**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 **Washington,
        D.C. 20549**
  
  **FORM
        10-Q**
  
  **(Mark
        One)**
 **x**
              **QUARTERLY
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934**
 
  **For
        the Quarterly Period Ended September 30, 2005**
  **OR**
   ̈
              **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: 000-50958**
  
 **CallWave
        Inc.**
 **(Exact
        name of registrant as specified in its charter)**
  
  **Delaware**
              
              **77-0490995****(State
                  or other jurisdiction of**
                **incorporation
                  or organization)**
              
              **(I.R.S.
                  Employer**
                **Identification
                  Number)**
 
  **136
        West Canon Perdido Street, Suite A, Santa Barbara, California
        93101**
 **(Address
        of principal executive offices)**
 **(Zip
        code)**
  **(805)
        690-4100**
 **(Registrant’s
        telephone number, including area code)**
  
  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 x NO  ̈
  Indicate
        by check mark whether the registrant is an accelerated filer (as defined
        in Rule
        12b-2 of the Exchange Act)    YES  ̈ NO x
  At
        October 31, 2005, the number of shares outstanding of the registrant’s common
        stock, $0.0001 par value, was 20,611,714.
   
 **CALLWAVE
        INC.**
 **Form
        10-Q**
 **For
        the Quarter Ended September 30, 2005**
 **INDEX**
  **Page No.****PART
                      I. FINANCIAL INFORMATION**Financial
                      StatementsCondensed
                      Consolidated Balance Sheets—September 30, 2005 (unaudited) and June 30,
                      2005
                  
                  1Condensed
                      Consolidated Statements of Income—Three Months Ended September 30, 2005
                      and 2004 (unaudited)
                  
                  2Notes
                      to Unaudited Condensed Consolidated Financial
                      Statements
                  
                  4Management’s
                      Discussion and Analysis of Financial Condition and Results
                      of
                      Operations
                  
                  12Quantitative
                      and Qualitative Disclosures About Market Risk
                  
                  33Controls
                      and Procedures
                  
                  33**PART
                      II. OTHER INFORMATION**Legal
                      Proceedings
                  
                  34Changes
                      in Securities, Use of Proceeds and Issuer Purchases of Equity
                      Securities
                  
                  35Defaults
                      Upon Senior Securities
                  
                  35Submission
                      of Matters to a Vote of Security Holders
                  
                  35Other
                      Information
                  
                  35Exhibits
                  
                  36Signatures
                  
                  37Exhibit
                      Index
                  
                  38Certifications
 **P****ART****I. F****INANCIAL****I****NFORMATION**
  **I****TEM****1. F****INANCIAL****S****TATEMENTS**
 **CALLWAVE,
        INC.**
 
  **CONDENSED
        CONSOLIDATED BALANCE SHEETS**
 **(in
        thousands, except par value)**
  **As
                  of**
                **September
                  30,**
                **2005**
              
              **As
                  of**
                **June
                  30,**
                **2005****(unaudited)****ASSETS**Current
                  assets:Cash
                  and cash equivalents
              
              $
              34,883
              
              $
              16,828Marketable
                  securities
              
              
              26,653
              
              
              39,996Restricted
                  cash
              
              
              335
              
              
              335Accounts
                  receivable; net of allowance for doubtful accounts of $347 and
                  $370
              
              
              4,867
              
              
              5,676Inventory
              
              
              --
              
              
              454Prepaid
                  income tax
              
              
              336
              
              
              113Other
                  current assets
              
              
              199
              
              
              476Total
                  current assets
              
              
              67,273
              
              
              63,878Property
                  and equipment, net
              
              
              1,867
              
              
              2,024Deferred
                  tax asset
              
              
              2,295
              
              
              2,929Other
                  assets
              
              
              156
              
              
              414Total
                  assets
              
              $
              71,591
              
              $
              69,245**Liabilities
                  And Stockholders’ Equity**Current
                  liabilities:Accounts
                  payable
              
              $
              798
              
              $
              801Accrued
                  payroll
              
              
              1,037
              
              
              1,014Deferred
                  revenue
              
              
              1,398
              
              
              1,587Income
                  taxes payable
              
              
              2
              
              
              --Other
                  current liabilities
              
              
              1,526
              
              
              1,447Total
                  current liabilities
              
              $
              4,761
              
              $
              4,849Commitments
                  and contingenciesStockholders’
                  equity:Common
                  stock, $0 par value; 100,000 and 50,000 shares authorized at September
                  30,
                  2005 and June 30, 2005, respectively; 20,599 and 19,799 shares
                  issued and
                  outstanding at September 30, 2005 and June 30, 2005,
                  respectively
              
              
              71,311
              
              
              70,296Deferred
                  compensation
              
              
              --
              
              
              (545
              )Accumulated
                  comprehensive income (loss)
              
              
              (82
              )
              
              (24
              )Accumulated
                  deficit
              
              
              (4,399
              )
              
              (5,331
              )Total
                  stockholders’ equity
              
              
              66,830
              
              
              64,396Total
                  liabilities and stockholders’ equity
              
              $
              71,591
              
              $
              69,245
 
  See
        accompanying notes
  1
  
 **CALLWAVE,
        INC.**
  **CONDENSED
        CONSOLIDATED STATEMENTS OF OPERATIONS**
 **(in
        thousands, except per share amounts)**
  **Three
                    Months ended**
                  **September
                    30,****2005**
                ****
                ****
                **2004****(unaudited)**Revenues
                
                $
                10,572
                
                $
                11,045Cost
                    of sales
                
                
                3,761
                
                
                3,202Gross
                    profit
                
                
                6,811
                
                
                7,843Operating
                    expenses:Sales
                    and marketing
                
                
                2,109
                
                
                2,116Research
                    and development
                
                
                1,216
                
                
                1,668General
                    and administrative
                
                
                2,182
                
                
                1,276Impairment
                    of long-lived assets
                
                
                243
                
                
                --Total
                    operating expenses
                
                
                5,750
                
                
                5,060Operating
                    income
                
                
                1,061
                
                
                2,783Interest
                    income
                
                
                505
                
                
                52Income
                    before income taxes
                
                
                1,565
                
                
                2,835Income
                    tax expense (benefit)
                
                
                633
                
                
                (66
                )Net
                    income
                
                $
                932
                
                $
                2,901Net
                    income per share:Basic
                
                $
                .05
                
                $
                0.44Diluted
                
                
                .04
                
                
                0.17Weighted-average
                    common shares outstanding:Basic
                
                
                20,374
                
                
                6,540Diluted
                
                
                21,160
                
                
                17,365
 
  See
        accompanying notes.
   2
  
 **CALLWAVE,
        INC.**
  **CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS**
 **(in
        thousands)**
  **Three
                  Months Ended**
                **September
                  30,****2005**
              
              **2004****(unaudited)****Cash
                  flows from operating activities:**Net
                  income
              
              $
              932
              
              $
              2,901Adjustments
                  to reconcile net income to net cash provided by operating
                  activities:Depreciation
                  and amortization
              
              
              217
              
              
              194Impairment
                  of long-lived assets
              
              
              243
              
              
              --Share
                  based compensation
              
              
              107
              
              
              46Deferred
                  tax asset
              
              
              634
              
              
              485Inventory
                  writeoff
              
              
              314
              
              
              --Bad
                  debt expense
              
              
              542
              
              
              191Changes
                  in operating assets and liabilities:Accounts
                  receivable, net of bad debt expense
              
              
              267
              
              
              (759
              )Inventory
              
              
              140
              
              
              --Prepaid
                  income tax
              
              
              (223
              )
              
              (58
              )Other
                  assets
              
              
              292
              
              
              608Accounts
                  payable
              
              
              (3
              )
              
              (42
              )Accrued
                  payroll
              
              
              23
              
              
              (133
              )Deferred
                  revenues
              
              
              (189
              )
              
              (54
              )Income
                  taxes payable
              
              
              2
              
              
              (781
              )Accrued
                  other liabilities
              
              
              79
              
              
              571Net
                  cash provided by operating activities
              
              
              3,377
              
              
              3,169**Cash
                  flows from investing activities:**Purchases
                  of marketable securities
              
              
              (3,180
              )
              
              (2,997
              )Sales
                  of marketable securities
              
              
              16,465
              
              
              --Purchases
                  of property and equipment
              
              
              (60
              )
              
              (159
              )Net
                  cash provided by (used in) investing activities
              
              
              13,225
              
              
              (3,156
              )**Cash
                  flows from financing activities:**Exercises
                  of stock options and warrants
              
              
              1,453
              
              
              137Costs
                  incurred in initial public offering
              
              
              --
              
              
              (1,522
              )Net
                  cash provided (used) by financing activities
              
              
              1,453
              
              
              (1,385
              )Net
                  increase (decrease) in cash and cash equivalents
              
              
              18,055
              
              
              (1,372
              )Cash
                  and cash equivalents at beginning of the period
              
              
              16,828
              
              
              6,187Cash
                  and cash equivalents at end of the period
              
              $
              34,883
              
              $
              4,815**Supplemental
                  disclosures of cash flow information**Cash
                  paid for:Income
                  taxes
              
              $
              223
              
              $
              288Interest
              
              
              --
              
              
              --**Supplemental
                  schedule of non-cash transactions**Equity
                  based deferred compensation
              
              $
              107
              
              $
              515
 
  See
        accompanying notes.
    3
  
 
 **CallWave
        Inc.**
  **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **(unaudited)**
  **1.
        The Company and Basis of Presentation**
  *Description
        of business* —CallWave,
        Inc. (CallWave, or the Company), was incorporated in August 1998, first marketed
        its free services in February 1999 and began marketing paid subscription
        services in April 2001. CallWave provides software-based communications
        application services that bridge calls across existing landline, mobile and
        Internet networks.
  *Basis
        of Presentation* —The
        accompanying unaudited condensed consolidated financial statements have been
        prepared on the same basis as the annual financial statements and, in the
        opinion of management, reflect all adjustments, which include only normal
        recurring adjustments, necessary to present fairly the Company’s financial
        position, results of operations and cash flows for the periods shown. The
        results of operations for such periods are not necessarily indicative of
        the
        results expected for a full year or for any future period.
  These
        financial statements should be read in conjunction with the consolidated
        financial statements and related notes included in the Company’s year end
        financial statements included in the Form 10-K filed with the Securities
        and
        Exchange Commission.
  *Use
        of estimates* —The
        preparation of financial statements in conformity with accounting principles
        generally accepted in the United States necessarily requires management 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. The primary accounts that are particularly
        sensitive to changes in estimates are the allowance for doubtful accounts,
        inventory allowance, net realizable value of investments and the valuation
        allowance for the deferred tax asset. Actual results could differ from those
        estimates.
  *Revenue
        recognition* —The
        Company earns revenues from paid subscriber services, and to a lesser extent,
        fees earned from local exchange carrier call termination access charges,
        advertisements and the offering of third-party products and services to our
        subscribers. Beginning in fiscal year 2005, the Company entered the prepaid
        mobile phone market by selling prepaid phones to a distributor and on a
        subsidized basis directly to its subscriber.
 
 The
        Company recognizes revenue in accordance with accounting principles generally
        accepted in the United States and with Securities and Exchange Commission
        Staff
        Accounting Bulletin 104 (SAB 104), *Revenue
        Recognition,*
 which
        clarifies certain existing accounting principles for the timing of revenue
        recognition and classification of revenues in the financial statements. The
        Company recognizes revenue ratably beginning when there is persuasive evidence
        of an arrangement, delivery has occurred or services have been rendered,
        the
        fees are fixed and determinable and collection is reasonably
        assured.
  In
        addition to the direct relationship that the Company has with the majority
        of
        its paid subscribers, the Company also has channel relationship agreements
        with
        Internet service providers (ISPs) and other companies whereby those companies’
        customers are offered a co-branded subscription service. When the agreement
        provides that the Company is the party responsible for providing the service,
        has control over the fees charged to customers and bears the credit risk,
        the
        company records the gross amount billed as revenue in accordance with Emerging
        Issues Task Force 99-19 (EITF 99-19), *Reporting Revenues Gross as a Principal Versus Net as an Agent* .
        When
        the agreement provides that CallWave receive a net payment from those companies,
        based upon the number of their customers registered for CallWave’s services,
        CallWave records the net amount received from those companies as revenue
        in
        accordance with EITF 99-19.
  4
 In
        the
        third quarter of fiscal 2005, the Company purchased prepaid phones and phone
        cards with the intention of reselling them with a 30-day free trial of
        CallWave’s application-based services and entered into an agreement to sell a
        portion of these prepaid phones and phone cards to a distributor. Revenue
        from
        the sale of prepaid phones and phone cards is recognized when the SAB 104
        criteria are met. The Company recognizes sales to this distributor on a
        sell-through basis and when the cash is collected from the distributor. The
        Company recognized $133,000 of revenue related to the sale to this distributor
        in the quarter ended September 30, 2005.
  Beginning
        in the fourth quarter of fiscal 2005, the Company began selling prepaid phones
        into which the CallWave technology is embedded to its subscriber base. These
        transactions contain multiple elements, including the phone, the minutes,
        and
        our CallWave service, to which we have applied EITF 00-21, *Revenue
        Arrangements with Multiple Deliverables.* The
        various elements of the arrangement are separable and each element is recognized
        separately in accordance with SAB 104. In accounting for multiple deliverables,
        management’s judgment is necessary when identifying the nature of deliverables
        in an arrangement as well as measuring and allocating fair value to the multiple
        deliverables.
 
