIP switching system has an
application programming interface to allow for the creation of software
application tools to create the enhanced control and functionality features. Our
engineering team has extensive experience in implementing value-added
applications that allow for greater flexibility in creating services and greater
control over network efficiencies and costs. We have developed technology to
provide control of the network and access to network utilization data to us and
to our customers. Customers can access their own customer service web interfaces
that can be used for operations, such as rate modification, customer activation
and deactivation, fraud/abuse detection and capacity utilization, among other
services. Customers can also utilize the interfaces to control costs by managing
traffic flow to their various network vendors, allowing them to least cost route
in the same way as large telecommunications companies.




Service
Developments




We
implemented technology to connect our network directly to local telephone
companies and wireless networks in the major metropolitan markets that we serve
through the addition of SS-7 capabilities to our VoIP infrastructure. SS-7
technology allows direct access to customers of local telephone companies. Prior
to the SS-7 implementation, we primarily connected to competitive local exchange
carriers, or CLECs, in each metropolitan market which in turn connected to the
local telephone company in that market.




The
combination of SS-7 technology and direct local telephone company
interconnections allows us to offer additional services to our customers and we
believe makes it easier for potential customers that use long distance companies
to transition their voice traffic to our VoIP network. The SS-7 technology also
allows us to offer an increased number of services and enhances our ability to
develop new services. We began connecting to the local telephone company
networks through the purchase of a significant amount of recurring fixed-cost
network interconnection capacity in late 2005 in anticipation of future growth.
In March 2006, we began utilizing the SS-7 connections to provide
services




Sales,
Marketing and Distribution




Carrier Services Sales
Strategy . We employ a direct sales approach for carrier sales, which is
led by experienced sales professionals with detailed knowledge of the carrier
industry. We provide product knowledge, product application consulting, pricing,
delivery, and performance information to potential customers so that they are
able to help us design services that meet their needs. As we expect to expand
the resources of our sales department, sales professionals will be increasingly
focused on customer, channel, and geographic levels that are intended to allow
us to manage the sales cycle more efficiently. We currently target traditional
purchasers of wholesale voice transport services including: inter-exchange
carriers, international-based carriers sending voice calls to the U.S., wireless
carriers, prepaid service providers, internet-based voice service providers,
such as broadband phone companies and cable companies.




We
complement our direct sales force with an agent-based sales channel. Through the
use of sales agents we reach a larger universe of potential customers. The agent
community in the telecommunication industry is large and well-established. A
typical agent promotes solutions from a variety of service providers into the
carrier buying community. Agents act as telecommunications consultants to the
customer, create long-term relationships and develop contacts within
organizations. A key role of the agent is to advise the customer of various
providers’ offerings.




Retail Services Sales
Strategy . We package our VoIP services into calling card and other
prepaid services and PIN products sold to retail customers of voice services.
These VoIP services are sold through retail distribution partners, including
general merchandise and discount retail chains, and do not require distributors
to invest in any new technology or to understand the underlying technologies
required to service and bill voice products. We enter into agreements with our
retail distribution partners that define the terms under which they sell our
services.




We design
specific products for each retail distribution partner to improve adoption of
our services and to improve their profitability. Retail distributors of our VoIP
services collect the revenue from the sale of our products and pass on a
majority of the cash collected, holding back a portion of the revenue as their
compensation for providing distribution services. We seek innovative ways to
expand the scope of our distribution channels and enhance our ability to
identify and retain distribution partners. In addition, we also intend to
cross-sell services through existing retail distribution partners.




Marketing Overview . We
create brand awareness and lead generation through our presence at key trade
shows, targeted mailings to specific industry carrier lists and buyers and trade
magazine advertising. Additionally, we maintain a web site presence and make
available collateral describing our services and business.




Competition




Carrier Services. When
selling to carrier customers, we primarily compete with other carriers,
including Verizon, Qwest and Global Crossing. We also compete with a number of
smaller IP-based providers that focus either on a specific product or set of
products or within a geographic region. We compete primarily on the basis of
transmission quality, network reliability, price and customer service and
support.




Retail Services. We compete
for retail distribution partners against long distance providers including
AT&T, MCI, Sprint and IDT who provide calling cards and prepaid services.
Retail distributors purchase these products based on price and private label
customization.




Our
Competitive Strengths




We
believe our highly flexible, scalable and secure VoIP infrastructure delivers
the cost and functionality benefits of VoIP technology to our customers. Since
inception, we have built our network on VoIP technology and do not have to make
investments to upgrade from less efficient circuit-based technology used by many
traditional carriers. We believe our VoIP network is robust and efficient, based
on redundancies in equipment and network transmission paths, and utilizes some
of the most advanced VoIP technology available.




We help
our carrier customers increase their margins by lowering the cost of their
wholesale voice transport usage, which enhances the economic value to them of
their existing end users. We help our retail customers access lower cost
VoIP-based solutions for their communications service needs by making our
services accessible through their existing residential and wireless phones. We
intend to continue investing in our VoIP infrastructure to improve and expand
our existing service offerings and to address the constantly evolving needs of
voice transport customers.




4
 Table of Contents




Our
competitive strengths include:




·
            State-of-the-art private VoIP
      infrastructure . We built our VoIP infrastructure from advanced IP
      technology. We are not burdened by some of the constraints commonly faced
      by traditional telecommunications companies that use circuit-based
      equipment. Legacy equipment is more difficult to combine with the latest
      add-on voice services and network transport technology because it
      typically uses proprietary embedded call control systems. We operate and
      maintain our VoIP technology with significantly less personnel and lower
      operating costs than switch-based technology achieving comparable
      capacity.




·
            Cost-efficient IP-based voice
      services . We believe our VoIP technology provides significant cost
      savings due to compression and routing efficiencies. In addition, we save
      money by using equipment that requires little space and significantly
      reduced electricity costs versus older circuit-switched equipment. Our
      management team has extensive experience in negotiating pricing and
      contract terms for these types of products and services. We pass a
      significant portion of our cost savings on to our customers to help drive
      sales growth.




·
            Experience marketing VoIP
      services . Our seasoned management team has significant experience
      with wireline and wireless telecommunications and experience with IP-based
      communications. Our knowledge of the VoIP industry, including familiarity
      with the hardware, software and vendors, allows us to advise potential
      customers on how to incorporate the technology to increase profitability
      and increase customer reach. Members of our management team have marketed
      VoIP services to a wide range of customers and have been instrumental in
      developing new products to meet individual customer
    demands.




·
            Product flexibility and speed
      of deployment . We believe our private network equipment provides a
      high level of integration between the installation of voice services and
      billing and customer care functions. We believe our VoIP technology
      software, specifically developed to facilitate the sharing of data across
      different systems, allows us to create and deploy new products more
      quickly than traditional communications companies. We also utilize our
      VoIP infrastructure to tailor retail products to the individual needs of
      our retail distribution partners.




·
            Strong engineering team with
      experience in both voice and data networking . Our engineering team
      is comprised of individuals with backgrounds in networking, software
      development, database administration and telecommunications installations.
      We believe that our engineering team is among the most experienced in
      understanding VoIP services and the related software applications. Members
      of our engineering team have successfully deployed leading-edge technology
      in prior businesses, including the build-outs of both a national web
      hosting service and a large IP-based voice service
  network.




Intellectual
      Property




Our
intellectual property is an important element of our business, but we believe
that our competitive advantage depends primarily on the experience of our
management team and the knowledge and skill of our engineering and technology
staff. Our management team and technical staff periodically review our
technological developments to identify core technology that provides us with a
competitive advantage. We rely on a combination of patent, copyright, trademark
and trade secret laws both domestically and internationally and confidentiality
procedures to protect our intellectual property rights. Further, our employees
and independent contractors are required to sign agreements acknowledging that
all inventions, trade secrets, copyrights, works of authorship, developments and
other processes generated by them on our behalf are our property, and assigning
to us any ownership that they may claim in those matters. Our standard form
agreements for carrier customers and retail distribution partners also contain
provisions designed to protect our intellectual property rights.




We are
the owners of one patent and two patent applications filed with the U.S. Patent
and Trademark Office. Our patent relates to a system for routing toll free
telephone calls. Both of our patent applications have been published. One patent
application relates to the technology which combines instant messenger services
with voice services. The other application relates to a method for transporting
voice calls utilizing a combination of Internet Protocol and Asynchronous
Transfer Mode. We are working with legal counsel to make all necessary filings
to advance the examination of both patent applications.




We are
the owner of numerous trademarks and service marks for telecommunication
services, phone cards, computer software, computer hardware, and telephone sets
and have applied for registration of our trademarks and service marks to
establish and protect our brand names as part of our intellectual property
strategy.




In
addition, we have non-exclusive license agreements with respect to technology
and related databases from third parties related to the operations of our VoIP
platform and the provision of certain service features. We believe our licenses
will be renewable or replaceable on commercially reasonable terms.




Governmental
Regulation




We are
subject to federal, state, local and foreign laws, regulations, and orders
affecting the rates, terms, and conditions of certain service and product
offerings, costs, and other aspects of operations, including relations with
other service providers. Regulation varies in each jurisdiction and may change
in response to judicial proceedings, legislative and administrative proposals,
government policies, competition, and technological developments.




The
Federal Communications Commission, or FCC, has jurisdiction over our facilities
and services to the extent they are used in the provision of interstate or
international communications services. State regulatory commissions, commonly
referred to as public service commissions or public utilities commissions, or
PSCs or PUCs, generally have jurisdiction over facilities and services to the
extent they are used in the provision of intrastate services. Local governments
may assert authority to regulate aspects of our business through zoning
requirements, permit or right-of-way procedures, taxation and franchise
requirements. Foreign laws and regulations apply to communications that
originate or terminate in a foreign country. Generally, the FCC and PSCs have
not regulated Internet, video conferencing, or certain data services, although
the underlying communications components of such offerings may be regulated. Our
operations also are subject to various environmental, building, safety, health,
and other governmental laws and regulations.




Federal
law generally preempts any inconsistent state or local statutes and regulations
that restrict the provision of competitive local, long distance and information
services. Consequently, we are generally free to provide a broad range of
communications services in every state. While this federal preemption greatly
increases our potential for growth, it also increases the amount of competition
to which we may be subject. It is also possible, despite the general federal
preemption, that state or local regulatory agencies will assert jurisdiction
over our services.




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IP-based
enhanced voice services are currently exempt from the reporting and pricing
restrictions placed on common carriers by the FCC. However, there are several
state and federal regulatory proceedings further defining what specific service
offerings qualify for this exemption. Due to the growing acceptance and
deployment of VoIP services, the FCC and a number of state PSCs are conducting
regulatory proceedings that could affect the regulatoryduties and rights of
entities that provide IP-based voice applications. There is regulatory
uncertainty as to the imposition of access charges, which are used to compensate
local exchange carriers to originate or terminate calls, and other taxes, fees
and surcharges on VoIP services, including those that use the public switched
telephone network. There is regulatory uncertainty as to the imposition of
traditional retail, common carrier regulation on VoIP products and
services.




The use
of the public Internet and private Internet protocol networks to provide voice
communications services, including VoIP, is a relatively recent market
development. The provision of such services is largely unregulated within the
U.S. There are, however, several pending FCC proceedings that will likely affect
the regulatory status of Internet telephony and other IP-enabled services.
Principal among them is an IP-Enabled Services rulemaking instituted on February
12, 2004, which will examine numerous regulatory issues relating to VoIP. The
FCC also has several pending declaratory rulings regarding the regulatory
classification of certain IP-enabled services or arrangements. We cannot predict
when the FCC may take action in these proceedings, or what action the FCC will
take. Any of these proceedings could have an adverse impact on our
business.




The
concept of net neutrality asserts that network operators should not be allowed
to charge content or application providers extra for faster delivery or other
preferential treatment. On August 5, 2005, the FCC adopted a policy statement
setting forth the following net neutrality guidelines: (1) consumers are
entitled to access the lawful Internet content of their choice; (2) consumers
are entitled to run applications and use services of their choice, subject to
the needs of law enforcement; (3) consumers are entitled to connect their choice
of legal devices that do not harm the network; and (4) consumers are entitled to
competition among network providers, application and service providers, and
content providers. Although the policy statement is not legally binding, it does
set forth the FCC’s current view on net neutrality. On March 22, 2007, the FCC
announced that it will issue a Notice of Inquiry to examine further the
practices of broadband network providers and whether the policy statement should
incorporate a new principle of nondiscrimination. Notwithstanding its earlier
stated policy statement, the FCC could reverse its position or decide not to
implement the policy in its on-going regulatory proceedings. Further, federal
legislation may also address net neutrality in a manner that requires, permits
or disallows the FCC to implement its stated net neutrality policy. Such
legislation could also require the FCC to modify its policy in whole or in part.
Because some of our VoIP products and services utilize the networks of third
parties, regulation and potential legislation concerning net neutrality could
impact our business. Further, some of our carrier customers rely, in part, on
the enforcement of net neutrality principles in order to offer their VoIP
services. If our carrier customers are adversely impacted by legislative or
regulatory action concerning net neutrality, it could also adversely impact
us.




On May
19, 2005, the FCC issued an order requiring interconnected VoIP service
providers to provide Enhanced 911 capabilities to their subscribers. The FCC
issued another order on August 5, 2005 requiring interconnected IP-based voice
service providers and network providers to comply with the Communications
Assistance for Law Enforcement Act (“CALEA”), which establishes federal
requirements for wiretapping and other electronic surveillance capabilities.
This order was upheld by the U.S. Court of Appeals for the D.C. Circuit on
June 9, 2006. The new requirements are scheduled to take effect on May 14,
2007. Although we intend to comply with CALEA, we may be required to expend
significant resources to do so. If we do not comply with CALEA, the FCC may
subject us to fines and penalties. Additionally, we were required to submit a
CALEA Monitoring Report on February 12, 2007 and a CALEA Systems Security Plan
on March 12, 2007, however, the reports were not timely filed with the FCC. The
FCC may subject us to fines and penalties if we fail to file the reports or
because we were late in filing the reports with the FCC.




The FCC
is also considering several petitions filed by individual companies concerning
the rights and obligations of providers of IP-based voice services, and networks
that handle IP-based voice traffic or that exchange that traffic with operators
of Public Switched Telephone Network, or PSTN, facilities.




State
PSCs are also conducting regulatory proceedings that could impact our rights and
obligations with respect to IP-based voice applications. Previously, the
Minnesota Public Utilities Commission, or the MPUC, ruled that Vonage’s
DigitalVoice service was a telephone service under state law, and ordered Vonage
to obtain state certification, file tariffs, and comply with 911 requirements
before continuing to offer the service in the state. Vonage filed a request in
the U.S. District Court for the District of Minnesota to enjoin the MPUC’s
decision. On October 16, 2003, a federal judge granted Vonage’s request for an
injunction, concluding that Vonage provides an information service immune from
state regulation and thereby barring the MPUC from enforcing its decision. On
December 22, 2004, the U.S. Court of Appeals for the Eighth Circuit affirmed the
District Court’s decision on the basis of the FCC’s determination that Vonage’s
service was interstate and noted that the MPUC would be free to challenge the
injunction if it or another party prevailed on an appeal of the FCC’s Vonage
order.




The
California Public Utilities Commission, or the CPUC, on February 11, 2004,
initiated a rulemaking about the appropriate regulatory framework to govern
VoIP. Among the issues the CPUC may consider is whether VoIP is subject to
CPUC’s regulatory authority, including whether VoIP providers should be required
to contribute to state universal service programs, whether VoIP providers should
be required to pay intrastate access charges, whether VoIP should be subject to
basic consumer protection rules, and whether exempting VoIP providers from
requirements applicable to traditional voice providers would create unfair
competitive advantages for VoIP providers.




Proceedings
and petitions relating to IP-based voice applications are also under
consideration in a number of other states, including but not limited to Alabama,
Kansas, New York, North Dakota, Missouri, Ohio, Oregon, Pennsylvania, Virginia,
Washington, and Wisconsin.




We cannot
predict the outcome of any of these petitions and regulatory proceedings or any
similar petitions and regulatory proceedings pending before the FCC or state
public utility commissions. Moreover, we cannot predict how their outcomes may
affect our operations or whether the FCC or state public utility commissions
will impose additional requirements, regulations or charges upon our provision
of IP communications services.




The
Communications Act of 1934 requires that every telecommunications carrier
contribute, on an equitable and non-discriminatory basis, to federal universal
service mechanisms established by the FCC, and the FCC also requires providers
of non-common carrier telecommunications to contribute to universal service,
subject to some exclusions and limitations. At present, these contributions are
calculated based on contributors’ interstate and international revenue derived
from U.S. end users for telecommunications or telecommunications services, as
those terms are defined under FCC regulations. The FCC invited public comment on
how to further reform the manner in which the FCC assesses carrier contributions
to the universal service fund including the standing of VoIP service providers
in regards to the universal service fund mechanism. On June 27, 2006, the FCC
released an order adopting interim modifications to its universal service rules
to require providers of interconnected VoIP services to contribute to the
Universal Service Fund. This order has been appealed to the U.S. Court of
Appeals for the D.C. Circuit, which appeal remains pending. We are unable to
predict whether the FCC’s interim rules will be upheld on appeal or made
permanent, or if they will be subject to further reconsideration or review nor
the cumulative effect of these rule changes on our business.




Changes
or uncertainties in the regulations applicable to our business and the
communications industry may negatively affect our business. If regulatory
approvals become a requirement, delays in receiving required regulatory
approvals may result in higher costs and lower revenues. Further, changes in
communications, trade, monetary, fiscal and tax policies in the U.S. may
negatively impact our results of operations.




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 Table of Contents




Employees




As of
December 31, 2008, we had 37 employees, all of whom were full time and located
in the United States. We have never had a work stoppage and none of our
employees is represented by a labor organization or under any collective
bargaining arrangements. We consider our employee relations to be
good.




Item1A. Risk Factors




Our
business is subject to a variety of risks and uncertainties, which are described
below. If any of these risks materialize, our business, financial condition or
operating results could be adversely affected. The risks described below are not
the only ones we face. Additional risks not currently known to us or that we
currently do not deem material also may become important factors that may
materially and adversely affect our business.




Risks
Related To Our Business




We
have a limited operating history, which could make it difficult to accurately
evaluate our business and prospects.




We began
offering VoIP services in March 2004. Accordingly, we have a limited operating
history and, as a result, we have limited financial data that you can use to
evaluate our business and prospects. In addition, we derive nearly all of our
revenue from VoIP services, which utilize a relatively new technology that has
undergone rapid changes in its short history. Our business model is also
evolving and it may not be successful. As a result of these factors, the future
revenue and income potential of our business is uncertain. Although we have
experienced revenue growth in the past, we have not been able to sustain this
growth. Any evaluation of our business and our prospects must be considered in
light of these factors and the risks and uncertainties often encountered by
companies in our stage of development. Some of these risks and uncertainties
relate to our ability to do the following:




·
            maintain
      and expand our current relationships, and develop new relationships, with
      carrier customers, retail distribution partners, network vendors and
      equipment providers;




·
            continue
      to grow our revenue and meet anticipated growth
  targets;




·
            manage
      our expanding operations and implement and improve our operational,
      financial and management controls;




·
            adapt
      to industry consolidation;




·
            continue
      to grow our sales force and marketing
efforts;




·
            successfully
      introduce new, and upgrade our existing, VoIP technologies and
      services;




·
            respond
      to government regulations and legislation relating to VoIP, traditional
      telecommunications services, the Internet, IP-based services and other
      aspects of our business;




·
            respond
      effectively to competition; and




·
            attract
      and retain qualified management and
employees.




If we are
unable to address these risks, our business, results of operations and prospects
could suffer.




We
have a history of losses and we may not achieve profitability in the future,
which raises substantial doubt about our ability to continue as a going
concern.




For the
years ended December 31, 2008 and 2007, we incurred net losses of $9.4 million
and $16.9 million, respectively, and negative cash flows from operations of $3.9
million and $9.7 million for the years ended December 31, 2008 and 2007,
respectively. We expect to continue to incur losses, and we may not become
profitable for the foreseeable future. In addition, as a public company, we
incur increased legal and accounting costs and other expenses related to
maintaining our trading status pursuant to SEC and NASD rules and regulations.
We will have to generate and sustain significantly increased revenue to achieve
profitability. Our revenue growth trends in prior periods may not be
sustainable, and we may not achieve sufficient revenue to achieve or maintain
profitability. We may incur significant losses in the future for a number of
reasons, including those discussed in other risk factors and factors that we
cannot foresee.  We have past due balances with certain vendors that
may result in collection actions unless we settle them.  We may not
obtain sufficient funds to bring these accounts current.





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 Table of Contents




Our ability to continue as a going
concern depends upon the success of our financings as well as our ability to
increase our revenue base and generate cash from operations.  In
November and December 2007, the Company received $600,000 and in the period from
January to June 2008 the Company received an additional $1,320,000 and an
additional $462,500 from November 2008 to February 2009 pursuant to the sale of
secured notes with individual investors for general working capital. (See Note 6
to the Consolidated Financial Statements.) The terms of the secured notes are 13
to 18 months maturity with an interest rate of 13% per annum due at the maturity
date.  The secured notes are secured by substantially all of the assets of
the Company.  The Company is also required to pay an origination fee of
3.00% and documentation fee of 2.50% of the principal amount of the secured
notes at the maturity date.  Prepayment of the credit facilities requires
payment of interest that would have accrued through maturity, discounted by 20%,
in addition to principal, accrued interest and fees. The Company can continue to
sell similar secured notes up to a maximum offering of $3 million.  In
addition, the Company entered into a revolving credit agreement, effective as of
April 30, 2008 (see Note 11 to the Consolidated Financial Statements) pursuant
to which the Company originally could access funds up to $1,500,000 such access
increased to $2,000,000 per Amendment No. 1 to the agreement in September 2008
and to $2,400,000 per Amendment no. 2 to the agreement in November
2008.  The Company is in negotiations with the lender regarding an
increase to the revolving credit agreement.




Such
additional financings are necessary in order to fund ongoing operations until
such time as the Company can achieve positive cash flow from operations. The
Company is in the process of securing this required additional financing,
however there can be no assurance that we will be successful in completing the
required financing or that we will continue to increase our
revenue..




Our
operating results may fluctuate in the future, which could make our results of
operations difficult to predict or cause them to fall short of
expectations.




Our
future operating results may vary significantly from quarter to quarter due to a
variety of factors, many of which are beyond our control and could cause our
results to be below investors’ expectations, causing the value of our securities
to fall. Because our business is evolving, our historical operating results may
not be useful in predicting our future operating results. Factors that may
increase the volatility of our operating results include the
following:




·
            the
      addition of new carrier customers and retail distribution partners or the
      loss of existing customers and retail distribution
    partners;




·
            changes
      in demand and pricing for our VoIP
services;




·
            the
      timing of our introduction of new VoIP products and services and the costs
      we incur to develop these
technologies;




·
            the
      timing and amount of sales and marketing expenses incurred to attract new
      carrier customers and retail distribution
  partners;




·
            changes
      in the economic prospects of carrier customers or the economy generally,
      which could alter current or prospective need for voice services, or could
      increase the time it takes us to close sales with
    customers;




·
            changes
      in our pricing policies, the pricing policies of our competitors or the
      pricing of VoIP services or traditional voice services
      generally;




·
            costs
      related to acquisitions of businesses or technologies;
  and




·
            the
      use of VoIP as a replacement for traditional voice services is a
      relatively new occurrence and carrier customers have not settled into
      consistent spending patterns.




If
we fail to manage our growth effectively, our business could be adversely
affected.




We have
experienced rapid growth in our operations and to a lesser extent, our
headcount, and we may experience continued growth in our business, both through
acquisitions and internal growth. This growth will continue to place significant
demands on our management and our operational and financial resources. In
particular, continued growth will make it more difficult for us to accomplish
the following:




·
            recruit,
      train and retain a sufficient number of highly skilled
      personnel;




·
            maintain
      our customer service standards;




·
            maintain
      the quality of our VoIP platform;




·
            develop
      and improve our operational, financial and management controls and
      maintain adequate reporting systems and
  procedures;




·
            successfully
      scale our VoIP platform, including network, software and other technology,
      to accommodate a larger business;
and




·
            maintain
      carrier and end user satisfaction.




The
improvements required to manage our growth will require us to make significant
expenditures and allocate valuable management resources.




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 Table of Contents




Our
industry is highly competitive and competitive pressures could prevent us from
competing successfully in the voice transport services industry.




The
carrier and retail markets for voice transport services are intensely
competitive. We expect this competition to continue to increase because there
are currently no significant barriers to entry into our market. We compete both
for wholesale carrier business and for retail consumption of voice transport
services. We compete for wholesale carrier business on the basis of a number of
factors, including price, quality, geographic reach and customer service. Our
competitors often are large, well-established in the communications industry and
enjoy several competitive advantages over us, including:




·
            greater
      financial and personnel resources;




·
            greater
      name recognition;




·
            established
      relationships with greater numbers of wholesale
  carriers;




·
            established
      distribution networks;




·
            greater
      experience in obtaining and maintaining FCC and other regulatory approvals
      for products and product enhancements and greater experience in developing
      compliance programs under U.S. federal, state and local laws and
      regulations;




·
            greater
      experience in lobbying the U.S. Congress and state legislatures for the
      enactment of legislation favorable to their
  interests;




·
            greater
      experience in product research and
development;




·
            greater
      experience in launching, marketing, distributing and selling products;
      and




·
            broader-based
      and deeper product lines.




Our
primary current and potential competitors consist of carriers including
AT&T, Sprint, Verizon, Qwest, Level (3) and Global Crossing, other start-up
VoIP providers that have been formed in the recent past and IP networking
companies that are attempting to add voice as a supplement to their current data
services offerings.




We also
compete with companies focused on the distribution of retail voice services and
expect to compete with companies providing VoIP services and broadband IP phones
and videophones.




If
we lose any member of our senior management team and are unable to find a
suitable replacement, we may not have the depth of senior management resources
required to efficiently manage our business and execute our growth
strategy.




We depend
on the continued contributions of our senior management and skilled employees.
We do not maintain key person life insurance policies on any of our officers.
There is a risk that the loss of a significant number of key personnel could
have negative effects on our results of operations. We may not be able to
attract and hire highly skilled personnel to replace lost employees necessary to
carry out our business plan. There is also a risk that management may not be
able to adopt an organizational structure that meets its objectives, including
managing costs and attracting and retaining key employees.  Our Chief
Financial Officer departed the Company in December 2008. His departure and the
arrival of his replacement were discussed in filings with the Securities and
Exchange Commission on Forms 8K dated December 9 and December 10,
2008.




We also
need to hire additional members of senior management to adequately manage our
growing business. We may not be able to identify and attract additional
qualified senior management. Competition for senior management in our industry
is intense. Qualified individuals are in high demand, and we may incur
significant costs to attract them. If we are unable to attract and retain
qualified senior management we may not be able to implement our business
strategy effectively and our revenue may decline. Our success is substantially
dependent on the performance of our executive officers and key employees. Given
our early stage of development, we are dependent on our ability to retain and
motivate high quality personnel. An inability to engage qualified personnel
could materially adversely affect our ability to market our VoIP services. The
loss of one or more of our key employees or our inability to hire and retain
other qualified employees could have a material adverse effect on our business.
See “Management”.




A
substantial portion of our revenue is generated from a limited number of carrier
customers, and if we lose a major customer our revenue could
decrease.




A
substantial portion of our revenue is generated from a limited number of our
carrier customers. Our top 10 customers have accounted for approximately 47.4%
and 54.6% of our revenues for the years ended December 31, 2008 and 2007,
respectively. We expect that a limited number of carrier customers may continue
to account for a significant percentage of our revenue and the loss of, or
material reduction of their purchases could decrease our revenue and harm our
business.




We
are dependent on a limited number of suppliers and on other capacity
providers.




We
currently depend on critical services and equipment from a small number of
suppliers. There is no guarantee that these suppliers will continue to offer us
the services and equipment we require. If we cannot obtain adequate replacement
equipment or services from our suppliers or acceptable alternate vendors, we
could experience a material impact on our financial condition and operating
results. In addition, we rely on other providers for network capacity beyond
what we provide over our own network and there is a risk that current capacity
providers may cease to provide capacity at economically justifiable
rates.




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 Table of Contents




We
are dependent on providers of local telecommunications services to reach the end
users for our services.




We
currently depend on providers of local telecommunications services to provide
end users with access to substantially all of our VoIP services. In the future,
we may utilize other local telecommunications services suppliers to reach end
users such as wireless carriers, cable companies, power companies and other
providers of local broadband services. There is no guarantee that these
suppliers will continue to offer the services we require, that these services
will be available on economic terms sufficient to execute on our business model
or that these suppliers will continue to do business with us. If we cannot
obtain adequate replacement services from our suppliers or acceptable alternate
vendors, we could experience a material impact on our financial condition and
operating results.  We have a settlement agreement with a significant
provider of our local services related to payment for past amounts due of
approximately $1.9 million and past disputes in the amount of approximately $1.4
million. We are not in compliance with our payment obligations under this
agreement; the resulting potential termination of the related local services and
collection proceedings would have a material adverse impact on our operating
results, financial condition and business performance.




We
may from time to time be subject to disputes with customers, vendors and other
third parties relating to amounts claimed due for services which we may not be
able to resolve in our favor.




It is not
unusual in our industry to occasionally have disagreements with vendors and
other third parties relating to amounts claimed due in connection with the
services provided by us or companies like us.  To the extent we are
unable to favorably resolve these disputes, our revenues, profitability or cash
may be adversely affected.  We currently have a dispute reserve of
approximately $2.3 million which is management’s estimate of disputes that will
be resolved in our favor.  The majority of this dispute reserve
relates to the difference in pricing that we expect to pay when calls originate
and terminate in different U.S. states or international jurisdictions versus the
characterizations of these calls as being originated and terminated within the
same U.S. state.




We are
currently in an FCC mediation process with a third party organization that
represents a significant number of the payphone operating companies in the
U.S.  They are attempting to collect an unspecified amount for
payphone originated calls for which they claim that they have not already
received compensation.  If we are unable to resolve this dispute it
could have a material adverse impact on our operating results, financial
condition and business performance.




We
may pursue the acquisition of other businesses in order to grow our customer
base and access technology and talent, and any such acquisition may not achieve
the desired results or could result in operating difficulties, dilution and
other harmful consequences.




We
completed the acquisition of ATI in March 2006. We expect to pursue additional
acquisitions in the future as a key component of our business strategy. We do
not know if we will be able to successfully complete any future acquisitions.
Furthermore, we do not know that we will be able to successfully integrate any
other acquired business, product or technology or retain any key employees of
any acquired business. Integrating any business, product or technology we
acquire could be expensive and time-consuming, disrupt our ongoing business and
distract our management. If we are unable to integrate any acquired businesses,
products or technologies effectively, our results of operations and financial
condition will suffer. There may not be attractive acquisition opportunities
available to us in the future. In addition, acquisitions involve numerous risks,
any of which could harm our business, including:




·
            diversion
      of management’s attention and resources from other business
      concerns;




·
            difficulties
      and expenditures associated with integrating the operations and employees
      from the acquired company into our organization, and integrating each
      company’s accounting, management information, human resources and other
      administrative systems to permit effective
  management;




·
            inability
      to maintain the key business relationships and the reputations of the
      acquired businesses;




·
            ineffectiveness
      or incompatibility of acquired technologies or services with our existing
      technologies and systems;




·
            potential
      loss of key employees of acquired
businesses;




·
            responsibility
      for liabilities of acquired
businesses;




·
            unavailability
      of favorable financing for future
acquisitions;




·
            inability
      to maintain our standards, controls, procedures and policies, which could
      affect our ability to receive an unqualified attestation from our
      independent accountants regarding management’s required assessment of the
      effectiveness of our internal control structure and procedures for
      financial reporting; and




·
            increased
      fixed costs.




The
acquisition of another business, particularly in another country, can subject us
to liabilities and claims arising out of such business, including tax
liabilities and liabilities arising under foreign regulations. Future
acquisitions would also likely require additional financing, resulting in an
increase in our indebtedness or the issuance of additional capital stock which
could be dilutive to holders of shares issued in this offering. Finally, any
amortization or charges resulting from the costs of acquisitions could harm our
operating results.




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 Table of Contents




Sales
of our IP devices may be severely limited due to their failure to gain broad
market acceptance.




