UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549








FORM 10-Q








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





For the Quarterly Period Ended September 30, 2010





OR





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


For the transition period from _____________________to______________________





Commission File Number: 000-51572















PokerTek, Inc.


(Exact name of registrant as specified in its charter)





North Carolina

61-1455265(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification No.)
  1150 Crews Road, Suite F, Matthews, North Carolina 28105(Address of principal executive offices) (Zip Code)





(704) 849-0860(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 o





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).                                        Yes  o     No   o





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





o
Large accelerated filer
o
Accelerated filero
Non-accelerated filer (do not check if a smaller reporting company)
x
Smaller reporting company





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





As of November 8, 2010, there were 15,068,080 shares outstanding of the registrant’s common stock.


















POKERTEK, INC.





TABLE OF CONTENTS








PagePART I – FINANCIAL INFORMATIONItem 1.
Financial Statements
1Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
13Item 3.
Quantitative and Qualitative Disclosures about Market Risk
17Item 4.
Controls and Procedures
17PART II – OTHER INFORMATIONItem 5.
Other Information
18Item 6.
Exhibits
19Signatures
20Exhibit Index
21












POKERTEK, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(unaudited)Three Months Ended September 30,


Nine Months Ended September 30,2010


2009


2010


2009Revenue

$
1,450,709


$
1,327,603


$
4,300,669


$
4,046,411Cost of revenue


401,786



767,295



1,542,737



2,301,810Gross profit


1,048,923



560,308



2,757,932



1,744,601Operating Expenses:Selling, general and administrative


1,205,146



1,109,963



3,514,684



4,192,178Research and development


264,703



272,757



797,139



919,527Share-based compensation expense


173,722



217,277



543,765



580,612Depreciation


33,916



47,376



107,621



147,879Total operating expenses


1,677,487



1,647,373



4,963,209



5,840,196Operating loss


(628,564
)


(1,087,065
)


(2,205,277
)


(4,095,595
)Interest expense, net


(33,973
)


(76,403
)


(103,546
)


(257,674
)Net loss from continuing operations before income taxes


(662,537
)


(1,163,468
)


(2,308,823
)


(4,353,269
)Income tax provision


(14,188
)


(19,117
)


(52,795
)


(83,087
)Net loss from continuing operations


(676,725
)


(1,182,585
)


(2,361,618
)


(4,436,356
)Income (loss) from discontinued operations


32,215



(102,903
)


(1,179,372
)


(300,078
)Net loss

$
(644,510
)

$
(1,285,488
)

$
(3,540,990
)

$
(4,736,434
)Net loss from continuing operations per common share - basic and diluted

$
(0.05
)

$
(0.10
)

$
(0.16
)

$
(0.39
)Net income (loss) from discontinued operations per common share - basic and diluted

$
0.00


$
(0.01
)

$
(0.08
)

$
(0.03
)Net loss per common share - basic and diluted

$
(0.04
)

$
(0.11
)

$
(0.24
)

$
(0.42
)Weighted average common shares outstanding - basic and diluted


15,000,055



11,811,726



14,569,355



11,287,756







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






1





POKERTEK, INC.CONSOLIDATED BALANCE SHEETS(unaudited)Assets

September 30, 2010


December 31, 2009Current assets:Cash and cash equivalents

$
822,026


$
636,374Accounts receivable, net


871,494



1,179,604Inventory


1,186,015



1,336,810Prepaid expenses and other assets


224,546



169,845Current assets of discontinued operations


602,346



1,906,962Total current assets


3,706,427



5,229,595Long-term assets:PokerPro systems, net


2,213,470



2,408,161Property and equipment, net


108,180



211,478Other assets


417,194



433,865Total long-term assets


2,738,844



3,053,504Total assets

$
6,445,271


$
8,283,099Liabilities and Shareholders' EquityCurrent liabilities:Accounts payable

$
442,271


$
498,573Accrued liabilities


687,416



745,349Deferred revenue


761,127



438,846Long-term debt, current portion


42,930



26,239Current liability - related party


19,500



-Current liabilities of discontinued operations


227,455



261,198Total current liabilities


2,180,699



1,970,205Long-term liabilities:Deferred revenue


146,500



-Long-term liability - related party


377,000



-Long-term debt


800,000



812,396Total long-term liabilities


1,323,500



812,396Total liabilities


3,504,199



2,782,601Commitments and contingenciesShareholders' equity:Preferred stock, no par value per share; authorized 5,000,000, none issued and outstanding