 *Deferred
        revenue* —Deferred
        revenue consists of customer prepayments of subscription fees, which will
        be
        earned in the future under agreements existing at the balance sheet date.
        Deferred revenue is amortized ratably over the period in which services are
        provided.
  *Marketable
        securities—* Marketable
        securities consist of investment grade government agency and corporate debt
        securities due within one year. Investments with maturities beyond one year
        are
        classified as short-term based on their highly liquid nature and because
        such
        investments represent the investment of cash that is available for current
        operations. All investments are classified as available-for-sale and are
        recorded at market value. Unrealized gains and losses are reflected in other
        comprehensive income.
  *Comprehensive
        income (loss):* Comprehensive net income was $874,000 and $2,901,000 for the three months
        ended
        September 30, 2005 and 2004, respectively. The comprehensive net income differs
        from the net income by the net unrealized gain or loss on short-term
        investments.
  *Inventories:* Inventories consist of finished goods and are stated at the lower of cost
        or
        market, cost being determined under the first-in, first-out method. Inventory
        at
        September 30, 2005 consisted of the following:
 
 **Inventory
                  - Distributors**
              
              **Inventory
                  -**
                **CallWave**
              
              **Total**
                **Inventory**At
                  Cost
              
              $
              153,000
              
              $
              236,000
              
              $
              389,000Valuation
                  Allowance
              
              
              (153,000
              )
              
              (236,000
              )
              
              (389,000
              )Total
                  inventory
              
              
              --
              
              
              --
              
              
              --
 
 
 For
        the
        quarter ended September 30, 2005 we recorded an impairment allowance against
        inventory in the amount of $389,000, an increase of $314,000 from the balance
        at
        June 30, 2005, to reduce the inventory balance to its net realizable value.
        Management’s judgment is required in determining net realizable value and the
        extent of any impairment to our inventory. Judgment is also required in
        determining the collectibility of amounts that are due from our distributors
        as
        a result of selling our inventory through to end customers.
  *Concentrations
        of credit risk* —The
        Company has a concentration of credit risk from an agreement with a vendor
        for
        billing and collection services provided for a portion of the Company’s paid
        users. The Company would be subject to sustaining a loss relative to its
        current
        receivable balance if the vendor failed to perform under the terms of the
        agreement. The receivable from the vendor at September 30, 2005 and June
        30,
        2005 was $4,422,000 and $5,152,000, respectively.
  The
        Company’s cash balances at financial institutions exceed the maximum amounts
        insured by the Federal Deposit Insurance Corporation.
  *Investments
        in minority owned companies* —The
        Company accounts for investments in minority interests of other companies
        over
        which it does not exercise significant influence on the cost method in
        accordance with ** SFAS
        115 *,
        Accounting for Certain Investments in Debt and Equity
        Securities* .
        Under
        the cost method, an investment is carried at cost until it is sold or there
        is
        evidence that changes in the business environment or other facts and
        circumstances suggest it may be other than temporarily impaired. In the event
        of
        other than temporary impairment, the Company will reduce the carrying amount
        to
        the estimated fair value measured by comparing the carrying amount of an
        asset
        to future net cash flows expected to be generated by the asset in accordance
        with SFAS 144, *Accounting
        for the Impairment or Disposal of Long-Lived Assets.*
 
 5
 *Share-Based
        Compensation* —The
        Company adopted FAS 123(R), *Share-Based
        Payment,* using
        the
        modified-prospective-transition-method as of July 1, 2005. Historically,
        the
        company elected to account for employee stock compensation under the fair
        value
        method in accordance with SFAS 123, *Accounting
        for Stock-Based Compensation,* and had
        reflected compensation expense related to the fair value of options issued
        to
        employees in the statement of operations. See further discussion in Note
        4.
  *Income
        taxes* —Income
        taxes are recorded in accordance with SFAS 109, *Accounting for Income Taxes* .
        SFAS
        109 requires the recognition of deferred tax assets and liabilities to reflect
        the future tax consequences of events that have been recognized in the Company’s
        financial statements or tax returns. Measurement of the deferred items is
        based
        on enacted tax laws. In the event the future consequences of differences
        between
        financial reporting bases and tax bases of the Company’s assets and liabilities
        result in a deferred tax asset, SFAS 109 requires an evaluation of the
        probability of being able to realize the future benefits indicated by such
        assets. A valuation allowance related to a deferred tax asset is recorded
        when
        it is more likely than not that some portion or all of the deferred tax asset
        will not be realized.
  *Net
        income per share* —The
        Company computes net income per share in accordance with SFAS 128, *Earnings per Share* .
        Under
        the provisions of SFAS 128, basic net income per share is computed using
        the
        weighted-average number of common shares outstanding during the period. Diluted
        net income per share is computed using the weighted-average number of common
        shares and, if dilutive, potential common shares outstanding during the period.
        Potential common shares consist of shares issuable upon exercise of stock
        options and warrants and conversion of convertible preferred stock. The dilutive
        effect of outstanding stock options and warrants is reflected in diluted
        income
        per share by application of the treasury stock method. As of July 1, 2005,
        the
        date the Company adopted FAS 123(R), deferred compensation related to unvested
        outstanding options is included as a component of proceeds upon exercise
        in
        calculation of the diluted shares under the treasury stock method. This
        inclusion had an immaterial effect on net income per share for the quarter
        ended
        September 30, 2005. Convertible preferred stock is reflected on an if-converted
        basis.
  The
        following table sets forth the computation of basic and diluted net income
        per
        share:
 
  **Three
                  Months Ended**
                **September
                  30,****2005**
              
              **2004****(unaudited,
                  in thousands except per share data)**Basic
                  and diluted net income per share:Net
                  income attributable to common stockholders
              
              $
              932
              
              $
              2,901Weighted-average
                  common shares outstanding
              
              
              20,374
              
              
              6,540Effect
                  of dilutive securities:Add:
                  Stock options and warrants
              
              
              796
              
              
              2,379Add:
                  Convertible preferred shares
              
              
              --
              
              
              8,446Weighted-average
                  common shares outstanding for diluted calculation
              
              
              21,160
              
              
              17,365**Net
                  income per share:**Basic
              
              $
              0.05
              
              $
              0.44Diluted
              
              
              0.04
              
              
              0.17
 
  Options
        to purchase 1,073,000 and 154,000 shares with exercise prices equal to or
        greater than the average fair value of common stock were outstanding during
        the
        three months ended September 30, 2005 and 2004, respectively. These options
        were
        excluded from the respective computations of diluted earnings per share because
        their effect would be anti-dilutive.
  6
 **2.
        Related Party Transactions**
  In
        February 2004, the Company entered into an agreement with Insight Venture
        Management, LLC, an affiliate of Insight Venture Associates IV, LLC, a
        shareholder of the Company, to make available to it certain of Insight’s
        business development personnel to assist the Company with market assessment,
        research and analysis. Under the terms of this agreement, the Company paid
        Insight $75,000 per year, payable in four quarterly installments at the end
        of
        each calendar quarter. The price paid in this transaction was determined
        by
        considering the market rate for business development personnel possessing
        similar skills and experience. The Company terminated this agreement in February
        2005.
  **3.
        Stockholders’ Equity**
  *Common
        Stock*
  As
        of
        September 30, 2005, the Company is authorized to issue 100,000,000 shares
        of
        common stock. As of September 30, 2005, 2,448,000 shares of common stock
        are
        reserved for the 120,000 warrants and 2,328,000 stock options issued and
        outstanding.
  The
        Company’s board of directors has the authority without further action by the
        stockholders, to issue up to 10,000,000 shares of preferred stock in one
        or more
        series, to establish from time to time the number of shares to be included
        in
        each such series, to fix the rights, preferences and privileges of the shares
        of
        each wholly unissued series and any qualifications, limitations or restrictions
        thereon, and to increase or decrease the number of shares of any such series
        (but below the number of shares of such series then outstanding).
  *Warrants*
  As
        of
        September 30, 2005, the Company has issued and outstanding warrants to purchase
        up to 120,000 shares of common stock at exercise prices of between $0.55
        -
        $4.00. The Company had 293,000 warrants issued and outstanding at June 30,
        2005,
        and 173,000 warrants were exercised during the three months ended September
        30,
        2005.
  **4.
        Share-Based Payments**
 
 ***FAS
        123(R) Adoption***
 At
        September 30, 2005, the Company has three stock-based employee compensation
        plans which are described more fully below. Prior to July 1, 2005, the Company
        accounted for those plans under the recognition and measurement provisions
        of
        FASB Statement No. 123, *Accounting
        for Stock-Based Compensation.* Effective
        July 1, 2005, the Company adopted the fair value recognition provisions of
        FASB
        Statement No. 123(R), *Share-Based
        Payment* ,
        using
        the modified-prospective-transition method. Under that transition method,
        compensation cost recognized in the three months ended September 30, 2005
        includes the compensation expense that had been recognized under FAS 123
        reduced
        by the amount of (a) estimated forfeitures related to the share-based payments
        granted prior to, but not yet vested as of July 1, 2005, and (b) estimated
        forfeitures for all share based payments granted subsequent to July 1, 2005.
        Results for prior periods have not been restated.
 
 As
        a
        result of adopting FAS 123(R) on July 1, 2005, the Company’s income before
        income taxes and net income for the three months ended September 30, 2005,
        are
        $43,600 higher than if it had continued to account for forfeitures as they
        occurred which was permissible under FAS 123 but not under FAS 123(R).
 
 FAS
        123(R) requires companies to record as paid-in-capital, any tax benefits
        resulting from tax deductions in excess of the compensation cost recognized
        for
        those options (excess tax benefits) unless the company has net operating
        losses.
        In accordance with FAS 123(R) guidance regarding companies with net operating
        losses, the Company will not record any excess tax benefits until the deduction
        actually reduce taxes payable.
  7
 ***Stock
        Option Plans***
  At
        September 30, 2005, the Company has three share-based compensation plans,
        which
        are described below. Compensation cost that has been charged against income
        for
        those plans was $107,000 and $42,000 for the three months ended September
        30,
        2005 and 2004, respectively.
 
 The
        Company’s stock option plans consist of the 2004 Option Plan, the 2000 Option
        Plan and the 1999 Option Plan. Shares reserved under these plans at September
        30, 2005, consist of 1,700,000 shares, 2,250,000 shares and 1,350,000 shares
        authorized of which 724,548, 1,268,343 and 335,370 options are outstanding
        under
        the 2004, 2000 and 1999 Option Plans, respectively.
  The
        Company’s board of directors grants options at an exercise price equal to the
        fair market value of the Company’s common stock at the date on which the grant
        is approved by the board. Stock options granted prior to the Company’s initial
        public offering had a term of ten years from the date on which the grant
        is
        approved by the board. Options granted subsequent to the Company’s initial
        public offering have a term of five years. Generally, stock options vest
        1/8th
        after six months, and 1/48th per month thereafter, becoming fully vested
        in four
        years. The weighted-average fair value of stock options granted is estimated
        at
        the date of grant using the Black-Scholes option pricing model and the following
        assumptions:
 
 **Three Months Ended**
                  **September
                    30,****2005**
                
                
                **2004**Weighted
                    average fair value of stock options granted
                
                $
                1.98
                
                
                $
                1.57Risk
                    free interest rate
                
                
                4.12
                %
                
                
                4.28
                %Expected
                    life (in years)
                
                
                4.0
                
                
                
                4.0Expected
                    volatility
                
                
                50.00
                %
                
                
                0.00
                %Expected
                    dividend yield
                
                
                0.00
                %
                
                
                0.00
                %
 
 Expected
        volatilities are based on the historical volatility of the Company’s stock and
        other factors. The Company uses historical data to estimate option exercise
        and
        employee termination within the model. Separate groups of options with similar
        pricing are considered separately for valuation purposes. The expected term
        of
        options granted represents the period of time that options granted are expected
        to be outstanding. The risk-free rate for periods within the contractual
        life of
        the option is based on the U.S. Treasury rate in effect at the time of the
        grant.
  A
        summary
        of option activity under the plans as of September 30, 2005, and changes
        during
        the quarter then ended is presented below:
  **Number of Share****s**
              
              **Weighted-**
                **Average Exercise**
                **Price**
              
              **Weighted-**
                **Average Contractual**
                **Term**
              
              **Aggregate
                  Intrinsic****Value****Balance
                  June 30, 2005**
              
              
              **2,502,189**
              
              **$**
              **3.48**Options
                  granted
              
              
              471,826
              
              
              4.56Options
                  exercised
              
              
              (627,923
              )
              
              1.63Options
                  forfeited or expired
              
              
              (17,403
              )
              
              3.49**Balance
                  September 30, 2005**
              
              
              **2,328,689**
              
              **$**
              **4.20**
              
              
              **6.2**
              
              **$**
              **995,000****Exercisable
                  at September 30, 2005**
              
              
              **1,132,413**
              
              **$**
              **3.13**
              
              
              **6.1**
              
              **$**
              **995,000**
 
 The
        total
        intrinsic value of options exercised during the quarters ended September
        30,
        2005 and 2004, was $1,924,000 and $13,000, respectively.
  A
        summary
        of the status of the Company’s nonvested shares as of September 30, 2005 and
        changes during the three month period ended September 30, 2005, is presented
        below:
 
 **Nonvested
                  Shares**
              
              **Shares**
              
              **Weighted-Average
                  Grant-Date Fair Value**Nonvested
                  at July 1, 2005
              
              
              828,737
              
              $
              1.36Granted
              
              
              471,826
              
              
              1.98Vested
              
              
              (88,054
              )
              
              1.13Forfeited
              
              
              (16,233
              )
              
              0.58Nonvested
                  at September 30, 2005
              
              
              1,196,276
              
              $
              1.63
 
 8
 As
        of
        September 30, 2005, there was $1.4 million of total unrecognized compensation
        cost related to nonvested share-based compensation arrangements granted under
        the plans. That cost is expected to be recognized over a weighted-average
        period
        of 2.3 years. The total fair value of shares vested during the three months
        ended September 30, 2005 and 2004 was $99,500 and $50,700,
        respectively.
 