In the
future, we intend to sell IP devices and related services. Market acceptance
requires, among other things, that we




·
            educate
      consumers on the benefits of our
products;




·
            commit
      a substantial amount of human and financial resources to secure strategic
      partnerships and otherwise support the retail and/or carrier distribution
      of our products;




·
            develop
      our own sales, marketing and support activities to consumers, broadband
      providers and retailers; and




·
            establish
      a sufficient number of retail locations carrying our
    products.




In the
event we are unable to achieve any or all of these objectives, consumers may
perceive little or no benefit from our products and may be unwilling to pay for
them.




Rapid
technological changes in the industry in which we operate our business or the
market in which we intend to sell our IP devices may render such devices
obsolete or otherwise harm us competitively.




We
operate in a highly technological industry segment that is subject to rapid and
frequent changes in technology and market demand. Frequently such changes can
immediately and unexpectedly render existing technologies obsolete. Management
expects that technology developed in the future will be superior to the
technology that we (and others) now have. Our success depends on our ability to
assimilate new technologies into our VoIP infrastructure and our IP devices and
to properly train engineers, sales staff, distributors and resellers in the use
of our technology. The success of our future service offerings or devices
depends on several factors, including but not limited to proper new product
definition, product cost, timely completion and market introduction of such
services, differentiation of our future products from those of our competitors
and market acceptance of these products. Competing technologies developed by
others may render our current or future developed products or technologies
obsolete or noncompetitive. The failure of our new product development efforts
could have a detrimental effect on our business and results of
operations.




If
we discover IP device defects, we may have product-related liabilities that may
cause us to lose revenues or delay market acceptance of our IP
devices.




Devices
as complex as those we intend to offer frequently contain errors, defects, and
functional limitations when first introduced or as new versions are released. We
have in the past experienced such errors, defects or functional
limitations.




We intend
to sell devices into markets that are demanding of robust, reliable and fully
functional products. Therefore, delivery of devices with production defects or
reliability, quality, or compatibility problems could significantly delay or
hinder market acceptance, which could damage our credibility with our customers
and adversely affect our ability to attract new customers. Moreover, such
errors, defects, or functional limitations could cause problems, interruptions,
delays, or a cessation of sales to our customers. Alleviating such problems may
require significant expenditures of capital and resources by us. Despite our
testing, our suppliers or our customers may find errors, defects or functional
limitations in new products after commencement of commercial production, which
could result in additional development costs, loss of, or delays in, market
acceptance, diversion of technical and other resources from our other
development efforts, product repair or replacement costs, claims by our
customers or others against us, or the loss of credibility with prospective
customers.




Uncertainty
or negative publicity may negatively affect the VoIP industry generally and our
business.




There is
a possibility that uncertainty regarding broad market acceptance of VoIP
technology or adverse publicity or negative perceptions about the VoIP industry
as a whole could hinder our ability to obtain new customers or undermine our
commercial relationship with existing customers. Further, the adoption of VoIP
in the telecommunications industry may not materialize and, even if there is
such adoption, our business may not benefit from it.




Our
ability to protect our intellectual property is uncertain.




We rely
on patent protection, trade secrets, know-how and contractual means to protect
our proprietary technology.  Patents may afford only limited
protection and may not adequately protect our rights or permit us to gain or
keep any competitive advantage. For example, our pending U.S. patent
applications may not issue as patents in a form that will be advantageous to us,
or may issue and be subsequently successfully challenged by others and
invalidated. In addition, our pending patent applications include claims to
material aspects of our products and methods that are not currently protected by
issued patents. Furthermore, competitors may be able to design around the claims
of our patents, or develop products or methods outside the scope of our issued
claims which provide outcomes which are comparable to ours. We also rely on
know-how and trade secrets to maintain our competitive position. Confidentiality
agreements or other agreements with our employees, consultants and advisors may
not be enforceable or may not provide meaningful protection for our proprietary
technology, know-how, trade secrets, or other proprietary information in the
event of misappropriation, unauthorized use or disclosure or other breaches of
the agreements, or, even if such agreements are legally enforceable, we may not
have adequate remedies for breaches of such agreements. The failure of our
patents or agreements to protect our proprietary technology could result in
significantly lower revenues, reduced profit margins or loss of market
share.




The
market for our products depends to a significant extent upon the goodwill
associated with our trademarks and service marks. We own, or have licenses to
use, the material trademarks, service marks and trade names used in connection
with the packaging, marketing and distribution of our products in the markets
where those products are sold. Therefore, trademark protection is important to
our business. Although most of our trademarks and service marks are registered
in the U.S., we may not be successful in asserting trademark protection. In
addition, the laws of certain foreign countries may not protect our trademarks
or service marks to the same extent as the laws of the U.S. The loss or
infringement of our trademarks or service marks could impair the goodwill
associated with our brands, harm our reputation and have a material adverse
effect on our financial results.




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Network
failures or delays may result in the loss of our customers or expose us to
potential liability.




Our VoIP
network infrastructure uses a collection of communications equipment, software,
operating protocols and applications for the transport of voice among multiple
locations. Given the complexity of the network, it is possible that there could
be severe disruptions in our ability to timely turn up service requests,
minimize service interruptions and meet requirements of customer service level
agreements. We have critical systems in our Los Angeles, California and New
York, New York collocation facilities. Our California facilities are located in
areas with a high risk of major earthquakes. Our facilities and network are also
subject to break-ins, sabotage, intentional acts of vandalism and terrorism and
to potential disruptions if the operators of these facilities encounter
financial difficulties. Some of our systems may not be fully redundant, and our
disaster recovery planning cannot account for all eventualities. The occurrence
of a natural disaster, an operator’s decision to close a facility we are using
without adequate notice for financial reasons or other unanticipated problems at
our facilities could result in lengthy interruptions in our service. Network
failures or delays in the turn up of services could cause business interruptions
resulting in possible losses to our customers. Such failures or delays may
expose us to claims by our customers and may result in the loss of
customers.




VoIP
networks are vulnerable to unauthorized access or use by outside
parties.




While we
built a private secure fiber optic infrastructure to minimize security risks
from third party unauthorized sources, no network is invulnerable to hackers. A
small percentage of voice traffic transported across our network may at times
utilize the public internet. However, providing entry or exit points to our
customers via the internet could enable computer hackers to access our network,
and could lead to the impairment, failure or theft of our services. Further, it
could also lead to the unauthorized interception and monitoring of end user
voice calls. Unauthorized access or use may have an adverse impact on our
services and reputation.




Our
products or activities may infringe, or may be alleged to infringe, upon
intellectual property rights of others.




We may
encounter future litigation by third parties based on claims that our products
or activities infringe the intellectual property rights of others, or that we
have misappropriated the trade secrets of others. If any litigation or claims
are resolved against us, we may be required to do one or more of the
following:




·
            cease
      selling, incorporating or using any of our products that incorporates the
      infringed intellectual property, which would adversely affect our revenue
      or costs or both;




·
            obtain
      a license from the holder of the infringed intellectual property right,
      which might be costly or might not be available on reasonable terms, if at
      all; or




·
            redesign
      our products to make them non-infringing, which could be costly and
      time-consuming and may not be possible at
all.




Because
patent applications can take many months to be published, there may be pending
applications, unknown to us, that may later result in issued patents that our
products or product candidates or processes may infringe. These patent
applications may have priority over patent applications filed by us. Disputes
may arise regarding the ownership or inventorship of our intellectual property.
There also could be existing patents of which we are unaware that our products
may be infringing. As the number of participants in the market grows, the
possibility of patent infringement claims against us increases. It is difficult,
if not impossible, to determine how such disputes would be
resolved.




Furthermore,
because of the substantial amount of discovery required in connection with
patent litigation, there is a risk that some of our confidential information
could be required to be publicly disclosed. In addition, during the course of
patent litigation, there could be public announcements of the results of
hearings, motions or other interim proceedings or developments in the
litigation. Any litigation claims against us may cause us to incur substantial
costs and could place a significant strain on our financial resources, divert
the attention of management or restrict our core business.




We
may be subject to damages resulting from claims that we, or our employees, have
wrongfully used or disclosed alleged trade secrets of former
employers.




Some of
our employees were previously employed at other communications companies,
including our competitors or potential competitors. Although no such claims
against us are currently pending, we may be subject to claims that we or these
employees have inadvertently or otherwise used or disclosed trade secrets or
other proprietary information of their former employers. Litigation may be
necessary to defend against these claims. Even if we are successful in defending
against these claims, litigation could result in substantial costs and be a
distraction to management. If we fail in defending such claims, in addition to
paying monetary damages, we may lose valuable intellectual property rights or
personnel. A loss of key research personnel or their work product could hamper
or prevent our ability to commercialize product candidates, which could severely
harm our business.




We
are exposed to various possible claims relating to our business and our
insurance may not fully protect us.




We may
incur uninsured liabilities and losses as a result of the conduct of our
business. For example, network failures or security breaches could subject us to
claims by our customers, and physical damage to the leased facilities in which
we maintain our equipment could result in damage or loss to our equipment. We
plan to maintain comprehensive liability and property insurance which may not
replace the full value of our potential liabilities or losses or cover such
claims. We will also evaluate the availability and cost of business interruption
insurance. However, should uninsured losses occur, shareholders could lose their
invested capital.




The
costs incurred by us to develop, implement, and enhance our VoIP services may be
higher than anticipated, which could hurt our ability to earn a
profit.




We may
incur substantial cost overruns in the development and establishment of our VoIP
services. For example, delays in the SS-7 enhancement to our VoIP infrastructure
will cause us to incur monthly costs related to equipment and network components
we are not able to fully utilize. Unanticipated costs may force us to obtain
additional capital or financing from other sources, or may cause the loss of
your entire investment in our common stock if we are unable to obtain the
additional funds necessary to implement our business plan.




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We
may need to raise additional funds in the future and such funds may not be
available on acceptable terms or at all.




We may
need to raise additional funds in the future for any number of reasons,
including:




·
            the
      loss of revenues generated by sales of our services and
      products;




·
            the
      upfront and ongoing costs associated with expanding and enhancing our VoIP
      infrastructure;




·
            the
      costs associated with expanding our sales and marketing
      efforts;




·
            the
      expenses we incur in manufacturing and selling our services and
      products;




·
            the
      costs of developing new products or
  technologies;




·
            the
      cost of obtaining and maintaining regulatory approval or clearance of our
      products and products in development;
and




·
            the
      number and timing of acquisitions and other strategic
      transactions.




If we
issue equity or debt securities to raise additional funds, our existing
shareholders may experience dilution and the new equity or debt securities may
have rights, preferences and privileges senior to those of our existing
shareholders. In addition, if we raise additional funds through collaboration,
licensing or other similar arrangements, it may be necessary to relinquish
valuable rights to our potential products or proprietary technologies, or grant
licenses on terms that are not favorable to us. If we cannot raise funds on
acceptable terms or at all, we may not be able to develop or enhance our
products, execute our business plan, take advantage of future opportunities or
respond to competitive pressures or unanticipated customer requirements. In
these events, our ability to achieve our development and commercialization goals
would be adversely affected.




Additional
Risks Related to Regulation




Our
industry is subject to regulation that could adversely impact our
business.




Traditional
telephone service has been subject to significant federal and state regulation.
Internet services generally have been subject to far less regulation. Because
aspects of VoIP are similar to the traditional telephone services provided by
incumbent local exchange carriers and other aspects are similar to the services
provided by Internet service providers, the VoIP industry has not fit easily
within the existing regulatory framework of communications law, and until
recently has developed in an environment largely free from
regulation.




The
Federal Communications Commission, or FCC, the U.S. Congress and various
regulatory bodies in the states and in foreign countries have begun to assert
regulatory authority over VoIP providers, and are evaluating how VoIP may be
regulated in the future. In addition, while some of the existing regulation
concerning VoIP is applicable to the entire industry, many regulatory
proceedings are focused on specific companies or categories of VoIP services. As
a result, both the application of existing rules to us and our competitors and
the effects of future regulatory developments are uncertain.




Communications
services are generally subject to regulation at the federal, state, local and
international levels. These regulations affect us, our customers, and our
existing and potential competitors. Delays in receiving required regulatory
approvals, completing interconnection agreements or other agreements with local
exchange carriers or the adoption of new and adverse regulations may have a
material adverse effect on us. In addition, future legislative and judicial
actions could have a material adverse effect on us.




Federal
legislation generally provides for significant deregulation of the U.S.
communications industry, including the information service, local exchange, long
distance and cable television industries. This legislation remains subject to
judicial review and additional FCC rulemaking. As a result, we cannot predict
the legislation’s effect on our future operations. Regulatory proceedings are
under way or are being contemplated by federal and state authorities regarding
items relevant to our business. These actions could have a material adverse
effect on our business.




Future
legislation or regulation of the Internet and/or voice and video over IP
services could restrict our business, prevent us from offering service or
increase our cost of doing business.




At
present there are few laws, regulations or rulings that specifically address
access to commerce and communications services that utilize internet protocol,
including VoIP. We are unable to predict the impact, if any, that future
legislation, judicial decisions or regulations concerning internet protocol
products and services may have on our business, financial condition, and results
of operations. Regulation may be targeted towards, among other things, fees,
charges, surcharges, and taxation of VoIP services, liability for information
retrieved from or transmitted over the Internet, online content regulation, user
privacy, data protection, pricing, content, copyrights, distribution, electronic
contracts and other communications, filing requirements, consumer protection,
public safety issues like enhanced 911 emergency service, or E911, the
Communications Assistance for Law Enforcement Act, or CALEA, the provision of
online payment services, broadband residential Internet access, and the
characteristics and quality of products and services, any of which could
restrict our business or increase our cost of doing business. The increasing
growth of the VoIP market and popularity of VoIP products and services heighten
the risk that governmental agencies will seek to regulate VoIP and the
Internet.




Many
regulatory actions are underway or are being contemplated by governmental
agencies. Several states of the U.S. and municipalities have recently shown an
interest in regulating VoIP services, as they do for providers of traditional
telephone service. If this trend continues, and if such regulation is not
preempted by action of the U.S. federal government, we may become subject to a
variety of inconsistent state and local regulations and taxes, which would
increase our costs of doing business, and adversely affect our operating results
and future prospects.




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On
February 12, 2004, the FCC initiated a notice of proposed rulemaking to update
FCC policy and consider the appropriate regulatory classification for VoIP and
other IP enabled services. On November 9, 2004, the FCC ruled that Vonage’s VoIP
service and similar services are jurisdictionally interstate and not subject to
state certification, tariffing and other common carrier regulations, including
911. This ruling was subsequently appealed by several states, but was affirmed
by the U.S. Court of Appeals for the Eighth Circuit on March 21, 2007. There is
risk that a regulatory agency could require us to conform to rules that are
unsuitable for IP communications technologies or rules that cannot be complied
with due to the nature and efficiencies of IP routing, or are unnecessary or
unreasonable in light of the manner in which we offer service to our customers.
It is not possible to separate the Internet, or any service offered over it,
into intrastate and interstate transmission components. While suitable
alternatives may be developed in the future, the current IP network does not
enable us to identify the geographic path of the traffic.




On June
27, 2006, the FCC released an order adopting interim modifications to its
universal service rules to require providers of interconnected VoIP services to
contribute to the Universal Service Fund. This order was subsequently appealed
to the U.S. Court of Appeals for the D.C. Circuit, which appeal remains pending.
If the FCC’s interim rules are upheld on appeal or are made permanent, the
cumulative effect of these rule changes could increase our cost of doing
business.




Our
products must comply with industry standards, FCC regulations, state, local,
country-specific and international regulations, and changes may require us to
modify existing products and/or services.




In
addition to reliability and quality standards, the market acceptance of VoIP is
dependent upon the adoption of industry standards so that products from multiple
manufacturers are able to communicate with each other. Our VoIP products and
services rely heavily on communication standards such as SIP, H.323 and SS-7 and
network standards such as TCP/IP to interoperate with other vendors’ equipment.
There is currently a lack of agreement among industry leaders about which
standard should be used for a particular application, and about the definition
of the standards themselves. These standards, as well as audio and video
compression standards, continue to evolve. We also must comply with certain
rules and regulations of the FCC regarding electromagnetic radiation and safety
standards established by Underwriters Laboratories, as well as similar
regulations and standards applicable in other countries. Standards are
continuously being modified and replaced. As standards evolve, we may be
required to modify our existing products or develop and support new versions of
our products. We must comply with certain federal, state and local requirements
regarding how we interact with our customers, including consumer protection,
privacy and billing issues, the provision of 911 emergency service and the
quality of service we provide to our customers. The failure of our products and
services to comply, or delays in compliance, with various existing and evolving
standards could delay or interrupt volume production of our VoIP telephony
products, subject us to fines or other imposed penalties, or harm the perception
and adoption rates of our service, any of which would have a material adverse
effect on our business, financial condition or operating results.




There
may be risks associated with the lack of 911 emergency dialing or the
limitations associated with E911 emergency dialing with our VoIP
services.




In the
future, we intend to sell and support IP devices. In May 2005, the FCC
unanimously adopted an Order and Notice of Proposed Rulemaking, or NPRM, that
requires some VoIP providers to provide emergency 911, or E911, service. On June
3, 2005, the FCC released the text of the First Report and Order and Notice of
Proposed Rulemaking in the VoIP E911 proceeding, or the VoIP E911 Order. As a
result of the VoIP E911 Order, VoIP service providers that interconnect to the
public switched telephone network, or PSTN, or interconnected VoIP providers,
will be required to offer the same 911 emergency calling capabilities offered by
traditional landline phone companies. All interconnected VoIP providers must
deliver 911 calls to the appropriate local public safety answering point, or
PSAP, along with call back number and location, where the PSAP is able to
receive that information. E911 must be included in the basic service offering;
it cannot be an optional or extra feature. The PSAP delivery obligation, along
with call back number and location information must be provided regardless of
whether the service is “fixed” or “nomadic.” User registration of location is
permissible initially, although the FCC is committed to an advanced form of E911
that will determine user location without user intervention, one of the topics
of the further NPRM to be released eventually. The VoIP E911 Order mandates that
existing and prospective customers must be notified of the capabilities and
limitations of VoIP service with respect to emergency calling, and
interconnected VoIP providers must obtain and maintain affirmative
acknowledgement from each customer that the customer has read and understood the
notice of limitations and distribute warning labels or stickers alerting
consumers and other potential users of the limitations of VoIP 911 service to
each new subscriber prior to the initiation of service. In addition, an
interconnected VoIP provider must make it possible for customers to update their
address (i.e., change their registered location) via at least one option that
requires no equipment other than that needed to access the VoIP service. All
interconnected VoIP providers were required to comply with the requirements of
the VoIP E911 Order by November 28, 2005. On November 7, 2005, the FCC’s
Enforcement Bureau issued a Public Notice with respect to that requirement. The
notice stated that providers that had not fully complied with E911 requirements
were not required to discontinue services to existing customers, but that the
FCC expected such providers to discontinue marketing their services and
accepting new customers in areas where the providers could not offer E911
capabilities. However, in order to comply, interconnected VoIP providers must
obtain access to incumbent local exchange carrier, or ILEC, facilities. In some
cases, ILECs have denied VoIP providers access to these necessary facilities.
Pending legislation may address whether ILECs have legal obligations to provide
access to these necessary facilities.




The VoIP
E911 Order will increase our cost of doing business and may adversely affect our
ability to deliver service to new and existing end users in all geographic
regions. We cannot guarantee that E911 service will be available to all of our
subscribers. The VoIP E911 Order or follow-on orders or clarifications and
potential legislation could have a material adverse effect on our business,
financial condition and operating results.




The
IP devices we intend to offer could be adversely impacted if network operators
are permitted to restrict or degrade access to their broadband
networks.




The
concept of net neutrality asserts that network operators should not be allowed
to charge content or application providers fees for faster delivery or other
preferential treatment. On August 5, 2005, the FCC adopted a policy statement
setting forth the following net neutrality guidelines: (1) consumers are
entitled to access the lawful Internet content of their choice; (2) consumers
are entitled to run applications and use services of their choice, subject to
the needs of law enforcement; (3) consumers are entitled to connect their choice
of legal devices that do not harm the network; and (4) consumers are entitled to
competition among network providers, application and service providers, and
content providers. The policy statement is not legally binding, though it does
set forth the FCC’s current view on net neutrality. On March 22, 2007, the FCC
announced that it will issue a Notice of Inquiry to examine further the
practices of broadband network providers and whether the policy statement should
incorporate a new principle of nondiscrimination. Notwithstanding its earlier
policy statement, the FCC could reverse its position or decide not to implement
the policy in its ongoing regulatory proceedings. Further, federal legislation
may also address net neutrality in a manner that requires, permits or disallows
the FCC to implement its stated net neutrality policy. Such legislation could
also require the FCC to modify its policy in whole or in part. Because some of
our IP devices and services may utilize the networks of third parties,
regulation and potential legislation concerning net neutrality could impact our
business. Further, some of our carrier customers rely, in part, on the
implementation of net neutrality principles in order to offer their VoIP
services. If our carrier customers are adversely impacted by legislative or
regulatory action concerning net neutrality, it could also adversely impact
us.




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Uncertainty
regarding whether certain of our services are classified as “telecommunications”
or “information” services makes it difficult to predict whether we will need to
pay additional charges, surcharges, fees and/or taxes to provide our services
and whether we are subject to state and local regulation.




There are
many unresolved proceedings at the FCC intended to address whether various types
of VoIP services are properly classified as telecommunications services and/or
information services. Federal legislation may also impact this determination. If
our services are determined to be telecommunications services, we may be subject
to additional regulation, including but not limited to the application of
additional charges, surcharges, taxes and fees that would adversely impact our
business. If it is determined that we provide telecommunications services, we
could also be required to comply with state regulation and the related filing
requirements that could adversely impact our business.




We
may from time to time be subject to disputes with customers and vendors relating
to amounts invoiced for services provided which we may not be able to resolve in
our favor.




It is not
unusual in our industry to occasionally have disagreements with vendors relating
to amounts billed for services provided between the recipient of the services
and the vendor. To the extent we are unable to favorably resolve these disputes,
our revenues, profitability or cash may be adversely affected.




Risks
Related to our Common Stock




Our
common stock may be considered a “penny stock” and may be difficult to
sell.




The
Securities and Exchange Commission has adopted regulations which generally
define “penny stock” to be an equity security that has a market price of less
than $5.00 per share or an exercise price of less than $5.00 per share, subject
to specific exemptions. The market price of our common stock is less than $5.00
per share and therefore may be designated as a “penny stock” according to
Securities and Exchange Commission rules. This designation requires any broker
or dealer selling these securities to disclose certain information concerning
the transaction, obtain a written agreement from the purchaser and determine
that the purchaser is reasonably suitable to purchase the securities. These
rules may restrict the ability of brokers or dealers to sell our common stock
and may affect the ability of investors to sell their shares. In addition, since
our common stock is currently traded on the NASD’s OTC Bulletin Board, investors
may find it difficult to obtain accurate quotations of our common stock and may
experience a lack of buyers to purchase such stock or a lack of market makers to
support the stock price.




Security
analysts of major brokerage firms may not provide coverage of us since there is
no incentive for brokerage firms to recommend the purchase of our common stock.
No assurance can be given that brokerage firms will want to conduct any
secondary public offerings on our behalf in the future.




Our
principal shareholders have significant voting power and may take actions that
may not be in the best interest of other shareholders.




As of
December 31, 2008, our executive officers, directors, and principal shareholders
who hold 5% or more of our outstanding common stock beneficially owned, in the
aggregate, approximately 87% of our outstanding common stock. These shareholders
are able to exercise significant control over all matters requiring shareholder
approval, including the election of directors and approval of significant
corporate transactions. This concentration of ownership may have the effect of
delaying or preventing a change in control and might adversely affect the market
price of our common stock. This concentration of ownership may not be in the
best interests of all our shareholders.




We
incur increased costs and risks as a result of being a public company,
particularly in the context of Section 404 of the Sarbanes-Oxley Act of
2002.




We incur
increased costs as a result of becoming a public company and from compliance
activities related to the Sarbanes-Oxley Act of 2002, or SOX, as well as new
rules subsequently implemented by the Securities and Exchange Commission and the
NASD, and these costs may continue to increase. These new rules and regulations
have increased our legal and financial compliance costs and made some activities
more time-consuming and costly. In addition, we incur costs associated with our
public company reporting requirements. These rules and regulations to make it
more expensive for us to obtain certain types of insurance, including directors’
and officers’ liability insurance and we may be forced to accept reduced policy
limits and coverage in the future or incur substantially higher costs to obtain
the same or similar coverage. The impact of these events also could make it more
difficult for us to attract and retain qualified persons to serve on our board
of directors, our board committees or as executive officers. We are presently
evaluating and monitoring developments with respect to new rules and regulations
and cannot predict the amount of the additional costs we may incur or the timing
of such costs.




Section
404 of SOX requires us to include an internal controls report from management in
our Annual Reports on Form 10-K, and we are required to expend significant
resources in developing the necessary documentation and testing procedures.
Given the risks inherent in the design and operation of internal controls over
financial reporting, we evaluated our system of internal controls and concluded
that our internal controls over financial reporting is not effective. If our
internal controls are not designed or operating effectively, we are required to
disclose that our internal control over financial reporting was not effective.
Investors may lose confidence in the reliability of our financial statements,
which could cause the market price of our common stock to decline and which
could affect our ability to run our business as we otherwise would like
to.




15
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Our
management has identified a number of material weaknesses in our internal
control over financial reporting as of December 31, 2008, which, if not
sufficiently remediated, could result in material misstatements in our annual or
interim financial statements in future periods.




In
connection with our management’s assessment of our internal control over
financial reporting as required under Section 404 of the Sarbanes-Oxley Act of
2002, our management identified a number of material weaknesses in our internal
control over financial reporting as of December 31, 2008. A material
weakness is a deficiency, or a combination of deficiencies, in internal control
over financial reporting, such that there is a reasonable possibility that a
material misstatement of our annual or interim financial statements will not be
prevented or detected on a timely basis. As a result, our management has
concluded that we did not maintain effective internal control over financial
reporting as of December 31, 2008.




We are in
the process of implementing remediation efforts with respect to these material
weaknesses. However, if these remediation efforts are insufficient to address
these material weaknesses, or if additional material weaknesses in our internal
control over financial reporting are discovered in the future, we may fail to
meet our future reporting obligations, our financial statements may contain
material misstatements and our financial conditions and results of operations
may be adversely impacted. Any such failure could also adversely affect our
results of periodic management assessment regarding the effectiveness of our
internal control over financial reporting, as required by the SEC's rules under
Section 404 of the Sarbanes-Oxley Act of 2002. The existence of a material
weakness could result in errors in our financial statements that could result in
a restatement of financial statements or failure to meet reporting obligations,
which in turn could cause investors to lose confidence in reported financial
information leading to a decline in our stock price.




Although
we believe that these remediation efforts will enable us to improve our internal
control over financial reporting, we cannot assure you that these remediation
efforts will remediate the material weaknesses identified or that any additional
material weaknesses will not arise in the future due to a failure to implement
and maintain adequate internal control over financial reporting. Furthermore,
there are inherent limitations to the effectiveness of controls and procedures,
including the possibility of human error and circumvention or overriding of
controls and procedures





The
market price of our common stock may be volatile.




The
market price of our common stock has been and will likely continue to be highly
volatile, as is the stock market in general. Some of the factors that may
materially affect the market price of our common stock are beyond our control,
such as changes in financial estimates by industry and securities analysts,
conditions or trends in the communications industry, announcements made by our
competitors or sales of our common stock. These factors may materially adversely
affect the market price of our common stock, regardless of our
performance.




In
addition, the public stock markets have experienced extreme price and trading
volume volatility. This volatility has significantly affected the market prices
of securities of many companies for reasons frequently unrelated to the
operating performance of the specific companies. These broad market fluctuations
may adversely affect the market price of our common stock.




Factors
which may adversely affect market prices of our common stock.




Market
prices for our common stock will be influenced by a number of factors,
including:




·
            the
      issuance of new equity securities pursuant to a future offering or
      acquisition;




·
            changes
      in interest rates;




·
            competitive
      developments, including announcements by competitors of new products or
      services or significant contracts, acquisitions, strategic partnerships,
      joint ventures or capital
commitments;




·
            variations
      in quarterly operating results;




·
            changes
      in financial estimates by securities
analysts;




·
            the
      depth and liquidity of the market for our common
  stock;




·
            investor
      perceptions of us and the communications industry generally;
      and




·
            general
      economic and other national
conditions.




There
is no assurance of an established public trading market, and the failure to
establish one would adversely affect the ability of our investors to sell their
securities in the public market.




At
present, there is minimal trading of our securities, and there can be no
assurance that an active trading market will develop. Our common stock, however,
is traded on the OTC Bulletin Board. The OTC Bulletin Board is an inter-dealer,
over-the-counter market that provides significantly less liquidity than the
NASD’s automated quotation system, or NASDAQ Stock Market. Quotes for stocks
included on the OTC Bulletin Board are not listed in the financial sections of
newspapers as are those for the NASDAQ Stock Market. Therefore, prices for
securities traded solely on the OTC Bulletin Board may be difficult to obtain
and holders of common stock may be unable to resell their securities at or near
their original price or at any price.




16
 Table of Contents




A
significant number of our shares will be eligible for sale, and their sale could
depress the market price of our common stock.




Sales of
a significant number of shares of our common stock in the public market could
harm the market price of our common stock. In May 2007 and January 2008 we
registered an aggregate of 21,429,000 shares and shares underlying warrants, or
36% of our common stock currently outstanding, for resale in the public market
pursuant a Form SB-2 registration statements. As such shares of our common stock
are resold in the public market, the supply of our common stock will increase,
which could decrease its price. Some or all of our shares of common stock as
well as shares of common stock underlying warrants and options may also be
offered from time to time in the open market pursuant to an effective
registration statement or Rule 144, and these sales may have a depressive effect
on the market for our shares of common stock. In general, a person who has held
restricted shares for a period of six months may, upon filing with the
Securities and Exchange Commission a notification on Form 144, sell into the
market shares of our common stock.




Shares
eligible for future sale may adversely affect the market price of our common
stock.




The
former non-affiliated securities holders of InterMetro Delaware who received
shares of our common stock in the Business Combination will be eligible to sell
all of their shares of common stock by means of ordinary brokerage transactions
in the open market pursuant to Rule 144 promulgated under the Securities Act of
1933, as amended (the “Securities Act”), Rule 144, commencing on May 10, 2008
which is the expiration date of the lock-up agreement entered into by all
InterMetro Delaware securities holders at the time of the Business
Combination.  Rule 144 permits, under certain circumstances, the sale
of securities, without any limitations, by a non-affiliate that has satisfied a
one-year holding period. Any substantial resale, and the possibility of
substantial resales, of the common stock under Rule 144 may have an adverse
effect on the market price of our common stock by creating an excessive
supply.




Provisions
in our articles of incorporation and bylaws and under Nevada law may discourage,
delay or prevent a change of control of our company or changes in our management
and, therefore, depress the trading price of our common stock.




Our
articles of incorporation and bylaws contain provisions that could depress the
trading price of our common stock by acting to discourage, delay or prevent a
change of control of our company or changes in our management that the
shareholders of our company may deem advantageous. These
provisions:




·
            authorize
      the issuance of “blank check” preferred stock that our board of directors
      could issue to increase the number of outstanding shares to discourage a
      takeover attempt;




·
            allow
      shareholders to request that we call a special meeting of our shareholders
      only if the requesting shareholders hold of record at least a majority of
      the outstanding shares of common
stock;




·
            provide
      that the board of directors is expressly authorized to make, alter, amend
      or repeal our bylaws; and




·
            provide
      that business to be conducted at any special meeting of shareholders be
      limited to matters relating to the purposes stated in the applicable
      notice of meeting.




We
do not foresee paying cash dividends in the foreseeable future.




We have
not paid cash dividends on our stock and do not plan to pay cash dividends on
our common stock in the foreseeable future.




Item2. Description of Property




Our
principal executive office is located in Simi Valley, California, where we lease
a facility with 18,674 square feet of space for approximately $22,281 per month
under a lease that expired in March 2009. Subsequent to December 31, 2008, the
Company negotiated a extension of the lease through June 30, 2009. We believe
that our space will be adequate for our needs and that suitable additional or
substitute space in the future will be available to accommodate the foreseeable
expansion of our operations. We also lease collocation space for our VoIP
equipment in carrier class telecommunications facilities in major metropolitan
markets throughout the U.S. and expect to add additional collocation facilities
as we expand our VoIP network.