-



-Common stock, no par value per share; authorized 100,000,000 shares, issued and outstanding 15,068,080 and 14,015,658 shares at September 30, 2010 and December 31, 2009, respectively


-



-Additional paid-in capital


46,481,736



45,500,172Accumulated deficit


(43,540,664
)


(39,999,674
)Total shareholders' equity


2,941,072



5,500,498Total liabilities and shareholders' equity

$
6,445,271


$
8,283,099





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






2




POKERTEK, INC.CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY(unaudited)Common Stock


Additional

Paid-in


Accumulated


Total

Shareholders'Shares


Value


Capital


Deficit


EquityBalance, December 31, 2009


14,015,658


$
-


$
45,500,172


$
(39,999,674
)

$
5,500,498Share-based compensation


65,385



-



224,099



-



224,099Net loss


-



-



-



(856,593
)


(856,593
)Balance, March 31, 2010


14,081,043



-



45,724,271



(40,856,267
)


4,868,004Share-based compensation


65,385



-



149,497



-



149,497Issuances of common stock, net


773,637



-



444,564



-



444,564Net loss


-



-



-



(2,039,887
)


(2,039,887
)Balance, June 30, 2010


14,920,065


$
-


$
46,318,332


$
(42,896,154
)

$
3,422,178Share-based compensation


91,889



-



223,255



-



223,255Expenses of common stock, net






-



(59,851
)


-



(59,851
)Issuances of common stock for warrant conversions


56,126



-



-



-



-Net loss


-



-



-



(644,510
)


(644,510
)Balance, September 30, 2010


15,068,080


$
-


$
46,481,736


$
(43,540,664
)

$
2,941,072








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






3





POKERTEK, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)Nine Months Ended

September 30,2010


2009Cash flows from operating activities:Net loss

$
(3,540,990
)

$
(4,736,434
)Net loss from discontinued operations


1,179,372



300,078Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization


1,437,017



2,152,712Gain on sale of property and equipment


(1,440
)


-Share-based compensation expense


543,765



580,612Provision for accounts and other receivables


30,961



22,858Change in assets and liabilities:Accounts and other receivables


217,260



223,445Prepaid expenses and other assets


122,457



164,543Deferred cost


-



(72,184
)Inventory


547,295



(105,145
)PokerPro systems


(1,105,705
)


(128,221
)Accounts payable and accrued expenses


(65,735
)


(436,901
)Deferred revenue


468,781



66,964Net cash used in operating activities from continuing operations


(166,962
)


(1,967,673
)Net cash provided by operating activities from discontinued operations


96,087



80,216Net cash used in operating activities


(70,875
)


(1,887,457
)Cash flows from investing activities:Purchases of property and equipment


(5,688
)


(1,471
)Proceeds from sale of equipment


2,805



-Sale of investments


-



3,900,000Net cash provided by (used in) investing activities


(2,883
)


3,898,529Cash flows from financing activities:Repayments of short-term debt


-



(2,865,357
)Proceeds from issuance of common stock, net


284,115



500,000Repayments of capital lease


(24,705
)


(17,718
)Net cash provided by (used in) financing activities


259,410



(2,383,075
)Net increase (decrease) in cash and cash equivalents


185,652



(372,003
)Cash and cash equivalents, beginning of period


636,374



1,481,530Cash and cash equivalents, end of period

$
822,026


$
1,109,527Supplemental Disclosure of Cash Flow InformationCash paid for:Interest

$
56,096


$
164,567Income taxes

$
62,042


$
106,919Non-cash transactions:Gaming inventory purchase - related party

$
396,500


$
-Issuance of common stock for commitment fee

$
100,598


$
-Purchase of Gaming assets with capital lease

$
29,000


$
-Issuance of common stock in satisfaction of long-term debt

$
-


$
1,200,000Issuance of common stock as payment for inventory of discontinued operations

$
-


$
480,250Issuance of common stock as payment of interest

$
-


$
33,124





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






4





POKERTEK, INC.


NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS








Note 1.                      Nature of Business and Basis of Presentation





Nature of Business





PokerTek, Inc. (“PokerTek” or the “Company”) is engaged in the development, manufacture, and marketing of electronic poker-related products for use in the gaming market.





The Company previously had two product lines, PokerPro® gaming products and Heads-Up ChallengeTM amusement products.  On August 5, 2010, the Company approved a plan to discontinue the operations of its Amusement segment. The operations of the Amusement segment is reflected as a Discontinued Operation beginning with the September 30, 2010 reporting date.