 **5.
        Investment in Minority Owned Company**
  On
        January 6, 2005, the Company acquired a minority interest in a UK company
        (the
        investee) for $125,000 which was recorded on the cost method of accounting
        for
        investments in accordance with SFAS No. 115, *Accounting for Certain Investments in Debt and Equity
        Securities.* Additionally, the investee issued to the Company a $125,000 promissory note
        due
        January 6, 2011. The promissory note is convertible into common stock in
        certain
        circumstances and bears interest at 4% per year, compounded monthly. The
        Company
        also purchased a license to the investee’s technology for five years for
        $125,000, which is amortized to expense over the life of the license. A total
        of
        $375,000 was recorded as Other Assets. At September 30, 2005, the Company
        determined that the investment in and receivable from the investee was other
        than temporarily impaired and recorded an impairment loss in the amount of
        $253,000. This impairment loss was partially offset by a gain of $10,000
        on the
        sale of an asset that had been previously written off.
  **6.
        Commitments and Contingencies**
  *Leases*
  The
        Company leases office space under non-cancelable operating leases. Rental
        expense under operating lease agreements was $127,000 and $119,000 for the
        three
        months ended September 30, 2005 and 2004, respectively.
  Future
        minimum commitments remaining under these agreements as of September 30,
        2005,
        are as follows:
  **Minimum**
                **Commitment****(in thousands)****Fiscal
                  Year Ending September 30:**2005
              
              $
              5722006
              
              
              6452007
              
              
              5912008
              
              
              4292009
              
              
              368
 
  *Other
        Commitments and Contingencies*
  The
        Company has long-distance service agreements with four carriers. As of September
        30, 2005, minimum obligations under these agreements due within one year
        total
        $708,000. However, the Company expects to maintain some form of long-distance
        service agreements indefinitely, and will likely assume similar obligations
        following the expiration of these agreements. As of September 30, 2005, minimum
        obligations due within one year under agreements with providers of billing
        and
        collection services total $54,000.
  The
        Company and its subsidiaries are subject to certain claims and may encounter
        future legal claims in the normal course of business. In the opinion of the
        Company’s management, the resolution of existing legal claims are not expected
        to have a material adverse impact on the Company’s financial position, results
        of operations or cash flows. See Note 8 for additional discussion of
        litigation.
  **7.
        Income Taxes**
  9
 The
        provision for income taxes consists of the following for each of the periods
        ended:
  **Three Months Ended**
                  **September
                    30,****2005**
                
                
                **2004**Current
                    federal provision
                
                $
                --
                
                
                $
                208Current
                    state
                
                
                --
                
                
                
                151Deferred
                    (benefit)
                
                
                633
                
                
                
                (425
                )$
                633
                
                
                $
                (66
                )
 In
        assessing the realizability of deferred tax assets, management considers
        whether
        it is more likely than not that some portion or all of the deferred tax assets
        will be realized. The ultimate realization of deferred tax assets is dependent
        upon the generation of future taxable income during periods in which temporary
        differences and net operating losses become deductible and tax credits become
        usable. Use of net operating loss and other carryforwards are limited by
        the
“change of ownership” rules described below. Due to the uncertainty surrounding
        the timing of realizing the benefits of its favorable tax attributes in future
        tax returns, the Company has placed a valuation allowance against its otherwise
        recognizable deferred tax assets. The valuation allowance increased by
        approximately $750,000 during the quarter ended September 30, 2005, primarily
        due to the increase in deferred tax assets relating to temporary timing
        differences, stock-based tax deductions and tax credit carryforwards.
  As
        of
        September 30, 2005, the Company has cumulative net operating loss carryforwards
        for federal and California income tax purposes of approximately $5 million
        and
        $6.6 million, respectively. The losses begin to expire in fiscal year 2009
        if
        unused. In addition, the Company has available tax credit carryforwards of
        approximately $2,000,000 and $500,000 for federal and California tax purposes,
        respectively. The federal tax credits begin to expire in 2028. California
        tax
        credits can be carried over indefinitely.
  Due
        to
        the “change of ownership” provision of the Tax Reform Act of 1986, utilization
        of the Company’s net operating loss and tax credit carryforwards are subject to
        an annual limitation against taxable income in future periods. As a result
        of
        the annual limitation, a portion of these carryforwards may expire before
        ultimately becoming available to reduce future income tax liabilities. In
        addition, the Company is preparing an analysis of the change of ownership
        provision on its California state operating loss carryforwards. Management
        believes that such analysis may result in the recording of an additional
        deferred tax asset with a corresponding valuation allowance subject to the
        realization analysis discussed above.
  On
        September 11, 2002, the Governor of California signed into law new tax
        legislation that suspended the use of California net operating loss
        carryforwards in the Company’s tax years ending June 30, 2003 and 2004. As a
        result, the Company cannot use its California net operating loss carryforwards
        to offset its taxable income for the years ended June 30, 2003 and 2004.
        The
        Company eliminated its California tax using tax credit carryforwards for
        both
        periods. This suspension will not apply to the Company’s tax years ending June
        30, 2005, and beyond.
 
 **8** . **Litigation**
  In
        July
        2004, a licensing agent for j2 Global Communications, Inc., or j2, sent to
        the
        Company a letter suggesting that an aspect of its services may employ inventions
        covered by U. S. Patent No. 6,350,066, or the ‘066 patent, and offering a
        non-exclusive license for that patent. On August 24, 2004, j2 filed
        a
        complaint against the Company in the United States District Court for the
        Central District of California alleging that the Company’s operations infringe
        the ‘066 patent. j2’s complaint seeks unspecified damages and permanent
        injunctive relief, among other relief. On December 30, 2004, the Company
        agreed to stipulate to amend the above-referenced complaint to include two
        additional patents, specifically U. S. Patent Nos. 6,564,321, or the ‘321
        patent, and 6,208,638, or the ‘638 patent. On April 19, 2005, the Company
        agreed to stipulate to a further amendment to the above-referred complaint
        to
        include an allegation that the Company infringes the claims of U.S. Patent
        No. 6,857,074, or the ‘074 patent. Although the Company is confident that
        it does not infringe the asserted patents, the Company’s efforts to defend
        against j2’s assertions will be expensive and time-consuming. The Company
        presently projects that if the litigation continues at its present pace,
        then
        the Company is likely to incur a material amount of attorneys’ fees and costs in
        the litigation, and that the amount of litigation costs and fees incurred
        in the
        next twelve months may be in the range of $1 million.
  10
 The
        Company in October 2004 received a letter from counsel to Web Telephony,
        LLC, or
        Web Telephony, implying that our operations infringe certain claims in U.S.
        Patent No. 6,445,694, “Internet Controlled Telephone System,” or the ‘694
        patent, and U.S. Patent No. 6,785,266, “Internet Controlled Telephone
        System,” or the ‘266 patent. On January 19, 2005, the Company filed in the
        United States District Court for the Central District of California an action
        for declaratory relief, in which the Company is seeking to have the court
        declare that the Company does not infringe the ‘694 patent or the ‘266 patent.
        The Company has received an opinion of counsel that the Company’s operations do
        not infringe ‘694 patent or ‘266 patent, although the Company can offer no
        assurance that a court would agree with that opinion. Web Telephony has filed
        a
        motion to dismiss the complaint, alleging that the court lacks personal
        jurisdiction over Web Telephony. The Company filed a First Amended Complaint
        on
        May 2, 2005, adding a cause of action for interference with prospective economic
        advantage. Web Telephony filed an Answer to the First Amended Complaint on
        September 6, 2005, and counterclaimed, alleging infringement of the ‘694 and
‘266 patents.
  On
        July
        1, 2005, Catch Curve, Inc., a Delaware corporation, or Catch Curve, filed
        a
        complaint against the Company in the United States District Court for the
        Central District of California (Action No. CV05-4819) alleging that the
        Company’s operations infringe U.S. Patents No 6,785,021, or the ‘021 Patent,
        U.S. Patent No. 6,643,034, or the ‘034 Patent, U.S. Patent No. 5,291,302,
        or the ‘302 Patent, and U.S. Patent No. 4,994,926, or the ‘926 Patent. The
        Company has obtained an extension of time in which to file its answer to
        that
        complaint. The Company has received from intellectual property counsel opinions
        that the Company’s present operations do not infringe the claims of the ‘021
        patent, the ‘034 patent, the ‘302 patent, or the ‘926 patent. By reason thereof,
        the Company is confident that it does not infringe the asserted patents of
        Catch
        Curve.
 
 In
        the
        event of an adverse result in the j2 litigation, the Web Telephony litigation,
        the Catch Curve litigation, or in any other litigation between the Company
        and
        third parties that may arise in the future with respect to intellectual property
        rights relevant to the Company’s services, the Company could be required to pay
        substantial damages, including treble damages if a court determines that
        the
        Company has willfully infringed a third party’s patent rights, to cease the use
        and sale of infringing services, to expend significant resources to develop
        non-infringing technology, or to obtain licenses to the infringing technology.
        The Company cannot be certain that licenses will be available on commercially
        reasonable terms, or at all, from j2 or Web Telephony or Catch Curve, or
        any
        third party that has such intellectual property claims against us. In addition,
        litigation frequently involves substantial expenditures and can require
        significant management attention even if the Company ultimately prevails.
        Accordingly, the Company cannot predict whether the j2 litigation, the Web
        Telephony litigation or the Catch Curve litigation will have a material adverse
        effect on the Company’s business, operating results, financial condition or cash
        flows. Due to the early stage of these three actions, and because neither
        j2,
        nor Web Telephony, nor Catch Curve has sought specified damages, the Company
        cannot determine with precision the outcome of the litigation or any costs
        or
        payments resulting from the litigation or the settlement of any of those
        actions. Accordingly, no provision for any loss which may result from the
        j2
        litigation or the Web Telephony litigation or the Catch Curve litigation
        has
        been recorded in the accompanying financial statements. In addition, the
        Company
        and its subsidiary in the future may encounter legal claims in the normal
        course
        of business. In the opinion of the Company, the costs associated with the
        resolution of existing legal claims cannot be precisely estimated at this
        time,
        and the Company has not yet determined whether such costs will have a material
        adverse impact on the Company’s financial position, results of operations or
        cash flows.
 
  11
  **ITEM
        2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
        OPERATIONS**
  *This
        section and other parts of this Form 10-Q contain forward-looking statements
        that involve risks and uncertainties. Forward-looking statements can be
        identified by words such as
“anticipates,”“expects,”“believes,”“plans,”“predicts,” and similar terms.
        Forward-looking statements are not guarantees of future performance and our
        actual results may differ significantly from the results discussed in the
        forward-looking statements. Factors that might cause such differences include,
        but are not limited to, those discussed in the subsection entitled “Risk
        Factors” below. The following discussion should be read in conjunction with our
        Annual Report on Form 10-K filed September 15, 2005, and the consolidated
        financial statements and notes thereto included elsewhere in this Form 10-Q.
        We
        assume no obligation to revise or update any forward-looking statements for
        any
        reason, except as required by law.*
  **Overview**
  Historically,
        we have provided application services on a subscription basis that add features
        and enhanced functionality to the telecommunications services used by mainstream
        consumers and small and home offices. Our software-based services are delivered
        on our proprietary Enhanced Services Platform, which allows subscribers to
        manage calls across existing landline, mobile and Internet networks. As of
        September 30, 2005, we had approximately 790,000 total subscribers
        for
        these application services. Because our services improve the utilization
        of
        existing telecommunications services by our subscribers, we believe that
        our
        application services complement the efforts of landline, mobile and Internet
        service providers to reduce their subscriber churn. This has allowed us to
        establish cooperative relationships with network service providers.
  In
        the
        fourth quarter of fiscal 2005, we began test marketing a new mobile product
        that
        was officially launched in the first quarter of fiscal 2006. We provide mobile
        subscribers with subsidized cell phones in the first month of service. As
        of
        September 30, 2005, we had approximately 10,000 paying subscribers for the
        mobile service. We account for the cell phones and fulfillment expenses as
        cost
        of sales which affects our gross margin.
  **Critical
        Accounting Policies and the Use of Estimates**
  *Revenue
        recognition* .
        We earn
        revenues primarily from paid subscriber services and to a lesser extent,
        fees
        earned from local exchange carrier call termination access charges and the
        offering of third-party products and services to our subscribers. Beginning
        in
        2005, we entered the prepaid mobile phone market by selling prepaid phones
        directly to its subscriber base and to a distributor.
  We
        recognize revenue in accordance with accounting principles generally accepted
        in
        the United States and with Securities and Exchange Commission Staff Accounting
        Bulletin 104 (SAB 104), *Revenue Recognition* ,
        which
        clarifies certain existing accounting principles for the timing of revenue
        recognition and classification of revenues in the financial statements, we
        recognize revenue beginning when there is persuasive evidence of an arrangement,
        delivery has occurred or services have been rendered, the fees are fixed
        and
        determinable and collection is reasonably assured. Our subscriber revenues
        consist of monthly recurring subscription fees. We recognize revenue ratably
        over the subscription period when the SAB 104 criteria are met.
  In
        addition to the direct relationship that we have with the majority of our
        paid
        subscribers, we also have indirect relationship agreements with Internet
        service
        providers (ISPs) and other companies whereby those companies’ customers are
        offered a co-branded subscription service. When the agreement provides that
        we
        are the party responsible for providing the service, we have control over
        the
        fees charged to customers and bear the credit risk, we record the gross amount
        billed as revenue in accordance with Emerging Issues Task Force 99-19 (EITF
        99-19), *Reporting Revenues Gross as a Principal Versus Net as an Agent* .
        When
        the agreement provides that we receive a net payment from those companies,
        based
        upon the number of their customers registered for our services, we record
        the
        net amount received from those companies as revenue in accordance with EITF
        99-19.
  12
 In
        the
        third quarter of fiscal 2005, we purchased prepaid phones and phone cards
        with
        the intention of reselling them with a 30-day free trial of our
        application-based services and entered into an agreement to sell the prepaid
        phones and a portion of the phone cards to a distributor. Revenue from the
        sale
        of prepaid phones and phone cards is recognized when the SAB 104 criteria
        are
        met. We recognize sales to distributors on a sell-through basis when we collect
        the cash from the distributor. We have recognized $133,000 of revenue related
        to
        the sale to this distributor in the quarter ended September 30,
        2005.
  In
        the
        fourth quarter of fiscal 2005, we began selling prepaid phones embedded with
        our
        technology to our subscriber base. These transactions contain multiple elements,
        including the phone, the minutes, and our service, to which we have applied
        EITF
        00-21, *Revenue Arrangements with Multiple Deliverables.* The
        various elements of the arrangement are separable and each element is recognized
        separately in accordance with SAB 104. In accounting for multiple deliverables,
        management’s judgment is necessary when identifying the nature of deliverables
        in an arrangement as well as measuring and allocating fair value to the multiple
        deliverables.
  *Allowances
        for Doubtful Accounts*
  We
        record
        an allowance for doubtful accounts based on our historical experience with
        bad
        debts. We periodically review and negotiate bad debt reserves held by the
        local
        telephone companies and the third party that manages our billing relationship
        with the telephone companies. Judgment is required when we assess the
        realization of receivables, including assessing the probability of collection.
        Our allowance for doubtful accounts totaled $347,000 as of September 30,
        2005 and $370,000 as of June 30, 2005. Our allowance for doubtful
        accounts
        is correlated with our aggregate billings through the local telephone
        companies.
  *Investments
        in minority owned companies* —We
        account for investments in minority interests of other companies over which
        we
        do not exercise significant influence on the cost method in accordance
        with *Accounting for Certain Investments in Debt and Equity Securities (SFAS
        115)* .
        Under
        the cost method, an investment is carried at cost until it is sold or there
        is
        evidence that changes in the business environment or other facts and
        circumstances suggest it may be other than temporarily impaired. In the event
        of
        other than temporary impairment, we will reduce the carrying amount to the
        estimated fair value measured by comparing the carrying amount of an asset
        to
        future net cash flows expected to be generated by the asset in accordance
        with
        SFAS 144, *Accounting
        for the Impairment or Disposal of Long-Lived Assets.*
  *Inventories*
  Inventories
        consist of finished goods and are stated at the lower of cost or net realizable
        cost, cost being determined under the first-in, first-out method. For the
        quarter ended September 30, 2005, we have recorded an impairment allowance
        against inventory in the amount of $389,000, an increase of $314,000 from
        the
        balance at June 30, 2005. Of this amount, a total of $153,000, or an increase
        of
        $78,000 from June 30, 2005, relates to sales to distributors made in March
        2005
        and accounted for on the sell-through method. This reflects that amount in
        inventory at September 30, 2005, for which no payment has been received.
        Additionally, we recorded an impairment allowance of $236,000 related to
        CallWave-owned inventory as the marketing strategy related to this inventory
        changed in the first quarter of fiscal 2006 to fully subsidize these sales.
        Management’s judgment is required in determining net realizable value and the
        extent of any impairment to our inventory. Judgment is also required in
        determining the collectibility of amounts that are due from our distributors
        as
        a result of selling our inventory through to end customers.
  *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. At September 30, 2005, we had
        deferred tax assets of $6.6 million. Due to the uncertainty of realizing
        a
        portion of these deferred tax assets, we have maintained a valuation allowance
        of $4.3 million as an offset against the deferred tax assets. Such uncertainty
        primarily relates to the potential for future taxable income as well as the
        amount, limitation, and expiration of loss carryforwards and tax credits
        which
        begin expiring in 2009. In addition, pursuant to Sections 382 and 383 of
        the
        Internal Revenue Code, annual use of our net operating loss carryforwards
        may be
        limited in the event of a cumulative change in ownership of more than 50%
        within
        a three-year period. Management has determined that it is more likely than
        not
        that the net $2.3 million deferred tax assets will be realized within the
        2006
        and 2007 fiscal years. We will continue to assess the likelihood of realization
        of such assets. As future events and estimates change, we will adjust the
        valuation allowance pursuant to SFAS 109, if necessary, which may impact
        the tax
        provision or equity or both.
 