Item3. Legal Proceedings





From time
to time we may be involved in litigation of claims relating to disputes of the
cost and quality of services provided by us, our network component vendors,
providers of general and administrative services and employees. We may also be
involved with litigation of claims of alleged infringement, misuse or
misappropriation of intellectual property rights of third parties. In the normal
course of business, we may also be subject to claims arising out of our
operations, and may file collection claims against delinquent customers.
  We cannot predict the outcome of any of these proceedings at this
time.  In cases where a Court has stayed proceeding, we can not
predict how long the Court’s stay (if any) will remain in place.  A ruling
against us in any of the proceedings listed below could have a material adverse
impact on our operating results, financial condition and business
performance.





Telscape
Communications - On January 15, 2008, Telscape Communications, Inc. (“Telscape”)
filed a lawsuit against the Company asserting unpaid invoices.  The
matter is resolved.





Blue
Casa Communication, Inc.
–  On December 12, 2007, Blue Casa Communications, Inc. (“Blue Casa”) filed
a complaint asserting various causes of action, including breach of contract,
breach of implied contract and unjust enrichment.   Blue Casa claims
that the Company owes Blue Casa payment of access charges in the amount of
$300,000.  The Company denies that it owes Blue Casa payment of access
charges.  On March 9, 2009, the Court renewed a stay for an additional 180
days to provide an opportunity for the Federal Communications Commission to
clarify issues central to the litigation.




17
 Table of Contents




Cantata
Technology, Inc. – On
August 12, 2008, Cantata filed a lawsuit against the Company asserting a breach
of contract claim arising out of the parties’ May 2, 2006 term sheet related to
an equipment purchase agreement.  Cantata is seeking $1.1 million for
the equipment together with interest, costs and attorney fees. Cantata is also
seeking $63,000 for support services allegedly provided during the parties’
relationship.  As discussed in Note 4, the Company has accrued
$1,084,000 due to Cantata as of December 31, 2008.  The Company
accrued additional interest of $300,000 as a contingent liability related to
this law suit.   The Company has filed a counterclaim against
Cantata and a third party claim against its parent company,
Dialogic.  The Company is vigorously asserting its claims against
Cantata and Dialogic.





Hypercube/KMC
– On April 30, 2007, the Company initiated litigation against KMC Data, LLC and
its affiliate Hypercube, LLC (collectively referred to herein as “KMC”), or (the
“KMC Litigation”).  KMC, in turn, filed various counterclaims against the
Company.  The KMC Litigation concerns the issue of whether or to what
extent the Company is obligated to pay KMC certain fees related to the
transmission and routing of wireless communications traffic, and if so, what
rates would be appropriate.  As of March 31, 2009, there are approximately
$1.2 million of charges by KMC that the Company disputes. The Company has
recorded these disputes as an offset to accounts payable at December 31, 2008.
As of December 31, 2008, the Company has recorded the $1.2 million in accounts
payable, with a corresponding offset to unresolved disputed
amounts.  On August 6, 2007, the Court stayed the KMC Litigation
pending referral of certain issues in the case to the Federal Communications
Commission under the doctrine of primary jurisdiction.  The case is
currently stayed.  The Company cannot predict the outcome of these
proceedings at this time or how long the Court’s stay will remain in
place.  A ruling against the Company could have a material adverse impact
on our operating results, financial condition and business
performance.





In
addition, the following vendors, carriers and customers have sent written notice
of their claims and/or  intent to file suit against the
Company:





A Local
Exchange Carrier – A local exchange carrier (LEC) invoiced the Company access
charges in connection with certain wireless originated calls of a third party
provider.  During the period from November 2008 through February 2009, the
Company paid the LEC’s invoiced charges in connection with these wireless
originated calls.  During this time frame, the Company submitted disputes
to the LEC for the wireless call charges equaling approximately $337,000. 
The LEC has denied the disputes submitted by the Company.  The Company has
withheld payment to the LEC asserting that it has overpaid for services. 
To date, the Company and the LEC have not resolved the
dispute.





An
Interexchange Carrier – An interexchange carrier (IXC) asserts to the Company
that it is owed approximately $1.1 million in past due disputed and undisputed
charges.  The carrier has threatened to disconnect services to the Company
and to initiate litigation against the Company.  The carrier and the
Company have been engaged in discussions to resolve these payment issues. 
If the carrier suspends its provision of services to the Company or initiates
litigation against the Company, it could have a material adverse impact on the
Company’s operating results, financial condition and business
performance.





A
Collocation Provider – A provider of collocation services is asserting that it
is due monies in connection with collocation services previously
provided.  The claimed dollar amount is $194,783.  The
service provider has threatened to file a complaint against the
Company.





Federal
Communications Commission - On November 26, 2008, the
Company  received letters of inquiry from the Federal Communications
Commission (“FCC”) in connection with nonpayment of certain fees and surcharges
required pursuant to the FCC’s regulations.  The Company has provided
documentation to the FCC in connection with these inquiries and is actively
cooperating with the FCC’s investigations.  The Company can not
identify the total amount that may be due as a result of this
inquiry  but believes the inquiry primarily relates to Universal
Service Fund charges as described in the paragraph below.





Universal
Service Administrative Company – The Universal Service Administrative Company
(USAC) administers the Universal Service Fund (USF).  The Company did not
make all of the payments claimed by the USAC in a timely manner, including
payments owed pursuant to agreed upon payment plans with the Company.  The
USAC has transferred some of these unpaid amounts to the Federal Communications
Commission (FCC) for collection.  The FCC may transfer the unpaid amounts
to the Department of the Treasury.  If the amounts are not resolved, they
may then be transferred to the Department of Justice for collection
action.  With each transfer, additional fees, surcharges and penalties
are added to the amount due.  As of February 28, 2009, USAC and the FCC
have claimed approximately $410,000 is due and payable in connection with the
USF.  The Company is working with USAC and the FCC to resolve these
amounts.





On March
20, 2009, Laura Murtaugh resigned as corporate secretary.  Robert
Grden will serve as interim corporate secretary.




Item4. Submission of Matters to a Vote of Security
Holders




No
matters were submitted during the fourth quarter of the fiscal year covered by
this report to a vote of security holders.






18
 Table of Contents





PART
II




Item5. Market for Common Equity and Related Stockholder
Matters




Common
Stock




Our
common stock is listed on the OTC Bulletin Board and trades under the symbol
“IMTO.” At the close of business on March 31, 2009, there were 65,643,901 issued
and outstanding common shares which were held by approximately 86 shareholders
of record, of which 18,035,000shares were free trading. The balance is restricted stock as that term is
used in Rule 144 of the Securities Exchange Act of 1934, as amended (the
“Exchange Act”).




There is
currently minimal trading volume for our securities.  The following
table sets forth certain information with respect to the high and low market
prices of our common stock for the periods indicated in the 3 months ended March
31, 2009 and in the years ending December 31, 2008 and 2007.  These
quotations, as provided by the OTC Bulletin Board, reflect inter-dealer prices,
without retail mark-up, mark-down or commission and may not represent actual
transaction prices between dealers.







Year
                                            
                                            Quarter
                                            
                                            High
                                            
                                            Low2009
                                            
                                            First
                                            
                                            $
                                            0.08
                                            
                                            $
                                            0.012008
                                            
                                            Fourth
                                            
                                            
                                            0.44
                                            
                                            
                                            0.01Third
                                            
                                            
                                            0.50
                                            
                                            
                                            0.44Second
                                            
                                            
                                            0.50
                                            
                                            
                                            0.15First
                                            
                                            
                                            0.51
                                            
                                            
                                            0.152007
                                            
                                            Fourth
                                            
                                            
                                            1.55
                                            
                                            
                                            0.24Third
                                            
                                            
                                            2.10
                                            
                                            
                                            1.50Second
                                            
                                            
                                            2.00
                                            
                                            
                                            1.45First
                                            
                                            
                                            2.60
                                            
                                            
                                            1.37




Dividends




We have
not declared or paid any cash dividends on our common stock and we do not expect
to pay any cash dividends in the foreseeable future. The decision whether to pay
cash dividends on our common stock will be made by our Board of Directors, in
their discretion, and will depend on our financial condition, operating results,
capital requirements and other factors that our Board of Directors considers
significant. We currently intend to retain our earnings for funding growth and,
therefore, do not expect to pay any dividends in the foreseeable
future.




Equity
Compensation Plan Information





Plan
      Category
                  
                  Number
      of
                    Securities
      to be Issued
                    Upon
      Exercise of
                    Outstanding
      Stock Options
                  
                  Weighted-Average
                    Exercise
      Price of
                    Outstanding
      Stock
                    Options
                  
                  Number
      of
                    Securities
                    Remaining
                    Available
      for
                    Future Issuance
                    Under
      Equity
                    Compensation
                    PlansEquity
      Compensation plans not approved by security holders2004
      Stock Option Plan
                  
                  5,406,743
                  
                  $
                  0.14
                  
                  -
      0-2007
      Omnibus Stock and Incentive Plan
                  
                  2,950,000
                  
                  $
                  0.25
                  
                  8,932,170






19
 Table of Contents




2004
Stock Option Plan




Our Board
of Directors voted unanimously to cause the Company to assume all stock options
under the 2004 Stock Plan of InterMetro Delaware (the “2004 Plan”), which were
issued and outstanding immediately prior to the closing of the Business
Combination, which closed on or about December 29, 2006. All InterMetro Delaware
stock options were converted into options to purchase shares of our common stock
as of December 29, 2006. Upon the shareholders ratification of the 2004 Plan
pursuant to the Schedule 14C Information Statement filed with the Securities and
Exchange Commission declared effective May 10, 2007, we froze any further grants
of stock options under the 2004 Plan. Any shares reserved for issuance under the
2004 Plan that are not needed for outstanding options granted under that plan
will be cancelled and returned to treasury shares. The number of outstanding
stock options and the exercise prices were adjusted in the same proportion as
the exchange ratio for the outstanding common stock in the Business Combination.
The exercise periods and other terms and conditions remained the same.
Accordingly, as of December 31, 2008, we had stock options to purchase
approximately 5,406,742 shares of our common stock outstanding under the 2004
plan of which approximately 4,528,724 vest as follows: 20% on the date of grant
and 1/16 of the balance each quarter thereafter until the remaining stock
options have vested and approximately 878,018 of which as follows: 50% on the
date of grant and 50% at one year after the date of grant. The exchanged stock
options are exercisable for a period of ten years from the date of initial grant
by InterMetro at exercise prices ranging from $0.0406 to $0.9738.




For the
fiscal year ended December 31, 2006, InterMetro Delaware issued stock options to
purchase 86,765 shares of  common stock under the 2004 Plan at an
average exercise price of $5.37 per share (exchangeable for stock options to
purchase 908,826 shares of our common stock at an average exercise price of
$0.513) to employees and directors.   For the fiscal years ended
December 31, 2008 and 2007, InterMetro issued no stock options under the 2004
plan and 308,077 options that had previously been issued were forfeited as a
consequence of an employee departure.  As of December 31, 2008,
1,232,320 of the Company’s outstanding stock options issued pursuant to the 2004
Plan have been exercised.




Omnibus
Stock and Incentive Plan




Effective
January 19, 2007, our Board of Directors approved the 2007 Omnibus Stock and
Incentive Plan (the “2007 Plan”) for directors, officers, employees, and
consultants. Our shareholders ratified the 2007 Plan pursuant to the Schedule
14C Information Statement filed with the Securities and Exchange Commission
which was declared effective on May 10, 2007. The 2007 Plan allows any of the
following types of awards, to be granted alone or in tandem with other awards:
(1) Stock options which may be either incentive stock options (“ISOs”), which
are intended to satisfy the requirements of Section 422 of the Internal Revenue
Code of 1986, as amended, or nonstatutory stock options (“NSOs”), which are not
intended to meet those requirements; (2) restricted stock which is common stock
that is subject to restrictions, including a prohibition against transfer and a
substantial risk of forfeiture, until the end of a “restricted period” during
which the grantee must satisfy certain vesting conditions; (3) restricted stock
units which entitle the grantee to receive common stock, or cash (or other
property) based on the value of common stock, after a “restricted period” during
which the grantee must satisfy certain vesting conditions or the restricted
stock unit is forfeited; (4) stock appreciation rights which entitle the grantee
to receive, with respect to a specified number of shares of common stock, any
increase in the value of the shares from the date the award is granted to the
date the right is exercised; and (5) other types of equity-based compensation
which may include shares of common stock granted upon the achievement of
performance objectives.




The 2007
Plan will be administered by the Compensation Committee once this committee is
formed, which will at all times be composed of two or more members of the Board
of Directors who are not our employees or consultants. Any employee or director
of, or consultant for, us or any of our subsidiaries or other affiliates will be
eligible to receive awards under the 2007 Plan. We have reserved 8,903,410
shares of common stock for awards under the 2007 Plan. In addition, on each
anniversary of the 2007 Plan’s effective date on or before the fifth anniversary
of the effective date, the aggregate number of shares of our common stock
available for issuance under the 2007 Plan will be increased by the lesser of
(a) 5% of the total number of shares of our common stock outstanding as of the
December 31 immediately preceding the anniversary, (b) 4,713,570 shares, or (c)
a lesser number of shares of our common stock that our board, in its sole
discretion, determines. In general, shares reserved for awards that lapse or are
canceled will be added back to the pool of shares available for awards under the
2007 Plan.




Awards
under the 2007 Plan are forfeitable until they become vested. An award will
become vested only if the vesting conditions set forth in the award agreement
(as determined by the Compensation Committee) are satisfied. The vesting
conditions may include performance of services for a specified period,
achievement of performance objectives, or a combination of both. The
Compensation Committee also will have authority to provide for accelerated
vesting upon occurrence of an event such as a change in control. The 2007 Plan
specifically prohibits the Compensation Committee from repricing any stock
options or stock appreciation rights. In general, awards under the 2007 Plan may
not be assigned or transferred except by will or the laws of descent and
distribution. However, the Compensation Committee may allow the transfer of NSOs
to members of a 2007 Plan participant’s immediate family or to a trust,
partnership, or corporation in which the parties in interest are limited to the
participant and members of the participant’s immediate family.




The Board
of Directors or the Compensation Committee may amend, alter, suspend, or
terminate the 2007 Plan at any time. If necessary to comply with any applicable
law (including stock exchange rules), we will first obtain stockholder approval.
Amendments, alterations, suspensions, and termination of the 2007 Plan generally
may not impair a participant’s (or a beneficiary’s) rights under an outstanding
award. However, rights may be impaired if necessary to comply with an applicable
law or accounting principles (including a change in the law or accounting
principles) pursuant to a written agreement with the participant. Unless it is
terminated sooner, the 2007 Plan will terminate upon the earlier of June 23,
2016 or the date all shares available for issuance under the 2007 Plan have been
issued and vested.




For the fiscal year ended December 31,
2007, InterMetro issued 2,350,000 shares of common stock under the 2007 plan at
an average exercise price of $0.25 per share to
employees.For
the fiscal year ended December 31, 2008,weissued600,000shares of common stock under the 2007
Plan at an average exercise price of $0.25 per share to
employees.   As of December31, 2008, none of the Company’s outstanding
stock options issued pursuant to the 2007 Plan have been
exercised.




20
 Table of Contents




Item6. Management’s Discussion and Analysis of Results of Operations
and Financial Condition




Cautionary
Statements




This
Annual Report contains financial projections and other “forward-looking
statements,” as that term is used in federal securities laws, about our
financial condition, results of operations and business. These statements
include, among others: statements concerning the potential for revenues and
expenses and other matters that are not historical facts. These statements may
be made expressly in this Annual Report. You can find many of these statements
by looking for words such as “believes,” “expects,” “anticipates,” “estimates,”
or similar expressions used in this Annual Report. These forward-looking
statements are subject to numerous assumptions, risks and uncertainties that may
cause our actual results to be materially different from any future results
expressed or implied by us in those statements. The most important facts that
could prevent us from achieving our stated goals include, but are not limited
to, the following:




(a) volatility
or decline of our stock price;




(b) potential
fluctuation in quarterly results;




(c) our
failure to earn revenues or profits;




(d) inadequate
capital and barriers to raising capital or to obtaining the financing needed to
implement its business plans;




(e) changes
in demand for our products and services;




(f) rapid and
significant changes in markets;




(g) litigation
with or legal claims and allegations by outside parties;




(h) insufficient
revenues to cover operating costs;




(i) the
possibility we may be unable to manage our growth;




(j) extensive
competition;




(k) loss of
members of our senior management;




(l) our
dependence on local exchange carriers;




(m) our need
to effectively integrate businesses we acquire;




(n) risks
related to acceptance, changes in, and failure and security of, technology;
and




(o) regulatory
interpretations and changes.




We
caution you not to place undue reliance on the statements, which speak only as
of the date of this Annual Report. The cautionary statements contained or
referred to in this section should be considered in connection with any
subsequent written or oral forward-looking statements that we or persons acting
on behalf of us may issue. We do not undertake any obligation to review or
confirm analysts’ expectations or estimates or to release publicly any revisions
to any forward-looking statements to reflect events or circumstances after the
date of this Annual Report or to reflect the occurrence of unanticipated
events.




21
 Table of Contents




The
following discussion should be read in conjunction with our consolidated
financial statements and notes to those statements.




Background




InterMetro
Communications, Inc. (hereinafter, “we,” “us,”  “InterMetro” or the
“Company”) is a Nevada corporation which through its wholly owned subsidiary,
InterMetro Communications, Inc. (Delaware) (hereinafter, “InterMetro Delaware”),
is engaged in the business of providing voice over Internet Protocol (“VoIP”)
communications services. On December 29, 2006, InterMetro, a public “shell”
company, completed a business combination with InterMetro Delaware whereby
InterMetro Delaware became our wholly-owned subsidiary. For financial reporting
purposes, InterMetro Delaware was considered the accounting acquirer in the
business combination.




General





We have
built a national, private, proprietary voice-over Internet Protocol, or VoIP,
network infrastructure offering an alternative to traditional long distance
network providers. We use our network infrastructure to deliver voice calling
services to traditional long distance carriers, broadband phone companies, VoIP
service providers, wireless providers, other communications companies and end
users. Our VoIP network utilizes proprietary software, configurations and
processes, advanced Internet Protocol, or IP, switching equipment and
fiber-optic lines to deliver carrier-quality VoIP services that can be
substituted transparently for traditional long distance services. We believe
VoIP technology is generally more cost efficient than the circuit-based
technologies predominantly used in existing long distance networks and is easier
to integrate with enhanced IP communications services such as web-enabled phone
call dialing, unified messaging and video conferencing services.




We focus
on providing the national transport component of voice services over our private
VoIP infrastructure. This entails connecting phone calls of carriers or end
users, such as wireless subscribers, residential customers and broadband phone
users, in one metropolitan market to carriers or end users in a second
metropolitan market by carrying them over our VoIP infrastructure. We compress
and dynamically route the phone calls on our network allowing us to carry up to
approximately eight times the number of calls carried by a traditional long
distance company over an equivalent amount of bandwidth. In addition, we believe
our VoIP equipment costs significantly less than traditional long distance
equipment and is less expensive to operate and maintain. Our proprietary network
configuration enables us to quickly, without modifying the existing network, add
equipment that increases our geographic coverage and calling
capacity.




We enhanced our network’s functionality
by implementing Signaling System 7, or SS-7, technology. SS-7 allows access to
customers of the local telephone companies, as well as customers of wireless
carriers. SS-7 is the established industry standard for reliable call
completion, and it also provides interoperability between our VoIP
infrastructure and traditional telephone company
networks.  While
we expect to continue to add to capacity, as of September 30, 2008 and 2007, the
SS-7 network expansion was a fully operating and revenue generating component of
our VoIP infrastructure.  We believe that increasing voice minutes
utilizing our network expansion will ultimately generate increasing gross
margins approximating those generated prior to the network expansion. A key
aspect of our current business strategy is to focus on sales to increase these
voice minutes.




Overview




History . InterMetro began
business as a VoIP on December 29, 2006 and began generating revenue at that
time. Since then, we have increased our revenue to approximately
$25.1 million for the year ended December 31, 2008.





Our
corporate headquarters is located in Simi Valley, California. We lease
collocation space for our VoIP equipment in carrier-class telecommunications
facilities in metropolitan markets throughout the U.S. and expect to add
additional collocation facilities as we expand our VoIP network.





Trends
in Our Industry and Business





A number
of trends in our industry and business could have a significant effect on our
operations and our financial results. These trends include:




Increased competition for end users
of voice services . We believe there are an increasing number of
companies competing for the end users of voice services that have traditionally
been serviced by the large incumbent carriers. The competition has come from
wireless carriers, competitive local exchange carriers, or CLECs, and
interexchange carriers, or IXCs, and more recently from broadband VoIP
providers, including cable companies and DSL companies offering broadband VoIP
services over their own IP networks. All of these companies provide national
calling capabilities as part of their service offerings, however, most of them
do not operate complete national network infrastructures. These companies
previously purchased national transport services exclusively from traditional
carriers, but are increasingly purchasing transport services from
us.




Merger and acquisition activities of
traditional long distance carriers . Recently, the three largest
operators of traditional long distance service networks were acquired by or have
merged with several of the largest local wireline and wireless
telecommunications companies. AT&T Corp. was acquired by SBC Communications
Inc., MCI, Inc. was acquired by Verizon Communications, Inc. and Sprint
Corporation and Nextel Communications, Inc. engaged in a merger transaction.
While we believe it is too early to tell what effects these transactions will
have on the market for national voice transport services, we may be negatively
affected by these events if these companies increase their end user bases, which
could potentially decrease the amount of services purchased by our carrier
customers. In addition, these companies have greater financial and personnel
resources and greater name recognition. However, we could potentially benefit
from the continued consolidation in the industry, which has resulted in fewer
competitors.




Regulation . Our business has
developed in an environment largely free from regulation. However, the Federal
Communications Commission (“FCC”) and many state regulatory agencies have begun
to examine how VoIP services could be regulated, and a number of initiatives
could have an impact on our business. These regulatory initiatives include, but
are not limited to, proposed reforms for universal service, the intercarrier
compensation system, FCC rulemaking regarding emergency calling services related
to broadband IP devices, and the assertion of state regulatory authority over
us. Complying with regulatory developments may impact our business by increasing
our operating expenses, including legal fees, requiring us to make significant
capital expenditures or increasing the taxes and regulatory fees applicable to
our services. One of the benefits of our implementation of SS-7 technology is to
enable us to purchase facilities from incumbent local exchange carriers under
switched access tariffs. By purchasing these traditional access services, we
help mitigate the risk of potential new regulation related to VoIP.




22
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Our
Business Model




Historically,
we have been successful in implementing our business plan through the expansion
of our VoIP infrastructure. Since our inception, we have grown our customer
base, including the customers from our recent acquisition, to include over 200
customers, including several large publicly-traded telecommunications companies
and retail distribution partners. In connection with the addition of customers
and the provision of related voice services, we have expanded our national VoIP
infrastructure.




In 2006,
we also began to dedicate significant resources to acquisition growth,
completing our first acquisition of ATI in  March 2006. We
acquired ATI to add minutes to our network and to access new sales channels and
customers. We plan to grow our business through direct sales activities and
potentially through acquisitions.




Revenue . We generate revenue
primarily from the sale of voice minutes that are transported across our VoIP
infrastructure. In addition, ATI, as a reseller, generates revenues from the
sale of voice minutes that are currently transported across other telecom
service providers’ networks. However, we have migrated some of these revenues on
to our VoIP infrastructure, and intend to migrate a significant portion of ATI’s
revenues in the future. We negotiate rates per minute with our carrier customers
on a case-by-case basis. The voice minutes that we sell through our retail
distribution partners are typically priced at per minute rates, are packaged as
calling cards and are competitive with traditional calling cards and prepaid
services. Our carrier customer services agreements and our retail distribution
partner agreements are typically one year in length with automatic renewals. We
generally bill our customers on a weekly or monthly basis with either a prepaid
balance required at the beginning of the week or month of service delivery or
with net terms determined by the customers’ creditworthiness. Factors that
affect our ability to increase revenue include:




·
            Changes
      in the average rate per minute that we charge our
    customers.





Our voice
services are sold on a price per minute basis. The rate per minute for each
customer varies based on several factors, including volume of voice services
purchased, a customer’s creditworthiness, and, increasingly, use of our SS-7
based services, which are priced higher than our other voice transport
services.




·
            Increasing
      the net number of customers utilizing our VoIP
  services.




Our
ability to increase revenue is primarily based on the number of carrier
customers and retail distribution partners that we are able to attract and
retain, as revenue is generated on a recurring basis from our customer base. We
expect increases in our customer base primarily through the expansion of our
direct sales force and our marketing programs. Our customer retention efforts
are primarily based on providing high quality voice services and superior
customer service. We expect that the addition of SS-7 based services to our
network will significantly increase the universe of potential customers for our
services because many customers will only connect to a voice service provider
through SS-7 based interconnections.




·
            Increasing
      the average revenue we generate per
customer.




We
increase the revenue generated from existing customers by expanding the number
of geographic markets connected to our VoIP infrastructure. Also, we are
typically one of several providers of voice transport services for our larger
customers, and can gain a greater share of a customer’s revenue by consistently
providing high quality voice service.




·
            Acquisitions.




We expect
to expand our revenue base through the acquisition of other voice service
providers. We plan to continue to acquire businesses whose primary cost
component is voice services or whose technologies expand or enhance our VoIP
service offerings.




We expect
that our revenue will increase in the future primarily through the addition of
new customers gained from our direct sales and marketing activities and from
acquisitions.




Network Costs . Our network,
or operating, costs are primarily comprised of fixed cost and usage based
network components. In addition, ATI incurs usage based costs from its
underlying telecom service providers. We generally pay our fixed network
component providers at the beginning or end of the month in which the service is
provided and we pay for usage based components on a weekly or monthly basis
after the delivery of services. Some of our vendors require a prepayment or a
deposit based on recurring monthly expenditures or anticipated usage volumes.
Our fixed network costs include:




·
            SS-7
      based interconnection costs.




We added
a significant amount of capacity, measured by the number of simultaneous phone
calls our VoIP infrastructure can connect in a geographic market, by connecting
directly to local phone companies through SS-7 based interconnections purchased
on a monthly recurring fixed cost basis. As we expand our network capacity and
expand our network to new geographic markets, SS-7 based interconnection
capacity will be the primary component of our fixed network costs.





·
            Competitive
      local exchange carrier costs.






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 Table of Contents




The
interconnections between our VoIP infrastructure and our customers’ end users,
as well as our retail customers, have historically been purchased on a monthly
recurring fixed cost basis from competitive local exchange carriers, or CLECs.
Historically, CLEC interconnections had been our largest component of fixed
network costs.





·
            Other
      fixed costs.




Other
significant fixed costs components of our VoIP infrastructure include private
fiber-optic circuits and private managed IP bandwidth that interconnect our
geographic markets, monthly leasing costs for the collocation space used to
house our networking equipment in various geographic markets, local loop
circuits that are purchased to connect our VoIP infrastructure to our customers
and usage based vendors within each geographic market. Other fixed network costs
include depreciation expense on our network equipment and monthly subscription
fees paid to various network administrative services.




The
usage-based cost components of our network include:




·
            Off-net
      costs.




In order
to provide services to our customers in geographic areas where we do not have
existing or sufficient VoIP infrastructure capacity, we purchase transport
services from traditional long distance providers and resellers, as well as from
other VoIP infrastructure companies. We refer to these costs as “off-net” costs.
Off-net costs are billed on a per minute basis with rates that vary
significantly based on the particular geographic area to which a call is being
connected.




·
            SS-7
      based interconnections with local
carriers.




The SS-7
based interconnection services and those we intend to purchase for the provision
of a majority of our future services, include a usage based, per minute cost
component. The rates per minute for this usage based component are significantly
lower than the per minute rates for off-net services. The usage based costs for
SS-7 services are expected to be the largest cost component of our network as we
grow revenue utilizing SS-7 technology.




Our
fixed-cost network components generally do not experience significant price
fluctuations. Factors that affect these network components include:




·
            Efficient
      utilization of fixed-cost network
components.




Our
customers utilize our services in identifiable fixed daily and weekly patterns.
Customer usage patterns are characterized by relatively short periods of high
volume usage, leaving a significant amount of time during each day where the
network components remain idle.




Our
ability to attract customers with different traffic patterns, such as customers
who cater to residential calling services, which typically spike during evening
hours, with customers who sell enterprise services primarily for use during
business hours, increases the overall utilization of our fixed-cost network
components. This decreases our overall cost of operations as a percentage of
revenues.





·
            Strategic
      purchase of fixed-cost network
components.




Our
ability to purchase the appropriate amount of fixed-cost network capacity to (1)
adequately accommodate periods of higher call volume from existing customers,
(2) anticipate future revenue growth attributed to new customers, and (3) expand
services for new and existing customers in new geographic markets is a key
factor in managing the percentage of fixed costs we incur as a percentage of
revenue.




From time
to time, we also make strategic decisions to add capacity with newly deployed
technologies, such as the SS-7 based services, which require purchasing a large
amount of network capacity in many geographic markets prior to the initiation of
customer revenue.




We expect
that both our fixed-cost and usage-based network costs will increase in the
future primarily due to the expansion of our VoIP infrastructure and use of
off-net providers related to the expected growth in our revenues.




Our
usage-based network components costs are affected by:




·
            Fluctuations
      in per minute rates of off-net service
  providers.




Increasing
the volume of services we purchase from our vendors typically lowers our average
off-net rate per minute, based on volume discounts. Another factor in the
determination of our average rate per minute is the mix of voice services we use
by carrier type, with large fluctuations based on the carrier type of the end
user which can be local exchange carriers, wireless providers or other voice
service providers.




·
            Sales
      mix of our VoIP infrastructure capacity versus off-net
      services.






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 Table of Contents




Our
ability to sell services connecting our on-net geographic markets, rather than
off-net areas, affects the volume of usage based off-net services we purchase as
a percentage of revenue.




·
            Acquisitions
      of telecommunications businesses.




We expect
to continue to make acquisitions of telecommunications companies. As we complete
these acquisitions and add an acquired company’s traffic and revenue to our
operations, we may incur increased usage-based network costs. These increased
costs will come from traffic that remains with the acquired company’s
pre-existing carrier and from any of the acquired company’s traffic that we
migrate to our SS-7 services or our off-net carriers. We may also experience
decreases in usage based charges for traffic of the acquired company that we
migrate to our network. The migration of traffic onto our network requires
network construction to the acquired company’s customer base, which may take
several months or longer to complete.




Sales and Marketing Expense.
Sales and marketing expenses include salaries, sales commissions, benefits,
travel and related expenses for our direct sales force, marketing and sales
support functions. Our sales and marketing expenses also include payments to our
agents that source carrier customers and retail distribution partners. Agents
are primarily paid commissions based on a percentage of the revenues that their
customer relationships generate. In addition, from time to time we may cover a
portion or all of the expenses related to printing physical cards and related
posters and other marketing collateral. All marketing costs associated with
increasing our retail consumer user base are expensed in the period in which
they are incurred. We expect that our sales and marketing expenses will increase
in the future primarily due to increases in our direct sales force.




General and Administrative
Expense. General and administrative expenses include salaries, benefits
and expenses for our executive, finance, legal and human resources personnel and
include the costs of being a public company. In addition, general and
administrative expenses include fees for professional services, occupancy costs
and our insurance costs, and depreciation expense on our non-network depreciable
assets. Our general and administrative expenses also include stock-based
compensation on option grants to our employees and options and warrant grants to
non-employees for goods and services received.




Results of
Operations




The
following table sets forth, for the periods indicated, the results of our
operations expressed as a percentage of revenue:





Year
      Ended December 31,2008
              
              
              2007Net
      revenues
              
              
              100
              %
              
              
              100
              %Network
      costs
              
              
              91
              
              
              
              103Gross
      profit
              
              
              9
              
              
              
              (3
              )Operating
      expenses:Sales
      and marketing
              
              
              7
              
              
              
              9General
      and administrative
              
              
              23
              
              
              
              35Impairment
      of goodwill
              
              
              6
              
              
              
              -Total
      operating
      expenses
              
              
              36
              
              
              
              44Operating
      loss
              
              
              (27
              )
              
              
              (47
              )Interest
      expense
              
              
              10
              
              
              
              2Loss
      on liability of options and warrants
              
              
              -
              
              
              
              25Loss
      before provision for income tax
              
              
              (37
              )
              
              
              (74
              )Provision
      for income taxes
              
              
              (-
              )
              
              
              (-
              )Net
      loss
              
              
              (37
              )%
              
              
              (74
              )%




Year
Ended December 31, 2008 Compared to Year Ended December 31, 2007





Net Revenues.  Net
revenues increased $2.4 million, or 10.7%, to $25.1 million for the year ended
December 31, 2008 from $22.7 million for the year ended December 31, 2007. We
have been increasing new customers which contributed approximately $3.1 million
in additional revenues in the twelve months ending December 31, 2008 and have
also had increasing revenue from existing customers.  This increase
was partially offset by the reduction in revenues attributable to both
decreasing revenues from existing customers and the loss of certain
customers.