The PokerPro system consists of electronic poker table(s) and related peripheral equipment providing commercial casinos, tribal casinos, cruise ships and card clubs with a fully-automated poker-room environment designed to improve the profitability of poker by enhancing the operator’s revenue opportunities and decreasing startup and operating costs.





Basis of Presentation and Significant Accounting Policies





The accompanying consolidated financial statements include the accounts of PokerTek, Inc. and its consolidated subsidiaries. All significant intercompany transactions and accounts have been eliminated.





These consolidated financial statements should be read in conjunction with the consolidated financial statements and related footnotes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. Certain reclassifications have been made to prior periods’ financial information to conform to the current period presentation. There were no material changes during the most recent fiscal quarter in the Company’s significant accounting policies as described in the Annual Report.





The accompanying consolidated financial statements have been prepared without audit and are presented in accordance with Article 8-03 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States (“U.S. GAAP”) for annual financial statements. In the opinion of management, these consolidated financial statementsinclude all adjustments, which consist only of normal recurring adjustments, necessary for a fair statement of the Company’s results of operations for the periods presented. The results of operations for the three and nine months ended September 30, 2010 are not necessarily indicative of the results to be expected for the entire year.





Recent Accounting Pronouncements





In January 2010, the FASB issued an amendment to the fair value measurement and disclosure standard improving disclosures about fair value measurements. This amended guidance requires separate disclosure of significant transfers in and out of Levels 1 and 2 and the reasons for the transfers. The amended guidance also requires that in the Level 3 reconciliation, the information about purchases, sales, issuances, and settlements be disclosed separately on a gross basis rather than as one net number. The guidance for the Level 1 and 2 disclosures was adopted on January 1, 2010 and did not have an impact on the Company’s consolidated financial position, results of operations, or cash flows. The guidance for the activity in Level 3 disclosures is effective January 1, 2011 and will not have an impact on the Company’s consolidated financial position, results of operations or cash flows as the amended guidance provides only disclosure requirements. The Company had no transfers between Level 1, 2, or 3 inputs during the nine months ended September 30, 2010.





In February 2010, the FASB issued amended guidance on subsequent events. Under this amended guidance, SEC filers are no longer required to disclose the date through which subsequent events have been evaluated in originally issued and revised financial statements. This guidance was effective immediately, and the Company adopted these new requirements for the quarter ended March 31, 2010.





Note 2.                      Operations and Liquidity Management





Historically, the Company has incurred net losses and used cash from financing activities to fund its operations. Over the past several quarters, the Company reduced its operating expenses in order to improve its operating results and reduce its use of cash. As of September 30, 2010, the Company’s cash balance was approximately $0.8 million.  The level of cash needed to fund operations and the Company’s ability to conduct its business for the next year is influenced primarily by the following factors:





●
The pace of growth and the related spending on market penetration, regulatory efforts and related investments in inventory.





●
The successful transition to a heavier mix of recurring revenue, which generates less upfront cash compared to selling directly to an international distributor but still requires significant investments in inventory.






5




●
Management’s ability to control operating expenses and negotiate favorable payment terms with the Company’s customers and vendors as the business grows internationally and becomes more geographically diverse.





●
Management’s ability to access the capital markets and maintain availability under its credit line.





●
The impact of the economy or other factors on customers and suppliers, including the impact on demand for the Company’s products and customers’ ability to pay on a timely basis.





Management’s operating plan for the remainder of 2010 and 2011 is to balance revenue growth with operating expense control and working capital management while carefully monitoring the impact of growth on cash needs and cash balances. Should it become necessary, management plans to reduce expenditures related to inventory procurement and decrease variable operating expenses. In addition, management may also seek to raise additional capital or expand its credit facilities to bolster liquidity and to accelerate business growth during the remainder of 2010 and 2011.





Note 3.                      Discontinued Operations





In August 2010, the Company decided to exit its Amusement business.  The Company’s decision was based on the deteriorating performance of the segment during the first half of 2010, the outlook for the Amusement industry and the significant decline in demand and pricing power for our Heads-Up Challenge product.





The Company evaluated the trend of declining selling prices and margins in the first half of 2010 and determined the carrying value of the Amusement assets required adjustment to reflect those assets at the lower of cost or market based on estimated future cash flows.  In addition, the Company’s obligations to purchase additional Amusement product was determined to be an unfavorable purchase commitment requiring recognition in the financial statements.   These non-recurring costs totaled $1.1 million and are reflected in the accompanying consolidated statements of operations.