 13
 *Share-Based
        Compensation* —We
        adopted FAS 123(R), *Share-Based
        Payment,* using
        the
        modified- prospective-transition-method. Historically, we elected to account
        for
        employee stock compensation under the fair value method in accordance with
        SFAS
        123, *Accounting
        for Stock-Based Compensation,* and had
        reflected compensation expense related to the fair value of options issued
        to
        employees in the statement of operations. Under FAS 123(R), stock-based
        compensation is recorded based upon the fair value of the awards granted,
        using
        a Black-Scholes option pricing model, which includes the fair value of the
        underlying shares on the date of grant, an estimate of the options to be
        forfeited and the exercise price. Adoption of FAS 123(R) had an immaterial
        impact on our financial statements as we have been recording share-based
        compensation expense under FAS 123 since inception and as we have net operating
        loss carryforwards which prevent us from recognizing excess tax benefits
        until
        the excess tax benefits are used to offset income taxes payable.
 
 **Results
        of Operations**
  The
        following tables set forth our statement of operations data for each of the
        periods indicated.
  **Three
                  Months Ended**
                **September
                  30,****2005**
              
              **2004****Statement
                  of Operations Data:**Revenues
              
              $
              10,572
              
              $
              11,045Cost
                  of sales
              
              
              3,761
              
              
              3,202Gross
                  profit
              
              
              6,811
              
              
              7,843Operating
                  expenses:Sales
                  and marketing
              
              
              2,109
              
              
              2,116Research
                  and development
              
              
              1,216
              
              
              1,668General
                  and administrative
              
              
              2,182
              
              
              1,276Impairment
                  of long-lived assets
              
              
              243
              
              
              --Total
                  operating expenses
              
              
              5,750
              
              
              5,060Operating
                  income
              
              
              1,061
              
              
              2,783Interest
                  income (expense), net
              
              
              506
              
              
              52Income
                  before income taxes
              
              
              1,565
              
              
              2,835Income
                  tax expense (benefit)
              
              
              633
              
              
              (66
              )Net
                  income
              
              $
              932
              
              $
              2,901
 
  14
  
 ***Three
        Months Ended September 30, 2005 and September 30,
        2004***
  *Revenues.* Revenues
        were $10,572,000 for the three months ended September 30, 2005, compared
        to
        $11,045,000 for the three months ended September 30, 2004, a decrease of
        $473,000, or 4%. Subscription revenues were $9,830,000 for the three months
        ended September 30, 2005, representing 93% of revenues, compared to $10,657,000
        for the three months ended September 30, 2004, representing 96% of revenues,
        a
        decrease of $827,000, or 8%. The decrease in our subscription revenues for
        the
        three months ended September 30, 2005 was attributable primarily to a decrease
        in the number of total subscribers from approximately 823,000 at September
        30,
        2004 to approximately 790,000 at September 30, 2005. Revenues from sales
        to
        distributors were $133,000 for the quarter ended September 30, 2005. Revenues
        from our newly-launched sales of mobile phones were $207,000 for the quarter
        ended September 30, 2005, reflecting 10,000 subscribers to the mobile phone
        service.
  *Cost
        of sales.* Cost of
        sales was $3,761,000 for the three months ended September 30, 2005, compared
        to
        $3,202,000 for the three months ended September 30, 2004, an increase of
        $559,000, or 17%. Cost of sales increased as mobile customer acquisition
        costs,
        such as the cost of mobile phones and fulfillment expenses, are charged to
        cost
        of sales. Cost of sales also includes impairment charges to reduce to fair
        value
        inventory at distributors accounted for under the sell-through method and
        to the
        mobile phones in inventory of $78,000 and $36,000, respectively. For the
        three
        months ended September 30, 2005, the total cost of sales related to mobile
        subscriptions was $525,000, which was partially offset by the decreased cost
        of
        sales related to the decreased number of landline subscribers. As a result,
        our
        gross margins decreased from 71% for the three months ended September 30,
        2004
        to 64% for the three months ended September 30, 2005.
  *Sales
        and marketing.* Sales
        and marketing expenses were $2,109,000, or 20% of revenues, for the three
        months
        ended September 30, 2005, compared to $2,116,000, or 19% of revenues, for
        the
        three months ended September 30, 2004, a decrease of $7,000. Sales and marketing
        expenses decreased due to reduced customer acquisition spend of $627,000
        (net of
        an increase to customer acquisition costs due to recording an impairment
        allowance on phone cards in the amount of $201,000) offset by additional
        expenses related to our call center of $499,000. Previously, the call center
        performed a technical support role and its expenses were allocated across
        all
        three operating expense categories. The focus of our call center has shifted
        from technical support to landline customer retention and mobile sales and
        the
        related costs are now charged to sales and marketing.
  *Research
        and development.* Research
        and development expenses were $1,216,000, or 12% of revenues, for the three
        months ended September 30, 2005, compared to $1,668,000, or 15% of revenues,
        for
        the three months ended September 30, 2004, a decrease of $452,000, or 27%.
        The
        decrease in research and development expenses was due in part to the shift
        in
        focus and in costs of the call center to sales and marketing which reduced
        research and development costs by $361,000. Additionally, staffing costs
        decreased by $133,000 related to employee turnover. We expect research and
        development costs to increase in future quarters.
  *General
        and administrative.* General
        and administrative expenses were $2,182,000, or 21% of revenues for the three
        months ended September 30, 2005, compared to $1,276,000, or 12% of revenues,
        for
        the three months ended September 30, 2004, an increase of $906,000, or 71%.
        The
        increase in general and administrative expenses was due primarily to an increase
        in legal, bad debt, insurance, investor relations, employee-related and Board
        of
        Directors costs. Specifically, directors & officers liability insurance
        costs increased $171,000, legal costs increased $150,000 and bad debts expense
        increased $350,000 in the three months ended September 30, 2005 as compared
        to
        the same period in 2004. Bad debts expense for the three months ended September
        30, 2004, reflected the benefit of a reduced estimate of bad debts expense.
 
 *Impairment
        loss.* As of
        September 30, 2005, we determined based on an analysis of future cash flows
        that
        our investment in and receivable from a company in which we had a minority
        interest was other than temporarily impaired. Accordingly, we recorded an
        impairment loss in the amount of $253,000 which was partially offset by a
        gain
        of $10,000 on the sale of an asset that had previously been written
        off.
  *Income
        tax provision* .
        We
        recognized an income tax provision for the three months ended September 30,
        2005
        and an income tax benefit for the three months ended September 30, 2004 of
        $633,000 and $(66,000), respectively. In prior periods we have recognized
        a tax
        provision benefit related to the reduction of the valuation allowance associated
        with the deferred tax asset. The total deferred tax asset is $6.6 million
        and
        has been offset by a valuation allowance of $4.3 million with the net deferred
        tax asset representing our best estimate of the realization of our deferred
        tax
        assets. We have not recognized the benefit of the remaining deferred tax
        assets
        as we have not determined that it is more likely than not that we will be
        able
        to use them to offset income taxes payable as it is uncertain as to when
        these
        deferred tax assets will be realized. We will continue to assess the likelihood
        of realization of our net deferred tax assets and will adjust the balance
        accordingly.
  15
 *Net
        income.* Net
        income was $932,000 for the three months ended September 30, 2005, compared
        to
        $2,901,000 for the three months ended September 30, 2004, a decrease of
        $1,969,000 or 68%. This decrease in net income was primarily the result of
        an
        increase in cost of sales related to our entry into the mobile phone market,
        increased general and administrative expenses related to operating as a public
        company and a tax provision of $633,000 in the three months ended September
        30,
        2005, an increase of 699,000 over the same period in 2004. During the three
        months ended September 30, 2005, our revenues decreased by $473,000, while
        our
        cost of sales increased by $559,000 and operating expenses increased by
        $690,000. Our net margin was 9% and 26% for the three months ended September
        30,
        2005 and 2004, respectively.
  **Liquidity
        and Capital Resources**
  At
        September 30, 2005, our principal sources of liquidity were cash and cash
        equivalents of $34,883,000, marketable securities of $26,653,000, and accounts
        receivable net of allowance for doubtful accounts of $4,867,000.
  *Accounts
        Receivable.* Our
        accounts receivable were $4,867,000 as of September 30, 2005, compared to
        $4,258,000 as of September 30, 2004, an increase of $609,000, or 15%. This
        increase is attributable to a number of factors, none of which reflect, in
        our
        view, any deterioration in our expected realization of those accounts
        receivable. In the last half of fiscal 2005 and continuing into 2006, we
        billed
        installation fees which has the effect of increasing accounts receivable
        but the
        fees are amortized to revenue over the period the subscriber is estimated
        to be
        a customer. This has caused accounts receivable balances to increase as a
        percent of revenues. Substantially all of our accounts receivable represent
        amounts owing from our subscribers’ local exchange carriers, or LECs, which
        collect and remit to us charges due to us from our subscribers. This increase
        is
        due to decreased billing and collections costs per dollars billed through
        phone
        companies. Amounts billed per subscriber through telephone companies increased
        during the first quarter of fiscal 2006, and because billing and collection
        costs through telephone companies is driven primarily by the number of
        subscribers billed and not by the dollars billed, billing and collection
        costs
        per dollars billed decreased. Billing and collections costs are netted against
        accounts receivable since we receive payments from customers net of the fees
        charged by the billing companies.
 
 Net
        cash
        provided by operating activities was $3,377,000 for the three months ended
        September 30, 2005 and consisted of $932,000 of net income, $324,000 in
        depreciation and amortization, $809,000 in accounts receivable, net of bad
        debt
        expense, $634,000 decrease in our net deferred tax asset, and a decrease
        in
        inventory and other assets of $454,000 and $292,000, respectively.
  Net
        cash
        provided by investing activities was $13,225,000 for the three months ended
        September 30, 2005, which consisted of purchases of $3,180,000 of marketable
        securities and $60,000 of property and equipment offset by sales of marketable
        securities of $16,465,000.
  Net
        cash
        provided by financing activities was $1,453,000 for the three months ended
        September 30, 2005, and consisted of proceeds from exercises of stock options
        and warrants.
 
 We
        expect
        that our cash on hand at September 30, 2005, along with cash generated from
        operations, will be adequate to fund our operations for at least the next
        twelve
        months. However, we reexamine our cash requirements periodically in light
        of
        changes in our business.
  16
 
 **Risks
        Related To Our Business**
  **Our
        ability to expand our revenues and profitability will be dependent upon our
        ability to successfully market our services to mobile phone
        users.**
  We
        grew
        our business by developing a base of subscribers who use our services to
        manage
        their telecommunications services on their traditional, or “landline,”
        telephone. In the future, however, we intend to devote substantial resources
        to
        marketing our services to users of mobile telecommunications services. Those
        mobile telecommunications services are in a different market segment than
        that
        in which we traditionally have competed, and therefore we will need to
        understand this new market segment in order to be successful. In
        offering our services to customers in this new market segment, we may make
        investments in assets that will not prove to have long-term value, we therefore
        may need to write off those investments prior to the end of their useful
        life,
        and such write-offs may adversely affect our results of operations. In addition,
        our ability to successfully implement and
        market our mobile telephone services is dependent upon a number of technical
        factors that are beyond our control, including the cooperation of service
        providers in allowing our customers to transition the use of their existing
        mobile telephone number to our service, as well as a number of operating
        challenges beyond our control, including the marketing of our new services
        to
        mobile telephone users. Finally, the cost structure of that new market segment
        is different from that of the landline segment in which we traditionally
        have
        competed. If we fail to understand the demands of consumers in this new market
        segment, or if we fail to understand and adapt to the cost structure or
        technical demands of operating in this new market segment, then we will not
        be
        able to achieve growth in our revenues and profits, and our results of
        operations and financial condition would be adversely affected.
  **Our
        ability to successfully market our services to mobile phone users will be
        dependent upon our success in entering into and managing indirect distribution
        relationships.**
  We
        grew
        our business by directly marketing our landline services to consumers and
        small
        businesses through Internet advertising. We intend to promote our services
        to
        mobile phone users through “indirect” distribution arrangements in which we
        enter into distribution agreements with telecommunications service providers,
        who agree to distribute our services to their subscribers. We do not have
        significant experience in developing and managing those indirect relationships.
        There typically is a long lead time required to conclude agreements for such
        arrangements, additional time is thereafter required to implement each
        agreed-upon arrangement, and the actual pace of implementation is dependent
        upon
        cooperation and support from the companies with which we enter into those
        arrangements. In addition, even if we are able to put such indirect distribution
        relationships in place, the extent to which the service provider’s customers
        subscribe for our services will be dependent in substantial part upon the
        pace
        and manner in which the service provider implements and promotes our services,
        which are outside of our control. If we are unable to successfully implement
        those indirect distribution relationships, then we may not realize substantial
        growth in our subscribers for our mobile services, we will not realize
        substantial growth in revenues or profitability, and our results of operations
        and financial condition will be adversely affected.
 