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 Table of Contents




Network
Costs.  Network costs decreased $555,000, or 2.3%, to $22.9
million for the year ended December 31, 2008 from $23.4 million for the year
ended December 31, 2007.  Included within total network costs,
variable network costs increased by $197,000 to $20.5 million (81.6% of
revenues) for the year ended December 31,2008 from $20.3 million (89.5% of
revenues) for the year ended December 31,2007, even as revenues increased by
10.7% as a result of increased efficiency in network
utilization.  Fixed network costs decreased by $789,000 to $2.4
million for the year ended December 31, 2008 from $3.2 million for the year
ended December 31, 2007, with the decrease coming primarily from the elimination
of underutilized network components that were in operation during year ended
December 31, 2007.  There were no significant fixed network expenses
added during the year ended December 31, 2008.  Through the migration
of existing customers to the SS-7 based infrastructure and the addition of new
customers, the Company expects to generate improved gross margins as it
increases the utilization of its SS-7 network infrastructure.




Gross
margin increased to 8.8% for the year ended December 31, 2008 from a gross
margin of (3.4)% for the year ended December 31, 2007. This increase in gross
margin was attributable to the increasing utilization of capacity and decreased
fixed network costs. The Company expects to continue to generate improved gross
margins as it increases the utilization of its SS-7 network infrastructure in
the future through increased sales.




Depreciation
expense included within network costs for the year ended December 31, 2008 was
$575,000 (2.3% of net revenues) as compared to $975,000 (4.3% of net revenues)
for the year ended December 31, 2007.




Sales and Marketing. Sales
and marketing expenses decreased $333,000, or 16.1% to $1.7 million for the year
ended December 31, 2008 from $2.1 million for the year ended December 31, 2007.
Sales and marketing expenses as a percentage of net revenues were 6.9% and 9.1%
for the year ended December 31, 2008 and 2007, respectively.  The
Company’s efforts to minimize expenses in sales and marketing resulted in
decreased expenses for advertising, consulting, outsourced customer service,
salaries and promotions, partially offset by an increase in agent
commissions.




General and Administrative.
General and administrative expenses decreased $2.1 million or 26.3% to $5.9
million for the year ended December 31, 2008 from $8.0 million for the year
ended December 31, 2007. General and administrative expenses as a percentage of
net revenues were 23.4% and 35.2% for the year ended December 31, 2008 and 2007,
respectively. The year ended December 31, 2007 included a $819,000 non-recurring
charge related to warrants.  The additional $1.3 million decrease in
general and administrative expenses for the year ended December 31,2008 is
primarily attributable to a $790,000 reduction in professional service fees and
a $572,000 reduction in payroll related expenses due to reduction in
workforce.  General and Administrative expense for 2008 includes bad
debt expense of $220,000. Certain professional service fees in the year ended
December 31, 2007 were non-recurring fees attributable to becoming a publicly
traded company.




Interest Expense, net.
Interest expense, net increased $2.1 million to $2.6 million for the year ended
December 31, 2008 from $460,000 for the year ended December 31,
2007.  Interest expense for the year ended December 31, 2008 includes
$1.4 million amortization of debt discount, $300,000 related to a contingent
liability, $219,000 secured note interest and $119,000 line of credit
interest.





Option and Warrant Liability.
In the year ended December 31, 2007, we incurred a loss on option and warrant
liability of $5.6 million. This loss represents the change in estimated value of
our liability for options granted under our 2004 Plan that are exercisable but
for which we did not have adequate unissued authorized common stock. The value
of this estimated liability was $5.4 million and $11.0 million at
December 31, 2006 and March 31, 2007, respectively. This liability was
created on December 29, 2006 as a result of the business combination between
InterMetro and Lucy’s Cafe and therefore had no effect on the year ended
December 31, 2006. Pursuant to the Company’s May 2007 filing and subsequent
effectiveness of the definitive Schedule 14C Information Statement and the
increase in authorized shares of common stock to 150,000,000 as described
in Note 8 to the Consolidated Financial Statements, there is no remaining
liability for these options at December 31, 2007.




Liquidity
and Capital Resources




At
December 31, 2008, we had $171,000 in cash as compared to $277,000 in cash at
December 31, 2007.





The
Company’s working capital position, defined as current assets less current
liabilities, has historically been negative and was negative $17.3 million at
December 31, 2008 as compared to negative $12.0 million at December 31, 2007.
The decrease in working capital was primarily due to the cash used in operating
activities of $3.9 million. Included in current liabilities at December 31, 2008
was $1.2 million due under strategic equipment agreements used to finance
equipment purchases. The Company has agreements with vendors that allow for
significantly longer terms than the terms for payment offered to the majority of
its customers.




Significant
changes in cash flows for December 31, 2008 as compared to December 31,
2007:




Net cash
used in operating activities was $3.9 million for the year ended December 31,
2007 as compared to net cash used in operating activities of $9.7 million for
the year ended December 31, 2006. The most significant change that decreased the
use of cash from operating activities was the lower net loss for the year ended
December 31, 2008 of approximately $9.4 million.  Significant
adjustments increasing cash from operating activities in 2008 were impairment of
goodwill of $1.5 million, amortization of debt discount of $1.0 million, an
increase in accounts payable and accrued expenses of $2.3 million and the
add-back of non cash depreciation and amortization expense of $635,000 and stock
based compensation of $247,000.




Net cash
used in investing activities for the year ended December 31, 2008 was $39,000
which was attributable to the purchase of network-related equipment as compared
to $77,000 for the year ended December 31, 2007.




Net cash
provided by financing activities for the year ended December 31, 2008 was $3.9
million as compared to cash provided by financing activities of $10.0 million
for the year ended December 31, 2007. Net cash provided for the year ended
December 31, 2008 included $1.3 million proceeds from secured notes, advances
of  $310,000 from related parties and $2.4 million proceeds from lines
of credit.  Net cash provided for the year ended December 31, 2007
included the receipt of approximately $10.2 million in gross proceeds from our
sale of common stock in December 2006 (proceeds were held in escrow at December
 31, 2006)  and $600,000 in proceeds from bridge financing during
the fourth quarter of fiscal 2007.  These inflows were partially
offset by the repayment of our related party credit facilities of $1.1 million
in 2007 and  repayment of amount due to a related party of $140,000
and principal payments of capital lease obligations of $142,000 in
2008.




26
 Table of Contents




The
Company has incurred net losses of $9.4 million and $16.9 million and negative
cash flow from operations of $3.9 million and $9.7 million for the years ended
December 31, 2008 and 2007, respectively. As of December 31, 2008, the Company
has a working capital deficit of $17.3 million. The Company plans to use its
current cash balance and capital raised from outside sources to fund future
operating losses until the Company has grown revenues so that cash flows from
operating activities are sufficient to sustain operations without the need for
outside capital. The Company will need additional cash from outside financing
sources to continue current operations and achieve its growth strategies,
including cash for use in the completion of potential acquisitions.





In November and December 2007, the
Company received $600,000 and in the period from January to June 2008 the
Company received an additional $1,320,000 and an additional $462,500 from
November 2008 to February 2009 pursuant to the sale of secured notes with
individual investors for general working capital pursuant, $810,000 from related
parties. The terms of the secured notes are 13 to 18 months maturity with an
interest rate of 13% per annum due at the maturity date.  The secured notes
are secured by substantially all of the assets of the Company.  The Company
is also required to pay an origination fee of 3.00% and documentation fee of
2.50% of the principal amount of the secured notes at the maturity date. 
Prepayment of the credit facilities requires payment of interest that would have
accrued through maturity, discounted by 20%, in addition to principal, accrued
interest and fees. The Company can continue to sell similar secured notes up to
a maximum offering of $3 million. In addition, the Company entered into a
revolving credit agreement, effective as of April 30, 2008 (see Note 11 to the
Consolidated Financial Statements) pursuant to which the Company originally
could access funds up to $1,500,000 such access increased to $2,000,000 per
Amendment No. 1 to the agreement in September 2008 and to $2,400,000 per
Amendment no. 2 to the agreement in November 2008.  The Company is in
negotiations with the lender regarding an increase to the revolving credit
agreement.




Such
additional financings are necessary in order to fund ongoing operations until
such time as the Company can achieve positive cash flow from operations. There
can be no assurance that we will be successful in completing this required
financing or that we will continue to expand our revenue




The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern.  As discussed in Note 1, the
Company incurred net losses of $ 9,126,000 and $16,915,000 for the years ended
December 31, 2008 and 2007, respectively, and as of December 31, 2008, the
Company’s current liabilities exceeded its current assets by $16,961,000 and the
Company had a deficit in stockholders’ equity of
$15,644,000.  Negative cash flows from operations were $3,921,000 and
$9,747,000 for the years ended December 31, 2008 and 2007, respectively  
The Company also anticipates that it will not have sufficient cash flow to fund
its operations through the end of fiscal 2009.  These factors, among
others, as discussed in Note 1 to the consolidated financial statements, raise
substantial doubt about the Company’s ability to continue as a going
concern.  Management’s plans in regard to these matters are also described
in Note 1.  The consolidated financial statements do not include any
adjustments relating to the recoverability and classification of asset carrying
amounts or the amount and classification of liabilities that might result should
the Company be unable to continue as a going concern





Our
long-term operating cash requirements include the capital necessary to fund the
expansion of capacity and continuing implementation of SS-7 technology in our
existing metropolitan markets as well as expansion of our network infrastructure
to additional metropolitan markets. We expect cash flow from operating
activities of our existing network to offset the negative cash flow from
operating activities and cash spent on financing of our capacity and
metropolitan market expansions. We intend to adhere to a go-forward policy of
fully funding all network infrastructure expansions in advance and intend to
expand while maintaining sufficient cash to cover our projected needs. To the
extent our plans change, we may need to seek additional funding by accessing the
equity or debt capital markets. There is uncertainty regarding whether some of
our VoIP services should be classified as telecommunications services. Any VoIP
services so classified may be subject to third-party access charges, taxes and
fees. If access charges, taxes and fees are imposed on services we have provided
or continue to provide, it could have a material adverse effect on our results
of operations, financial condition and working capital.




In
addition, we may pursue acquisitions that require a portion or all of our cash
on hand to complete and may also require us to seek additional funding. Our net
losses to date may prevent us from obtaining additional funds on favorable terms
or at all. Because of our history of net losses and our limited tangible assets,
we do not fit traditional credit lending criteria, which could make it difficult
for us to obtain loans or to access the debt capital markets. If additional
funds were raised through the issuance of convertible debt or equity securities,
the percentage of stock owned by our then-current stockholders would be reduced.
Furthermore, such convertible debt and equity securities may have rights,
preferences or privileges senior to those of our then-current equity securities.
The sale of convertible debt securities or additional equity securities could
result in additional dilution to our stockholders. The incurrence of
indebtedness would result in incurring debt service obligations and could result
in operating and financial covenants that would restrict our operations. In
addition, there can be no assurance that any additional financing will be
available on acceptable terms, if at all.




Credit
Facilities





Revolving Credit
Facility – In April 2008, the Company entered into a convertible
revolving credit agreement pursuant to which the Company may access funds up to
$1.5 million.  In September 2008, the Company entered into Amendment
No. 1 to the agreement which increased the access to $2.0 million and in
November 2008 the Company entered into Amendment No 2 to the agreement which
increased the access to $2.4 million.  As of December 31, 2008, the
Company is permitted to borrow an amount not to exceed 120% of its eligible
accounts receivable. As of December 31, 2008, the Company has borrowed $2.4
million. The Company's obligations are secured by all of the assets of the
Company.  The availability of loan amounts under the revolving credit
agreement expires on April 30, 2009.  Annual interest on the
loans is equal to the greater of (i) the sum of (A) the Prime Rate
(B) 4% or (ii) 10%, and shall be payable in arrears prior to the maturity
date, on the first business day of each calendar month, and in full on April 30,
2009. (See Note 11 to the Consolidated Financial Statements for detailed
discussion.)




Critical
Accounting Policies and the Use of Estimates




Our
financial statements are prepared in accordance with accounting principles
generally accepted in the U.S. The preparation of these financial statements
requires us to make estimates and assumptions that affect the reported amounts
of assets, liabilities, revenue, costs and expenses and related disclosures. We
base our estimates on historical experience and on various other assumptions
that we believe to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying value of assets and
liabilities that are not readily apparent from other sources. We evaluate our
estimates and assumptions on an ongoing basis. Actual results may differ from
these estimates under different assumptions or conditions.




We
believe that the following accounting policies involve the greatest degree of
judgment and complexity. Accordingly, these are the policies we believe are the
most critical to aid in fully understanding and evaluating our financial
condition and results of operations.




Revenue Recognition. We
recognize our VoIP services revenues when services are provided, primarily on
usage. Revenues derived from sales of calling cards through related distribution
partners are deferred upon the sale of the cards. These deferred revenues are
recognized as revenues generally when all usage of the cards occurs. We
recognize revenue in the period that services are delivered and when the
following criteria have been met: persuasive evidence of an arrangement exists,
the fees are fixed and determinable, no significant performance obligations
remain for us and collection of the related receivable is reasonably assured.
Our deferred revenues consist of fees received or billed in advance of the
delivery of the services or services performed in which cash receipt is not
reasonably assured. This revenue is recognized when the services are provided
and no significant performance obligations remain or when cash is received for
previously performed services. We assess the likelihood of collection based on a
number of factors, including past transaction history with the customer and the
credit worthiness of the customer. Generally, we do not request collateral from
our customers. If we determine that collection of revenues are not reasonably
assured, we defer the recognition of revenue until the time collection becomes
reasonably assured, which is generally upon receipt of cash.




27
 Table of Contents




Stock-Based Compensation.Effective January 1, 2006,
we adopted SFAS No. 123(R), “Share-Based Payments.”  Since January 1,
2006, our stock-based compensation has been based on the balance of deferred
stock-based compensation for unvested awards at January 1, 2006, using the
intrinsic value as previously recorded under APB 25, and the fair value of
the awards on the date of grant for awards after January 1, 2006. The adoption
of SFAS No. 123(R) has resulted and will continue to result in higher
amounts of stock-based compensation for awards granted after January 1, 2006
than would have been recorded if we had continued to apply the provisions of APB
25. For the options granted prior to January 1, 2006, the intrinsic value per
share is being recognized as compensation expense over the applicable vesting
period (which equals the service period). For those options granted January 1,
2006 and thereafter, compensation expense was determined based on the fair value
of the options and is being recognized in our Consolidated Statement of
Operations over the applicable vesting period (which equals the service
period).  We estimated the fair value of each option award on the date
of grant using the Black-Scholes option-pricing model using various assumptions.
Expected volatility is based on the historical volatility of a peer group of
publicly traded entities. The expected term of options granted is derived from
the average midpoint between vesting and the contractual term, as described in
the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107,
“Share-Based Payment.” The risk-free rate for the expected term of the option is
based on the U.S. Treasury yield curve in effect at the time of
grant.




We
account for equity instruments issued to non-employees in accordance with the
provisions of SFAS 123(R), “Accounting for Stock-Based Compensation,” and
Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity
Instruments That are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling Goods or Services.” All transactions involving goods or
services as the consideration received for the issuance of equity instruments
are accounted for based on the fair value of the consideration received or the
fair value of the equity instrument issued, whichever is more readily measured.
The measurement date of the fair value of the equity instrument issued is the
earlier of the date on which the counterparty’s performance is complete or the
date on which it is probable that performance will occur.




Accounts
Receivable and the Allowance for Doubtful Accounts




Accounts
receivable consist of trade receivables arising in the normal course of
business. We do not charge interest on our trade receivables. The allowance for
doubtful accounts is our best estimate of the amount of probable credit losses
in our existing accounts receivable. We review our allowance for doubtful
accounts monthly. We determine the allowance based upon historical write-off
experience, payment history and by reviewing significant past due balances for
individual collectibility. If estimated allowances for uncollectible accounts
subsequently prove insufficient, additional allowance may be
required.




Impairment
of Long-Lived Assets




We assess
impairment of our other long-lived assets in accordance with the provisions of
SFAS 144, Accounting for the
Impairment or Disposal of Long-lived Assets. An impairment review is
performed whenever events or changes in circumstances indicate that the carrying
value may not be recoverable. Factors considered by us include:




·Significant
      underperformance relative to expected historical or projected future
      operating results;




·Significant
      changes in the manner of use of the acquired assets or the strategy for
      our overall business; and




·Significant
      negative industry or economic
trends.




When we
determine that the carrying value of a long-lived asset may not be recoverable
based upon the existence of one or more of the above indicators of impairment,
an estimate is made of the future undiscounted cash flows expected to result
from the use of the asset and its eventual disposition. If the sum of the
expected future undiscounted cash flows and eventual disposition is less than
the carrying amount of the asset, an impairment loss is recognized in the amount
by which the carrying amount of the asset exceeds the fair value of the asset,
based on the fair market value if available, or discounted cash flows if not. To
date, we have not had an impairment of long-lived assets and are not aware of
the existence of any indicators of impairment.




Goodwill


We record
goodwill when consideration paid in a business acquisition exceeds the fair
value of the net tangible assets and the identified intangible assets acquired.
The Company accounts for goodwill and intangible assets in accordance with SFAS
No. 142, “Goodwill and Other Intangible Assets.” SFAS 142 requires that goodwill
and intangible assets with indefinite useful lives not be amortized, but instead
be tested for impairment at least annually or whenever changes in circumstances
indicate that the carrying value of the goodwill may not be recoverable. SFAS
No. 142 also requires the Company to amortize intangible assets over their
respective finite lives up to their estimated residual values.  At
December 31, 2008, the Company has determined that circumstances indicate that
the full carrying value of the Company’s goodwill is not recoverable and has
taken a charge for the impairment of goodwill. (See Note 2 to the Consolidated
Financial Statements  for a more detailed discussion of goodwill
impairment.)




Accounting
for Income Taxes




We
account for income taxes using the asset and liability method in accordance with
SFAS 109, Accounting for
Income Taxes, which requires the recognition of deferred tax assets and
liabilities for the expected future tax consequences of temporary differences
between the carrying amounts and tax bases of the assets and liabilities. We
periodically review the likelihood that we will realize the value of our
deferred tax assets and liabilities to determine if a valuation allowance is
necessary. We have concluded that it is more likely than not that we will not
have sufficient taxable income of an appropriate character within the
carryforward period permitted by current law to allow for the utilization of
certain of the deductible amounts generating deferred tax assets; therefore, a
full valuation allowance has been established to reduce the deferred tax assets
to zero at December 31, 2008 and 2007. In addition, we operate within multiple
domestic taxing jurisdictions and are subject to audit in those jurisdictions.
These audits can involve complex issues, which may require an extended period of
time for resolution. Although we believe that our financial statements reflect a
reasonable assessment of our income tax liability, it is possible that the
ultimate resolution of these issues could significantly differ from our original
estimates.




28
 Table of Contents




Net
Operating Loss Carryforwards




As of
December 31, 2008 and 2007, our net operating loss carryforwards for federal tax
purposes were approximately $17.7 and $14.0 million,
respectively.  These net operating losses occurred subsequent to our
business combination in December 2006.




Contingencies
and Litigation




We
evaluate contingent liabilities including threatened or pending litigation in
accordance with SFAS 5, “Accounting for Contingencies” and record accruals when
the outcome of these matters is deemed probable and the liability is reasonably
estimable. We make these assessments based on the facts and circumstances and in
some instances based in part on the advice of outside legal
counsel.




It is not
unusual in our industry to occasionally have disagreements with vendors relating
to the amounts billed for services provided. We currently have disputes with
vendors that we believe did not bill certain charges correctly. While we have
paid the undisputed amounts billed for these non-recurring charges based on rate
information provided by these vendors, as of December 31, 2008, there is
approximately $3.5 million of unresolved charges in dispute. We are in
discussion with these vendors regarding these charges and may take additional
action as deemed necessary against these vendors in the future as part of the
dispute resolution process.




Contractual
Obligations




Our major
outstanding contractual obligations relate to our capital lease obligations
related to purchases of fixed assets, amounts due under our strategic equipment
agreement, operating lease obligations, and other contractual obligations,
primarily consisting of the underlying elements of our network. There are no
significant provisions in our agreements with our network partners that are
likely to create, increase, or accelerate obligations due thereunder other than
changes in usage fees that are directly proportional to the volume of activity
in the normal course of our business operations. We have no long-term
obligations of more than three years.




The
following table reflects a summary of our contractual obligations at December
31, 2008:





Payments
      Due by Period
                      (In
      Thousands)Contractual
      Obligations
                    
                    Total
                    
                    
                    Less
      than
                      1
      year
                    
                    
                    1-3
      years
                    
                    
                    3-5
      years
                    
                    
                    more
      than
                      5
      yearsCapital
      lease obligations
                    
                    $
                    133
                    
                    
                    $
                    133
                    
                    
                    $
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —Operating
      lease obligations
                    
                    
                    66
                    
                    
                    
                    66
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —Total
                    
                    $
                    199
                    
                    
                    $
                    199
                    
                    
                    $
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —









Off-Balance
Sheet Arrangements




We
currently do not have any outstanding derivative financial instruments,
off-balance sheet guarantees, interest rate swap transactions, foreign currency
forward contracts or any other off-balance sheet arrangements.




Quantitative
and Qualitative Disclosures Regarding Market Risk




Foreign Currency Market Risks
.. We currently do not have significant exposure to foreign currency exchange
rates as all of our sales are denominated in U.S. dollars.




Interest Rate Market Risk .
Our cash is invested in bank deposits and money market funds denominated in U.S.
dollars. The carrying value of our cash, restricted cash, accounts receivable,
deposits, other current assets, trade accounts payable, accrued expenses,
deferred revenue and customer deposits, and current portion of long-term capital
lease obligations approximate fair value because of the short period of time to
maturity. At December 31, 2008, the carrying value of the capital lease
obligations approximate fair value as their contractual interest rates
approximate market yields for similar debt instruments.




Recent
Accounting Pronouncements





For a
discussion of the impact of recently issued accounting pronouncements, see the
subsection entitled "Recent Accounting Pronouncements" contained in Note 1
of the Notes to Consolidated Financial Statements under "Item 8. Financial
Statements and Supplementary Data."




29
 Table of Contents




Item7. Financial Statements of InterMetro Communications,
Inc.




See the
Index to Consolidated Financial Statements on Page F-1 attached
hereto.




Item8. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure





Effective
as of November 3, 2008, we replaced Mayer Hoffman McCann P.C. (“MHM”) as our
independent registered public accounting firm. MHM had been previously engaged
as the principal accountant to audit our financial statements. The decision to
change accountants was recommended and approved by the Company’s Audit Committee
and Board of Directors.  During the fiscal years ended December 31,
2006 and 2007 through November 3, 2008, the Company did not have any
disagreements with MHM on any matter of accounting principles or practices,
financial statement disclosure, or auditing scope or procedure which, if not
resolved to MHM satisfaction, would have caused it to make reference to the
subject matter of the disagreement in connection with its report.




The
firm of Gumbiner Savett Inc. (“GSI”), our current independent registered public
accounting firm, was retained  on November 3, 2008.  We
reported the above change in accountants on Form 8-K filed with the Securities
and Exchange Commission on November 6, 2008.




Item8A(T). Controls and Procedures




Evaluation of Disclosure
Controls and Procedures




As
required by Rules 13a-15(e) and 15d-15(e) under the Exchange Act, we carried out
an evaluation of the effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the period covered by this Annual
Report. This evaluation was carried out under the supervision and with the
participation of our Chief Executive Officer and our Chief Financial
Officer.




The
Company maintains a set of disclosure controls and procedures designed to ensure
that information required to be disclosed by the Company in the reports filed
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified by the Securities and Exchange Commission’s rules and
forms. Disclosure controls are also designed with the objective of ensuring that
this information is accumulated and communicated to the Company’s management,
including the Company’s Chief Executive Officer and Chief Financial Officer, as
appropriate, to allow timely decisions regarding required
disclosure.




Based
upon their evaluation as of the end of the period covered by this report, the
Company’s Chief Executive Officer and Chief Financial Officer were not able to
conclude that, the Company’s disclosure controls and procedures are effective to
ensure that information required to be included in the Company’s periodic
Securities and Exchange Commission filings is recorded, processed, summarized,
and reported within the time periods specified in the Securities and Exchange
Commission rules and forms. Therefore, under Section 404 of the Sarbanne’s-Oxley
Act of 2002, they must conclude that these controls and procedures are not
effective.




Internal Control over
Financial Reporting




The
Company’s board of directors was advised by GSI, the Company’s independent
registered public accounting firm, that during their performance of audit
procedures for 2008, GSI identified material weaknesses as defined in Public
Company Accounting Oversight Board Standard No. 5,  in the Company’s
internal control over financial reporting and in the segregation of duties
within the accounting department. The Company is not an accelerated filer and
GSI did not perform an audit of the Company’s internal controls. These
weaknesses were identified in connection with the audit of the financial
statements and reported pursuant to the requirements under Statement on Auditing
Standards No. 61, Communications with Audit Committees.




The
Company’s control over financial reporting has been identified based on the
number of error corrections and adjustments to Company prepared audit schedules
made by the Company as part of completing a timely audit process, none of which
were individually material weaknesses. Additionally, the Company identified
significant deficiencies surrounding the financial reporting process.
Collectively, these represent a material weakness in the financial reporting
process.




It was
also identified that the size of the Company’s accounting staff prohibited its
ability to properly segregate duties, a material weakness that could lead to the
inability of the Company’s internal control system to timely identify and
resolve accounting and disclosure matters.




Management’s Annual Report
on Internal Control Over Financial Reporting





Management
is responsible for establishing and maintaining adequate internal control over
financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange
Act. Internal control over financial reporting is a process designed to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements in accordance with GAAP. Because of its
inherent limitations, internal control over financial reporting may not prevent
or detect misstatements. Also, projection of any evaluation of effectiveness to
future periods is subject to the risk that controls may become inadequate
because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.




Management
conducted, with the participation of our Chief Executive Officer and our Chief
Financial Officer, an assessment, including testing of the effectiveness, of our
internal control over financial reporting as of December 31, 2007.
Management’s assessment of internal control over financial reporting was
conducted using the criteria in Internal Control over Financial
Reporting - Guidance for Smaller Public Companies issued by the Committee
of Sponsoring Organizations of the Treadway Commission (“COSO”).




30
 Table of Contents




A
material weakness is a deficiency, or a combination of deficiencies, in internal
control over financial reporting, such that there is a reasonable possibility
that a material misstatement of our annual or interim financial statements will
not be prevented or detected on a timely basis. In connection with our
management’s assessment of our internal control over financial reporting as
required under Section 404 of the Sarbanes-Oxley Act of 2002, we identified the
following material weaknesses in our internal control over financial reporting
as of December 31, 2008:




·
            While
      we have implemented control procedures for reviewing all material
      financial reporting items and test these control processes, certain of our
      control procedures are not sufficient to prevent the risk that a potential
      material misstatement of the financial statements would occur without
      being prevented or detected, specifically with regards to dispute reserves
      for accounts payable, accruals for third party charges and certain equity
      accounts. In each case, the Company does not have adequate staffing to
      ensure that the monitoring  processes mitigate risks that
      external information used is correct and, in the case of equity accounts,
      that the Company has personnel with adequate understanding of the
      applicability of accounting principles.·
            We
      have not maintained sufficient evidence to support that certain of our
      internal controls over financial reporting activities were performed on a
      timely basis, specifically related to confirmation testing of disputes of
      information received from our vendors, variance analysis, accounts
      receivable analyses and equity
accounts.




·
            Due
      to the small size of our Company, we have not adequately divided, or
      compensated for, functions among personnel to reduce the risk that a
      potential material misstatement of the financial statements would occur
      without being prevented or detected with regards to certain of our equity
      accounts. Specifically, with regards to equity awards, at times
      information used in our financial reporting is not able to be given to
      additional competent staff to mitigate the risk of erroneous or
      inappropriate actions.




Because
of the material weaknesses noted above, management has concluded that we did not
maintain effective internal control over financial reporting as of December 31,
2008, based on Internal
Control over Financial Reporting - Guidance for Smaller Public Companies
issued by (“COSO”).




Remediation
of Material Weaknesses in Internal Control Over Financial Reporting




We are in
the process of implementing remediation efforts with respect to the material
weaknesses noted above as follows:




·
            We
      plan to improve our monitoring processes and add additional staff
      resources to monitor our dispute reserves, accruals for third party
      charges and equity reporting activities.·
            We
      intend on developing specific policies and procedures around the nature
      and retention of evidence of the operation of controls. For example, where
      other forms of sign-off and evidence of timeliness do not exist, reviews
      will be evidenced via sign-off (including signature and
    date).




·
            We
      are considering re-assigning roles and responsibilities in order to
      improve segregations of duties with regards to control activities for our
      equity accounts.




We
believe the foregoing efforts will enable us to improve our internal control
over financial reporting. Management is committed to continuing efforts aimed at
improving the design adequacy and operational effectiveness of its system of
internal controls. The remediation efforts noted above will be subject to our
internal control assessment, testing and evaluation process.




Changes
in Internal Control Over Financial Reporting




There
were no changes in our internal control over financial reporting during the
three months  ended December 31, 2008 that materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.




This
annual report does not include an attestation report of the Company’ registered
public accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by the
Company’s registered public accounting firm pursuant to temporary rules of the
Securities and Exchange Commission that permits us to provide only management’s
report in this annual report.




Item8B. Other Information




None.




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 Table of Contents




PART
III




Item9. Directors, Executive Officers, Promoters and Control Persons;
Compliance with Section 16(a) of Exchange Act









The
following table lists our executive officers and directors as of December 31,
2008:




Name
                
                Age
                
                PositionCharles
      Rice
                
                45
                
                President,
      Chief Executive Officer and Chairman of the BoardJon
      deOng
                
                35
                
                Chief
      Technology Officer, DirectorKen
      Fish
                
                49
                
                Chief
      Financial OfficerJoshua
      Touber(1)
                
                46
                
                DirectorRobert
      Grden(1)
                
                45
                
                DirectorDouglas
      Benson(1)
                
                76
                
                Director


——————


(1)
Member of the Audit Committee




Charles
Rice has served as a Director and as our Chief Executive Officer and
President since December 29, 2006.  Mr. Rice is the founder of
InterMetro Delaware and has served as the Chairman, Chief Executive Officer and
President since its inception in July 2003. Under Mr. Rice’s leadership,
InterMetro Delaware was ranked 46th in Entrepreneur magazine’s June 2006 Hot 100
Fastest Growing Businesses in America. From 1999 to 2003, Mr. Rice was
Chairman, Chief Executive Officer, and President of CNM Network, Inc., or CNM, a
national VoIP carrier. Mr. Rice joined CNM in 1997 and became a member of
its board of directors in 1998. From 1998 to 1999, Mr. Rice served as CNM’s
Vice President and Chief Operating Officer. Prior to CNM, Mr. Rice spent
over 15 years in executive positions. Mr. Rice attended California State
University of Northridge.




Jon deOng
has served as our Chief Technology Officer since December 29, 2006 and as a
Director since January 19, 2007. Mr. deOng has served as
InterMetro Delaware’s Chief Technology Officer and a director since its
inception in July 2003. Prior to joining InterMetro Delaware,
Mr. deOng served as the Chief Technology Officer for CNM from 1999 to 2003
and served as a member of CNM’s board of directors from 1999 to 2003. From 1998
to 1999, Mr. deOng served as Vice President of Technology at CNM. Prior to
CNM, Mr. deOng was responsible for managing the development and deployment
of Netcom On-line Communication Services, Inc.’s Business Center, the core
infrastructure systems of Netcom’s web hosting service, later acquired by ICG
Communications, Inc. Mr. deOng attended the University of
Texas.