The results of operations and related non-recurring costs associated with the Amusement business have been presented as discontinued operations for all periods.  Additionally, the assets and liabilities of the discontinued operations have been segregated in the accompanying consolidated balance sheets.





The statements of operations for the discontinued operations for the three and nine months ended September 30, 2009 and 2010 consisted of the following: Three Months Ended

September 30,


Nine Months Ended

September 30,2010


2009


2010


2009Revenue

$
251,433


$
234,078


$
832,191


$
1,170,170Cost of revenue


176,880



195,565



1,708,909



1,028,118Gross profit


74,553



38,513



(876,718
)


142,052Operating Expenses:Selling, general and administrative


41,305



115,786



107,101



371,862Research and development


-



6,885



7,922



15,436Share-based compensation expense


1,033



3,687



4,586



9,729Depreciation


-



15,058



183,045



45,103Total operating expenses


42,338



141,416



302,654



442,130Net income (loss) from discontinued operations

$
32,215


$
(102,903
)

$
(1,179,372
)

$
(300,078
)







6





Assets and liabilities of discontinued operations at September 30, 2010 and December 31, 2009 consisted of the following: September 30,


December 31,2010


2009Assets:Accounts receivable

$
94,466


$
8,064Inventory


417,085



1,145,429Heads-Up Challenge units, net


90,795



570,425Property and equipment, net


-



183,044Total assets

$
602,346


$
1,906,962Liabilities:Accounts payable

$
12,352


$
19,903Accrued liabilities


152,337



77,435Deferred revenue


62,766



163,860Total liabilities

$
227,455


$
261,198








Note 4.                      Inventory





Inventory at September 30, 2010 and December 31, 2009 consisted of the following: September 30,


December 31,2010


2009Raw materials and components

$
778,780


$
1,060,143PokerPro systems in process


346,860



458,078Finished goods


361,895



153,524Reserve


(301,520
)


(334,935
)Inventory, net

$
1,186,015


$
1,336,810








Note 5.                      Prepaid Expenses and Other Assets





Prepaid expenses and other assets at September 30, 2010 and December 31, 2009 consisted of the following: September 30,


December 31,2010


2009Prepaid expenses

$
89,585


$
103,053Stock issuance commitment fee, net


102,604



-Other


32,357



66,792Prepaid expenses and other assets

$
224,546


$
169,845Deferred licensing fees, net

$
299,823


$
364,482Long-term receivable


59,889



-Other


57,482



69,383Other assets

$
417,194


$
433,865






7





Note 6.                      PokerPro Systems, net





PokerPro systems, net at September 30, 2010 and December 31, 2009 consisted of the following: September 30,


December 31,2010


2009PokerPro systems

$
7,474,236


$
7,831,243Less: accumulated depreciation and amortization


(5,260,766
)


(5,423,082
)PokerPro systems, net

$
2,213,470


$
2,408,161








Note 7.                      Property and Equipment





Property and equipment at September 30, 2010 and December 31, 2009 consisted of the following: September 30,


December 31,2010


2009Equipment

$
431,119


$
434,389Leasehold improvements


199,948



199,948Capitalized software


157,067



157,067788,134



791,404Less: accumulated depreciation


(679,954
)


(579,926
)Property and equipment, net

$
108,180


$
211,478





Capitalized software consists of purchased software, consulting and capitalized internal costs related to the purchase and implementation of a new internal-use enterprise resource management system. Accumulated depreciation on capitalized software at September 30, 2010 was $100,290. The software portion of this systems investment was financed through a capital lease obligation (see Note 9, “Debt”).





Note 8.                      Accrued Liabilities





Accrued liabilities at September 30, 2010 and December 31, 2009 consisted of the following:


September 30,


December 31,2010


2009Professional fees

$
168,609


$
179,968Other liabilities and customer deposits


518,807



565,381Accrued liabilities

$
687,416


$
745,349








8





Note 9.                      Debt





The Company’s outstanding debt balances as of September 30, 2010 and December 31, 2009 consisted of the following: September 30,


December 31,2010


2009SVB Credit Facility

$
-


$
-Founders' Loan


800,000



800,000Capital lease obligation


42,930



38,635Total debt


842,930



838,635Current portion of debt


42,930



26,239Long-term portion of debt

$
800,000


$
812,396








SVB Credit Facility: The Company maintains a credit facility with Silicon Valley Bank to support the Company’s working capital needs (the “SVB Credit Facility”). On October 27, 2010, the Company entered into amendments to the SVB Credit Facility, which extended the maturity date for the facility to October 20, 2011, adjusted the facility amount to have a Facility Limit of $900,000 with maximum advances determined based on the composition of the Company’s eligible accounts receivable and inventory balances and modified certain other provisions of the facility.