 **Our
        ability to successfully implement indirect distribution arrangements is
        dependent upon our ability to integrate our technology with that of the
        companies that distribute our services.**
 
 In
        order
        for our indirect distribution arrangements to be successful, the companies
        with
        whom we enter into indirect distribution arrangements must be able to integrate
        our services with their own service offerings. That integration process requires
        that our technology operate effectively with the service platforms from which
        those companies deliver telecommunications services to their customers. The
        integration of our services with the service platform of those other companies
        is a complex process that requires not only that our respective technology
        platforms operate together, but also that our engineering departments work
        effectively together at a technical level in integrating our respective
        services. Those tasks require time, we may encounter technical difficulties
        that
        occasion delay, and we may uncover other technical difficulties that adversely
        affect the customer's ability to fully utilize our services or even our ability
        to integrate our services at all. If we are unable to overcome those challenges,
        then our indirect distribution strategy may be adversely affected, and we
        may
        not be able to achieve the revenue and profitability gains that we are seeking
        to achieve from our mobile services.
  17
 **The
        use of indirect distribution arrangements may cause us to realize lower revenues
        and profitability than we traditionally have realized from “direct” distribution
        of our services.**
  We
        expect
        that the principal growth in subscribers to our mobile services will come
        primarily from the implementation of indirect distribution arrangements.
        While
        these arrangements typically deliver subscribers to us at a lower subscriber
        acquisition cost than our traditional sources of subscribers, they also tend
        to
        generate a lower average revenue per user, or “ARPU,” than the traditional
“direct” sources of subscribers. In order to achieve substantial future revenue
        growth from these “indirect” distribution arrangements, we will need to
        implement indirect distribution arrangements that afford us broad exposure
        to
        significant potential subscribers, and we will need the other parties to
        those
        arrangements to cooperate with us in distributing our services to their
        customers. If we are unable to accomplish those objectives, then we may not
        achieve future revenue growth, and our results of operations will be adversely
        affected.
  **If
        telecommunications customers integrate their landline and mobile services
        at a
        rate that is slower than what we predict, then we may experience delays in
        realizing growth in revenues and profitability from our mobile
        services.**
  We
        have
        decided to devote substantial resources to our services for mobile telephone
        users because we believe that consumers are making more substantial use of
        their
        mobile phones and are reducing their use of traditional landline phones.
        If the
        pace of that changeover to mobile telecommunications services unfolds more
        slowly than we currently foresee it occurring, then the proportion of mass
        market consumers who are ready to subscribe for our mobile services may be
        much
        smaller than is necessary to support substantial growth in our revenues and
        profitability. If the proportion of consumers who subscribe for our mobile
        services is correspondingly lower, then our results of operations and financial
        condition will be adversely affected.
  **Because
        we are unable to predict with precision the rate at which consumers will
        subscribe for our mobile services, our results of operations may be
        correspondingly less predictable, our stock price therefore may be more
        volatile, and our stockholders may suffer losses.**
  For
        the
        past several years we have marketed our landline services directly to consumers
        and have assembled a substantial amount of data that allowed us to predict
        our
        subscriber counts, revenues, and profits with some reliability. As our business
        increasingly emphasizes the delivery of mobile services, however, we will
        be
        operating in a new market segment and offering to potential customers new
        services that have not been marketed or sold by us or any other company.
        As a
        result, we have little historical data with which to predict with any precision
        the rate at which our services will be accepted by consumers or the prices
        at
        which consumers may be willing to subscribe for those services. Consequently,
        we
        may experience significantly greater swings in our revenues and profitability
        than in the past, our stock price may become increasingly volatile, and our
        stockholders may realize losses in the value of their shares.
  **As
        we market our mobile services through pre-paid mobile telephone arrangements,
        our results from operations will be dependent upon our ability to manage
        inventories.**
  We
        are
        implementing our new mobile calling services, in part, by purchasing mobile
        telephones and prepaid phone cards, packaging our mobile services with those
        items, and selling those items to distributors, who then re-sell them to
        end
        users. This method of distribution requires that we actually purchase and
        own
        those phones prior to the time when we sell them to our distributors. Our
        ability to sell those phones at an acceptable gross margin may be adversely
        affected by a number of factors, including increases in material or labor
        costs,
        excess inventory, obsolescence charges from our vendors, prolonged holding
        periods, our inability to anticipate product demands, and price competition
        in
        the market for such items. If we are unable to successfully manage those
        factors, then our results of operations may be adversely affected as we purchase
        and market increasing numbers of those pre-paid mobile phones and phone
        cards.
  **If
        network service providers elect to bundle services similar to ours that they
        obtain from other providers or to develop such services themselves as part
        of
        their product offering, we could lose many of our paid
        subscribers.**
  18
 The
        market for communications and information services is competitive, and many
        service providers attempt to attract and retain subscribers by offering a
        variety of services. While service providers that provide Internet call waiting
        and call management services generally impose a separate charge, those service
        providers may in the future bundle such services with their other service
        offerings, thereby effectively offering these services for no incremental
        fee.
        If we lose subscribers to those network service providers that bundle services
        that are competitive with ours and we are unable to find replacement subscribers
        willing to pay for our services, our business, revenues and profitability
        would
        be adversely affected.
  **As
        the subscribers for and revenues from our traditional landline business erode
        over time, any growth in our profitability and revenues will be increasingly
        dependent upon our ability to successfully market our services to subscribers
        for our mobile services.**
  Consumers
        and small and home office, or SOHO, users are switching from dial-up to
        broadband at an increasing pace. As a result, we expect that the number of
        actual and prospective subscribers for our landline services will decline
        over
        time. We therefore have made a conscious decision to reduce the amount of
        resources that we traditionally have devoted to attracting and retaining
        subscribers for our landline services, and instead we are investing those
        resources in expanding our mobile services. Consequently, the number or our
        landline subscribers is likely to decline over time. As a result, if we are
        unable to successfully increase our revenues and profits from subscribers
        for
        our mobile service, then our overall revenues and profits may decline over
        time.
  **Increased
        marketing costs for Internet advertising may cause further erosion in our
        traditional landline business.**
  Our
        subscriber acquisition costs for our traditional land-line customers are
        dependent largely upon our ability to purchase multiple types of advertising
        at
        a reasonable cost. Our advertising costs vary over time, depending upon a
        number
        of factors, some of which are beyond our control, such as seasonality, the
        particular mix of advertising we use and the rate at which we convert potential
        subscribers into paid subscribers, and consolidation among companies that
        control advertising channels. We have experienced an increase in subscriber
        acquisition costs in the recent periods. Given our belief that our revenues
        from
        our traditional landline business will decline over time, we have decided
        not to
        increase the amount of money that we spend on Internet advertising for our
        landline services. As a result, we are realizing both reduced marketing
        expenditures and a higher unit cost for the advertising services that we
        purchase. We expect that those two factors will occasion an acceleration
        in the
        decline of our landline business over time.
  **We
        are dependent upon billing arrangements with regional telephone companies
        for
        collecting fees from many of our subscribers.**
  We
        currently collect the majority of our revenues through billing arrangements
        in
        which our subscribers’ regional telephone companies collect our service fees
        from our subscribers and forward those fees to us. We collect the remainder
        of
        our revenues through our subscribers’ credit cards and checks. If the telephone
        companies terminated those billing arrangements, or if the cost of those
        arrangements increased significantly, we may be unable to continue to collect
        a
        significant portion of our revenues in this manner, and instead would have
        to
        collect those revenues through use of subscribers’ credit cards, by having
        subscribers mail checks to us, or by other means. Because many subscribers
        prefer to pay for our services through their telephone bills, any need to
        rely
        upon alternative means to collect a significant portion of our revenues may
        lead
        to a loss of a substantial portion of the subscribers who currently pay for
        our
        services as part of their monthly bill from their telephone company, a decline
        in the rate at which we increase the number of our paid subscribers, or
        significant delinquencies in payments by our subscribers. If we are not able
        to
        successfully manage and maintain these billing relationships, our bad debt
        reserves may increase and we may lose subscribers that prefer paying for
        our
        services on their local telephone bill.
  **If
        we fail to maintain effective internal financial and managerial systems and
        procedures, our results of operations may be adversely
        affected.**
  As
        we
        expand our operations and offer new services, there is a risk that our systems
        and procedures may not be adequate to support our operations or ensure proper
        identification of and proper accounting treatment for our activities. Our
        failure to maintain and implement such adequate systems and procedures could
        adversely affect the information on which we base our decisions, thereby
        causing
        us to make inappropriate business decisions. Those incorrect decisions in
        turn,
        could adversely affect our business, financial condition, and results of
        operation.
  19
 **We
        face competition from well-capitalized hardware vendors, software vendors
        and
        service providers against whom we may not be able to successfully
        compete.**
  Competition
        in the communications and information services industries is intense. We
        face
        competition for our offerings from Internet service providers, such as AOL,
        landline and wireless telephone companies, such as AT&T, cable companies and
        other communications hardware, software and services vendors. These companies
        are better capitalized, have greater name recognition and significantly larger
        existing subscriber bases than we do. We may also face competition in the
        future
        from communications hardware and software companies that are currently focused
        on other markets. If these or other companies provide services similar to
        ours,
        we may not be able to compete effectively, which would harm our results of
        operations and financial condition.
  **There
        are limited barriers to entry for other companies to provide services that
        compete with ours.**
  Telecommunications
        services were historically provided by companies that made substantial capital
        investments in their networks. The size of those investments and the time
        required to deploy those networks served as significant barriers to entry
        into
        such markets. In contrast, we provide software-based enhanced services that
        do
        not require substantial capital expenditures to deploy and maintain. As a
        result, other companies with strong technical staffs and knowledge of the
        communications and information services industries could compete with us
        without
        facing significant capital expenditures or other barriers to entry. As a
        result,
        we may face increasing competition from companies with significantly greater
        resources than we have, which may force us to reduce our prices and increase
        our
        operating expenses to remain competitive. If we are not able to compete
        successfully with these companies, we may lose customers or fail to grow
        our
        business as we anticipate, either of which could harm our financial condition,
        results of operations and prospects.
  **We
        rely upon the networks of numerous long-distance and local carriers to provide
        services to our subscribers. If the cost of these services were to increase,
        we
        may not be able to profitably provide our services to our
        subscribers.**
  In
        providing services to our subscribers, we incur a number of underlying
        telecommunications costs which are beyond our control. In order to deliver
        our
        services to our subscribers, our customers must subscribe to certain ancillary
        services from their telecommunications providers that re-route certain telephone
        calls from our subscribers’ telephone lines to toll-free numbers that we have
        leased at our software-based switching facility, which facilitates the receipt
        of the call by the number that the subscribers designate. Our services rely
        in
        part upon the toll-free long-distance and local services that we purchase
        from
        network service providers. The cost of these services, which we integrate
        into
        our service offerings, or which subscribers assume directly, is beyond our
        control and may increase for a number of reasons, including:
  •
              
              a
                  general increase in wholesale long-distance rates or charges for
                  call
                  forwarding services;•
              
              an
                  election by service providers to implement a new pricing structure
                  on the
                  services that we currently purchase;•
              
              an
                  election by third-party service providers to impose charges for
                  services
                  which are currently toll-free; and•
              