Ken Fish
has served as Chief Financial Officer since December 2008.  Prior to this
role, he held a variety of accounting, corporate finance, and corporate strategy
and development roles with Fortune 500 and S&P 500 corporations for over 15
years.  Mr. Fish holds a Bachelor of Arts degree from
Princeton University and a Masters of Business Administration from The
University of California.




Joshua
Touber has served as a director since January 19, 2007. Mr. Touber
has served as a director of InterMetro Delaware since March 2004.
Mr. Touber is currently President of Touber Media, LLC, a media consulting
firm. From 1998 to 2003, Mr. Touber was the Chief Operating Officer of
Ascent Media Creative Services Group, a subsidiary of Liberty Media Group. In
1995, Mr. Touber founded Virtuosity, a telecommunication services provider
that developed the “virtual assistant” product category under the “Wildfire”
brand name and has served as its President since its inception.




Robert
Grden has served as a director since January 19, 2007. Mr. Grden has
served as a director of InterMetro Delaware since August 2004. Mr. Grden is
currently the Deputy County Treasurer for the Wayne County Michigan Treasurer’s
office, a position he has held since 1991. Prior to that, he was a management
consultant with Ernst & Young LLP serving clients in a variety of
industries. Mr. Grden is also the current Chairman of, and has served the
last seven years on, the Board of Trustees of the Wayne County Retirement
Commission where he oversees certain employee compensation and benefit
plans.




Douglas
Benson has served as a director since January 19, 2007. Dr. Benson
has served as a director of InterMetro Delaware since May 2006. Dr. Benson
is currently the Chief Executive Officer of the Edwin S. Johnston Company, a
real estate investment and development company, a position he has held for the
past 20 years. Dr. Benson was a founder and majority shareholder of
Heritage Bank, a commercial bank in Michigan. Dr. Benson served on the
board of directors of Andrews University for over 10 years. Dr. Benson
holds a Bachelor of Arts degree from Andrews University and a Doctor of
Medicine from Loma Linda University.




Vincent
Arena served as our Chief Financial Officer from December 29, 2006 and as
a Director from January 19, 2007 until his departure form the Company in
December 2008.  The departure of Mr. Arena and arrival of Mr. Fish
were discussed in filings with the Securities and Exchange Commission on Forms
8K dated December 9 and December 10,  2008.




Former
Management Relationships




Messrs.
Rice, deOng and Arena held positions for several years as executive officers of
CNM Network, Inc. until their departure in June 2003. After their departure, CNM
relocated its headquarters and in December 2003, changed its company name. In
September 2004, 15 months after management’s departure, the entity formerly
known as CNM filed a voluntary bankruptcy proceeding in the U.S. Bankruptcy
Court - Central District of California.




32
 Table of Contents




Limitation
of Liability and Indemnification of Officers and Directors;
Insurance




Our
Articles of Incorporation limits the liability of directors to the maximum
extent permitted by Nevada law. Nevada law provides that directors of a
corporation will not be personally liable for monetary damages for breach of
their fiduciary duties as directors, except liability for:




·
            any
      breach of their duty of loyalty to the corporation or its
      shareholders;




·
            acts
      or omissions not in good faith or which involve intentional misconduct or
      a knowing violation of law;




·
            unlawful
      payments of dividends or unlawful stock repurchases or redemptions;
      or




·
            any
      transaction from which the director derived an improper personal
      benefit.




Our
Bylaws provide that we will indemnify our directors, officers, employees and
other agents to the fullest extent permitted by law.




We have
separate indemnification agreements with our directors and officers, in addition
to the indemnification provided for in our Bylaws. These agreements, among other
things, provide that we will indemnify our directors and officers for certain
expenses (including attorneys’ fees), judgments, fines and settlement amounts
incurred by a director or executive officer in any action or proceeding arising
out of such person’s services as one of our directors or officers, or rendering
services at our request, to any of our subsidiaries or any other company or
enterprise. We believe that these provisions and agreements are necessary to
attract and retain qualified persons as directors and officers.




Insofar
as an indemnification for liabilities arising under the Securities Act may be
permitted for directors, officers or persons controlling us pursuant to the
foregoing provisions, we have been informed that in the opinion of the
Securities and Exchange Commission each indemnification is against public policy
as expressed in the Securities Act and is therefore unenforceable.




Legal
Proceedings




There is
no pending litigation or proceeding involving any of our directors or officers
as to which indemnification is required or permitted, and we are not aware of
any threatened litigation or proceeding that may result in a claim for
indemnification.




Executive
Officers, Directors and Committees




Executive
Officers




Our
executive officers are appointed by and serve at the discretion of our Board of
Directors. We have employment agreements with our executive officers, which are
discussed below under the heading “Executive Compensation – Employment
Agreements.”




Board
of Directors




Our Board
of Directors currently consists of six directors. Messrs. Benson, Grden and
Touber are “independent” as defined in NASD Marketplace Rule 4200(a)(15). Mr.
Rice, who is our President and Mr. deOng, who is our Chief Technology Officer,
are not independent. We plan to appoint additional independent directors so that
a majority of our directors are independent.




The Board
of Directors is divided into three classes, Class I, Class II and Class III,
with each class serving staggered three-year terms.  The members of
the classes are divided as follows:




·
            Class
      I, whose term expires at the annual meeting of the shareholders to be held
      in 2008, is comprised of Messrs. Joshua Touber and Douglas
      Benson;




·
            Class
      II, whose term expires at the annual meeting of the shareholders to be
      held in 2009, is comprised of Mr.. Robert Grden;
  and




·
            Class
      III, whose term expires at the annual meeting of shareholders to be held
      in 2010, is comprised of Messrs. Charles Rice and Jon
    deOng.




33
 Table of Contents




Our
Amended and Restated Bylaws provide that the number of persons constituting our
Board of Directors may be fixed from time to time, but only by a resolution
adopted by a majority of our Board of Directors and provided that such number
cannot be less than three nor more than eleven. Vacancies on the Board of
Directors and newly created directorships resulting from any increase in the
authorized number of directors will be filled by a majority vote of the
directors then in office, even if less than a quorum, or by the sole remaining
director. Any additional directorships resulting from an increase in the number
of directors will be distributed among the three classes so that, as nearly as
possible, each class will consist of one-third (1/3) of the total number of
directors. This classification of the Board of Directors may have the effect of
delaying or preventing changes in the control of or management of the Company.
Our directors may be removed only for cause by the affirmative vote of holders
of at least 66 2/3% of our then outstanding capital stock voting together as a
single class.




Committees
of the Board of Directors




Our Board
of Directors currently has a standing Audit Committee. We plan to establish a
Compensation Committee and a Nominating and Governance Committee. Until such
committees are established, matters otherwise addressed by such committees will
be acted upon by the majority of independent directors. The following is a brief
description of our committees and contemplated committees.




Audit
Committee




Messrs.
Benson, Grden and Touber are the current members of our Audit Committee. Mr.
Grden has been appointed to serve as chairman of the Audit Committee. Mr. Grden
meets the applicable NASD listing standards for designation as an “Audit
Committee Financial Expert.”




Pursuant
to the Audit Committee charter, the functions of our Audit Committee
includes:




·
            meeting
      with our management periodically to consider the adequacy of our internal
      controls and the objectivity of our financial
  reporting;




·
            engaging
      and pre-approving audit and non-audit services to be rendered by our
      independent auditors;




·
            recommending
      to our Board of Directors the engagement of our independent auditors and
      oversight of the work of our independent
  auditors;




·
            reviewing
      our financial statements and periodic reports and discussing the
      statements and reports with our management, including any significant
      adjustments, management judgments and estimates, new accounting policies
      and disagreements with management;




·
            establishing
      procedures for the receipt, retention and treatment of complaints received
      by us regarding accounting, internal accounting controls and auditing
      matters;




·
            administering
      and discussing with management and our independent auditors our code of
      ethics; and reviewing and approving all related-party transactions in
      accordance with applicable listing exchange
  rules.




Report
of the Audit Committee




Our Audit
Committee has reviewed and discussed our audited financial statements for the
fiscal year ended December 31, 2008 with senior management. The Audit Committee
has also discussed with GSI, our independent auditors, the matters required to
be discussed by the Statement on Auditing Standards No. 61 (Communication with
Audit Committees) and received the written disclosures and the letter from GSI
required by Independence Standards Board Standard No. 1 (Independence Discussion
with Audit Committees). The Audit Committee has discussed with GSI the
independence of GSI as our auditors. Finally, in considering whether the
independent auditors provision of non-audit services to the Company is
compatible with the auditors’ independence for GSI, the Company’s Audit
Committee has recommended to the Board of Directors that our audited financial
statements be included in our Annual Report on Form 10-K for the fiscal year
ended December 31, 2008 for filing with the United States Securities and
Exchange Commission. Our Audit Committee did not submit a formal report
regarding its findings.




AUDIT
COMMITTEE




Robert
Grden


Joshua
Touber


Douglas
Benson




Notwithstanding
anything to the contrary set forth in any of our previous or future filings
under the Securities Act or the Exchange Act that might incorporate this report
in future filings with the Securities and Exchange Commission, in whole or in
part, the foregoing report shall not be deemed to be incorporated by reference
into any such filing.




Code
of Conduct




We have
adopted a Code of Conduct that applies to all of our directors, officers and
employees. The text of the Code of Conduct has been posted on InterMetro’s
Internet website and can be viewed at http://www.intermetro.net/conduct.htm
.. Any waiver of the provisions of the Code of Conduct for executive officers and
directors may be made only by the Audit Committee and, in the case of a waiver
for members of the Audit Committee, by the Board of Directors. Any such waivers
will be promptly disclosed to our shareholders.




34
 Table of Contents




Compliance
with Section 16(A) of Exchange Act




Section
16(a) of the Exchange Act requires our officers and directors, and certain
persons who own more than 10% of a registered class of our equity securities
(collectively, “Reporting Persons”), to file reports of ownership and changes in
ownership (“Section 16 Reports”) with the Securities and Exchange Commission.
Reporting Persons are required by the Securities and Exchange Commission to
furnish us with copies of all Section 16 Reports they file.




Based
solely on its review of the copies of such Section 16 Reports received by it, or
written representations received from certain Reporting Persons, all Section
16(a) filing requirements applicable to our Reporting Persons during and with
respect to the fiscal year ended December 31, 2008 have been complied with on a
timely basis.




Item10. Executive Compensation




Executive
Officer Compensation




The
following table summarizes compensation paid or accrued by the Company for the
years ended December 31, 2008 and 2007 for services rendered in all capacities,
by our chief executive officer and the other most highly compensated executive
officers during the fiscal years ended December 31, 2008 and 2007.




Summary
Compensation Table




Name
      and
                      Principal
                      Position
                    
                    Year
                    
                    Salary
                    
                    Bonus
                    
                    Option
                      Awards
                    
                    Non-Equity
                      Incentive
      Plan
                      Compensation
                    
                    Non-Qualified
                      Deferred
                      Compensation
                      Earnings
                    
                    All
      Other
                      Compensation(1)
                    
                    TotalCharles
      Rice
                      Chief
      Executive Officer and President
                    
                    2008
                      2007
                    
                    $
                    150,439
                      268,295
                    
                    0
                      0
                    
                    0
                      0
                    
                    0
                      0
                    
                    0
                      0
                    
                    $
                    21,764
                      21,727
                    
                    $
                    172,203
                      290,022Jon
      deOng
                      Chief
      Technology Officer
                    
                    2008
                      2007
                    
                    $
                    126,506
                      225,612
                    
                    0
                      0
                    
                    0
                      0
                    
                    0
                      0
                    
                    0
                      0
                    
                    $
                    17,616
                      17,775
                    
                    $
                    144,122
                      243,387Vincent
      Arena former Chief Financial Officer
                    
                    2008
                      2007
                    
                    $
                    126,506
                      222,581
                    
                    0
                      0
                    
                    0
                      0
                    
                    0
                      0
                    
                    0
                      0
                    
                    $
                    13,034
                      13,515
                    
                    $
                    139,540
                      236,096Ken
      Fish(2) Chief Financial Officer
                    
                    2008
                    
                    $
                    0
                    
                    0
                    
                    0
                    
                    0
                    
                    0
                    
                    $
                    0
                    
                    $
                    0




——————


(1)
            Amounts
      primarily represent medical insurance premiums and reimbursements for
      automobile and electronic communication device
  expenses.


(2)
            Mr.
      Fish was first paid in January of
2009.




Employment
Agreements




Effective
on or about January 1, 2007, we assumed from InterMetro Delaware certain
employment agreements with our Chief Executive Officer, Charles Rice, Chief
Technical Officer and Jon deOng. Each of the agreements was originally entered
into as of January 1, 2004 and has a term ending on December 31, 2009, with
automatic one-year extensions unless either we or the executive provides notice
of intention not to renew the agreement at least 60 days prior to the end of its
term.




The
agreement with Mr. Rice provides for an initial base annual salary of
$220,000 and a discretionary annual bonus target of up to 100% of his base
annual salary.  Mr. Rice accepted a salary reduction to $150,000 for
the year ended December 31, 2008.  The agreement with Mr. deOng
provides for an initial base annual salary of $185,000 and a discretionary
annual bonus target of up to 75% of his base annual salary.  Mr. deOng
accepted a salary reduction to $125,000 in the year ended December 31,
2008.  We anticipate senior executive bonuses under each of these
agreements will be determined based on various factors, including revenue
achievement and operating income (loss) before depreciation and amortization
targets, as well as personal contributions. These performance factors may change
from year to year. Each of these agreements calls for an 11% yearly increase in
annual base salary.




Pursuant
to the employment agreements, Mr. Rice and Mr. deOng, were each
granted, on January 2, 2004, options to purchase 308,080 shares of our common
stock, as adjusted for the Business Combination. The options for Mr. Rice
have an exercise price of $0.0446 per share and the options for
Mr. deOng  have an exercise price of $0.0406. Mr. deOng’s options
have an exercise period of ten years from the date of grant and Mr. Rice’s
options have an exercise period of five years from the date of grant. The
options were 20% vested upon grant, and 1/16 of the unvested options vest each
calendar year quarter from the grant date.




These
employment agreements may be terminated by us if the executive acts with gross
negligence in the performance of his duties resulting in a breach of his
fiduciary duties to us, our board, or our shareholders (provided that we give
the executive notice of the basis for the termination and an opportunity for 30
days to cease committing the alleged conduct).




Severance
benefits are payable under the agreements if the executive’s employment is
terminated (i) if we materially breach the employment agreement or terminates
the agreement other than for gross negligence (as described above), (ii) upon
the death or disability of the executive, or (iii) on account of non-renewal of
the employment agreement after a change in control of our ownership. These
severance benefits include (i) a lump sum payment equal to the greater of the
sum of the executive’s annual compensation and accrued but unpaid bonus payable
through the end of the term of the employment agreement or one year of the
executive’s annual base compensation, (ii) continuation medical insurance
coverage and other benefits through the end of the term, and (iii) full
vesting of all unvested stock options, with the ability to exercise all options
granted under the agreement for the remainder of their term.




35
 Table of Contents




If the
executive terminates his employment for reasons other than our breach of the
agreement, he will not be entitled to severance benefits and will have a period
of 90 days after notification of termination to exercise his vested options. If
the executive’s employment is terminated for gross negligence (as described
above), the executive will not be entitled to severance benefits, but he will be
entitled to exercise his vested stock options for the remainder of their
term.




Outstanding
Equity Awards




The
following table sets forth information for each of our executive officers
regarding the number of shares subject to exercisable and unexercisable stock
options to purchase shares of our common stock at the fiscal year ended December
31, 2008.




Outstanding
Equity Awards at Fiscal Year-End





Name
                          
                          Number
      of
                            Securities
                            Underlying
                            Unexercised
                            Options
                            Exercisable(1)
                          
                          Number
      of
                            Securities
                            Underlying
                            Unexercised
                            Options
                            Unexercisable(1)
                          
                          Option
                            Exercise
                            Price
                          
                          Option
                            Expiration
                            DateCharles
      Rice
                          
                          308,080
                          
                          
                          - 0
      -
                          
                          $
                          0.0446
                          
                          1/2/09Chairman,
      Chief Executive Officer, and PresidentJon
      deOng
                          
                          308,080
                          
                          
                          - 0
      -
                          
                          $
                          0.0406
                          
                          1/2/14Chief
      Technology OfficerKen
      Fish
                          
                          - 0
      -
                          
                          
                          - 0
      -
                          
                          $
                          0
                          
                          -Chief
      Financial Officer


——————


(1)
            Stock
      options were granted under our 2004 Stock Plan and vested 20% on the date
      of grant and 1/16 of the balance each quarter thereafter until the
      remaining stock options were
vested.




Director
Compensation




As of
January 19, 2007, we approved the following non-employee director compensation
program. We will pay our non-employee directors $1,000 per board meeting
attended in person and $500 for each telephonic meeting. In addition, we will
compensate members of our board committees as follows: (i) each member of our
Audit Committee will receive $500 per meeting and (ii) each member of our
Compensation Committee and Nominating and Governance Committee will receive $350
per meeting. The Chairman of our Audit Committee will also receive an annual
retainer of $5,000 per year. We intend to grant our directors options under our
2007 Plan in an amount to be determined prior to grant.




The
following table summarizes the compensation paid or accrued by InterMetro for
the year ended December 31, 2008 to InterMetro’s directors.




Director
Compensation





Name
                      
                      Fees
                        Earned or
                        Paid
      in
                        Cash
                      
                      
                      Stock
                        Awards
                      
                      
                      Option
                        Awards
                      
                      
                      Non-Equity
                        Incentive
      Plan
                        Compensation
                      
                      
                      Change
      in
                        Pension
      Value
                        and Nonqualified
                        Deferred
                        Compensation
                        Earnings
                      
                      
                      All
      Other
                        Compensation(1)
                      
                      
                      TotalJoshua
      Touber, Director
                      
                      $
                      6,000
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      $
                      5,085
                      
                      
                      $
                      11,085Robert
      Grden, Director
                      
                      $
                      10,000
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      $
                      10,000Douglas
      Benson, Director
                      
                      $
                      4,000
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      $
                      4,000


——————




(1)Amount
included in this Form 10-KSB primarily represents medical insurance
premiums.




36
 Table of Contents





Item11. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters




The
following table sets forth certain information regarding the beneficial
ownership of our common stock as of December 31, 2008, by (i) each director,
(ii) each executive officer, (iii) all directors and executive officers as a
group, and (iv) each person who beneficially owns more than five percent of our
common stock. Beneficial ownership is determined in accordance with the rules of
the Securities and Exchange Commission. In computing the number of shares
beneficially owned by a person and the percentage of ownership of that person,
shares of common stock subject to options held by that person that are currently
exercisable or become exercisable within 60 days of  December 31, 2008
are deemed outstanding even if they have not actually been exercised. Those
shares, however, are not deemed outstanding for the purpose of computing the
percentage ownership of any other person. The percentage ownership of each
beneficial owner is based on 59,575,194 outstanding shares of common stock.
Except as otherwise listed below, the address of each person is c/o InterMetro
Communications, Inc., 2685 Park Center Drive, Building A, Simi Valley,
California 93065. Except as indicated, each person listed below has sole voting
and investment power with respect to the shares set forth opposite such person’s
name.




Name
      and Title of Beneficial Owner
                                                    
                                                    Number
      of
                                                      Shares
      Beneficially
                                                      Owned(1)
                                                    
                                                    Percentage
                                                      OwnershipCharles
      Rice
                                                    
                                                    
                                                    37,648,731
                                                    (2)
                                                    
                                                    
                                                    52.4
                                                    %Chairman,
      President,Chief Executive Officer and
      SecretaryJon
      deOng
                                                    
                                                    
                                                    2,693,162
                                                    (3)
                                                    
                                                    
                                                    4.1
                                                    %Chief Technology
      OfficerJoshua
      Touber
                                                    
                                                    
                                                    1,605,411
                                                    (4)
                                                    
                                                    
                                                    2.4
                                                    %DirectorRobert
      Grden
                                                    
                                                    
                                                    184,848
                                                    (5)
                                                    
                                                    
                                                    *DirectorDouglas
      Benson
                                                    
                                                    
                                                    4,013,091
                                                    (6)
                                                    
                                                    
                                                    6.1
                                                    %DirectorDirectors
      and executive officers
                                                    
                                                    
                                                    43,452,051
                                                    
                                                    
                                                    
                                                    59.3
                                                    %as a group (6
      persons)Vincent
      Arena
                                                      Former
      Chief Financial Officer
                                                    
                                                    
                                                    2,485,358
                                                    (7)
                                                    
                                                    
                                                    3.8
                                                    %David
      Singer
                                                      President,
      Advanced Tel, Inc.
                                                    
                                                    
                                                    4,089,930
                                                    
                                                    
                                                    
                                                    6.2
                                                    %David
      Marshall
                                                    
                                                    
                                                    6,317,767
                                                    (8)
                                                    
                                                    
                                                    9.5
                                                    %9229 Sunset
      BoulevardSuite 505Los Angeles, CA
    90069Mitchell
      Pindus
                                                    
                                                    
                                                    3,034,607
                                                    (9)
                                                    
                                                    
                                                    4.6
                                                    %228 S. Medio
    DriveLos Angeles, CA
      90049Hunter
      World Markets, Inc.
                                                    
                                                    
                                                    8,579,000
                                                    (10)
                                                    
                                                    
                                                    11.6
                                                    %9300 Wilshire
      BoulevardPenthouse SuiteBeverly Hills, CA
      92012


——————


*
      Indicates beneficial ownership of less than one
  percent.






37
 Table of Contents





(1)
            Unless
      otherwise indicated and subject to applicable community property laws, to
      our knowledge each stockholder named in the table possesses sole voting
      and investment power with respect to all shares of common stock, except
      for those owned jointly with that person’s
  spouse.





(2)
            Includes
      357,123 shares which may be purchased pursuant to warrants and stock
      options that are exercisable within 60 days of December 31, 2008. Also
      includes 5,108,141 shares over which Mr. Rice would have voting power
      pursuant to voting agreements upon the exercise of stock options under the
      2004 Plan and 2007 Plan and an additional 9,288,595 shares owned by
      certain of our employees over which Mr. Rice maintains voting
      control. Mr. Rice has granted options to certain individuals to
      purchase a total of 1,016,686 shares of his common stock. These options
      expire on May 15, 2009. Includes 5,306,893 shares and warrants to purchase
      1,010,874 shares owned by David Marshall, the manager of an advisor to us,
      and his affiliates over which Mr. Rice has voting power for a period
      of two years from December 29, 2006 with respect to all matters (4,000,000
      shares) and with respect to the selection of directors (the balance of the
      shares). Mr. Marshall purchased 2,500,000 of these shares from
      Mr. Rice for $150,000 prior to the closing of the Business
      Combination. Also includes 2,554,587 shares and warrants to purchase
      480,020 shares owned by Mitchell Pindus and his affiliates over which
      Mr. Rice has voting power for a period of two years from December 29,
      2006 with respect to the selection of
directors.





(3)
            Includes
      308,080 shares which may be purchased pursuant to stock options that are
      exercisable within 60 days of December 31,
2008.





(4)
            Includes
      842,459 shares which may be purchased pursuant to warrants and stock
      options that are exercisable within 60 days of December 31, 2008. Also
      includes 61,623 shares and warrants to purchase 61,623 shares which are
      owned by Laurel Research, Inc., of which Mr. Touber is President,
      pursuant to warrants that are exercisable within 60 days of December 31,
      2008.





(5)
            Includes
      184,848 shares which may be purchased pursuant to stock options that are
      exercisable within 60 days of December 31,
2008.





(6)
            Includes
      369,694 shares which may be purchased pursuant to warrants and stock
      options that are exercisable within 60 days of December 31,
      2008.





(7)
            Includes
      308,080 shares which may be purchased pursuant to stock options that are
      exercisable within 60 days of December 31,
2008.





(8)
            Includes
      680,065 shares owned by David Marshall Inc., of which David Marshall is
      the chief executive officer; 478,240 shares owned by the David Marshall
      Pension Trust, of which Mr. Marshall is the trustee; 373,441 shares
      which may be purchased by David Marshall Inc. pursuant to warrants that
      are exercisable within 60 days of  December 31, 2008; 637,443
      shares which may be purchased by the David Marshall Pension Trust pursuant
      to warrants that are exercisable within 60 days of  December 31,
      2008; 648,588 shares owned by Glenhaven Corporation, of which
      Mr. Marshall is the chief executive officer, and 3,500,000 shares
      owned by Santa Monica Capital, LLC, of which Mr. Marshall is the
      manager. These shares are subject to a voting agreement pursuant to which
      Charles Rice has voting power for a period of two years from December 29,
      2006 with respect to all matters (4,000,000 shares) and with respect to
      the selection of directors (the balance of the
  shares).





(9)
            Includes
      1,846,664 shares owned by the Pindus Living Trust, of which
      Mr. Pindus is the co-trustee; 561,184 shares owned by the Mitchell R.
      Pindus Individual Retirement Account; 48,913 shares owned by the Myles
      Pindus Trust, of which Mr. Pindus is the trustee; 48,913 shares owned
      by the Tobias Pindus Trust, of which Mr. Pindus is the trustee;
      48,913 shares owned by the Erin Pindus Trust, of which Mr. Pindus is
      the trustee; 248,961 shares which may be purchased by the Pindus Living
      Trust pursuant to warrants that are exercisable within 60 days
      of  December 31, 2008; 231,059 shares which may be purchased by
      the Mitchell R. Pindus Individual Retirement Account pursuant to warrants
      that are exercisable within 60 days of December 31, 2008. These shares are
      subject to a voting agreement pursuant to which Charles Rice has voting
      power for a period of two years from December 29, 2006 with respect to the
      selection of directors.





(10)
            Includes
      3,885,000 shares of common stock owned by Hunter World Markets, Inc.
      (“Hunter”) and its affiliates and 4,694,000 shares which may be purchased
      by Hunter and its affiliates pursuant to warrants that are exercisable
      within 60 days of December 31, 2008. Todd M. Ficeto is President, Chief
      Executive Officer, and control person of Hunter and may be deemed to have
      voting and investment power over the shares held by Hunter.
      Mr. Ficeto disclaims beneficial ownership of the shares held by
      Hunter except to the extent of his pecuniary interest therein. Includes
      250,000 shares held by Mr. Ficeto. Includes 25,000 shares held by
      Hunter Ficeto and 25,000 shares held by Natalia Ficeto. Mr. Ficeto is
      the father of Hunter Ficeto and Natalia Ficeto and may be considered the
      control person of shares held by
them.












38
 Table of Contents




Item12. Certain Relationships and Related Transactions, and
Director Independence




Certain
Relationships and Related Transactions




Consulting
Services




David
Marshall, a beneficial owner of 10.4% of our common stock, the Chief Executive
Officer of Glenhaven Corporation, an advisor to InterMetro until December 2006,
and the agent for InterMetro’s Series A lenders prior to the repayment of the
Series A Notes, entered into a three-year consulting agreement with us under
which Santa Monica Capital LLC (an affiliate of Mr. Marshall) will receive
$13,000 per month (subject to a minimum increase of 5% per year) and 5% of all
gross proceeds derived from new business referrals and introductions made by
Santa Monica Capital LLC.




Securities
Issuances




In
December 2006, Santa Monica Capital, LLC, an affiliate of David Marshall,
purchased 1,000,000 shares and Mitchell Pindus purchased 500,000 shares of the
6,500,000 shares of our common stock purchased from our then controlling
stockholder prior to the Business Combination. Further, also in December 2006,
David Marshall acquired 2,500,000 shares of our common stock, as adjusted for
the Business Combination, from Charles Rice, our Chairman, Chief Executive
Officer and President, on the closing of the Business Combination in
consideration for $150,000 payable to Mr. Rice within a twelve month period.
Upon the closing of the Business Combination and the Private Placement, David
Marshall and Mitchell Pindus beneficially owned 6,317,777 and 3,034,607 shares,
respectively, of our common stock, or approximately 10.4% and 5.1% of the common
stock outstanding. For more information on the ownership of David Marshall or
Mitchell Pindus. See “Item 11. Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters.”




Voting
Agreements




Upon the
closing of the Business Combination, David Marshall, Mitchell Pindus and their
affiliates agreed to enter into voting agreements with Charles Rice pursuant to
which Mr. Rice will vote all shares of our common stock owned by David Marshall,
Mitchell Pindus and their affiliates with respect to certain matters for a
period of two years from the date of the closing of the Business Combination.
These shares are subject to a voting agreement pursuant to which Charles Rice
has voting power for a period of ninety days from December 29, 2006 for all
shares for all matters, and for a period of two years from December 29, 2006
with respect to all matters (limited to 4,000,000 shares owned by Marshall and
his affiliates) and with respect to the selection of directors (the balance of
shares owned by Marshall and his affiliates and all shares owned by Pindus and
his affiliates).




In
December 2008, Charles Rice transferred 1,000,000 shares to Joshua Touber to
which Mr. Rice has voting power for a period of two years from December 31, 2008
for all shares for all matters.




Holders
of options under our 2004 Plan are required to enter into an agreement granting
Mr. Rice voting rights with respect to the common stock issued upon exercise of
their options, which agreements expire ten years after execution
thereof.




Holders
of common stock purchased from Mr. Rice pursuant to options have entered into a
shareholders’ agreement granting Mr. Rice voting rights with respect to the
common stock issued upon exercise of their options, which agreements expire ten
years after execution thereof.




Indemnification
Agreements




We have
indemnification agreements with each of our directors, officers and certain
employees. The indemnification agreements provide that the director or officer
will be indemnified to the fullest extent not prohibited by law for claims
arising in such person’s capacity as a director or officer no later than 30 days
after written demand to us. The agreements further provide that in the event of
a change of control, we would seek legal advice from a special independent
counsel selected by us and approved by the officer or director, who has not
performed services for either party for five years, to determine the extent to
which the officer or director would be entitled to an indemnity under applicable
law. We believe that these agreements are necessary to attract and retain
skilled management with experience relevant to our industry.




Registration
Rights




In
connection with our Business Combination and Private Placement on December 29,
2006, we agreed to file two registration statements on Form SB-2 pursuant to
Rule 415 of the Securities Act. The first of which we agreed to file within
thirty 30 days after the date of the closing of the Private Placement to cover
the resale of the 10,235,000 shares of our common stock issued in the Private
Placement and the second of which we agreed to file within 10 business days of
the date six months after the effective date of the first registration statement
to register certain shares of our common stock that were outstanding prior to
the Business Combination, or the Existing Shares, and the shares underlying
warrants issued to the placement agent and its affiliates.




The first
registration statement on Form SB-2 was declared effective by the SEC on May 10,
2007.  The second registration statement on Form SB-2 was declared
effective by the SEC on January 31, 2008.




Employment
Agreements




We have
employment agreements with our executive officers described under “Item 10.
Executive Compensation — Employment Agreements.”




Director
Independence




See “Item
9. Directors, Executive Officers, Promoters and Control Persons; Compliance with
Section 16(A) of Exchange Act — Executive Officers, Directors and Committees —
Board of Directors.”




39
 Table of Contents
  Item13. Exhibits




(a) Exhibits


3.1*
                Articles
      of Incorporation3.2**
                Amended
      and Restated Articles of Incorporation3.3**+
                Amended
      and Restated Bylaws4.1*
                Specimen
      Certificate for Common Stock4.2**
                2004
      Stock Option Plan4.3**
                2007
      Omnibus Stock and Incentive Plan4.4**
                Form
      of Stock Option Agreement4.5****
                Form
      of Placement Agent Warrant4.6****
                Form
      of Bridge Financing Warrant4.7***
                Form
      of Exchange Agreement, dated as of December 29, 20064.8***
                Credit
      Term Agreement for the Bridge Financing, dated December 14,
      20064.9***
                Initial
      Registration Rights Agreement, dated as of December 29,
    20064.10***
                Additional
      Registration Rights Agreement, dated as of December 29,
    20064.11****
                Stock
      Purchase Agreement dated as of March 30, 2006 between InterMetro and David
      Singer4.12.1
                Form
      of Secured Note Financing Warrant4.12.2
                Form
      of Secured Note Financing Warrant9.1***
                Voting
      Trust Agreement, dated as of December 29, 20069.2***
                Voting
      Trust Agreement, dated as of December 29, 200610.1****
                Employment
      Agreement dated as of January 1, 2004 between InterMetro and Charles Rice,
      as amended10.2****
                Employment
      Agreement dated as of January 1, 2004 between InterMetro and Jon deOng, as
      amended10.3****
                Employment
      Agreement dated as of January 1, 2004 between InterMetro and Vincent
      Arena, as amended10.4****
                Employment
      Agreement dated as of March 31, 2006 between Advanced Tel, Inc. and David
      Singer10.5****†
                Strategic
      Agreement dated as of May 2, 2004 between InterMetro and Qualitek
      Services, Inc.10.6****†
                Strategic
      Agreement dated as of May 2, 2006 between InterMetro and Cantata
      Technology, Inc.10.7****
                Office
      Lease between InterMetro and Pacific Simi Associates, LLC dated as of
      April 6, 200610.8****†
                Services
      Agreement between InterMetro and 99¢ Only Stores10.9****
                Form
      of Indemnification Agreement10.10***
                Placement
      Agent Agreement for the Private Placement, dated December 14,
      200610.11***
                Consulting
      Agreement with Advisor, dated as of December 29, 200610.12*****
                Loan
      and Security Agreement, dated January 16, 200810.13*****
                Form
      of Promissory Note10.14
                Loan and Security Agreement, dated April 20,
      200821.1****
                Subsidiaries
      of InterMetro Communications, Inc.31.1
                Section 302 Certification31.2
                Section 302 Certification32.1
                Section 906 Certification32.2
                Section 906
Certification


——————


*
            Incorporated
      by reference to the SB-2 filed with the Securities and Exchange Commission
      dated May 15, 2002.