The SVB Credit Facility bears interest at an annual rate equal to the greater of prime plus 2.0% or 6.5%.   The SVB Credit Facility includes covenants requiring the achievement of specified financial ratios and thresholds and contains other terms and conditions customary for this type of credit facility. As of September 30, 2010, the Company was in compliance with these covenants. The SVB Credit Facility is collateralized by security interests in substantially all of the assets of the Company and is senior to the Founder’s Loan.





As of September 30, 2010, there were no borrowings outstanding under the SVB Credit Facility.





Founders’ Loan:The Company entered into a loan agreement with Lyle A. Berman, James T. Crawford, Arthur L. Lomax and Gehrig H. White on March 24, 2008. Messrs. Crawford, Lomax and White are the founders of the Company. Each of the lenders is also a member of the board of directors, with Mr. Berman serving as Chairman and Mr. White serving as Vice Chairman. The $2.0 million loan originally called for cash interest at 13% with all unpaid principal and interest payable on March 24, 2010.





On July 9, 2009, the Founders’ Loan was amended to provide that monthly interest payments may be made, at the election of the holder, in common stock at a 13% annual interest rate pursuant to a formula or cash at a 9% annual interest rate. In addition, the maturity date of the loan was extended to March 21, 2012.





On September 10, 2009, the Company entered into an agreement with Lyle A. Berman, James T. Crawford, and Arthur L. Lomax to convert an aggregate $1.2 million principal amount of the loans into common stock.





The loan contains no restrictive covenants and, following the conversion described above, is collateralized by security interests in 62 PokerPro systems. Such interests have been subordinated to the SVB Credit Facility.





As of September 30, 2010, the carrying value of the Founders’ Loan was $0.8 million and its fair value was approximately $0.8 million.





Capital Lease Obligation: During 2008, the Company entered into capital lease obligations totaling $73,273 to finance the purchase of a new internal-use ERP system. These capital lease obligations have a term of 36 months, resulting in monthly payments of $2,396. At the end of the lease term, the Company has the option to purchase the software for $101. The net book value of the assets under lease at September 30, 2010 was $56,777.  Related depreciation expense recognized during the three and nine months ended September 30, 2010 and September 30, 2009 was $13,089 and $39,267, respectively, resulting in accumulated depreciation of $100,290 at September 30, 2010.





During September 2010, the Company entered into a capital lease obligation totaling $29,000 to finance the purchase of equipment. This capital lease obligation has a term of 12 months, resulting in monthly payments of $3,452. At the end of the lease term, the Company has the option to purchase the software for $1. The net book value of the asset under lease at September 30, 2010 was $26,583.  Related depreciation expense recognized during the three months ended September 30, 2010 was $2,417, resulting in accumulated depreciation of $2,417 at September 30, 2010.





Note 10.  Employee Benefit Plan





The Company has established a salary deferral plan under Section 401(k) of the Internal Revenue Code covering substantially all employees. The plan allows eligible employees to defer up to 15% of their annual compensation, subject to annual limitations established by the IRS. The Company matches the contributions equal to 100% on the first 3% of the deferral and 50% on the deferral from 3% to 5%.  For the three months ended September 30, 2010 and September 30, 2009, the Company recorded contribution expense of $11,355 and $16,862, respectively.  For the nine months ended September 30, 2010 and September 30, 2009, the Company recorded contribution expense of $29,452 and $63,953, respectively.






9





Note 11.                       Shareholders’ Equity





Private Placement Transaction





During the quarter ended June 30, 2010, the Company and four officers and directors and five private investors entered into Subscription Agreements providing for the issuance by the Company and the purchase by the investors of a total of 536,137 shares of Common Stock for an aggregate purchase price of $260,000 in a transaction exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”), pursuant to Section 4(6) and Regulation 506 under the Securities Act. The five private investors each received 10,000 common stock warrants at an exercise price of $1.00 for a total issuance of 50,000 common stock warrants.  The shares of common stock and warrants were recorded as equity.