              an
                  increase in subscriber usage patterns that increases the cost of
                  the
                  services that we purchase
  Our
        ability to offer services to our subscribers at competitive rates is partially
        dependent upon our ability to use that toll-free telephone network and our
        subsidiary’s ability to procure telephone network access and services on a
        reliable basis and at reasonable prices. If we are unable to effectively
        manage
        the cost of our underlying network services, then our pricing structure with
        a
        significant number of our subscribers would increase, which could make it
        difficult to conduct business at attractive margins.
  20
 **There
        are a limited number of long-distance and interconnection service providers
        that
        are able to provide the services on which we rely.**
  We
        currently have contracts with four service providers for long-distance services,
        and our wholly-owned subsidiary, Liberty Telecom, LLC also has interconnection
        agreements with other telecommunications companies, which together provide
        us
        with services that we integrate into our enhanced offerings. Each of those
        contracts may be terminated without cause by the service provider upon advance
        written notice. The required notice period, in each instance, is less than
        the
        amount of time that we would likely need to negotiate a contract with a
        successor provider and modify our system to re-route our subscribers’ inbound
        calls to that successor’s network. In addition, there are only a limited number
        of service providers with which we can contract to provide these services.
        As a
        result, if one or more of the service providers from which we currently procure
        long-distance or interconnection services were to terminate our existing
        contractual relationships, we may not be able to locate a substitute provider
        on
        a timely basis and upon reasonable terms, if at all, in order to avoid a
        disruption or loss of service to our subscribers. If we are not able to purchase
        access to sufficient long-distance and interconnection services at reasonable
        prices, we may not be able to profitably provide our services to our subscribers
        and our operating results and financial condition would be harmed.
  **We
        rely upon the Internet and other networks controlled by third parties to
        provide
        our services and if we are not able to maintain access to these networks
        at
        reasonable rates, we may not be able to profitably provide our
        services.**
  We
        provide our services by integrating and enhancing underlying services on
        other
        companies’ networks that rely on the public switched telephone network, across
        the private networks constructed and owned by other companies such as those
        in
        the cable industry, and across the Internet. If the owners of any one or
        more of
        those networks were either to refuse to transport calls to our subscribers,
        or
        were to impose significantly higher charges for those calls, or if applicable
        regulations were to impose significantly higher charges for those calls,
        we
        would likely face increased operating costs, our profitability could suffer
        and
        our business could be harmed.
  **Because
        a significant portion of our subscribers are price sensitive, we may not
        be able
        to increase the charges for our services without adversely affecting our
        ability
        to attract and retain paid subscribers.**
  Our
        subscribers are generally price sensitive. In response to that sensitivity,
        we
        have attempted to control our costs in order to be able to charge low
        subscription rates for our landline services, which generally range from
        $1.50
        to $7.95 per month, and are as high as $9.95 per month in limited circumstances.
        We expect that recruiting new subscribers may become more expensive on average
        if we increase our marketing efforts. If we experience significant cost
        increases or otherwise want to increase our margins, we may be unable to
        increase our monthly charges by an amount sufficient to allow us to maintain
        margins or our profitability, and our business and operating results could
        be
        adversely affected.
  21
 **We
        are dependent upon the availability of reasonably priced call-forwarding
        services to provide our services to the majority of our subscribers in a
        cost-effective manner.**
  Customers
        who subscribe to certain of our services typically subscribe to call-forwarding
        services from their local telephone service provider. Generally, these
        call-forwarding services are available to our subscribers at a reasonable
        price.
        If the service providers do not provide these services at a reasonable price,
        the overall price of obtaining our services may exceed the amount that our
        current and potential subscribers are willing to pay. If the prices for these
        services increase, a significant number of our subscribers may terminate
        their
        subscriptions for our services.
  **Because
        the secondary facility for our subsidiary’s existing telephone switching
        equipment is not yet fully operational, a catastrophic event at Liberty
        Telecom’s primary facility would cause the disruption of our services to
        subscribers.**
  Our
        enhanced services currently depend on telecommunications services from our
        subsidiary, Liberty Telecom, which are provided using a single call-switching
        facility in Reno, Nevada. A catastrophic event, such as an earthquake or
        a fire,
        that destroys part or all of the facility would disrupt our business and
        prevent
        us from providing services to our subscribers for an extended period of time.
        While Liberty Telecom is nearing completion of our secondary call-switching
        facility and we already are using this facility to provide some data and
        voice
        services to our subscribers, the second facility may not be fully operational
        on
        a timely basis, or at all. Because our subscribers expect our services to
        match
        the high reliability that characterizes services in the communications and
        information services industries generally, any failure in our ability to
        service
        our subscribers could cause us to lose significant numbers of subscribers,
        and
        make it more difficult to obtain new paid subscribers.
  **A
        system failure or a breach of our network security could delay or interrupt
        service to our subscribers or lead to a misappropriation of our confidential
        information.**
  Our
        operations are dependent upon our ability to protect our computer network
        from
        interruption, unauthorized entry, computer viruses and other similar events.
        In
        the past, we experienced one outage of our entire system which occurred
        following the failure of redundant components and lasted approximately two
        hours. From time to time, we have also experienced limited system interruptions.
        While these interruptions did not significantly harm our business, our existing
        and planned precautions may not be adequate to prevent a significant
        interruption in the operation of our network in the future. Despite the
        implementation of security measures, our infrastructure also may be vulnerable
        to computer viruses, hackers or similar disruptive problems caused by our
        subscribers, employees or other Internet users who attempt to invade public
        and
        private data networks. A system failure or a breach of our security measures
        may
        lead to a disruption in service, or the misappropriation of confidential
        information, which may result in significant liability to us and also may
        deter
        current and potential subscribers from using our services. Any system failure
        or
        security breach that causes interruptions or data loss in our operations
        or in
        the computer systems of our subscribers could cause us to lose paid subscribers
        and harm our business, prospects, financial condition and results of
        operations.
  **If
        we do not successfully anticipate the service demands of our subscribers,
        we may
        be unable to successfully attract and retain subscribers.**
  We
        must
        accurately forecast the features and functionality required by our current
        and
        potential subscribers. In addition, we must design and implement service
        enhancements that meet subscriber requirements in a timely and efficient
        manner.
        We may not successfully determine subscriber requirements and, therefore,
        may
        not be able to satisfy subscriber demands. Furthermore, as our current
        subscribers’ needs change, we may not be able to identify, design and implement
        in a timely and efficient manner services incorporating the type and level
        of
        features desired by our subscribers. If we fail to accurately determine or
        effectively market subscriber feature requirements or service enhancements,
        we
        may lose current subscribers or fail to attract new subscribers, and may
        be
        unable to grow our revenues.
  **Other
        persons may assert claims that our business operations or technology infringe
        or
        misappropriate their intellectual property rights, which could increase our
        costs of operation and distract management and could result in expensive
        settlement costs.**
  Other
        companies or individuals, including our competitors, may claim that we infringe
        or misappropriate their intellectual property rights. From time to time,
        third
        parties have contacted us, asserting that we may infringe their intellectual
        property rights. For example, in December 2003 and April 2004, a major
        communications infrastructure company delivered to one of our distributors
        two
        letters, in which we were not named, offering to negotiate with our distributor
        a nonexclusive license to certain patents that the infrastructure company
        believed to be relevant to our service and implying that our service may
        infringe those patents. As part of this process, we have received a legal
        opinion from our intellectual property counsel that our services do not infringe
        the patents of this infrastructure company, although there is no assurance
        that
        a court would agree with that opinion.
  We
        received a letter from America Online, Inc., or AOL, in September 2004 in
        which
        AOL offered to discuss with us a license to U. S. Patent No. 5,809,128, “Method
        and apparatus permitting notification and control of blocked incoming calls
        over
        a data network,” or the ‘128 patent, and implying that our services may infringe
        the ‘128 patent. In 2000 and 2001, we had periodically discussed a license for
        the ‘128 patent with Infointeractive Services, the company that owned the ‘128
        patent and was subsequently acquired by AOL. We have received an opinion
        of
        counsel that our operations did not and do not infringe the ‘128 patent,
        although we can offer no assurance that a court would agree with that opinion.
        AOL has substantial resources, and may elect to assert a claim that our
        operations infringe the ‘128 patent. If such a claim is asserted and we are
        unable to resolve the matter by agreement, then we would likely incur
        substantial attorneys’ fees to defend against any such claim. The outcome of any
        such claim is uncertain, and an adverse judgment would likely have a material
        adverse impact upon our business and results of operations.
  22
 In
        addition, in July 2004, the licensing agent for j2 Global Communications,
        Inc.,
        or j2, sent to us a letter suggesting that an aspect of our services may
        employ
        inventions covered by U.S. Patent No. 6,350,066, “Systems and methods for
        storing, delivering and managing messages,” or the ‘066 patent, which j2
        recently had acquired, and offering a non-exclusive license for that patent.
        On
        August 24, 2004, j2 filed a complaint against us in the United States District
        Court for the Central District of California, alleging that our operations
        infringe the ‘066 patent. j2’s complaint seeks injunctive relief and unspecified
        damages, among other relief. We have reviewed the ‘066 patent and believe that
        although the claims of the ‘066 patent disclose systems and methods that may
        resemble portions of our prior operations, we believe that we do not infringe
        any claim of the ‘066 patent in our present operations. On December 30, 2004, we
        agreed to stipulate to amend the above-referenced complaint to include two
        additional patents, specifically U. S. Patent No. 6,564,321, “Systems and
        methods for storing, delivering and managing messages,” or the ‘321 patent, and
        U.S. Patent No. 6,208,638, “Method and apparatus for transmission and retrieval
        of facsimile and audio messages over a circuit or packet switched network,” or
        the ‘638 patent. We believe that we do not infringe any of those claims, and
        have also received opinions from our patent counsel that the claims of those
        three j2 patents are not infringed by our operations. On April 19, 2005,
        the
        Company agreed to stipulate to a further amendment to the above-referenced
        complaint, to include an allegation that we infringe the claims of U.S. Patent
        No. 6,857,074, or the ‘074 patent. However, the outcome of any litigation is
        inherently uncertain. We can offer no assurance that our present operations
        or
        past operations will not be determined to infringe or to have infringed j2’s
        patents, and we anticipate that j2 will continue to pursue litigation with
        respect to its claims. Accordingly, we cannot predict whether j2’s claims will
        have a material adverse effect on our business, operating results, financial
        conditions and cash flows. We do presently project that if the litigation
        continues at its present pace, then we are likely to incur a material amount
        of
        attorneys’ fees and costs in the litigation. Please see the section titled
“Legal Proceedings” on page 14 for additional disclosure regarding the j2
        litigation.
  In
        October 2004, we received a letter from counsel to Web Telephony, LLC, or
        Web
        Telephony, implying that our operations infringe certain claims in U.S. Patent
        No. 6,445,694, “Internet Controlled Telephone System,” or the ‘694 patent, and
        U.S. Patent No. 6,785,266, “Internet Controlled Telephone System,” or the ‘266
        patent. On January 19, 2005, we filed in the United States District Court
        for
        the Central District of California an action for declaratory relief, in which
        we
        are seeking to have the court declare that we do not infringe the ‘694 patent or
        the ‘266 patent. We have received an opinion of counsel that our operations do
        not infringe ‘694 patent or ‘266 patent, although we can offer no assurance that
        a court would agree with that opinion. The Court recently rejected Web
        Telephony’s motion to dismiss and held that the Court has personal jurisdiction
        over Web Telephony. We filed a First Amended Complaint on May 2, 2005, adding
        a
        cause of action for interference with prospective economic advantage. Web
        Telephony filed an Answer to the First Amended Complaint on September 6,
        2005,
        and counterclaimed, alleging infringement of the ‘694 and ‘266 patents.
        Nonetheless, the outcome of the Web Telephony litigation is uncertain, and
        an
        adverse judgment would likely have a material adverse impact upon our business
        and results of operations.
  On
        July
        1, 2005, Catch Curve, Inc., a Delaware corporation, or Catch Curve, filed
        a
        complaint against us in the United States District Court for the Central
        District of California (Action No. CV05-4819) alleging that our operations
        infringe U.S. Patents No 6,785,021, or the ‘021 Patent, U.S. Patent No.
        6,643,034, or the ‘034 Patent, U.S. Patent No. 5,291,302, or the ‘302 Patent,
        and U.S. Patent No. 4,994,926, or the ‘926 Patent. We have obtained an extension
        of time in which to file our answer to that complaint. We have received from
        intellectual property counsel opinions that our present operations do not
        infringe the claims of the 021 patent, the ‘034 patent, the ‘302 patent, or the
‘926 patent. By reason thereof, we presently do not believe it is probable
        that
        we will suffer, by reason of such litigation, a material loss. However, the
        outcome of any litigation is uncertain, and it is premature to reach any
        definitive conclusions in that regard and an adverse outcome may have a material
        adverse effect upon our business and results of operations.
  A
        determination that we have infringed the intellectual property rights of
        a third
        party, including in any of the above-referenced matters, could expose us
        to
        substantial damages, restrict our operations or require us to procure costly
        licenses to the intellectual property that is the subject of the infringement
        claims. Such a license may not be available to us on acceptable terms or
        at all.
        Any effort to defend ourselves from assertions of infringement or
        misappropriation of a third party’s intellectual property rights, whether or not
        we are successful, would be expensive and time-consuming and would divert
        management resources. Any adverse determination that we have infringed the
        intellectual property rights of a third party, or the costs we incur to defend
        ourselves against such claims, whether or not we are successful, would have
        a
        material adverse impact on our business and results of operations.
  23
 Our
        customers or other companies with whom we have a commercial relationship
        could
        also become the target of litigation relating to the patent and other
        intellectual property rights of others. This could trigger support and
        indemnification obligations, which could result in substantial expenses,
        including the payment by us of costs and damages relating to patent
        infringement. In addition to the time and expense required for us to meet
        our
        support and indemnification obligations, any such litigation could hurt our
        relations with our customers and other companies. Thus, the sale of our services
        could decrease. Claims for indemnification may be made by third parties with
        whom we do business and such claims may harm our business, prospects, financial
        condition and results of operations.
  **We
        may not be able to protect and enforce our intellectual property rights,
        which
        could impair our ability to compete and reduce the value of our
        services.**
  We
        rely
        primarily upon a combination of trademark, trade secret, copyright and patent
        law protections, and contractual restrictions to protect our proprietary
        technology. Those measures may not provide meaningful protection. For example,
        any rights granted under any of our existing or future patents may not provide
        meaningful protection or any commercial advantage to us. Such patents could
        be
        challenged or circumvented by our competitors or declared invalid or
        unenforceable in judicial or administrative proceedings. The failure of any
        patents to adequately protect our technology would make it easier for our
        competitors to offer similar services. With respect to our proprietary rights,
        it may be possible for third parties to copy or otherwise obtain and use
        our
        proprietary technology or marks without authorization or to develop similar
        technology independently. Monitoring unauthorized use of our proprietary
        technology or marks is difficult and costly. We may not be able to detect
        unauthorized use of, or to take appropriate steps to enforce, our intellectual
        property rights, particularly in foreign countries where the laws may not
        protect our proprietary rights as fully as in the United States. If we commence
        an action to terminate a third party’s authorized use of our intellectual
        property rights, we may face challenges to the validity and enforceability
        of
        our proprietary rights and may not prevail in any litigation regarding those
        rights. Any efforts to enforce or determine the scope of our intellectual
        property rights, whether initiated by us or a third party, would be expensive
        and time-consuming, would divert management resources and could adversely
        affect
        our business, whether or not such litigation results in a determination
        favorable to us.
  **If
        we are unable to obtain additional telephone numbers, we may not be able
        to grow
        our subscriber base.**
  Our
        future success will depend in part upon our ability to procure sufficient
        quantities of telephone numbers in area codes where our subscribers are located
        at costs we can afford. The ability of telecommunications carriers to provide
        us
        with telephone numbers to be used in conjunction with our services depends
        on
        applicable regulations, the practices of telecommunications carriers that
        provide telephone numbers, and the level of demand for new telephone numbers.
        In
        addition, the Federal Communications Commission, or FCC, has regulations
        concerning numbering resource utilization. If Liberty Telecom does not
        sufficiently utilize the numbers assigned to it, it may have to relinquish
        control of those unused numbers. Furthermore, the FCC and state public utility
        commissions periodically review numbering utilization, and may in the future
        propose additional changes to regulations governing number assignment and
        availability. Failure to have access to telephone numbers in a timely and
        cost-effective manner, or the loss of use of numbers we have accessed or
        may
        access, could prevent us from entering some markets or slow our growth in
        the
        markets in which we currently sell our services.
  **Our
        Enhanced Services Platform is a complex hardware and software system that
        could
        fail and cause service interruptions to our subscribers.**
  Our
        hardware and software systems are complex and are critical to our business.
        If
        our systems fail, our subscribers might experience reduced levels of service
        or
        service interruptions. Software-based services, such as ours, may contain
        undetected errors or failures when introduced or when new versions are released.
        Errors may be found in our software before or after commercial release, and,
        as
        a result, we may experience development delays or a disruption of our services.
        Failures in our system or interruptions to our service could cause us to
        lose
        paid subscribers and harm our business, prospects, financial condition and
        results of operations.
  24
 **If
        we are unable to maintain access to national IP-protocol based networks,
        then
        our business and results of operations may be adversely
        affected.**
  Historically,
        to obtain our services, our subscribers had their calls routed on long-distance
        circuits through the public switched telephone network to our software switching
        facilities in Nevada. That structure requires that we often pay for
        long-distance telephone service. We expect to increasingly rely upon the
        public
        Internet or third-party managed Internet protocol networks, which would not
        change how we provision services to our subscribers, but would allow us to
        reduce our cost of sales by using more of the less expensive Internet and
        local
        telephone network minutes and fewer of the more expensive long-distance
        telephone network minutes. We recently entered into a contract with a provider
        of these Internet and managed Internet protocol network services, which is
        a
        privately managed Internet where access is controlled to ensure quality of
        service. If we are unable to establish and effectively manage such relationships
        on a cost-effective basis, or if the costs associated with Internet and local
        telephone network minutes increase, then our ability to manage our costs
        may be
        adversely affected and our results of operations may suffer.
  **Our
        success depends in large part upon our retention of our executive officers
        and
        our ability to hire and retain additional key personnel.**
  Our
        future performance depends in large part upon the continued services of our
        executive officers and other key technical, operations and management personnel.
        Our future success also depends on our continuing ability to attract and
        retain
        highly qualified technical, operations and managerial personnel. Competition
        for
        such personnel is intense, and we may not be able to retain our key employees
        or
        attract or retain other highly qualified technical, operations and management
        personnel in the future. The loss of the services of one or more of our
        executive officers or other key employees or our inability to attract and
        retain
        additional qualified personnel could harm our business and
        prospects.
  **We
        may need to raise additional capital to support the growth of our operations,
        but such additional funds may not be available.**
  Our
        future capital needs are difficult to predict. We may require additional
        capital
        in order to take advantage of opportunities, including strategic alliances
        and
        potential acquisitions, or to respond to changing business conditions and
        unanticipated competitive pressures. Additionally, funds generated from our
        operations may be less than anticipated. As of June 30, 2005, we had total
        working capital of $59.0 million and $16.8 million of cash and cash equivalents
        and $40.0 million of marketable securities. For the twelve months ending
        June
        30, 2006, we anticipate making capital expenditures of approximately $1.0
        million. While we believe that our current capital resources will be sufficient
        to fund our operations through the end of June 30, 2006, we may need to raise
        additional funds either by borrowing money or issuing additional equity in
        order
        to handle unforeseen contingencies or take advantage of new opportunities.
        We
        may not be able to raise such funds on favorable terms, if at all. If we
        are
        unable to obtain additional funds, then we may be unable to take advantage
        of
        new opportunities or take other actions that otherwise might be important
        to our
        business or prospects.
  **We
        may acquire other businesses or license technologies, and if we do, they
        could
        prove difficult to integrate, disrupt our business, dilute stockholder value
        and
        adversely affect our operating results.**
  Our
        business strategy in the future may include the acquisition of other businesses
        or licensing of technologies. We may not be able to identify, negotiate,
        integrate or finance any such future acquisition or license successfully.
        We
        have not acquired any companies to date and have no arrangements or agreements
        with respect to any potential acquisition and, therefore, have no experience
        with integrating other business operations or technologies with ours. If
        we
        engage in any such strategic transaction, then we may encounter unforeseen
        operating challenges and expenses that may require a significant amount of
        management time that otherwise would be devoted to running our operations.
        If we
        undertake acquisitions or other strategic transactions, then we may issue
        shares
        of stock that dilute the interests of existing stockholders; and we may incur
        debt, assume contingent liabilities, or create additional expenses related
        to
        amortizing intangible assets, any one or more of which may harm our business
        and
        results of operations.
  25
 **Risks
        Related To Our Industry**
  **We
        may not be able to respond to the rapid technological change of the
        communications and information services industries and, as a result, our
        business may be adversely affected.**
  The
        communications and information services industries are undergoing rapid and
        significant technological change. We cannot predict the effect of technological
        changes on our business. We expect that new services and technologies will
        emerge in the markets in which we compete. Those new services and technologies
        may be superior to the services and technologies that we provide or those
        new
        services may render our services and technologies obsolete. In addition,
        those
        services and technologies may not be compatible with ours. If we are not
        able to
        effectively respond to technological changes, the services we provide may
        no
        longer be attractive to our current and potential subscribers and our business,
        prospects, financial condition and results of operations may be
        harmed.
 