**
            Incorporated
      by reference to the Schedule 14C Information Statement filed with the
      Securities and Exchange Commission on March 6,
  2007.




**+
            Incorporated
      by reference to the Form 8K filed with the Securities and Exchange
      Commission dated June 28, 2007.




***
            Incorporated
      by reference to the Form 8K filed with the Securities and Exchange
      Commission dated January 8,
2007.




****
            Incorporated
      by reference to the SB-2 filed with the Securities and Exchange Commission
      dated February 9, 2007.




*****
            Incorporated
      by reference to the Form 10-KSB filed with the Securities and Exchange
      Commission dated April 14, 2008.




†
            Confidential
      treatment has been requested for portions of this Exhibit which have been
      filed separately with the Securities and Exchange Commission pursuant to
      Rule 406 promulgated under the Securities
Act.




(b) There
were no Current Reports on Form 8-K filed by the Company subsequent to the last
quarter of the fiscal year ended December 31, 2008.


40
 Table of Contents




Item14. Principal Accountant Fees and Services




MHM
served as our auditors for the year ended December 31, 2007. GSI is our
principal accountant firm, replacing MHN on November 3, 2008.  GSI has
not provided any non-audit services to us during the year ended December 31,
2008. The Audit Committee of our Board of Directors has considered whether the
provision of non-audit services are compatible with maintaining GSI
independence.




Each year
the independent auditor’s retention to audit our financial statements, including
the associated fee, is approved by the Board before the filing of the previous
year’s Annual Report on Form 10-K.




Audit
Fees (in thousands):





2008
                          
                          
                          2007Audit
      Fees (1)
                          
                          $
                          246
                          
                          
                          $
                          199Audit
      related fees (2)
                          
                          
                          24
                          
                          
                          
                          131All
      other fees
                          
                          
                          -
                          
                          
                          
                          -$
                          280
                          
                          
                          $
                          330


——————


(1)
            Audit
      Fees paid to Gumbiner Savett in 2008 were $25,000.  Audit Fees
      paid to Gumbiner Savett and MHM in 2008 and MHM in 2007 consist of fees
      for the audit of our financial statements and review of the interim
      financial statements included in our quarterly
  reports.




(2)
            Audit
      related fees paid to MHM in 2008 and 2007 consist primarily of fees for
      review of various S.E.C. filings.




Pre-Approval
Policies and Procedures of Audit and Non-Audit Services of Independent
Registered Public Accounting Firm




The Audit
Committee’s policy is to pre-approve, typically at the beginning of our fiscal
year, all audit and non-audit services, other than de minimis non-audit
services, to be provided by an independent registered public accounting firm.
These services may include, among others, audit services, audit-related
services, tax services and other services and such services are generally
subject to a specific budget. The independent registered public accounting firm
and management are required to periodically report to the full Board regarding
the extent of services provided by the independent registered public accounting
firm in accordance with this pre-approval, and the fees for the services
performed to date. As part of the Board’s review, the Board will evaluate other
known potential engagements of the independent auditor, including the scope of
work proposed to be performed and the proposed fees, and approve or reject each
service, taking into account whether the services are permissible under
applicable law and the possible impact of each non-audit service on the
independent auditor’s independence from management. At Audit Committee meetings
throughout the year, the auditor and management may present subsequent services
for approval. Typically, these would be services such as due diligence for an
acquisition, that would not have been known at the beginning of the
year.




The Audit
Committee has considered the provision of non-audit services, if any, provided
by our independent registered public accounting firm to be compatible with
maintaining their independence. The Audit Committee will continue to approve all
audit and permissible non-audit services provided by our independent registered
public accounting firm.




41
 Table of Contents




SIGNATURES




Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, as amended, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.





INTERMETRO
      COMMUNICATIONS, INC.Dated:
      April 15,
      2009
              By:
              /s/
      Charles
      RiceCharles
      Rice, Chairman of the Board,Chief
      Executive Officer, and
President




Pursuant
to the requirements of the Securities Exchange Act of 1934, as amended, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.





By:
                          /s/
      Charles
      Rice
                          
                          Dated:
      April 15, 2009Charles
      Rice, Chairman of the Board,Chief
      Executive Officer, and PresidentBy:
                          /s/
      Kenneth
      Fish
                          
                          Dated:
      April 15, 2009Kenneth
      FishChief
      Financial OfficerBy:
                          /s/
      Jon
      deOng
                          
                          Dated:
      April 15, 2009Jon
      deOngChief
      Technology Officer and DirectorBy:
                          /s/
      Joshua
      Touber
                          
                          Dated:
      April 15, 2009Joshua
      TouberDirectorBy:
                          /s/
      Robert
      Grden
                          
                          Dated:
      April 15, 2009Robert
      GrdenDirectorBy:
                          /s/
      Douglas
      Benson
                          
                          Dated:
      April 15, 2009Douglas
      BensonDirector







42
 Table of Contents




Index
to Financial Statement


PageReport of Independent Registered Public Accounting
      Firm
                  
                  F-2Consolidated Balance Sheets as of December 31, 2008 and
      2007
                  
                  F-3Consolidated Statements of Operations for the years ended
      December 31, 2008 and  2007
                  
                  F-4Consolidated
      Statements of Stockholders’ Deficit for the years ended December 31, 2008
      and2007
                  
                  F-5Consolidated Statements of Cash Flows for the years ended
      December 31, 2008 and 2007
                  
                  F-6Notes to Consolidated Financial
    Statements
                  
                  F-7
  
 Table of Contents
 
 
 REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM
  The Board
of Directors and Stockholders
  InterMetro
Communications, Inc.
  We have
audited the accompanying consolidated balance sheets of InterMetro
Communications, Inc. and subsidiaries (the “Company”) as of December 31, 2008
and 2007 and the related consolidated statements of operations, stockholders’
deficit and cash flows for each of the two years then ended.  These
consolidated financial statements are the responsibility of the Company’s
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
consolidated financial statements are free of material misstatement. The Company
is not required to have, nor were we engaged to perform, an audit of its
internal control over financial reporting. Our audits included consideration of
internal control over financial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the Company’s internal control
over financial reporting. Accordingly, we express no such opinion. An audit also
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the consolidated financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our
opinion.
  In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of the Company as
of  December 31, 2008 and 2007, and the results of its operations and
its cash flows for each of the two years then ended in conformity with U.S.
generally accepted accounting principles.
 
 The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern.  As discussed in Note 1 to
the consolidated financial statements, the Company incurred net losses of $
9,426,000 and $16,915,000 for the years ended December 31, 2008 and 2007,
respectively, and as of December 31, 2008, the Company had a working capital
deficit of $17,261,000 and a total stockholders’ deficit of
$15,944,000.  Negative cash flows from operations were $3,921,000 and
$9,747,000 for the years ended December 31, 2008 and 2007, respectively  
The Company anticipates that it will not have sufficient cash flow to fund its
operations through fiscal 2009 without the completion of additional
financing.
 
 These
factors, among others discussed below and as discussed in Note 1 to the
consolidated financial statements, raise substantial doubt about the Company’s
ability to continue as a going concern.  Management’s plans in regard to
these matters are also described in Note 1.  The consolidated financial
statements do not include any adjustments relating to the recoverability and
classification of asset carrying amounts or the amount and classification of
liabilities that might result should the Company be unable to continue as a
going concern.
 
 As
discussed in Note 11, the Company entered into agreements with Moriah Capital,
L.P. (“Moriah”) under which it could borrow up to $2,400,000.  At
December 31, 2008, the Company had borrowed $2,400,000.  These
agreements include financial and other covenants that the Company needed to
maintain at December 31, 2008.  The availability of loan amounts under
the agreements expires on April 30, 2009.  The Company was not in
compliance with certain covenants as of December 31, 2008, and accordingly,
Moriah could call the loan immediately payable at any time.
 
 As
discussed in Note 6, the Company is in default under its secured
notes.  Under the terms of the notes, upon an event of default, the
lenders have the right to, among other things, demand immediate payment or take
possession of all assets of the Company.  The Company has not received
notice from the lenders that it will take such actions; however, there can be no
assurance that they will not exercise their rights.  The Company and
the lenders are currently in discussions to waive the current
defaults.  There can be no assurance that the Company will be
successful in causing the defaults to be waived.
 
 As
discussed in Note 12, the Company is in disputes with some of its key vendors
and has breached a settlement agreement with a vendor it reached in April
2008.  If the Company is unable to reach settlements with its vendors
for the disputed amounts, the vendors may discontinue service, which may have a
material adverse affect on the Company’s operations.
 
  The
Company has other significant contingencies such as vendor disputes and lawsuits
discussed in Note 12 and obligations with respect to the warrants issued in
connection with the secured promissory notes discussed in Note 6 that could
cause an acceleration of the amounts due.
 
 The
matters detailed in the preceding paragraphs, individually or in the aggregate,
could have material adverse consequences to the Company at any
time.
 
  /s/
GUMBINER SAVETT INC.
 GUMBINER
SAVETT INC.
 
 Santa
Monica, California
 April 15,
2009
  F-2
 Table of Contents
  INTERMETROCOMMUNICATIONS, INC.
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 (In
thousands, except per share amounts)
 December
      31,2008
                                                    
                                                    
                                                    2007ASSETSCash
                                                    
                                                    $
                                                    171
                                                    
                                                    
                                                    $
                                                    277Accounts
      receivable, net of allowance for doubtful accounts of  $125 atDecember
      31, 2008 and 2007
                                                    
                                                    
                                                    2,333
                                                    
                                                    
                                                    
                                                    1,875Deposits
                                                    
                                                    
                                                    150
                                                    
                                                    
                                                    
                                                    180Other
      current assets
                                                    
                                                    
                                                    101
                                                    
                                                    
                                                    
                                                    333Total
      current assets
                                                    
                                                    
                                                    2,755
                                                    
                                                    
                                                    
                                                    2,665Property
      and equipment, net
                                                    
                                                    
                                                    377
                                                    
                                                    
                                                    
                                                    937Goodwill
                                                    
                                                    
                                                    900
                                                    
                                                    
                                                    
                                                    1,800Other
      intangible assets
                                                    
                                                    
                                                    82
                                                    
                                                    
                                                    
                                                    119Other
      long-term assets
                                                    
                                                    
                                                    36
                                                    
                                                    
                                                    
                                                    36Total
      Assets
                                                    
                                                    $
                                                    4,150
                                                    
                                                    
                                                    $
                                                    5,557LIABILITIES
      AND STOCKHOLDERS’ DEFICITAccounts
      payable, trade, net of disputed amounts of $3,402 in 2008 and $2,500 in
      2007
                                                    
                                                    $
                                                    10,395
                                                    
                                                    
                                                    $
                                                    8,924Accrued
      expenses
                                                    
                                                    
                                                    4,049
                                                    
                                                    
                                                    
                                                    3,519Bank
      overdraft
                                                    
                                                    
                                                    562
                                                    
                                                    
                                                    
                                                    464Deferred
      revenues and customer deposits
                                                    
                                                    
                                                    602
                                                    
                                                    
                                                    
                                                    586Borrowings
      under line of credit facilities net of debt discount of $487 in 2008 (in
      default)
                                                    
                                                    
                                                    2,112
                                                    
                                                    
                                                    
                                                    190Current
      portion of amounts and notes due to related party (in
    default)
                                                    
                                                    
                                                    75
                                                    
                                                    
                                                    
                                                    215Current
      portion of long-term capital lease obligations
                                                    
                                                    
                                                    133
                                                    
                                                    
                                                    
                                                    170Advances,
      including $310 and $330 from related parties in 2008 and
    2007
                                                    
                                                    
                                                    310
                                                    
                                                    
                                                    
                                                    600Secured
      promissory notes, including $500 from related parties, net of debt
      discount of $392  in 2008 (in default)
                                                    
                                                    
                                                    1,528
                                                    
                                                    
                                                    
                                                    —Liability
      for warrant put feature
                                                    
                                                    
                                                    250
                                                    
                                                    
                                                    
                                                    —Total
      current liabilities
                                                    
                                                    
                                                    20,016
                                                    
                                                    
                                                    
                                                    14,668Liability
      for warrant put feature
                                                    
                                                    
                                                    78
                                                    
                                                    
                                                    
                                                    —Capital
      lease obligations, net of current portion
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    
                                                    106Total
      liabilities
                                                    
                                                    
                                                    20,094
                                                    
                                                    
                                                    
                                                    14,774Commitments
      and contingencies (Note 12)Stockholders’
      DeficitPreferred
      stock — $0.001 par value; 10,000,000 shares authorized; 0 shares issued
      and outstanding at December 31, 2008 and 2007
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    
                                                    —Common
      stock — $0.001 par value;150,000,000 shares authorized at December 31,
      2008 and 2007; 65,643,901 and 59,575,194 shares issued and outstanding at
      December 31, 2008 and December 31, 2007
                                                    
                                                    
                                                    66
                                                    
                                                    
                                                    
                                                    60Additional
      paid-in capital
                                                    
                                                    
                                                    28,333
                                                    
                                                    
                                                    
                                                    25,807Deferred
      stock based compensation
                                                    
                                                    
                                                    —
                                                    
                                                    
                                                    
                                                    (167
                                                    )Accumulated
      deficit
                                                    
                                                    
                                                    (44,343
                                                    )
                                                    
                                                    
                                                    (34,917
                                                    )Total
      stockholders’ deficit
                                                    
                                                    
                                                    (15,944
                                                    )
                                                    
                                                    
                                                    (9,217
                                                    )Total
      Liabilities and Stockholders’ Deficit
                                                    
                                                    $
                                                    4,150
                                                    
                                                    
                                                    $
                                                    5,557
 
 See accompanying notes are an integral
part of these consolidated financial statements.
  F-3
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 (In
thousands, except per share amounts)
  Year
      Ended December 31,2008
                                        
                                        2007Net
      revenues
                                        
                                        $
                                        25,131
                                        
                                        
                                        $
                                        22,694Network
      costs
                                        
                                        
                                        22,912
                                        
                                        
                                        
                                        23,467Gross
      profit (loss)
                                        
                                        
                                        2,219
                                        
                                        
                                        
                                        (773
                                        )Operating
      expensesSales
      and marketing (includes stock based compensation of $44 and $106 for the
      years ended December 31, 2008 and 2007, respectively)
                                        
                                        
                                        1,739
                                        
                                        
                                        
                                        2,072General
      and administrative (includes stock based compensation of  $203
      and $1,487 for the years ended December 31, 2008 and 2007,
      respectively)
                                        
                                        
                                        5,887
                                        
                                        
                                        
                                        7,990Impairment
      of goodwill
                                        
                                        
                                        1,511Total
      operating expenses
                                        
                                        
                                        9,137
                                        
                                        
                                        
                                        10,062Operating
      loss
                                        
                                        
                                        (6,918
                                        )
                                        
                                        
                                        (10,835
                                        )Interest
      expense, net (includes stock based charges of $1,025 and $0 for the years
      ended December 31, 2008 and 2007, respectively)
                                        
                                        
                                        2,600
                                        
                                        
                                        
                                        460Gain
      on forgiveness of debt
                                        
                                        
                                        (92
                                        )
                                        
                                        
                                        —Loss
      on liability for options and warrants
                                        
                                        
                                        —
                                        
                                        
                                        
                                        5,615Loss
      before provision for income taxes
                                        
                                        
                                        (9,426
                                        )
                                        
                                        
                                        (16,910
                                        )Provision
      for income taxes
                                        
                                        
                                        —
                                        
                                        
                                        
                                        (5
                                        )Net
      loss
                                        
                                        $
                                        (9,426
                                        )
                                        
                                        $
                                        (16,915
                                        )Basic
      and diluted net loss per common share
                                        
                                        $
                                        (0.16
                                        )
                                        
                                        $
                                        (0.28
                                        )Shares
      used to calculate basic and diluted net loss per common
    share
                                        
                                        
                                        60,517
                                        
                                        
                                        
                                        59,575
  
 The accompanying notes are an integral
part of these consolidated financial statements.
  F-4
 Table of Contents
  INTERMETROCOMMUNICATIONS, INC.
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ DEFICIT
 (Dollars
in Thousands)
 Common
      Stock
                      
                      
                      Additional
                        Paid-In
                        Capital
                      
                      
                      Deferred
                        Stock
      Based
                        Compensation
                      
                      
                      Accumulated
                        Deficit
                      
                      
                      Total
                        Stockholders’
                        DeficitShares
                      
                      
                      AmountBalance
      at December 31, 2006
                      
                      
                      59,575,194
                      
                      
                      $
                      60
                      
                      
                      $
                      13,245
                      
                      
                      $
                      (373
                      )
                      
                      $
                      (18,002
                      )
                      
                      $
                      (5,070
                      )Amortization
      of stock-based compensation
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      1,387
                      
                      
                      
                      206
                      
                      
                      
                      —
                      
                      
                      
                      1,593Cash
      refunded from reduction of private placement fees
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      176
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      176Reclassification
      of Options and Warrants Liability to Equity
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      10,999
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      10,999Net
      loss for the year ended December 31, 2007
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      (16,915
                      )
                      
                      
                      (16,915
                      )Balance
      at December 31, 2007
                      
                      
                      59,575,194
                      
                      
                      
                      60
                      
                      
                      
                      25,807
                      
                      
                      
                      (167
                      )
                      
                      
                      (34,917
                      )
                      
                      
                      (9,217
                      )Reclassification
      of deferred stock-based compensation
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      (167
                      )
                      
                      
                      167
                      
                      
                      
                      —
                      
                      
                      
                      —Amortization
      of stock-based compensation
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      247
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      247Warrant
      issuance
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      1,575
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      1,575Cashless
      warrants exercise relating to equipment purchase
                      
                      
                      635,612
                      
                      
                      
                      1
                      
                      
                      
                      165
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      166Stock
      issuance for consulting services
                      
                      
                      200,000
                      
                      
                      
                      —
                      
                      
                      
                      100
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      100Stock
      issued for acquisition related earn-out
                      
                      
                      4,089,930
                      
                      
                      
                      4
                      
                      
                      
                      607
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      611Stock
      issued on cashless exercise of stock options
                      
                      
                      1,143,165
                      
                      
                      
                      1
                      
                      
                      
                      (1
                      )
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —Net
      loss for the year ended December 31, 2008
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      (9,426
                      )
                      
                      
                      (9,426
                      )Balance
      at December 31, 2008
                      
                      
                      65,643,901
                      
                      
                      $
                      66
                      
                      
                      $
                      28,333
                      
                      
                      $
                      —
                      
                      
                      $
                      (44,343
                      )
                      
                      $
                      (15,944
                      )
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
  F-5
 Table of Contents
  INTERMETROCOMMUNICATIONS, INC.
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 (Dollars
in Thousands)
 2008
                          
                          
                          2007Cash
      flows from operating activities:Net
      loss
                          
                          $
                          (9,426
                          )
                          
                          $
                          (16,915
                          )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
                          
                          
                          635
                          
                          
                          
                          1,046Stock
      based compensation
                          
                          
                          247
                          
                          
                          
                          1,593Amortization
      of debt discount
                          
                          
                          1,025
                          
                          
                          
                          —Impaired
      goodwill write-off
                          
                          
                          1,511
                          
                          
                          
                          —Stock
      issuance for consulting services
                          
                          
                          100
                          
                          
                          
                          —Loss
      on options and warrants
                          
                          
                          —
                          
                          
                          
                          5,615Gain
      on forgiveness of debt
                          
                          
                          (92
                          )
                          
                          
                          —(Increase)
      decrease in operating assets:Accounts
      receivable
                          
                          
                          (458
                          )
                          
                          
                          (726
                          )Deposits
                          
                          
                          30
                          
                          
                          
                          40Other
      current assets
                          
                          
                          232
                          
                          
                          
                          (118
                          )Other
      long-term assets
                          
                          
                          —
                          
                          
                          
                          (31
                          )Increase
      (decrease) in operating liabilities:Accounts
      payable, trade
                          
                          
                          1,470
                          
                          
                          
                          2,574Accrued
      expenses
                          
                          
                          789
                          
                          
                          
                          (2,309
                          )Deferred
      revenues and customer deposits
                          
                          
                          16
                          
                          
                          
                          (516
                          )Net
      cash used in operating activities
                          
                          
                          (3,921
                          )
                          
                          
                          (9,747
                          )Cash
      flows from investing activities:Purchase
      of property and equipment
                          
                          
                          (39
                          )
                          
                          
                          (77
                          )Cash
      flows from financing activities:Proceeds
      from secured notes
                          
                          
                          1,320
                          
                          
                          
                          600Net
      proceeds from escrow for private placement
                          
                          
                          —
                          
                          
                          
                          10,235Cash
      refunded from reduction of private placement fees
                          
                          
                          —
                          
                          
                          
                          176Borrowings
      from related party loans
                          
                          
                          310
                          
                          
                          
                          160Payment
      of amounts due to related party
                          
                          
                          (140
                          )
                          
                          
                          (355
                          )Bank
      overdraft
                          
                          
                          98
                          
                          
                          
                          464Proceeds
      from line of credit
                          
                          
                          2,408
                          
                          
                          
                          —Payment
      of amounts due on related party line of credit facility
                          
                          
                          —
                          
                          
                          
                          (1,125
                          )Principal
      payments on capital lease obligations
                          
                          
                          (142
                          )
                          
                          
                          (205
                          )Net
      cash provided by financing activities
                          
                          
                          3,854
                          
                          
                          
                          9,950Net
      increase (decrease) in cash
                          
                          
                          (106
                          )
                          
                          
                          126Cash
      at beginning of year
                          
                          
                          277
                          
                          
                          
                          151Cash
      at end of year
                          
                          $
                          171
                          
                          
                          $
                          277
 
 The accompanying notes are an integral
part of these consolidated financial statements.
 
 F-6
 Table of Contents
  INTERMETROCOMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
   1
— Nature of Operations and Summary of Significant Accounting
Policies
 
 Company Background -
InterMetro Communications, Inc., (hereinafter, “InterMetro” or the “Company”) is
a Nevada corporation which, through its wholly owned subsidiary, InterMetro
Communications, Inc. (Delaware) (hereinafter, “InterMetro Delaware”), is engaged
in the business of providing voice over Internet Protocol (“VoIP”)
communications services. The Company owns and operates state-of-the-art VoIP
switching equipment and network facilities that are utilized to provide
traditional phone companies, wireless phone companies, calling card companies
and marketers of calling cards with wholesale voice and data services, and
voice-enabled application services. The Company’s customers pay the Company for
minutes of utilization or bandwidth utilization on its national voice and data
network and the Company’s calling card marketing customers pay per calling card
sold. The Company’s business is located in Simi Valley, California.
  On
December 29, 2006, the Company consummated the acquisition of InterMetro
Delaware, a privately-held company, through a merger transaction (the “Business
Combination”) which resulted in a share exchange such that the InterMetro
Delaware Investors became the controlling shareholders of InterMetro, and such
that InterMetro Delaware became a wholly owned subsidiary of InterMetro. All
costs associated with the Business Combination were expensed as
incurred.
  Pursuant
to the Business Combination, the Company issued directly to the InterMetro
Delaware Investors, in two phases, a total of 41,540,194 shares of common stock
in exchange for all of their issued and outstanding shares of common stock (the
“Private Company Common Stock”) and preferred stock, and outstanding convertible
promissory notes on an as converted basis. The first phase issuance occurred
effectively on December 29, 2006 and included the issuance of 27,490,194
shares of common stock in exchange for the entire principal amount of the
convertible promissory notes and accrued interest due, all outstanding shares of
preferred stock and Private Company Common Stock held by non-employees, and a
portion of the Private Company Common Stock held by employees. On May 31, 2007,
the Company filed Amended and Restated Articles of Incorporation increasing the
Company’s authorized shares of common stock to 150,000,000, par value
$0.001 per share, at which time the second phase of 14,049,580 shares of common
stock were effectively issued in exchange for all of the remaining Private
Company Common Stock held by the employees of InterMetro Delaware. All
InterMetro Delaware securities were effectively cancelled except 100 shares of
Private Company Common Stock which represent 100% of the outstanding stock of
the wholly-owned subsidiary.
  Basis of Presentation - For
accounting purposes, the Business Combination was accounted for as a
recapitalization of InterMetro Delaware. Accordingly, the historical financial
statements of the Company reflect the historical operations and financial
statements of InterMetro Delaware before the Business
Combination.  See Note 2 for more detailed discussions of the Business
Combination.
  Going Concern - The
accompanying consolidated financial statements have been prepared assuming the
Company will continue as a going concern, which contemplates the realization of
assets and settlement of obligations in the normal course of business. The
Company incurred net losses of $9,426,000 and $16,915,000 for the years ended
December 31, 2008 and 2007, respectively.  In addition, the Company
had total shareholders’ deficit of $15,944,000 and a working capital deficit of
$17,261,000 as of December 31, 2008. Negative cash flows from operations were
$3,921,000 and $9,747,000 for the years ended December 31, 2008 and 2007,
respectively. The Company anticipates it will not have sufficient cash flows to
fund its operations through fiscal 2009 without the completion of additional
financing. The consolidated financial statements do not include any adjustments
relating to the recoverability and classification of asset carrying amounts or
the amount and classification of liabilities that might result should the
Company be unable to continue as a going concern.  The report from the
Company’s independent registered public accounting firm states that there is
substantial doubt about the Company’s ability to continue as a going
concern.
 
 As
discussed in Note 11, the Company entered into agreements with Moriah Capital,
L.P. (“Moriah”) under which it could borrow up to $2,400,000.  At
December 31, 2008, the Company had borrowed $2,400,000.  These
agreements include financial and other covenants that the Company needed to
maintain at December 31, 2008.  The availability of loan amounts under
the agreements expires on April 30, 2009.  The Company was not in
compliance with certain covenants as of December 31, 2008, and accordingly,
Moriah can call the loan immediately payable at any time.  The Company
has other significant matters of importance, including: other contingencies such
as vendor disputes and lawsuits discussed in Note 12; obligations with respect
to warrants issued in connection with the secured promissory notes discussed in
Note 6, and covenant defaults on the secured notes as discussed in Note 6 that
could cause an acceleration of those amount due.  These matters,
individually or in the aggregate, could have material adverse consequences to
the Company’s operations and financial condition at any time.
  Management
believes that the recent losses are primarily attributable to costs related to
building out and supporting a telecommunications infrastructure, and the
requirement for continued expansion of the customer base and the resultant
increase in revenues, in order for the Company to become profitable. The Company
continues to require outside financing until such time as it can achieve
positive cash flow from operations.   In November and December
2007, the Company received $600,000 and in the period from January to June 2008
the Company received an additional $1,320,000 and an additional $462,500 from
November 2008 to February 2009 pursuant to the sale of secured notes with
individual investors for general working capital. The terms of the secured notes
are 18 months maturity (beginning in June 2009) with an interest rate of 13% per
annum due at the maturity date.  The secured notes are secured by
substantially all of the assets of the Company.  The Company is also
required to pay an origination fee of 3.00% and documentation fee of 2.50% of
the principal amount of the secured notes at the maturity date.  Prepayment
of the credit facilities requires payment of interest that would have accrued
through maturity, discounted by 20%, in addition to principal, accrued interest
and fees. The Company can continue to sell similar secured notes up to a maximum
offering of $3 million.  In addition, the Company entered into a
revolving credit agreement, effective on April 30, 2008 (See Note 11) and
expiring on April 30, 2009, pursuant to which the Company could access funds up
to $2,400,000 per Amendment no. 2 to the agreement in November
2008.  The Company is in negotiations with the lender regarding an
increase to the revolving credit agreement.There can be no assurance
that the Company will be successful in completing this required financing or
that it will continue to expand its revenue.  Should the Company be
unsuccessful in this financing attempt, material adverse consequences could
occur should the Company be unable to secure alternate financing.
  F-7
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 The
Company will be required to obtain other financing during the next twelve months
or thereafter as a result of future business developments, including any
acquisitions of business assets or any shortfall of cash flows generated by
future operations in meeting the Company’s ongoing cash requirements. Such
financing alternatives could include selling additional equity or debt
securities, obtaining long or short-term credit facilities, or selling operating
assets. No assurance can be given, however, that the Company could obtain such
financing on terms favorable to the Company or at all. Any sale of additional
common stock or convertible equity or debt securities would result in additional
dilution to the Company’s stockholders.
 
 Principles of Consolidation -
The consolidated financial statements include the accounts of InterMetro,
InterMetro Delaware, and InterMetro Delaware’s wholly-owned
subsidiary, Advanced Tel, Inc. (“ATI”). All intercompany balances and
transactions have been eliminated in consolidation.
  Use of Estimates - In the
normal course of preparing financial statements in conformity with U.S.
generally accepted accounting principles, management is required to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.  See below for matters of significant
estimates.
 