Lincoln Park Transaction





On June 24, 2010 and amended on September 27, 2010, the Company signed a $5 million purchase agreement with LPC, an Illinois limited liability company.





Upon signing the agreement, LPC purchased 100,000 shares of common stock at a price of $1.00 per share and the Company received $100,000 in initial proceeds under the purchase agreement.  The Company also issued a warrant to purchase an additional 100,000 shares of our common stock at an exercise price of $1.10 per share and containing a call provision exercisable by us in the event common shares trade above $3.00 per share for 20 consecutive days





The Company entered into a registration rights agreement with LPC whereby the Company agreed to file a registration statement related to the transaction within 20 days with the U.S. Securities & Exchange Commission (“SEC”) covering the shares that have been issued or may be issued to LPC under the purchase agreement.  After the SEC declared effective the registration statement related to the transaction, the Company has the right over a 30-month period to sell shares of common stock to LPC every two business days in the amount of $50,000.  This amount may be increased by $100,000 if the closing price of our shares is above $1.25, by $200,000 if the closing price is above $1.75, by $350,000 if the closing price is above $2.50 and by $500,000 if the closing price is above $3.75.





The purchase price of the shares related to the $4.9 million of future funding will be based on the prevailing market prices of our shares at the time of sales without any fixed discount and subject to the floor price.  The purchase price is determined based on the lesser of the lowest sale price on the purchase date or the average of the lowest three closing prices during the preceding 12 days.





In consideration for entering into the agreement, the Company issued to LPC 137,500 shares of our common stock.  The Company shall issue up to 180,000 common shares on a pro rata basis only if and when the Company sell additional shares to LPC. These shares shall be held by LPC for 30 months or until such time as the Purchase Agreement is terminated





The Company will control the timing and amount of any future sales of shares to LPC and is under no obligation to sell any additional shares to LPC.  The purchase agreement may be terminated by us at any time at our discretion and without any cost to us. Except for a limitation on variable priced financings, there are no negative covenants, restrictions on future fundings, penalties or liquidated damages in the agreement.  The proceeds received by us under the common stock purchase agreement are expected to be used for working capital purposes.





The registration statement related to the LPC transaction was declared effective by the SEC on November 10, 2010, and all conditions precedent to commencement under the purchase agreement have been generally satisfied.  The Company now has the right to sell shares of common stock to LPC every two business days, as described above.






10




Stock Incentive Plan





Option activity under the Company’s stock incentive plans for the nine months ended September 30, 2010 was as follows: Weighted AverageShares


Exercise

Price


Remaining

Contractual

Term


Aggregate

Intrinsic ValueOutstanding at January 1, 2010


2,078,299


$
2.48



-



-Granted


327,000



0.64



-



-Exercised


-



-



-



-Forfeited


(132,100
)


4.87



-



-Expired


-



-



-



-Outstanding at September, 2010


2,273,199


$
2.10



8.4


$
(3,413,499
)Exercisable at September 30, 2010


927,631


$
3.53



7.4


$
(2,716,460
)








Note 12.  Income taxes





For the three months ended September 30, 2010 and September 30, 2009, the Company recognized a tax provision of $14,188 and $19,117, respectively.  For the nine months ended September 30, 2010 and September 30, 2009, the Company recognized a tax provision of $52,795 and $83,087, respectively.  These provisions are based principally on the Company’s estimated foreign income tax withholding liability, which is attributable to revenues generated outside of the United States.





The effective rates for the periods ending September 30, 2010 and 2009 differ from the U.S. federal statutory rate principally because: (1) the tax benefit arising from the Company’s net operating losses are fully offset by the valuation allowance established against the Company’s deferred tax assets: and (2) the Company incurs withholding taxes.





Note 13.  Related Party Transactions





Transactions with Aristocrat





License fees from and equipment sales to Aristocrat of $54,180 and $834, respectively, were recorded in the three months ended September 30, 2010, while $100,831 and $107,782, respectively, were recorded during the three months ended September 30, 2009.  License fees from and equipment sales to Aristocrat of $174,999 and $3,974, respectively, were recorded in the nine months ended September 30, 2010, while $414,283 and $209,806, respectively, were recorded during the nine months ended September 30, 2009.  As of September 30, 2010 and December 31, 2009, $36,700 and $150,448, respectively, were due from Aristocrat and included in accounts receivable in the accompanying Consolidated Balance Sheets.  As of September 30, 2010 and December 31, 2009, $16,818 and $0, respectively, were due to Aristocrat and included in accounts payable in the accompanying Consolidated Balance Sheets.