 **We
        may be required to incur significant costs to modify our systems in order
        to
        meet the requirements of the Communications Assistance to Law Enforcement
        Act.**
  The
        Communications Assistance to Law Enforcement Act, or CALEA, requires
        telecommunications carriers to have the capability to perform wiretaps and
        to
        record other call identifying information. There is substantial uncertainty
        within the industry as to how to implement these requirements with respect
        to
        packet-switched networks, such as that operated by Liberty Telecom. As Liberty
        Telecom expands its service offerings, further modifications to its local
        switching equipment may be necessary to comply with applicable laws and
        regulations. On March 12, 2004, the FCC issued a public notice seeking public
        comment with respect to a Petition for Rulemaking (Docket RM-10865) filed
        by the
        Department of Justice, Federal Bureau of Investigation and U.S. Drug Enforcement
        Agency, seeking to resolve various outstanding issues associated with the
        implementation of CALEA. In response to the issues raised by the Department
        of
        Justice, the Federal Bureau of Investigation, and other law enforcement
        agencies, the FCC, on August 12, 2004, issued a Notice of Proposed Rulemaking
        and Declaratory Ruling addressing various outstanding issues associated with
        the
        implementation of CALEA. That proceeding could result in additional regulatory
        burdens for us and for Liberty Telecom. Complying with CALEA and rules
        implementing CALEA may require us to incur substantial costs, which could
        negatively impact our results of operations.
  **Our
        services may become subject to burdensome regulations that could increase
        our
        costs or restrict our service offerings.**
  We
        provide our services through data transmissions over public telephone lines
        and
        other facilities provided by telecommunications companies. The underlying
        transmissions are typically subject to regulation by the FCC, state public
        utility commissions and, in the future, could become subject to regulation
        by
        foreign governmental authorities. These regulations affect the prices that
        we
        pay for transmission services, the competition we face from communications
        service providers that may choose to offer enhanced services similar to ours
        and
        other aspects of our market. As a software-based provider of enhanced services,
        we believe we are not currently subject to direct regulation by the FCC or
        generally by state public utility commissions, although our wholly-owned
        subsidiary, Liberty Telecom, is a telecommunications carrier subject to state
        and federal regulation as a Competitive Local Exchange Carrier. As
        communications services increasingly are delivered over the Internet and
        as we
        expand the services that we offer, our business may become increasingly
        regulated. Liberty Telecom is required to have a certificate of public
        convenience and necessity in order to operate in the state of Nevada as a
        Competitive Local Exchange Carrier. If Liberty Telecom were to lose its
        certificate, we may not be able to obtain access to telecommunications services
        at rates or on other terms and conditions that are as favorable as those
        that we
        currently have. As we introduce new offerings, it is possible that some of
        them
        may fall within existing telecommunications regulations, increasing our costs.
        Changes in the federal and state regulatory rules, or developments in the
        interpretation of existing regulations, could decrease our revenue, increase
        our
        costs or restrict our service offerings.
  **Future
        legislation, regulation, or legal decisions affecting the Internet, Internet
        telephony or IP-enabled services could restrict our business, prevent us
        from
        offering our services or increase our cost of doing
        business.**
  26
 At
        present there are few laws, regulations or rulings that specifically address
        access to or commerce on the Internet, including the provision of Internet
        protocol-based telephony and other IP-enabled services. We are unable to
        predict
        the impact, if any, that future legislation, regulations or legal decisions
        may
        have on our business. However, the growth in the market for IP-based telephony
        and other IP-enabled communications, and the popularity of these services,
        create the risk that governments and agencies increasingly will seek to regulate
        services such as our current offerings. Many legislative and regulatory actions
        are underway or are being contemplated by federal and state authorities,
        including the FCC and various state regulatory agencies. For
        example:
  §
              
              On
                  March 10, 2004, the FCC released a notice of proposed rulemaking
                  (Docket
                  04-36) and sought public comment regarding the regulatory classification,
                  rights and obligations of services supported by IP
                  technologies.
 
 §
              
              On
                  April 21, 2004, the FCC released a narrow declaratory ruling finding
                  that
                  certain Internet protocol telephony services are telecommunications
                  services upon which interstate access charges may be assessed.
                  Prior to
                  this decision, the FCC had never ruled that a service relying on
                  Internet-protocol technology was a telecommunications service.
                  The ruling
                  illustrates that certain Internet-protocol based services may become
                  subject to costs and regulations that, previously, were not thought
                  to be
                  applicable. This ruling, however, is not likely to have any direct
                  effect
                  on us in the near future.
  §
              
              At
                  an open meeting on August 5, 2005, the FCC unanimously adopted
                  an order
                  reclassifying wireline broadband Internet access services as information
                  services, thereby placing wireline broadband Internet access services
                  within the same general regulatory framework as cable modem services.
                  As
                  an information service, wireline broadband Internet access, like
                  cable
                  modem service, no longer is subject to regulation under Title II
                  of the
                  Communications Act of 1934, as amended, or the FCC’s Computer Inquiry
                  rules, but is subject to specific obligations imposed under Title
                  I of the
                  Act. Until the Commission releases the text of the decision, many
                  important details regarding the decision will remain unclear. However,
                  the
                  decision could potentially could enable ILECs to (1) refuse to
                  permit
                  subscribers to their broadband transmission services to use our
                  enhanced
                  services, (2) charge higher rates for underlying broadband transmission
                  service to subscribers to our enhanced services, or (3) bundle
                  enhanced
                  services that are similar to our enhanced services with their broadband
                  transmission services at such a rate that it becomes economically
                  unfeasible for us to compete with the ILEC. If one or more ILECs
                  take any
                  of those actions with explicit or tacit permission from the FCC,
                  then it
                  could have a material adverse impact upon our profitability and
                  the
                  results of our operations.
  §
              
              November
                  12, 2004, the FCC released an order preempting the September 11,
                  2003
                  order of the Minnesota Public Utilities Commission. In the preempted
                  Minnesota Order, the Minnesota Commission had asserted regulatory
                  jurisdiction over Vonage’s DigitalVoice service and ordered Vonage to
                  comply with all state statues and regulations relating to the offering
                  of
                  telephone service in Minnesota, which could have required Vonage,
                  among
                  other things, to obtain operating authority, file tariffs, and
                  provide and
                  fund 911 emergency services. In addition to preempting the Minnesota
                  Order, the FCC concluded that “comparable regulations of other states must
                  likewise yield to important federal objectives,” although the agency did
                  not identify, or preempt, any specific state regulations or orders
                  apart
                  from the Minnesota Order. Specifically, the FCC explained that,
“to the
                  extent that other VoIP services are not the same as Vonage’s but share
                  similar basic characteristics, we believe it highly unlikely that
                  the
                  Commission would fail to preempt state regulation of those services
                  to the
                  same extent.” The FCC, however, did not determine whether DigitalVoice or
                  any other IP-enabled service is an information or telecommunications
                  service, and thus the regulatory classification of these services
                  under
                  the Act remains an open issue. An appeal of the FCC’s preemption order is
                  currently pending.
  The
        specific services at issue in the FCC’s preemption order referenced above were
        offered to the public as substitutes for, or as substantially equivalent
        to,
        existing telecommunications services. In contrast, the services that we
        currently offer are not offered to the public as substitutes for, or as
        substantially equivalent to, existing telecommunications services. Our
        IP-enabled services allow our customers to manage calls which are initiated
        by
        third parties to our customers and completed over the local service facilities
        of our customers’ existing telecommunications service providers. As such, our
        customers could not use our service unless they are also separately receiving
        telecommunications services from their own service provider. Certain decisions
        adopted by state commissions before the FCC issued its preemption order
        suggested an increased interest by some state commissions in regulating services
        that may be perceived as the functional equivalent of local phone service.
        If
        state regulators attempt to regulate the enhanced services that we provide
        or
        determine that the enhanced services that we provide are currently subject
        to
        their regulatory provisions, then we may be faced with substantially increased
        regulatory burdens and costs.
  27
 Regulatory
        proceedings, legislative efforts and adjudications, including but not limited
        to
        some of those described above, may lead to the imposition of additional
        regulatory obligations and requirements on us in the provision of our services,
        including but not limited to certification requirements, interstate or
        intrastate access charges, regulatory fees, payments to universal service
        support funds, taxes related to Internet or IP-enabled communications,
        requirements to provide free access to certain users, regulations based on
        encryption concerns, consumer protection requirements and certain minimum
        service levels. We could conceivably become subject to requirements and
        obligations not only at the federal level, but also in any of the states
        in
        which we have customers or from which third persons initiate communications
        to
        call our customers, as well as in any of those jurisdictions in which facilities
        exist or activities occur which support our offerings. Further, if we expand
        into additional lines of business or make new service offerings, we could
        become
        subject to existing or future regulation or other legal requirements, including
        but not limited to those which apply to telecommunications services and the
        providers of such services. The impact of federal or state legislative,
        regulatory, or adjudicatory actions or requirements may include an increase
        in
        our costs, adversely affect how we conduct our business, and adversely affect
        our financial condition and results of operations.
  **Risks
        Related To Our Common Stock**
  **Our
        executive officers, directors and 5% stockholders own a significant percentage
        of our stock and will be able to exercise significant influence over stockholder
        votes.**
  Our
        executive officers, directors and 5% stockholders together beneficially own
        approximately 63.6% of our common stock, including shares subject to options
        and
        warrants that confer beneficial ownership of the underlying shares. Accordingly,
        these stockholders, for the foreseeable future will continue to have significant
        influence over our affairs including the election of directors and significant
        corporate transactions, such as a merger or other sale of our company or
        its
        assets. This concentrated control will limit the ability of shareholders
        to
        influence corporate matters and, as a result, we may take actions that our
        stockholders do not view as beneficial. For example, this concentration of
        ownership could have the effect of delaying or preventing a change in control
        or
        otherwise discouraging a potential acquirer from attempting to obtain control
        of
        us, which in turn could cause the market price of our common stock to decline
        or
        prevent our stockholders from realizing a premium over the market price for
        their shares of our common stock.
  **Provisions
        in Delaware law and our charter documents may make it difficult for a third
        party to acquire us and could depress the price of our common
        stock.**
  Provisions
        of Delaware law, our certificate of incorporation and our bylaws could make
        it
        more difficult for a third party to acquire control of us. For
        example:
  §
                  