 Revenue Recognition - VoIP
services are recognized as revenue when services are provided primarily based on
usage. Revenues derived from sales of calling cards through retail distribution
partners are deferred upon sale of the cards. These deferred revenues are
recognized as revenue generally at the time card minutes are expended. The
Company recognizes revenue in the period that services are delivered and when
the following criteria have been met: persuasive evidence of an arrangement
exists, the fees are fixed and determinable, no significant Company obligations
remain and collection is reasonably assured. Deferred revenue consists of fees
received or billed in advance of the delivery of the services or services
performed in which collection is not reasonably assured. This revenue is
recognized when the services are provided and no significant Company obligations
remain. The Company assesses the likelihood of collection based on a number of
factors, including past transaction history with the customer and the credit
worthiness of the customer. Generally, the Company does not request collateral
from customers. If the Company determines that collection of revenues are not
reasonably assured, amounts are deferred and recognized as revenue at the time
collection becomes reasonably assured, which is generally upon receipt of
cash.
  Accounts Receivable -
Accounts receivable consist of trade receivables arising in the normal course of
business. The Company does not charge interest on its trade receivables. The
allowance for doubtful accounts is the Company’s best estimate of the amount of
probable credit losses in the Company’s existing accounts receivable. The
Company reviews its allowance for doubtful accounts monthly. The Company
determines the allowance based upon historical write-off experience, payment
history and by reviewing significant past due balances for individual
collectibility. If estimated allowances for uncollectible accounts subsequently
prove insufficient, additional allowance may be required.  Bad debt
expense during 2008 amounted to $220,445.
  Network Costs - The Company’s
network costs consist of telecommunication costs, leasing collocation facilities
and certain build-outs, and depreciation of equipment related to the Company’s
network infrastructure. It is not unusual in the Company’s industry to
occasionally have disagreements with vendors relating to the amounts billed for
services provided between the recipient of those services and the vendor. As a
result, the Company currently has disputes with vendors that it believes did not
bill certain network charges correctly.  The Company’s policy is to include
amounts that it intends to dispute or that it has disputed in a reserve account
as an offset to accounts payable if management believes that the facts and
circumstances related to the dispute provide probable support that the dispute
will be resolved in the Company’s favor.
  Advertising Costs - The
Company expenses advertising costs as incurred. Advertising costs were included
in sales and marketing expenses and were $5,000 and $99,950 for the years ended
December 31, 2008 and 2007, respectively.
  Depreciation and Amortization
- Depreciation and amortization of property and equipment is computed using the
straight-line method based on the following estimated useful lives:
  Telecommunications
      equipment
              
              2-3
      yearsTelecommunications
      software
              
              18
      months to 2 yearsComputer
      equipment
              
              2
      yearsOffice
      equipment and furniture
              
              3
      yearsLeasehold
      improvements
              
              Useful
      life or remaining lease term, which ever is
  shorter
 
 Maintenance
and repairs are charged to expense as incurred; significant betterments are
capitalized.
  Impairment of Long-Lived
Assets - The Company assesses impairment of its other long-lived assets
in accordance with the provisions of Statement of Financial Accounting Standards
(“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-lived
Assets.” An impairment review is performed whenever events or changes in
circumstances indicate that the carrying value may not be recoverable. Factors
considered by the Company include:
  ·
              significant
      underperformance relative to expected historical or projected future
      operating results;
  ·
              significant
      changes in the manner of use of the acquired assets or the strategy for
      the Company’s overall business; and
  ·
              significant
      negative industry or economic
trends.
  F-8
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 When
management of the Company determines that the carrying value of a long-lived
asset may not be recoverable based upon the existence of one or more of the
above indicators of impairment, an estimate is made of the future undiscounted
cash flows expected to result from the use of the asset and its eventual
disposition. If the sum of the expected future undiscounted cash flows and
eventual disposition is less than the carrying amount of the asset, an
impairment loss is recognized in the amount by which the carrying amount of the
asset exceeds the fair value of the asset, based on the fair market value if
available, or discounted cash flows if not. To date, the Company has not had an
impairment of long-lived assets and is not aware of the existence of any
indicators of impairment.
  Goodwill and Intangible
Assets - The Company records goodwill when consideration paid in a
business acquisition exceeds the fair value of the net tangible assets and the
identified intangible assets acquired. The Company accounts for goodwill and
intangible assets in accordance with SFAS No. 142, “Goodwill and Other
Intangible Assets.” SFAS 142 requires that goodwill and intangible assets with
indefinite useful lives not be amortized, but instead be tested for impairment
at least annually or whenever changes in circumstances indicate that the
carrying value of the goodwill may not be recoverable. SFAS No. 142 also
requires the Company to amortize intangible assets over their respective finite
lives up to their estimated residual values.  At December 31, 2008,
the Company has determined that due to the decline in revenue and operating
income of ATI in 2008, the carrying value of the Company’s goodwill was not
fully recoverable and has taken a charge for the impairment of goodwill in the
amount of $1.5 million. (See Note 2)
 
 Vendor Disputes -The Company’s policy is
to include amounts that it intends to dispute or that it has disputed in a
reserve account as an offset to accounts payable if management believes that the
facts and circumstances related to the dispute provide probable support that the
dispute will be resolved in the Company’s favor.
 
 Stock-Based Compensation -
Effective January 1, 2006, the Company adopted SFAS No. 123(R),
“Share-Based Payments,” which revises SFAS 123, “Accounting for Stock-Based
Compensation” issued in 1995. The Company adopted SFAS 123(R) applying the
“modified prospective transition method” under which it continues to account for
nonvested equity awards outstanding at the date of adoption of SFAS 123(R) in
the same manner as they had been accounted for prior to adoption, that is, it
would continue to apply APB 25 in future periods to equity awards outstanding at
the date it adopted SFAS 123(R), unless the options are modified or
amended.
  For
grants to employees under the 2004 plan and 2007 plan in the years ended
December 31, 2008 and 2007, the Company estimated the fair value of each option
award on the date of grant using the Black-Scholes option-pricing model using
the assumptions noted in the following table.  Expected volatility is
based on the historical volatility of a peer group of publicly traded
entities.  The expected term of the options granted is derived from
the average midpoint between vesting and the contractual term, as described in
the SEC’s Staff Accounting Bulletin No. 107, “Share-Based
Payment.”  The risk-free rate for the expected term of the option is
based on the U.S. Treasury yield curve in effect at the time of
grant.  The assumptions used to value these employee options granted
during the years ended December 31, 2008 and 2007 were as follows:
 
 2008
                        
                        
                        2007Risk-free
      interest rate
                        
                        
                        1.9
                        %
                        
                        
                        3.2
                        %Expected
      lives (in years)
                        
                        
                        2.8
                        
                        
                        
                        2.8
      – 2.9Dividend
      yield
                        
                        
                        0
                        %
                        
                        
                        0
                        %Expected
      volatility
                        
                        
                        71
                        %
                        
                        
                        71%
      -72
                        %Forfeiture
      rate
                        
                        
                        0
                        %
                        
                        
                        0
                        %
  The
Company accounts for equity instruments issued to non-employees in accordance
with the provisions of SFAS 123(R). All transactions in which goods or services
are the consideration received for the issuance of equity instruments are
accounted for based on the fair value of the consideration received or the fair
value of the equity instrument issued, whichever is more readily measured. The
measurement date of the fair value of the equity instrument issued is the
earlier of the date on which the counterparty’s performance is complete or the
date on which it is probable that performance will occur.
 
 The
Company calculated the fair value of these non-employee grants as described in
SFAS 123(R) using the following range of assumptions:
 
 2008
                      
                      
                      2007Risk-free
      interest rate
                      
                      
                      4.4%
      - 4.8
                      %
                      
                      
                      4.4%
      - 4.8
                      %Expected
      lives (in years)
                      
                      4.3
      – 5.0 Years
                      
                      
                      4.3
      – 5.0 YearsDividend
      yield
                      
                      
                      0
                      %
                      
                      
                      0
                      %Expected
      volatility
                      
                      
                      89%
      - 93
                      %
                      
                      
                      89%
      - 93
                      %Forfeiture
      rate
                      
                      
                      0
                      %
                      
                      
                      0
                      %
  F-9
 Table of Contents
 INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  Concentration of Credit Risk
- Financial instruments that potentially subject the Company to concentrations
of credit risk consist primarily of cash, accounts receivable, accounts payable,
accrued expenses, and short term debt. The Company maintains its cash with a
major financial institution located in the United States. Some balances are
insured by the Federal Deposit Insurance Corporation up to $250,000.
Periodically throughout the year the Company maintained balances in excess of
federally insured limits. The Company encounters a certain amount of risk as a
result of a concentration of revenue from a few significant customers and
services provided from vendors. Credit is extended to customers based on an
evaluation of their financial condition. The Company generally does not require
collateral or other security to support accounts receivable. The Company
performs ongoing credit evaluations of its customers and records an allowance
for potential bad debts based on available information. To date, such losses, if
any, have been within management’s expectations.
  The
Company had one customer that accounted for 10% of net revenue for the year
ended December 31, 2007.
  The
Company had an accounts receivable balance from one customer that accounted for
21% of total accounts receivable at December 31, 2008.
  Income Taxes - The Company
accounts for income taxes in accordance with SFAS No. 109, “Accounting for
Income Taxes,” which requires recognition of deferred tax liabilities and assets
for the expected future tax consequences of events that have been included in
the financial statements or tax returns. Under this method, deferred tax
liabilities and assets are determined based on the temporary differences between
the financial statement and tax basis of assets and liabilities using presently
enacted tax rates in effect. Valuation allowances are established when necessary
to reduce deferred tax assets to the amounts expected to be
realized.
  Segment and Geographic
Information - The Company operates in one principal business segment
primarily in the United States. All of the operating results and identified
assets are located in the United States.
  Basic and Diluted Net Loss per
Common Share - Basic net loss per common share excludes dilution for
potential common stock issuances and is computed by dividing net loss by the
weighted-average number of common shares outstanding for the period. As the
Company reported a net loss for all periods presented, the conversion of
promissory notes and the exercise of stock options and warrants were not
considered in the computation of diluted net loss per common share because their
effect is anti-dilutive.  As of December 31, 2008, there were no
anti-dilutive shares.
  Recent Accounting
Pronouncements - In September 2006, the Financial
Accounting Standards Board (“FASB”) issued Statement of Financial Accounting
Standards (“SFAS”) No. 157, “Fair Value Measurements.” This statement defines
fair value, establishes a framework for measuring fair value in GAAP, and
expands disclosures about fair value measurements. The statement is effective
for the fiscal years beginning after November 15, 2007.  The Company
adopted SFAS 157 as of January 1, 2008 and has determined that the adoption
of this statement did not have an impact on its consolidated financial
statements.
  In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities,” including an amendment of FASB
Statement No. 115 (“SFAS 159”). SFAS 159 permits entities to choose to measure
many financial instruments and certain other items at fair value that are not
currently required to be measured at fair value. Unrealized gains and losses on
items for which the fair value option has been elected are reported in earnings.
SFAS 159 does not affect any existing accounting literature that requires
certain assets and liabilities to be carried at fair value. SFAS 159 is
effective for fiscal years beginning after November 15, 2007. The Company
adopted SFAS 159 as of January 1, 2008 and has determined that the adoption
of this statement did not have an impact on the consolidated financial
statements.
 
 In
December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business
Combinations,” (“SFAS No. 141(R)” ). SFAS No. 141(R) requires the
acquiring entity in a business combination to recognize all (and only) the
assets acquired and liabilities assumed in the transaction; establishes the
acquisition-date fair value as the measurement objective for all assets acquired
and liabilities assumed; and requires the acquirer to disclose to investors and
other users all of the information they need to evaluate and understand the
nature and financial effect of the business combination. SFAS 141(R) is
effective for business combinations which occur in fiscal years beginning on or
after December 15, 2008. The adoption of SFAS 141(R) will impact the accounting
for business combinations completed, if any, by the Company on or after January
1, 2009.
  In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements, an Amendment of ARB No. 51.” SFAS No. 160
amends ARB No. 51 to establish accounting and reporting standards for
noncontrolling interests in subsidiaries and for the deconsolidation of
subsidiaries. It clarifies that a noncontrolling interest in a subsidiary is an
ownership interest that should be reported as equity in the consolidated
financial statements. The provisions of SFAS No. 160 are effective for fiscal
years beginning on or after December 15, 2008, and interim periods within those
fiscal years. The Company is evaluating the impact of the adoption of
SFAS 160 and believes there will be no material impact on its consolidated
financial statements or financial condition.
 
 In March
2008, the FASB issued SFAS 161, “Disclosures about Derivative Instruments
and Hedging Activities, an amendment of SFAS 133.” This statement requires
enhanced disclosures about derivative instruments and hedging activities within
an entity by requiring the disclosure of the fair values of derivative
instruments and their gains and losses in a tabular format. It provides more
information about an entity's liquidity by requiring disclosure of derivative
features that are credit risk related, and it requires cross-referencing
within footnotes to enable financial statement users to locate important
information about derivative instruments. It is effective for financial
statements issued for fiscal years and interim periods beginning after
November 15, 2008, with early adoption permitted. The Company is evaluating
the impact of the adoption of SFAS 161 and believes there will be no
material impact on its consolidated financial statements or financial
condition.
  F-10
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In May
2008, the FASB issued SFAS No. 162 “The Hierarchy of Generally Accepted
Accounting Principles” (“SFAS 162”). SFAS 162 identifies the sources of
accounting principles and the framework for selecting the principles to be used
in the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles in the
United States. SFAS 162 is effective sixty days following the SEC’s approval of
PCAOB amendments to AU Section 411, “The Meaning of ‘Present fairly in
conformity with generally accepted accounting principles.” The Company is
currently evaluating the potential impact, if any, of the adoption of SFAS 162
on its consolidated financial statements.
  2
— Acquisition and Intangible Assets
  In
March 2006, the Company acquired all of the outstanding stock of Advanced
Tel, Inc. (“ATI”), a switchless reseller of wholesale long-distance services,
for a combination of shares of its common stock and cash. The Company acquired
ATI to increase its customer base, to add minutes and revenue to its network and
to access new sales channels. The initial portion of the purchase price included
308,079 shares of the Company’s common stock, a payable of $250,000 to be paid
over the six-month period following the closing and a $150,000 two-year
unsecured promissory note in an amount tied to ATI’s working capital of
$150,000.  These amounts were payable to the former selling
shareholder of ATI who was appointed President of ATI at the acquisition closing
date. As of December 31, 2008 and 2007, $75,000 and $215,000, respectively,
remained unpaid to the selling shareholder. The fair value of the shares issued
was based on the guaranteed price of $4.87 per share.  The number of
shares of common stock consideration paid to the selling shareholder of ATI was
subject to an adjustment (or the payment of additional cash in lieu thereof at
the option of the Company) if the trading price of the Company’s common stock
did not reach a minimum price of $4.87 per share during the two years following
the closing date.   The selling shareholder of ATI was also
entitled to contingent consideration of common shares and cash during the two
succeeding years from the acquisition date upon meeting certain performance
targets tied to revenue and profitability.  In December 2008, the
Company issued 4,089,930 shares of common stock, with a fair value of $611,043,
to the President of ATI as a result of an adjustment to the initial issuance of
common stock, and the contingent consideration.
 
 The net
tangible assets acquired and liabilities assumed in the acquisition were
recorded at fair value. The Company determined the valuation of the identifiable
intangible assets acquired in the transaction to be $182,620 using future
revenue assumptions and a valuation analysis.  At December 31, 2008,
the Company determined that due to the decline in revenue and operating income
of ATI, the carrying value of the goodwill was not fully recoverable and has
taken a charge for the impairment of goodwill during 2008 in the amount of
$1,511,000.
  3
— Other Current Assets
  The
following is a summary of the Company’s other current assets (in
thousands):
 
 December
      31,2008
                          
                          2007Employee
      advances
                          
                          $
                          40
                          
                          
                          $
                          66Federal
      excise tax receivable
                          
                          
                          —
                          
                          
                          
                          109Prepaid
      expenses
                          
                          
                          61
                          
                          
                          
                          158Other
      current assets
                          
                          $
                          101
                          
                          
                          $
                          333
  4
— Property and Equipment
  The
following is a summary of the Company’s property and equipment (in thousands):
 
 December
      31,2008
                                
                                
                                2007Telecommunications
      equipment
                                
                                $
                                3,257
                                
                                
                                $
                                3,218Computer
      equipment
                                
                                
                                174
                                
                                
                                
                                174Telecommunications
      software
                                
                                
                                107
                                
                                
                                
                                107Leasehold
      improvements, office equipment and furniture
                                
                                
                                86
                                
                                
                                
                                86Total
      property and equipment
                                
                                
                                3,624
                                
                                
                                
                                3,585Less:
      accumulated depreciation and amortization
                                
                                
                                (3,247
                                )
                                
                                
                                (2,648
                                )Property
      and equipment, net
                                
                                $
                                377
                                
                                
                                $
                                937
  Depreciation
expense included in network costs was $575,000 and $975,000 for the years ended
December 31, 2008 and 2007, respectively. Depreciation and amortization expense
included in general and administrative expenses were $24,000 and $35,000 for the
years ended December 31, 2008 and 2007, respectively.
  F-11
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In May
2004, the Company entered in an agreement with a vendor to provide certain
network equipment. Under the terms of this agreement, the Company may obtain
certain telecommunications equipment with a total purchase price of
approximately $5.2 million to expand its operations. Payment for these assets is
based on the actual underlying traffic utilized by each piece of equipment, plus
the issuance of a warrant to purchase shares of the Company’s common stock at an
exercise price of the Company’s most recent financing price per share. For
certain assets that may be purchased under this agreement, the Company has an
option to issue a predetermined warrant to purchase shares of the Company’s
common stock at an exercise price of the Company’s most recent financing price
per share as full payment.  In March 2008, through an addendum to the
agreement, the vendor exercised 635,612 of its warrants with a cash exercise
value of $165,936 in a cashless exchange for a $258,304 reduction in payables
due to the vendor resulting in a $92,369 gain on forgiveness of
debt.  At December 31, 2008, the Company had purchased
telecommunications equipment under this agreement totaling $1,439,000, of which
$386,000 and $651,501 remain to be paid at December 31, 2008 and 2007,
respectively.
 
 In
May 2006, the Company entered into a strategic agreement with Cantata
Technology, Inc. (“Cantata”), a VoIP equipment and support services provider.
Under the terms of this agreement, the Company obtained VoIP equipment to expand
its operations. Payments were scheduled to be based on the actual underlying
traffic utilized by each piece of equipment or fixed cash payments. As of
December 31, 2008, the Company had purchased VoIP equipment under this agreement
totaling $691,000.  The value of the equipment was based on the
present value of future scheduled payments.  As more fully explained
in Note 12, the Company was sued by Cantata for breach of contract and lack of
payment.  At December 31, 2008, the Company has accrued $1,096,000 due
to Cantata, which is equal to the undiscounted future scheduled
payments.  The difference between the undiscounted future payments and
the purchase price has been recorded to interest expense.
  5 — Accrued Expenses
  The
following is a summary of the Company’s accrued expenses (in
thousands):
 
 December
      31,2008
                        
                        
                        2007Amounts
      due under equipment agreements (in default)
                        
                        $
                        1,170
                        
                        
                        $
                        1,394Commissions,
      network costs and other general accruals
                        
                        
                        1,798
                        
                        
                        
                        1,125Deferred
      payroll and other payroll related liabilities
                        
                        
                        503
                        
                        
                        
                        525Interest
      due on convertible promissory notes and other debt
                        
                        
                        315
                        
                        
                        
                        5Funds
      held for payment to third parties
                        
                        
                        263
                        
                        
                        
                        470Accrued
      expenses
                        
                        $
                        4,049
                        
                        
                        $
                        3,519
  6
— Secured Promissory Notes
  In
November and December 2007, the Company received $600,000 in advance payments,
pursuant to the sale of secured notes with individual investors, including
$250,000 from a related party.   During the twelve months ended
December 31, 2008, the Company received an additional $1,320,000 pursuant to the
sale of additional secured notes with individual investors for a total of
$1,920,000 and the Company may continue to sell similar secured notes up to a
maximum offering of $3 million.  The secured notes mature 13 to 18
months after issuance and bear interest at a rate of 13% per annum due at the
maturity date. The notes contained an origination and documentation fee equal to
3% and 2.5%, respectively, of the original principal amount of the note that is
due on the date the Company makes its first prepayment or the maturity date. The
holder of each note has the right upon the occurrence of a financing equal to or
greater than $10 million, to convert the entire principal plus accrued interest
and origination and documentation fee, or any portion thereof, into either
securities sold in the financing at the price sold or common stock by dividing
the conversion amount by $1.00.  The secured notes are collateralized by
substantially all of the assets of the Company.
  In
connection with the notes, the Company issued two common stock purchase
warrants for every dollar received or 3.84 million common stock purchase
warrants with an exercise price of $1.00, 1.92 million of which expire on
January 16, 2013 (the “Initial Warrants”) and 1.92 million of which expire on
February 1, 2014 ( the “Additional Warrants”).  With respect to the
1.92 million Initial Warrants issued in this financing, if such warrants are
still held by the lenders at February 1, 2009, the lenders will be entitled to
receive a payment (the “Reference Payment”) to the extent that the volume
weighted average price per share for the 30 trading days ending January 30, 2009
(the “Reference Price”) is less than $1.00.  The Reference Payment will be
equal to the difference between $1.00 and the Reference Price.  The
Company, in its sole discretion, will have the right, but not the obligation, to
make this payment by issuing Common Stock, in lieu of cash, but in no event will
the amount of stock issued be more than one share per dollar invested by the
lenders. If the Company elects to make the above payment by issuing Common Stock
any time after the maturity date of the note until the first anniversary of the
date thereof the holder may submit the Common Stock to the Company for $0.15 per
share of Common Stock. The Company has offered to make the Reference Payment by
issuing one share of common stock per dollar invested and has received
acceptance of the offer in the form of shares requests from 13 of 15 secured
note holders as of the date of this filing.
  F-12
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 With
respect to the remaining 1.92 million Additional Warrants issued in this
financing that expire on February 1, 2014, if such warrants are still held by
the lenders at February 1, 2009, the lenders will be entitled to receive a
payment (the “Second Reference Payment”) to the extent that the volume weighted
average price per share for the 30 trading days ending January 30, 2009 (the
“Second Reference Price”) is less than $2.00.  The Second Reference Payment
will be equal to the difference between $2.00 and the Second Reference Price up
to a maximum value of $1.00.  The Company, in its sole discretion, will
have the right, but not the obligation, to make this payment by issuing Common
Stock, in lieu of cash, but in no event will the amount of stock issued be more
than one share per dollar invested by the lenders.  The Company has
offered to make the Second Reference Payment by issuing one share of common
stock per dollar invested and has received acceptance of the offer in the form
of shares requests from 13 of 15 secured note holders as of April 9,
2009.
  At
December 31, 2007, the advance payments carried a 10% interest rate. These funds
were received prior to the closing of the sale of the secured notes and grant of
stock warrants, which occurred on January 16, 2008 and the holders of the notes
did not have the legal rights or recourse to the secured notes, warrants or
other related features included in these agreements entered into in January
2008.  As a result, the advance payments for notes were recorded at
their total amount of $600,000 at December 31, 2007.
 
 Upon the
closing of the sale of the secured notes and grant of the warrants on January
16, 2008, the Company accounted for the transaction in accordance with the
provisions of Emerging Issues Task Force Issue No. 96-19, “Debtor’s Accounting
for a Modification or Exchange of Debt Instruments.”  Management
determined that the present value of the cash flows under the terms of the new
debt instrument were at least 10% different from the present value of the
remaining cash flows under the terms of the original instrument, resulting in a
debt modification.  Due to the substantial modification of terms, the
Company accounted for the transaction as a debt extinguishment.  As a
result, the original $600,000 recorded as of December 31, 2007 was extinguished
on January 16, 2008 and the new notes were recorded.
 
 The
Company allocated the proceeds received between the notes and warrants in
accordance with EITF Issue No. 98-5, “Accounting for Convertible Securities with
Beneficial Conversion Features or Contingently Adjustable Conversion
Ratios.”  The Company engaged an independent third party to perform
the valuation of the warrants on the respective issuance dates for warrants
issued during the three months ended March 31, 2008 and used the valuation for
the warrants issued January 16, 2008 to determine the value of warrants issued
in the three months ended June 30, 2008.  Rather than re-engaging an
independent third party to perform new valuations at the April 30, 2008 and June
16, 2008 warrant issuance dates, the Company determined that the closing stock
price of $0.25 at January 16, 2008 along with all other assumptions used for the
January 16, 2008 warrant valuation were materially representative of the
assumptions and resultant valuations that would be used for the warrant
issuances in the three month period ending June 30, 2008.  On this
basis, the value associated with all the warrants totaled $975,000 and was
recorded as an offset to the principal balance of the secured notes and is being
amortized into interest expense using the effective interest
method.  The total expense recorded by the Company was $583,000 for
the twelve months ended December 31, 2008. As of December 31, 2008, the net
amount of the notes was $1,528,000
 
 The
Initial Warrants also contain a put feature (not included in the Additional
Warrants), which gives the holder the option to put the warrant back to the
Company for $0.15 per share. The holder can exercise its put option after the
maturity date and has the ability to do so for one year. In addition, if the
Company pays stock out for the warrants at the maturity date, the holder would
have the right to put the common stock issued back to the Company for $0.15 per
share. In both instances, the Company has determined that the put option
associated with the Initial Warrants causes the instrument to contain a net cash
settlement feature. As a result, in accordance with SFAS 150, “Accounting for
Certain Financial Instruments with Characteristics of Both Liabilities and
Equity,” the put option in the Initial Warrants requires liability
treatment.  Additionally, in accordance with SFAS 133, “Accounting for
Derivative Instruments and Hedging Activities,” the Company will continue to
report the fair value of the put option until either the liability is paid or
the option is expired. Any changes in the fair value of the put liability will
be recorded as a gain or loss.  A put warrant liability of $78,000 was
determined and has been recorded as of December 31, 2008 using the same
valuation methodology as described in detail in the preceding paragraph in
regards to the warrant valuation for the twelve months ended December 31,
2008.  The Company did not obtain an additional third-party valuation
of the warrants issued or the revaluation of the liability associated with the
put feature of the warrants as of December 31, 2008 and the same range of
assumptions used at January 16, 2008.
  The
warrants and put feature associated with the $1,920,000 promissory notes from
the period ended December 31, 2008 were valued using the Black Sholes
formula.
 
 At
December 31, 2008, the Company was in default of certain non-payment related
items under the secured notes agreements.  The Company is working with
the note holders to remedy these defaults.
 
 In
November and December 2008, two secured note holders invested an additional
$310,000 in demand notes paying 13% interest per annum. No additional terms have
been defined.  Subsequent to December 31, 2008, there was an
additional $152,500 in demand notes issued to existing note holders under the
same terms.
  F-13
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 7
— Preferred Stock
  On May
31, 2007, the Company filed Amended and Restated Articles of Incorporation
authorizing 10,000,000 shares of preferred stock, par value $0.001 per share,
none of which were issued and outstanding as of December 31, 2007 and
2008.
  Prior to
the Business Combination, under InterMetro’s then effective Amended and Restated
Certificate of Incorporation (the “Private Company Articles”), which were
effectively replaced with the Company’s Amended and Restated Articles of
Incorporation at the time of the Business Combination which were replaced by the
Company’s current Amended and Restated Articles of Incorporation, the Company
had authorized 10,000,000 shares of preferred stock, of which, 2,000,000,
2,000,000 and 500,000 shares were designated Series A, Series A-1 and Series B
preferred stock, respectively. No shares of Series A or Series A-1 were ever
issued. The Company had no Series B preferred stock outstanding at December 31,
2006, as all outstanding Series B preferred shares were exchanged for shares of
common stock as part of the Business Combination as discussed
below.
  Exchange and
Cancellation of Series B Preferred Stock and Warrants – On December 29,
2006, all of the Series B Preferred Stock holders entered into two exchange
agreements to exchange their Series B Preferred Stock for common stock and
warrants to purchase common stock for warrants to purchase common stock.
Pursuant to the exchange agreements, holders of Series B Preferred Stock
received 10.4746 shares of common stock for each share of Series B Preferred
Stock in the first phase of the exchange and received warrants to purchase
common stock in exchange for their warrants to purchase common stock in the
second phase of the exchange. Accordingly, the Series B Preferred Stock holders
received an aggregate of approximately 1,232,441 shares of common stock in the
first phase of the exchange and received warrants to purchase approximately
1,232,441 shares of common stock in the second phase of the exchange. All of the
Series B Preferred Stock was cancelled on December 29, 2006 and all rights of
the Series B Preferred Stock holders related to the Series B Preferred Stock,
including rights of conversion, were effectively eliminated. At the same time
the Series B Preferred Stock holders entered into the exchange agreements,
all Series B Preferred Stock holders entered into lock-up agreements prohibiting
the sale of the Company’s common stock received by the Series B Preferred Stock
holders in the Business Combination until one year after the effective date of
the registration statement covering shares of common stock sold by the Company
in the private placement which closed concurrently with the Business Combination
on December 29, 2006.
  8
— Common Stock
  As of
December 31, 2008, the total number of authorized shares of common stock, par
value $0.001 per share, was 150,000,000, of which 65,643,901 shares were issued
and outstanding.
  Holders
of common stock are entitled to receive any dividends ratably, if declared by
the board of directors out of assets legally available for the payment of
dividends, subject to any preferential dividend rights of any outstanding
preferred stock. Holders of common stock are entitled to cast one vote for each
share held at all stockholder meetings for all purposes, including the election
of directors. The holders of more than 50% of the common stock issued and
outstanding and entitled to vote, present in person or by proxy, constitute a
quorum at all meetings of stockholders. The vote of the holders of a majority of
common stock present at such a meeting will decide any question brought before
such meeting. Upon liquidation or dissolution, the holder of each outstanding
share of common stock will be entitled to share equally in the Company’s assets
legally available for distribution to such stockholder after payment of all
liabilities and after distributions to preferred stockholders legally entitled
to such distributions. Holders of common stock do not have any preemptive,
subscription or redemption rights. All outstanding Shares of common stock are
fully paid and nonassessable. The holders of the common stock do not have any
registration rights with respect to the stock.
 
 Private Placement
of Securities – April 2008.In April 2008, the Company
entered into a revolving credit agreement, pursuant to which the Company
originally could borrow up to $1,500,000 which increased to $2,000,000 per
Amendment No. 1 to the agreement in September 2008 and to $2,400,000 per
Amendment No. 2 to the agreement in November 2008.  As part of the
original transaction, the lender received warrants to purchase 2,000,000 shares
of the Company’s common stock with an exercise price of $1.00 which expire on
April 30, 2015.  As part of the amendments, the lender received
warrants to purchase an additional 4,000,000 shares of the Company’s common
stock under the same terms as the original 2,000,000 warrants.
  Private Placement
of Securities –July 2008.In July 2008, the Company
issued 200,000 shares of stock pursuant to an agency agreement for services
related to potential financing activities, which had a fair value of
$100,000.
 
 Private Placement
of Securities – December 2008.In December 2008, the
Company issued 4,089,930 shares of common stock to the President of ATI as a
result of an earn-out evaluation performed by the Company, which had a fair
value of $611,043.
  F-14
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  9 — Stock Options and Warrants
  2004 Stock Option Plan –
Effective January 1, 2004, the Company’s Board of Directors adopted the 2004
Stock Option Plan for Directors, Officers, and Employees of and Consultants to
InterMetro Communications, Inc. (the “2004 Plan”). All stock options to purchase
common stock issued under the 2004 Plan were converted into stock options to
purchase shares of common stock in connection with the Business Combination. The
number of shares subject to the options and the exercise prices are presented on
a pro forma basis as if the Business Combination had occurred at the beginning
of the periods presented. The exercise periods and other terms and conditions of
the stock options remained the same.
  A total
of 5,730,222 shares of the Company’s common stock had been reserved for issuance
at December 31, 2008 and 2007 under the Company’s 2004 stock option plan. On
March 6, 2007, the Company froze any further grants of stock options under the
2004 Plan. Any shares reserved for issuance under the 2004 Plan that are not
needed for outstanding options granted under that plan will be cancelled and
returned to treasury shares.
  During the years ended December 31, 2007 and 2008, no options
were granted under the 2004 Plan. As of December 31, 2008, the Company has
granted a total of 5,714,819 stock options to the officers, directors, and
employees, and consultants of the Company, of which 308,077 expired in September
2007 and an additional 523,734 expired in the current year ended December 31,
2008.   In the three months ended March 31, 2008, the Company
issued 1,143,165 shares of common stock on the cashless exercise of 1,232,320
stock purchase options.  Of the remaining, 3,296,404 vest
as  follows: 20% on the date of grant and 1/16 of the balance each
quarter thereafter until the remaining stock options have vested and 878,018 of
which vest as follows: 50% on the date of grant and 50% at one year after the
date of grant. These stock options are exercisable for a period of ten years
from the date of grant and are exercisable at exercise prices ranging from
approximately $0.04 to $0.97 per share.
  Omnibus Stock and Incentive
Plan–Effective January 19, 2007,
the Company’s Board of Directors approved the 2007 Omnibus Stock and Incentive
Plan (the “2007 Plan”) for directors, officers, employees, and consultants. The
2007 Plan allows any of the following types of awards, to be granted alone or in
tandem with other awards: (1) Stock options which may be either incentive stock
options (“ISOs”), which are intended to satisfy the requirements of Section 422
of the Internal Revenue Code of 1986, as amended, or nonstatutory stock options
(“NSOs”), which are not intended to meet those requirements; (2) restricted
stock which is common stock that is subject to restrictions, including a
prohibition against transfer and a substantial risk of forfeiture, until the end
of a “restricted period” during which the grantee must satisfy certain vesting
conditions; (3) restricted stock units which entitle the grantee to receive
common stock, or cash (or other property) based on the value of common stock,
after a “restricted period” during which the grantee must satisfy certain
vesting conditions or the restricted stock unit is forfeited; (4) stock
appreciation rights which entitle the grantee to receive, with respect to a
specified number of shares of common stock, any increase in the value of the
shares from the date the award is granted to the date the right is exercised;
and (5) other types of equity-based compensation which may include shares of
common stock granted upon the achievement of performance
objectives.
  The 2007
Plan will be administered by the Company’s Compensation Committee. The Company
reserved 8,903,410 shares of common stock for awards under the 2007 Plan. In
addition, on each anniversary of the 2007 Plan’s effective date on or before the
fifth anniversary of the effective date, the aggregate number of shares of the
Company’s common stock available for issuance under the 2007 Plan will be
increased by the lesser of (a) 5% of the total number of shares of its common
stock outstanding as of the December 31 immediately preceding the anniversary,
(b) 4,713,570 shares, or (c) a lesser number of shares of its common stock that
its board, in its sole discretion, determines. In general, shares reserved for
awards that lapse or are canceled will be added back to the pool of shares
available for awards under the 2007 Plan.
 