The Company terminated its Exclusive Distribution Agreement and entered into an Equipment Purchase Arrangement with Aristocrat effective January 15, 2010. The Equipment Purchase Arrangement provides that the purchase price for the purchased equipment will be paid from the Company to Aristocrat as the purchased equipment is deployed and revenues are received by the Company. As revenues are received by the Company, the payment to Aristocrat will be calculated as 20% of the Company’s gross revenue attributable to each table, up to a specified cap per table.  The Company has recorded a liability of $396,500 related to its purchase of inventory, which is reflected in long-term liabilities-related party on the accompanying Consolidate Balance Sheet as of September 30, 2010.  No payments had been made to Aristocrat as of September 30, 2010.





The Company agreed to assume responsibility for (and take title to) certain PokerPro tables currently installed at specified customer locations. In return for transfer of these tables to the Company, the Company agreed to relieve Aristocrat of all responsibility and related costs to service, support, maintain, replace and repair those tables.





As of September 30, 2010 and December 31, 2009, Aristocrat owned 12.0% and 12.9%, respectively, of the Company’s common stock.





Transactions with ICP Electronics, Inc.





The Company purchased inventory and services from ICP Electronics, Inc. (“ICP”) for the nine month periods ended September 30, 2010 and September 30, 2009, of $405,697 and $316,014, respectively. As of September 30, 2010, $30,748 was due to ICP and included in accounts payable in the accompanying Consolidated Balance Sheets.  As of September 30, 2010, the Company had purchase obligations with ICP, Inc. totaling $239,417.  As of September 30, 2010 and December 31, 2009, ICP owned 4.6% and 4.9%, respectively, of the Company’s common stock. In August 2010, the Company amended its purchase commitment with ICP to immediately terminate its obligation to make the balance of 15 monthly payments of $39,389 in return for future deliveries of Heads-Up Challenge inventory in connection with its plan to exit the Amusement business.  Since the remaining inventory held by ICP will become obsolete and ultimately be scrapped, the Company agreed to make the following payments to ICP: $52,617.82 on August 5, 2010; $52,617.82 on September 1, 2010; and $52,617.83 on October 1, 2010.






11





Office Lease





The Company leases its office and manufacturing facility under an annual operating lease from an entity owned and controlled by the Company’s President and the Company’s Vice Chairman of the Board of Directors. The lease expires in August 2011. Rent expense recorded for the leased space for the three months ended September 30, 2010 and September 30, 2009, was $42,600 for both periods. Rent expense recorded for the leased space for the nine months ended September 30, 2010 and September 30, 2009, was $127,800 and $146,300, respectively.





Founders’ Loan





During the three months ended September 30, 2010 and September 30, 2009, the Company made $18,148 and $29,013, respectively, in aggregate interest payments in cash.  During the nine months ended September 30, 2010 and September 30, 2009, the Company made $54,049 and $136,574, respectively, in aggregate interest payments in cash.  Refer to Note 9, “Debt” for a description of the terms of this loan.





Note 14.  Segment Information





Following the Company’s exit from the Amusement business (see Note 3, “Discontinued Operations”), the Company has one reportable segment which is entirely focused on the gaming business.  The results of operations for the Amusement business have been reported as discontinued operations for all periods presented.





Revenues by Geographic Area





Revenues by geographic area are determined based on the location of the Company’s customers.  For the three months ended September 30, 2010 and 2009, sales to customers outside the United States accounted for 39% and 22% of the Company’s consolidated revenue, respectively.  For the nine months ended September 30, 2010 and 2009, sales to customers outside the United States accounted for 37% and 32% of the Company’s consolidated revenue, respectively.





The following provides financial information concerning the Company’s revenues by geographic area: Three months ended September 30,


Nine months ended September 30,2010


2009


2010


2009Revenue:United States

$
878,882


$
1,034,944


$
2,706,191


$
2,770,134North America, excluding U.S.


354,379



187,624



1,174,495



758,418Europe


76,093



28,631



157,809



258,242Other International


141,355



76,404



262,174



259,617$
1,450,709


$
1,327,603


$
4,300,669


$
4,046,411








Note 15.                       Commitments and Contingencies





Legal Proceedings





The Company is subject to claims and assertions in the ordinary course of business. Legal matters are inherently unpredictable and the Company's assessments may change based on future unknown or unexpected events.