                  we
                      are subject to Section 203 of the Delaware General Corporation
                      Law,
                      which would make it difficult for another party to acquire
                      us without the
                      approval of our board of directors;§
                  
                  our
                      certificate of incorporation authorizes our board of directors
                      to issue
                      preferred stock without requiring stockholder approval, and
                      preferred
                      stock could be issued as a defensive measure in response to
                      a takeover
                      proposal; and§
                  
                  our
                      certificate of incorporation or
                      bylaws:
  §
                  
                  creates
                      a classified board of directors;§
                  
                  prohibits
                      cumulative voting in the election of directors§
                  
                  limits
                      the persons who may call special meetings of our stockholders;
                      and§
                  
                  imposes
                      advance notice requirements for nominations for election to
                      our board of
                      directors and for proposing matters to be acted upon by our
                      stockholders.
  28
 These
            and
            other provisions of Delaware law, our certificate of incorporation and
            our
            bylaws may make it more difficult for a third party to acquire us even
            if an
            acquisition might be in the best interests of our stockholders, and the
            price at
            which shares of our common stock are purchased and sold therefore may
            be
            depressed.
  **We
        are incurring increased costs as a result of being a public
        company.**
  As
        a
        public company, we are incurring significant additional legal, accounting
        and
        other expenses. The Sarbanes-Oxley Act of 2002, as well as new rules
        subsequently implemented by the Securities and Exchange Commission and the
        Nasdaq National Market, require changes in corporate governance practices
        of
        public companies. These new rules and regulations have resulted in increased
        legal and financial compliance costs and management efforts and we expect
        those
        costs and efforts to continue to increase. It has become more expensive for
        us
        to obtain director and officer liability insurance, and it may become more
        difficult to obtain such insurance in the future, which may cause us to accept
        reduced policy limits and reduced coverage or to incur substantially higher
        costs to obtain the same or similar coverage. As a result, it may be more
        difficult for us to attract and retain qualified persons to serve on our
        board
        of directors or as executive officers. We cannot predict or estimate the
        amount
        of additional costs we may incur, but these additional costs and demands
        on
        management time and attention may harm our business and results of
        operations.
 
 **ITEM
        3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
        RISK**
  *Foreign
        currency exchange risk.* We do
        not currently do any business denominated in foreign currencies and, therefore,
        are not subject to any significant foreign currency exchange risk.
  *Interest
        rate sensitivity.* We had
        cash and cash equivalents totaling $34.9 million and marketable securities
        totaling $26.7 million at September 30, 2005, and cash and cash equivalents
        totaling $4.8 million and marketable securities totaling $10.0 million at
        September 30, 2004. Cash and cash equivalents were held for working
        capital
        purposes in depository accounts at FDIC-regulated banking institutions.
        Marketable securities consist of investment grade securities, corporate bonds,
        and government and agency securities. We do not enter into investments for
        trading or speculative purposes. Due to the short-term nature of these
        investments, we believe that we do not have any material exposure to changes
        in
        the fair value of our cash and cash equivalents or marketable securities
        as a
        result of changes in interest rates. Declines in interest rates, however,
        will
        reduce our future interest income.
 
 **ITEM
        4. CONTROLS AND PROCEDURES**
  **Item
        9. Changes in and Disagreements with Accountants on Accounting and Financial
        Disclosure**
  None.
 
 **Item
        9A. Controls and Procedures**
  (a) *Evaluation of disclosure controls and procedures.*
  Our
        management, with the participation of our chief executive officer and chief
        financial officer, evaluated the effectiveness of our disclosure controls
        and
        procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934
        as
        of the end of the period covered by this report. The evaluation included
        certain
        internal control areas in which we have made and are continuing to make changes
        to improve and enhance controls. In designing and evaluating the disclosure
        controls and procedures, management recognized that any controls and procedures,
        no matter how well designed and operated, can provide only reasonable assurance
        of achieving the desired control objectives, and management is required to
        apply
        its judgment in evaluating the cost benefit relationship of possible controls
        and procedures.
  29
 Our
        chief
        executive officer and chief financial officer concluded that our disclosure
        controls and procedures are effective, in all material respects, to ensure
        that
        information we are required to disclose in reports that we file or submit
        under
        the Exchange Act is recorded, processed, summarized and reported within the
        time
        periods specified in Securities and Exchange Commission rules and forms,
        and
        that such information is accumulated and communicated to our management,
        including our chief executive officer and chief financial officer, as
        appropriate, to allow timely decisions regarding required
        disclosure.
  (b) *Changes in internal controls over financial reporting.*
  There
        were no changes in our internal control over financial reporting that occurred
        during the period covered by this Quarterly Report on Form 10-Q that have
        materially affected, or are reasonably likely to materially affect, our internal
        control over financial reporting.
  We
        have
        identified areas of our internal controls requiring improvement, and are
        in the
        process of designing enhanced processes and controls. Areas for improvement
        include streamlining our billing processes, further limiting internal access
        to
        certain data systems and continuing to improve coordination across business
        functions. We plan to continue this initiative as well as prepare for our
        first
        management report on internal control over financial reporting, as required
        by
        Section 404 of the Sarbanes-Oxley Act of 2002. As a result, we expect to
        make
        changes in our internal control over financial reporting.
 
 **Item
        9B. Other Information**
  None.
 
 **PART
        II—OTHER INFORMATION**
 
 **ITEM
        1. LEGAL PROCEEDINGS**
  On
        July
        1, 2005, Catch Curve, Inc., a Delaware corporation, or Catch Curve, filed
        a
        complaint against us in the United States District Court for the Central
        District of California (Action No. CV05-4819), or the Action, alleging that
        the
        Company’s operations infringe U.S. Patents No 6,785,021, or the ‘021 patent,
        U.S. Patent No. 6,643,034, or the ‘034 patent, U.S. Patent No. 5,291,302, or the
‘302 patent, and U.S. Patent No. 4,994,926, or the ‘926 patent. We have obtained
        an extension of time in which to file an answer to that complaint. We have
        received from intellectual property counsel opinions that our present operations
        do not infringe the claims of the 021 patent, the ‘034 patent, the ‘302 patent,
        or the ‘926 patent. By reason thereof, we presently do not believe it is
        probable that we will suffer a material loss. However, it is premature to
        reach
        any definitive conclusions in that regard.
  On
        August
        24, 2004, j2 filed a complaint against us in the United States District Court
        for the Central District of California (Action No. CV04-7068), or the Action,
        alleging that our operations infringe U.S. Patent No. 6,350,066, or the ‘066
        patent. We have filed an answer, denying the claims asserted by j2 in that
        Action. On or about December 30, 2004, we agreed to a stipulated amendment
        to
        j2’s Complaint, permitting j2 to add allegations that we infringe U.S. Patents
        Nos. 6,208,638, or the ‘638 patent, and 6,564,321, or the ‘321 patent. On April
        20, 2005, we agreed to a stipulated amendment to j2’s complaint, permitting j2
        to add allegations that we infringe U.S. Patent No. 6,857,074, or the ‘074
        patent. We have received from intellectual property counsel opinions that
        our
        present operations do not infringe the claims of the ‘066 patent, the ‘638
        patent, the ‘321 patent, or the ‘074 patent. By reason thereof, we presently do
        not believe it is probable that we will suffer, by reason of such litigation,
        a
        material loss. However, it is premature to reach any definitive conclusions
        in
        that regard. Moreover, we presently project that if the litigation continues
        at
        this present pace, then we are likely to incur a material amount of attorneys’
        fees and costs in that litigation.
  On
        October 4, 2004, we received a letter from counsel to Web Telephony, LLC,
        or Web
        Telephony, asserting that our operations infringe U.S. Patents Nos. 6,445,694
        and 6,785,266, and demanding that we cease all infringing conduct. Our
        intellectual property counsel has issued to us an opinion that our operations
        do
        not infringe the claims of those patents. We and officials of Web Telephony
        engaged in discussions regarding those patents; in those discussions, Web
        Telephony asserted that our operations infringe the claims of those patents
        and
        proposed that we either purchase the patents or acquire a license to the
        patents. On January 19, 2005, we filed in the United States Federal District
        Court for the Central District of California a declaratory relief action
        (Action
        No. CV05-0443) against Web Telephony, seeking to have the Court declare that
        our
        operations do not infringe the claims of those patents. We filed a First
        Amended
        Complaint on May 2, 2005, adding a cause of action for interference with
        prospective economic advantage. Web Telephony filed an Answer to the First
        Amended Complaint on September 6, 2005, and counterclaimed, alleging
        infringement of the ‘694 and ‘266 patents. By reason of the opinions of counsel
        that we have obtained, we presently do not believe it is probable that we
        will
        suffer a material loss by reason of this matter.
  30
 In
        September 2004, we received a letter from America Online, Inc., in which
        AOL
        offered to grant to us a license to U.S. Patent No. 5,809,128, or
        the ‘128
        patent. We and AOL are engaged in business discussions at the present time,
        and
        it is unclear how those negotiations will be concluded. We have received
        from
        intellectual property counsel an opinion that our operations do not infringe
        the
        claims of the ‘128 patent. By reason thereof, we presently do not believe it is
        probable that we will suffer a material loss by reason of this
        matter.
 
 **ITEM
        2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
        PROCEEDS**
  ***Sales
        of Unregistered Securities***
  In
        the
        first quarter of fiscal 2006, warrant holders exercised stock purchase warrants
        previously issued by us, resulting in the issuance of 172,000 shares in exchange
        for $431,000. These shares of common stock were not registered under the
        Securities Act in reliance upon the exemption contained in Section 4(2) of
        the
        Securities Act. The recipients of securities in these transactions represented
        their intention to acquire the securities for investment only and not with
        a
        view to or for sale in connection with any distribution thereof, each such
        recipient had access to information about us and we had reasonable grounds
        for
        determining that each such recipient was an “accredited investor” as defined in
        Rule 501(a) under the Securities Act. Appropriate legends were affixed to
        share
        certificates and other instruments issued in such transactions. The sales
        of
        these securities were made without general solicitation or
        advertising.
  ***Use
        of Proceeds***
  On
        October 5, 2004, we closed the sale of 4,000,000 shares of our common
        stock
        in our initial public offering. The registration statement on Form S-1 (Reg.
        No.
        333-115438) we filed to register our common stock in the offering was declared
        effective by the SEC on September 29, 2004. After deducting expenses of the
        offering, we received net offering proceeds of approximately $35.2 million.
        From
        the time of receipt, October 5, 2004, through September 30, 2005,
        we have
        not used the proceeds of this offering but have invested them into investment
        grade government agency and corporate debt securities.
 
 **ITEM
        3. DEFAULTS UPON SENIOR SECURITIES**
  Not
        applicable.
 
 **ITEM
        4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**
  None.
 
 **ITEM
        5. OTHER INFORMATION**
  None.
 **ITEM
        6. EXHIBITS**
  **Exhibit**
                **Number**
              
              **Description**3.1
              
              Bylaws
                  of CallWave, Inc.10.1
              
              First
                  Amendment to 2004 Stock Incentive Plan.31.1
              
              Certification
                  of Chief Executive Officer pursuant to Securities Exchange Act
                  Rules
                  13a-14 and 15d-14, as adopted pursuant to Section 302 of the
                  Sarbanes-Oxley Act of 2002.31.2
              
              Certification
                  of Chief Financial Officer pursuant to Securities Exchange Act
                  Rules
                  13a-14 and 15d-14, as adopted pursuant to Section 302 of the
                  Sarbanes-Oxley Act of 2002.32.1
              
              Certification
                  of Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
                  as adopted
                  pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002.32.2
              
              Certification
                  of Chief Financial Officer pursuant to 18 U.S.C. Section 1350,
                  as adopted
                  pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002.
  31
  
 **SIGNATURES**
  Pursuant
        to the requirements 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.
  **CALLWAVE,
                  INC.,**Date:
                  November 14, 2005
              
              By:
              
              /s/
                  David F. HofstatterDavid
                  F. Hofstatter,President
                  and Chief Executive OfficerDate:
                  November 14, 2005
              
              By:
              
              /s/
                  C. Stephen CordialC.
                  Stephen CordialChief
                  Financial Officer(principal
                  financial and accounting officer)
 
   32
  
 **EXHIBIT
        INDEX**
 **Exhibit**
                  **Number**
                
                **Description**3.1
                
                Bylaws
                    of CallWave, Inc.10.1
                
                First
                    Amendment to 2004 Stock Incentive Plan.31.1
                
                Certification
                    of Chief Executive Officer pursuant to Securities Exchange Act
                    Rules
                    13a-14 and 15d-14, as adopted pursuant to Section 302 of the
                    Sarbanes-Oxley Act of 2002.31.2
                
                Certification
                    of Chief Financial Officer pursuant to Securities Exchange Act
                    Rules
                    13a-14 and 15d-14, as adopted pursuant to Section 302 of the
                    Sarbanes-Oxley Act of 2002.32.1
                
                Certification
                    of Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
                    as adopted
                    pursuant to Section 906 of the Sarbanes-Oxley Act of
                    2002.32.2
                
                Certification
                    of Chief Financial Officer pursuant to 18 U.S.C. Section 1350,
                    as adopted
                    pursuant to Section 906 of the Sarbanes-Oxley Act of
                    2002.
   33