 Awards
under the 2007 Plan are forfeitable until they become vested. An award will
become vested only if the vesting conditions set forth in the award are
satisfied. The vesting conditions may include performance of services for a
specified period, achievement of performance objectives, or a combination of
both. The Compensation Committee also has authority to provide for accelerated
vesting upon occurrence of an event such as a change in control. The 2007 Plan
specifically prohibits the Compensation Committee from repricing any stock
options or stock appreciation rights. In general, awards under the 2007 Plan may
not be assigned or transferred except by will or the laws of descent and
distribution. However, the Compensation Committee may allow the transfer of NSOs
to members of a 2007 Plan participant’s immediate family or to a trust,
partnership, or corporation in which the parties in interest are limited to the
participant and members of the participant’s immediate family.
  The Board
of Directors or the Compensation Committee may amend, alter, suspend, or
terminate the 2007 Plan at any time. If necessary to comply with any applicable
law (including stock exchange rules), the Company will first obtain stockholder
approval. Amendments, alterations, suspensions, and termination of the 2007 Plan
generally may not impair a participant’s (or a beneficiary’s) rights under an
outstanding award. However, rights may be impaired if necessary to comply with
an applicable law or accounting principles (including a change in the law or
accounting principles) pursuant to a written agreement with the participant.
Unless it is terminated sooner, the 2007 Plan will terminate upon the earlier of
June 23, 2016 or the date all shares available for issuance under the 2007 Plan
have been issued and vested.
  For the
year ended December 31, 2007, the Company granted 2,350,000 stock
options to purchase shares of common stock under the 2007 Plan at an
average exercise price of $0.25 per share to employees and directors. 1,095,000
of the shares granted were immediately vested at the date of grant. The Company
recognized $228,174 in compensation expense related to the immediate vesting of
the stock option grants. The remaining fair value is being recognized on a
straight line basis over the vesting term of the remaining
options.  For the year ended December 31, 2008, the Company granted
600,000 stock options to purchase shares of common stock under the 2007 Plan at
an average exercise price of $0.25 per share to employees and directors, 30%
vested at date of grant with the remaining vesting 1/12 per subsequent quarter
over the succeeding 3 years and expiring 5 years from date of
grant.  The Company recognized $1,197 of compensation expense related
to the 2008 grants.   As of December 31, 2008, none of the
Company’s outstanding stock options under the 2007 Plan have been
exercised.
  F-15
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  The
following presents a summary of activity under the Company’s 2004 and 2007 Plans
for the years ended December 31, 2007 and 2008:
  Number
      of Shares
                                                                        
                                                                        
                                                                        Price
      per Share
                                                                        
                                                                        
                                                                        Weighted
      Average Exercise Price
                                                                        
                                                                        
                                                                        Weighted
      Average Remaining Contractual Term
                                                                        
                                                                        
                                                                        Aggregate
      Intrinsic ValueOptions
      outstanding at December 31, 2006
                                                                        
                                                                        
                                                                        5,714,819
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        0.14Granted
      (weighted average fair value of $.19 per share)
                                                                        
                                                                        
                                                                        2,350,000
                                                                        
                                                                        
                                                                        
                                                                        0.25
                                                                        
                                                                        
                                                                        
                                                                        0.25Exercised
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        —Forfeited/expired
                                                                        
                                                                        
                                                                        (308,077
                                                                        )
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        0.04Options
      outstanding at December 31, 2007
                                                                        
                                                                        
                                                                        7,756,742
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        0.18
                                                                        
                                                                        
                                                                        
                                                                        7.56
                                                                        
                                                                        
                                                                        $
                                                                        821,508Granted
      (weighted average fair value of $.005 per share)
                                                                        
                                                                        
                                                                        600,000
                                                                        
                                                                        
                                                                        
                                                                        0.25
                                                                        
                                                                        
                                                                        
                                                                        0.25Exercised
                                                                        
                                                                        
                                                                        (1,232,320
                                                                        )
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        0.04
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        135,847Forfeited/expired
                                                                        
                                                                        
                                                                        (523,734
                                                                        )
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        0.04Options
      outstanding at December 31, 2008
                                                                        
                                                                        
                                                                        6,600,688
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        0.18
                                                                        
                                                                        
                                                                        
                                                                        7.16
                                                                        
                                                                        
                                                                        $
                                                                        0.0Options
      vested and expected to vest in the future at December 31,
    2008
                                                                        
                                                                        
                                                                        6,600,688
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        0.18
                                                                        
                                                                        
                                                                        
                                                                        7.16
                                                                        
                                                                        
                                                                        $
                                                                        0.0Options
      exercisable at December 31, 2008
                                                                        
                                                                        
                                                                        5,346,044
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        
                                                                        0.15
                                                                        
                                                                        
                                                                        
                                                                        6.85
                                                                        
                                                                        
                                                                        $
                                                                        0.0
 The
aggregate intrinsic value in the table above represents the total pretax
intrinsic value (the difference between the Company’s closing stock price on the
last day of the year ended December 31, 2008 and the exercises price, multiplied
by the number of in-the-money options) that would have been received by the
option holders had all option holders exercised their options on December 31,
2008.  This amount changes based on the fair market value of the
Company’s stock.  As of December 31, 2008, there remain 8,932,170
shares available for grant.
  Additional
information with respect to the outstanding options at December 31, 2008 is as
follows:
 
 Options
      Outstanding
                      
                      
                      
                      
                      
                      Options
      ExercisableExercise
      Prices
                      
                      
                      Number
                        of
      Shares
                      
                      
                      Average
                        Remaining
                        Contractual
                        Life
                        (in
      Years)
                      
                      
                      Weighted
                        Average
                        Exercise
                        Price
                      
                      
                      Number
                        of
      Shares
                      
                      
                      Weighted
                        Average
                        Exercise
      Price$
                      0.04
                      
                      
                      
                      1,478,748
                      
                      
                      
                      5.00
                      
                      
                      $
                      0.04
                      
                      
                      
                      1,478,748
                      
                      
                      $
                      0.040.04
                      
                      
                      
                      154,038
                      
                      
                      
                      5.25
                      
                      
                      
                      0.04
                      
                      
                      
                      154,039
                      
                      
                      
                      0.040.04
                      
                      
                      
                      431,307
                      
                      
                      
                      5.50
                      
                      
                      
                      0.04
                      
                      
                      
                      431,307
                      
                      
                      
                      0.040.04
                      
                      
                      
                      123,231
                      
                      
                      
                      6.00
                      
                      
                      
                      0.04
                      
                      
                      
                      123,231
                      
                      
                      
                      0.040.22
                      
                      
                      
                      277,269
                      
                      
                      
                      6.75
                      
                      
                      
                      0.22
                      
                      
                      
                      249,542
                      
                      
                      
                      0.220.25
                      
                      
                      
                      2,950,000
                      
                      
                      
                      8.75
                      
                      
                      
                      0.25
                      
                      
                      
                      1,879,586
                      
                      
                      
                      0.250.27
                      
                      
                      
                      338,884
                      
                      
                      
                      6.75
                      
                      
                      
                      0.27
                      
                      
                      
                      288,052
                      
                      
                      
                      0.270.41
                      
                      
                      
                      643,880
                      
                      
                      
                      7.00
                      
                      
                      
                      0.41
                      
                      
                      
                      561,316
                      
                      
                      
                      0.410.81
                      
                      
                      
                      110,908
                      
                      
                      
                      7.00
                      
                      
                      
                      0.81
                      
                      
                      
                      87,802
                      
                      
                      
                      0.810.97
                      
                      
                      
                      92,423
                      
                      
                      
                      7.25
                      
                      
                      
                      0.97
                      
                      
                      
                      92,423
                      
                      
                      
                      0.976,600,688
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      5,346,046
  F-16
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  For
option grants during the years ended December 31, 2008 and 2007, the
compensation cost was determined based on the fair value of the options, and is
being recognized over the applicable vesting.
  As of
December 31, 2008, there was $211,973 of total unrecognized compensation cost
related to unvested share based compensation arrangements granted under the 2004
and 2007 option plans. The cost is expected to be recognized over a weighted
average period of one year.
  Warrants – Historically, the
Company has issued warrants to providers of equipment financing.  For
a detailed description of the warrants issued in connection with equipment
financing arrangements, see Note 4. In the year ended December 31, 2008, a
vendor of network equipment exercised 635,612 of its warrants with a cash
exercise value of $165,936 in a cashless exchange for a $258,304 reduction in
payables due to the vendor that resulted in a $92,368 gain on forgiveness of
debt.
  In May
2007, warrants to purchase 410,761 shares of the Company common stock were
earned by a consultant to the Company, with a resulting charge under the fair
value method of $818,984.  This amount was recorded in general and
administrative expense in the year ended December 31, 2007.
 
 In April 30, 2008, theCompany
negotiated a revolving line of credit, which, as amended in September 2008 and
November 2008, allows the company to borrow up to $2.4
million.  Warrants to purchase 6,000,000 shares of the Company’s
common stock at $1.00 per share were issued in connection with this
facility.  See Note 11 for a detail of the warrants issued in
connection with this credit facility.
  10
— Liability for Options
 
 As of
December 29, 2006 (the date of the Business Combination), the Company did
not have a sufficient number of authorized shares for all share, option and
warrant holders. Accordingly, the exchange of securities pursuant to the
Business Combination was implemented in two phases with the second phase being
automatic upon the filing on May 31, 2007 of Amended and Restated Articles of
Incorporation which increased the number of authorized shares of the Company’s
common stock to 150,000,000 shares.
  In the
exchange agreements for the Business Combination, the InterMetro Delaware
investors agreed to defer the exchange of certain warrants until such time that
the Company increased the number of its authorized shares of common
stock to 150,000,000. Also, employees of the Company agreed to defer the
exchange of a portion of their common stock until such time that the Company had
increased the number of its authorized shares of common stock to
150,000,000. The exchange agreements did not provide for a deferral of exercise
rights for options issued under the 2004 Plan and the Company did not have
enough authorized shares to accommodate the exercise of these options.
Accordingly, effective on December 29, 2006, options under the 2004 Plan
were not exercisable concurrently on the closing of the Business Combination and
the Company determined that there was a liability for such options and included
the liability within the accompanying financial statements for the year ended
December 31, 2006. The options became exercisable without further act on the
part of the holders thereof on May 31, 2007.
  The
Company calculated the value of those options, valued under the fair value
method, which would be exercisable at a later date based on EITF No.
00-19, “Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company’s Own Stock.” The value associated with the
liability was estimated at $5,384,000 at December 29, 2006, the date of the
Business Combination, and was recorded as an offset to additional paid in
capital on that date. At December 31, 2006, the Company estimated that
there had been no change in the value of these options since the date of the
Business Combination. On May 31, 2007, the Company increased the number of
its authorized shares of common stock and determined that as of that date
there was no longer a liability for the options and the value associated with
the liability was credited to additional paid in capital. The Company determined
the fair market value of this liability to be $10,999,000 at May 31, 2007 and as
such recorded a derivative loss of $5,615,000 for the year ended December 31,
2007.
 
 The
Company calculated the fair value of these grants as described in SFAS 123(R)
using the following assumptions:
  December 31,
      2006
                          
                          
                          May
      31, 2007Risk-free
      interest rate
                          
                          
                          4.7
                          %
                          
                          
                          4.8
                          %Expected
      lives (in
      years)
                          
                          3.6
      years to 5.4
                          
                          
                          2.8
      to 4.5Dividend
      yield
                          
                          
                          0
                          %
                          
                          
                          0
                          %Expected
      volatility
                          
                          
                          84%-101
                          %
                          
                          
                          65%-92
                          %
  F-17
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  11
— Credit Facilities
 
 In
August 2006, the Company entered into unsecured credit facilities with an
aggregate value of $525,000 with certain of its directors and officers, for
general working capital. The facilities had one-year maturities and accrued
interest on outstanding principal at 10% per annum compounded monthly. Principal
and accrued interest were payable on August 31, 2007. In January 2007,
the Company repaid all of these facilities and all accrued fees and
interest.
  In
December 2006, the Company entered into a Term Credit Agreement under which it
borrowed $600,000 from The Hunter Fund Limited, an affiliate of an investment
banking company used in the Business Combination. The bridge loan principal and
all related fees and expenses were repaid in January 2007.
 
 ATI Bank Lines of Credit –
ATI has two $100,000 lines of credit.  The line of credit with Bank of
America has an interest rate of 7.13% per annum.  The line of credit
with Wells Fargo Bank has an interest rate of 6.50 percent per
annum.   The lines of credit are personally guaranteed by the
former stockholder of ATI.
 
 Revolving Credit
Facility-The
Company entered into agreements (the “Agreements”), effective as of April 30,
2008 (the “Closing Date”), with Moriah Capital, L.P. (“Moriah”), pursuant to
which the Company could borrow up to $2,400,000 per Amendments No. 1 and No. 2
to the Agreements (the “Amendments").
 
 Pursuant
to the Agreements, the Company was permitted to borrow an amount not to exceed
80% of its eligible accounts (as defined in the Agreements), net of all
discounts, allowances and credits given or claimed. Pursuant to the Amendments,
from September 10, 2008 through November 4, 2008 this borrowing base increased
to 110% of eligible accounts, from November 5, 2008 through December 15, 2008
increased to 135% of eligible accounts, from December 16, 2008 to January 15,
2009 decreases to 120% of eligible accounts, from January 16, 2009 through
February 15, 2009 decreases to 110% of the eligible accounts, from February 16,
2009 to March 15, 2009 decreases to 100% of eligible accounts and thereafter is
reduced to 85%.  As of December 31, 2008 the Company has borrowed
$2,400,000.  The Company's obligations under the loans are secured by
all of the assets of the Company, including but not limited to accounts
receivable; provided, however, that Moriah’s lien on the collateral other than
accounts receivable (as such terms are defined in the Agreements) are subject to
the prior lien of the holders of the Company’s outstanding secured
notes.  The Agreements include covenants that the Company must
maintain, including financial covenants pertaining to cash flow coverage of
interest and fixed charges, limitations on the ratio of debt to cash flow and a
minimum ratio of current assets to current liabilities.  As of
December 31, 2008, the Company was not in compliance with all of the covenants
and the availability of loan amounts under the Agreements expires on April
30, 2009.
 
 Annual
interest on the loans is equal to the greater of (i) the sum of (A) the
Prime Rate as reported in the “Money Rates” column of The Wall Street Journal,
adjusted as and when such Prime Rate changes plus (B) 4% or (ii) 10%, and
shall be payable in arrears prior to the maturity date, on the first business
day of each calendar month, and in full on April 30, 2009.  (See Note
1.)
 
 In
accordance with the agreement, the outstanding amount of the loan at any given
time may be converted into shares of the Company's common stock at the option of
the lender. The conversion price is $1.00, subject to adjustments and
limitations as provided in the Agreements.
  The
Company has also agreed to register the resale of shares of the Company's common
stock issuable under the Agreements and the shares issuable upon conversion of
the convertible note if the Company files a registration statement for its own
account or for the account of any holder of the Company’s common
stock.
 
 Subject
to certain conditions and limitations, the Company can terminate the ability to
fund loans under the Agreements at any time if there are no loans
outstanding.
  F-18
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 As part
of the original transaction, Moriah received warrants to purchase 2,000,000
shares of the Company’s common stock with an exercise price of $1.00 which
expire on April 30, 2015.  As part of the Amendments No.1 and No. 2 ,
Moriah received warrants to purchase an additional 1,000,000 and 3,000,000
shares, respectively, of the Company’s common stock under the same terms as the
original 2,000,000 warrants.   The Company accounts for the
issuance of detachable stock purchase warrants in accordance with APB No. 14 and
SFAS No. 150, whereby it separately measures the fair value of the debt and the
detachable warrants, and in the case of detachable warrants with put features to
the Company for cash, it also values the put feature as a separate component of
the detachable warrant, and allocates the proceeds from the debt on a pro-rata
basis to each. The resulting discount from the fair value of the debt allocated
to the warrant and put feature for cash, which are accounted for as paid-in
capital and a liability, respectively, is amortized over the estimated life of
the debt.   The warrants were valued using the Black-Scholes
option-pricing model using the assumptions noted in the table
below.  The value associated with the 6,000,000 warrants was $928,000
and was recorded as an offset to the principal balance of the revolving credit
facility and is being amortized on a straight-line basis over the term of the
Agreement.  As discussed below, the put option liability was $250,000
and the $678,000 difference was credited to Additional Paid in
Capital.  The expense recognized by the Company in the year ended
December 31, 2008 from the amortization of the debt discount was
$442,000.
 
 June
      30, 2008
                      
                      
                      September
      30, 2008
                      
                      
                      December
      31, 2008Risk-free
      interest rate
                      
                      
                      2.63
                      %
                      
                      
                      2.42
                      %
                      
                      
                      1.63
                      %Expected
      lives (in years)
                      
                      3.5
      years
                      
                      
                      3.5
      years
                      
                      
                      3.5
      yearsDividend
      yield
                      
                      
                      0
                      %
                      
                      
                      0
                      %
                      
                      
                      0
                      %Expected
      volatility
                      
                      
                      74.0
                      %
                      
                      
                      74.0
                      %
                      
                      
                      74.0
                      %Forfeiture
      rate
                      
                      
                      0
                      %
                      
                      
                      0
                      %
                      
                      
                      0
                      %
  The
Company has also granted Moriah an option as part of the Agreements and
Amendment pursuant to which Moriah can sell the warrants back to the Company for
$250,000 at any time during the 30 day period commencing on the earlier of the
prepayment in full of all loans or April 30, 2009. The Company has determined
that the put option associated with the warrants causes the instrument to
contain a net cash settlement feature. In accordance with SFAS 150, “Accounting
for Certain Financial Instruments with Characteristics of Both Liabilities and
Equity,” the put option requires liability treatment.  As a result,
the put warrant liability was recorded at the warrant purchase price of $250,000
as of December 31, 2008.
  12
— Commitments and Contingencies
  Equipment Leases –The Company leases equipment
under capital lease arrangements expiring on various dates through 2009.
Included in property and equipment, are the following assets held under capital
lease (dollars in thousands):
 
 December
      31,2008
                      
                      
                      2007Telecommunications
      equipment
                      
                      $
                      929
                      
                      
                      $
                      929Telecommunications
      software
                      
                      
                      96
                      
                      
                      
                      96Computer
      equipment
                      
                      
                      33
                      
                      
                      
                      33Leasehold
      improvements, office equipment and furniture
                      
                      
                      8
                      
                      
                      
                      8Total
      property and equipment under capital lease
                      
                      
                      1,066
                      
                      
                      
                      1,066Less:
      accumulated depreciation
                      
                      
                      (993
                      )
                      
                      
                      (818
                      )$
                      73
                      
                      
                      $
                      248
  The
future minimum lease payments under non-cancelable capital leases for the years
following December 31, 2008 are approximately $133,000 and are due in
2009.
  Facility Lease – The Company
leases its facilities under a non-cancelable operating lease that expired in
March 2009 and was extended through June 30, 2009 at an annual expense of
approximately $314,000. Rent expense for the Company’s facilities for the years
ended December 31, 2008 and 2007 was $314,000 and $299,000,
respectively.
  Vendor Agreements – The
Company has entered into agreements with its network partners and other vendors
for various services which are, in general, for periods of twelve months and
provide for month to month renewal periods.
  F-19
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Vendor Disputes – It is not
unusual in the Company’s industry to occasionally have disagreements with
vendors relating to the amounts billed for services provided between the
recipient of those services and the vendor, or in some cases, to receive
invoices from companies that the Company does not consider a vendor. The Company
currently has disputes with vendors and other companies that it believes did not
bill certain charges correctly or should not have billed any charges at all. The
Company’s policy is to include amounts that it intends to dispute or that it has
disputed in a reserve account as an offset to accounts payable if management
believes that the facts and circumstances related to the dispute provide
probable support that the dispute will be resolved in the Company’s
favor.  As of December 31, 2008, there were approximately
$3.4 million of disputed payables. The Company is in discussion with the
significant vendors, or companies that have sent invoices, regarding these
charges and it may take additional action as deemed necessary against these
vendors in the future as part of the dispute resolution process. Management does
not believe that any settlements would have a material adverse effect on the
Company’s financial position or results of operations. Management reviews
available information and determines the need for recording an estimate of the
potential exposure when the amount is probable, reasonable and estimable based
on SFAS 5, “Accounting for Contingencies.”
 
 In April
2008, the Company entered into a settlement agreement with a significant
provider of network services to the Company.  The settlement agreement
included a payment arrangement for past due amounts of approximately $3.0
million with full repayment due prior to December 31, 2008.  The
settlement agreement also provided a separate credit to the Company of
approximately $1.4 million for past disputes.  As of December 31,
2008, the Company was not in compliance with the payment terms of the agreement
and, therefore, was at risk of losing the $1.4 million credit and service
termination. The Company currently owes $2.4 million, net of the $1.4 million
credit, and is in discussions with the vendor.  The Company has not
received a notice of default.  The resulting potential termination of
the related service and collection proceedings would have a material adverse
impact on the Company’s operating results, financial condition, and business
performance.
 
 The
Company has periodically received “credit hold” and disconnect notices from
major telecommunications carriers.  Suspension of service by any major
carrier could have a material adverse effect on the company’s operations and
financial condition.  These disconnect notices were generated
primarily due to the non-payment of charges claimed by each carrier, including
some amounts disputed by the Company.  Service has been maintained
with each carrier, although further notices are possible if the Company is
unable to make timely payments to its counterparties or to resolve the disputed
amounts.  Such payments would be in addition to current charges
generated with such carriers.  During the first quarter of 2009, one
third party carrier suspended service to the Company due to non-payment of
bills.  The claims and counterclaims arising from this event have not
yet been resolved.
 
 The
Company has received notices from regulatory and taxing authorities in 27 states
regarding its failure to file certain documents including but not limited to
annual reports, articles of incorporation, and foreign corporation
status.  Additionally, the Company is in discussions with state-level
regulatory and taxing authorities regarding amounts that may be due to them
including minimum corporate taxes, registered corporation fees, sales and use
taxes, as well as penalties and interest.  The majority of these
matters pertain to the Company’s wholly-owned subsidiary ATI, and the amounts at
issue in most states are de
minimisand have been reserved.  The Company has provided
documentation to the various state authorities in connection with these
inquiries and is actively cooperating with their investigations.
 
 Legal Proceedings– On January 15, 2008, a
telecommunications carrier filed a lawsuit against the Company asserting unpaid
invoices.  The carrier is also one of the Company’s
customers.  On January 13, 2009, the parties entered into a settlement
agreement whereby the Company will credit the carrier’s account in the amount of
$20,000 each month for 18 months against which the carrier’s use of the
Company’s services will be charged, for a total credit of
$360,000.  Included in accounts payable as of December 31, 2008, is
$360,000 of amounts due to the carrier, which will be reduced by $20,000 per
month beginning in January 2009.
 
 Blue Casa
Communication, Inc.
–  On December 12, 2007, Blue Casa Communications, Inc. (“Blue Casa”) filed
a complaint against the Company asserting various causes of action, including
breach of contract, breach of implied contract and unjust
enrichment.   Blue Casa claims that the Company owes Blue Casa payment
of access charges in the amount of $300,000.  The Company denies that it
owes Blue Casa payment of access charges.  On March 9, 2009, the Court
renewed the stay for an additional 180 days.
  Cantata
Technology, Inc. – On
August 12, 2008, Cantata filed a lawsuit against the Company asserting a breach
of contract claim arising out of the parties’ term sheet dated May 2,
2006.  Cantata is seeking $1.1 million together with interest costs,
and attorney fees. Cantata is also seeking $63,000 for support services provided
during the second year of the parties’ relationship.  As discussed in
Note 4, the Company has accrued $1,096,000 due to Cantata as of December 31,
2008.  The Company accrued additional interest of $300,000 as a
contingent liability related to this law suit.   The Company has
filed a counterclaim against Cantata and a third party claim against its parent
company, Dialogic.  The Company is vigorously asserting its claims
against Cantata and Dialogic and does not expect a material adverse outcome from
this matter.
 
 Hypercube/KMC
– On April 30, 2007, the Company initiated litigation against KMC Data, LLC and
its affiliate Hypercube, LLC (collectively referred to herein as “KMC”), or (the
“KMC Litigation”).  KMC, in turn, filed various counterclaims against the
Company.  The KMC Litigation concerns the issue of whether or to what
extent the Company is obligated to pay KMC fees related to the transmission and
routing of wireless communications traffic, and if so, what rates would be
appropriate.  As of March 31, 2009, there are approximately $1.2 million of
charges that the Company disputes. The Company has recorded these disputes
as an offset to accounts payable at December 31, 2008. As of December 31, 2008,
the Company has recorded the $1.2 million in accounts payable, with a
corresponding offset to unresolved disputed amounts.  On August 6,
2007, the Court stayed the KMC Litigation pending referral of certain issues in
the case to the Federal Communications Commission under the doctrine of primary
jurisdiction.  The case is currently stayed.  The Company cannot
predict the outcome of these proceedings at this time or how long the Court’s
stay will remain in place.  A ruling against the Company could have a
material adverse impact on its operating results, financial condition and
business performance.
  F-20
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
addition, the following vendors, carriers and customers have sent written notice
of their intent to file suit against the Company:
 
 A Local
Exchange Carrier – A local exchange carrier (LEC) invoiced the Company access
charges in connection with certain wireless originated calls of a third party
provider.  During the period from November 2008 through February 2009, the
Company paid the LEC’s invoiced charges in connection with these wireless
originated calls.  During this time frame, the Company submitted disputes
to the LEC for the wireless call charges equaling approximately $337,000. 
The LEC has denied the disputes submitted by the Company.  The Company has
withheld payment to the LEC asserting that it has overpaid for services. 
To date, the Company and the LEC have not resolved the
dispute.
 
 An
Interexchange Carrier – An interexchange carrier (IXC) asserts to the
Company  that it is owed approximately $1.1 million in past due
disputed and undisputed charges.  The carrier has threatened to disconnect
services to the Company and to initiate litigation against the Company. 
The carrier and the Company have been engaged in discussions to resolve these
payment issues.  If the carrier suspends its provision of services to the
Company or initiates litigation against the Company, it could have a material
adverse impact on the Company’s operating results, financial condition and
business performance.
 
 Federal
Communications Commission - On November 26, 2008, the
Company  received letters of inquiry from the Federal Communications
Commission (“FCC”) in connection with nonpayment of fees and surcharges required
pursuant to the FCC’s regulations.  The Company has provided documentation
to the FCC in connection with these inquiries and is actively cooperating with
the FCC’s investigations.
 
 Universal
Service Administrative Company – The Universal Service Administrative Company
(USAC) administers the Universal Service Fund (USF).  The Company may not
have made all of the payments claimed by the USAC in a timely manner, including
payments owed pursuant to agreed upon payment plans with the Company.  The
USAC has transferred some of these unpaid amounts to the Federal Communications
Commission (FCC) for collection.  The FCC may transfer the unpaid amounts
to the Department of the Treasury.  If the amounts are not resolved, they
may then be transferred to the Department of Justice for collection
action.  With each transfer, additional fees, surcharges and penalties
are added to the amount due.  As of February 28, 2009, USAC and the FCC
have claimed approximately $410,000 is due and payable in connection with the
USF.  The Company is working with USAC and the FCC to resolve these
amounts.
 
 Consulting Agreement –
Commencing in December 2006, the Company entered into a three-year consulting
agreement with an affiliate of a stockholder and debt holder pursuant to which
the Company received services related to strategic planning, investor relations,
acquisitions, and corporate governance.  The Company was obligated to
pay $13,000 a month for these services, subject to annual
increases.  In June 2008, the parties orally agreed to cancel the
agreement and any future obligation.  Included in general and
administrative expense is $78,000 in 2008 and $156,000 in 2007 for these
services and included in accounts payable is $182,000 at December 31, 2008 and
$104,000 at December 31, 2007 for unpaid amounts.
  13
— Income Taxes
  At
December 31, 2008, the Company had net operating loss carryforwards to offset
future taxable income, if any, of approximately $18.0 million for Federal and
State taxes. The Federal net operating loss carryforwards begin to expire in
2021. The State net operating loss carryforwards begin to expire in
2008.
  The following is a summary of the
Company’s deferred tax assets and liabilities (dollars in
thousands):
 
 December
      31,2008
                          
                          
                          2007Current
      assets and liabilities:Deferred
      revenue
                          
                          $
                          20
                          
                          
                          $
                          (58
                          )Accrued
      expenses
                          
                          
                          335
                          
                          
                          
                          (9
                          )355
                          
                          
                          
                          (67
                          )Valuation
      allowance
                          
                          
                          (355
                          )
                          
                          
                          67Net
      current deferred tax asset
                          
                          $
                          —
                          
                          
                          $
                          —Non-current
      assets and liabilities:Depreciation
      and amortization
                          
                          $
                          31
                          
                          
                          $
                          53Net
      operating loss carryforward
                          
                          
                          17,736
                          
                          
                          
                          13,96617,767
                          
                          
                          
                          14,019Valuation
      allowance
                          
                          
                          (17,767
                          )
                          
                          
                          (14,019
                          )Net
      non-current deferred tax asset
                          
                          $
                          —
                          
                          
                          $
                          —
  F-21
 Table of Contents
  INTERMETRO
COMMUNICATIONS, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  The
reconciliation between the statutory income tax rate and the effective rate is
as follows:
 
 For
      the Year Ended
                                                  December
      31,2008
                                              
                                              
                                              2007Federal
      statutory tax rate
                                              
                                              
                                              (34
                                              )%
                                              
                                              
                                              (34
                                              )%State
      and local taxes
                                              
                                              
                                              (6
                                              )
                                              
                                              
                                              (6
                                              )Valuation
      reserve for income taxes
                                              
                                              
                                              40
                                              
                                              
                                              
                                              40Effective
      tax rate
                                              
                                              
                                              —
                                              %
                                              
                                              
                                              —
                                              %
  Management
has concluded that it is more likely than not that the Company will not have
sufficient taxable income within the carryforward period permitted by current
law to allow for the utilization of certain of the deductible amounts generating
the deferred tax assets; therefore, a full valuation allowance has been
established to reduce the net deferred tax assets to zero at December 31, 2008
and 2007.
  The
Company adopted FIN 48, Accounting for Uncertainty in Income
Taxes on January 1, 2007. The Company recognized no cumulative
effect adjustment as a result of adopting FIN 48.  At
December 31, 2008 and 2007, the Company did not have any unrecognized tax
benefits.
  14
— Cash Flow Disclosures
  The table
following presents a summary of the Company’s supplemental cash flow information
(dollars in thousands):
 
 Year
      Ended December 31,2008
                                    
                                    
                                    2007Cash
      paid:Interest
                                    
                                    $
                                    245
                                    
                                    
                                    $
                                    298Income
      taxes
                                    
                                    $
                                    —
                                    
                                    
                                    $
                                    5Non-cash
      information:Issuance
      of common stock for cashless exercise of warrants.
                                    
                                    $
                                    6
                                    
                                    
                                    $
                                    —Cancellation
      of debt due to loan modification
                                    
                                    $
                                    600
                                    
                                    
                                    $
                                    —Fair
      value of debt discount (net of put liability)
                                    
                                    $
                                    1,575
                                    
                                    
                                    $
                                    —Equipment
      obtained under capital leases
                                    
                                    $
                                    —
                                    
                                    
                                    $
                                    233Stock
      issued on cashless exercise of common stock purchase
    options
                                    
                                    $
                                    1
                                    
                                    
                                    $
                                    —Reclassification
      of options and warrants liability to equity
                                    
                                    $
                                    —
                                    
                                    
                                    $
                                    10,999
  15 — Fourth Quarter
Adjustment
  The
Company finalized the calculation of the earn-out as described in Note 2 and
recorded the issuance of 4,089,930 shares of common stock valued at $611,043 in
the three months ended December 31, 2008.
  16
— Subsequent Event
  The
following events have occurred since December 31, 2008:
 
 During
the first quarter of 2009, VenCore Solutions and the Company entered into an
agreement whereby Vencore agreed to refinance approximately $329,000 of leases
on equipment.  In conjunction with this event, the Company issued to
VenCore 50,000 shares of its common stock with a fair value of
$25,000.
   F-22
 Table of Contents