On August 21, 2009, a complaint was filed against the Company in the United States District Court for the District of Nevada by Marvin Roy Feldman. The plaintiff is seeking unspecified monetary damages related to the Company's distribution of PokerPro in Mexico. Prior to filing the complaint, the plaintiff provided correspondence to the Company requesting $250,000 or four PokerPro tables as compensation. While litigation is inherently unpredictable and subject to judicial and other risks beyond the Company’s control, the Company estimates the potential cost of this matter to range between $0 and $250,000. The Company believes that it has several meritorious defenses to these claims and intends to defend itself vigorously.






12





Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations





Forward-Looking Statements





This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Statements expressing expectations regarding our future (including pending gaming and patent approvals) and projections relating to products, sales, revenues and earnings are typical of such statements and are made under the Private Securities Litigation Reform Act of 1995.  These forward-looking statements include, but are not limited to, statements about our plans, objectives, representations and contentions and are not historical facts and typically are identified by use of terms such as "may," "will," "should," "could," "expect," "plan," "anticipate," "believe," "estimate," "predict," "potential," "continue" and similar words, although some forward-looking statements are expressed differently.





All forward-looking statements are subject to the risks and uncertainties inherent in predicting the future.  Our actual results may differ materially from those implied in these forward-looking statements as a result of many factors, including, but not limited to, overall industry environment, customer acceptance of our products, delay in the introduction of new products, further approvals of regulatory authorities, adverse court rulings and litigation costs, production and/or quality control problems, the denial, suspension or revocation of permits or licenses by regulatory or governmental authorities, termination or non-renewal of customer contracts, amendment or termination of our loans, disruption of our relationships with our suppliers, competitive pressures, general economic and political conditions, such as political instability, credit market uncertainty, inflationary pressures, the rate of economic growth or decline in our principal geographic markets, each of which may be amplified by recent disruptions in the U.S. and global financial markets, our ability to access the capital markets, our exposure to foreign currency and operational complexities associated with foreign operations, and our financial condition.  These and other risks and uncertainties are described in more detail in our most recent Annual Report on Form 10-K, as well as other reports and statements that we file with the Securities and Exchange Commission.





Forward-looking statements speak only as of the date they are made and should not be relied upon as representing our views as of any subsequent date.  We undertake no obligation to update or revise such statements to reflect new circumstances or unanticipated events as they occur, except as required by applicable laws, and you are urged to review and consider disclosures that we make in this and other reports that we file with the Securities and Exchange Commission that discuss factors germane to our business.





Overview





We are engaged in the development, manufacture and marketing of electronic table games.   We currently market our PokerPro® product to casinos, cruise line operators, racinos, card clubs, and lotteries worldwide. We are also introducing additional games on our electronic table games platform, and have announced that Blackjack will be our first non-poker offering.





Over the past year, we have adjusted our marketing strategy to target those markets with less competition and more favorable conditions for electronic table games.  In connection with this transition, we increased our focus on penetrating international gaming markets, including Canada, Mexico, and Europe. We terminated Aristocrat’s exclusive distribution agreement in January 2010 and are marketing our products on a direct basis worldwide. We believe these changes allow us to focus our resources on those markets that offer the best opportunity to build a strong business.





In August 2010 we approved a plan to discontinue our amusement business to focus on our higher-margin gaming business.   We recognized $1.1 million in non-recurring charges in the second quarter of 2010 to reflect our amusement assets at net realizable value and to reflect an unfavorable purchase commitment. Excluding the non-recurring charges from the amusement business, results from our continuing gaming operations improved as a result of higher margins on the recurring revenues and lower operating expenses.





We are committed to increasing our penetration in our new target markets, continuing to control our spending and expect our financial results for 2010 to continue to improve as we execute our strategic plan. However, we have limited financial resources and our ability to raise capital on favorable terms is not known and may impact our ability to grow and to fully implement our strategic plans. We also expect economic sluggishness and tight credit markets to continue, which may impact revenues from existing customers as well as our ability to attract new customers. Changes in consumer confidence and spending and/or significant changes in the gaming and amusement markets or our ability to obtain financing could have a material impact on our future consolidated financial position, results of operations or cash flows.





Results of Operations for the Three Months Ended September 30, 2010 Compared to the Three Months Ended September 30, 2009





Revenues. Revenues increased by $0.1 million (9%) to $1.5 million for the three months ended September 30, 2010 as compared to $1.3 million for the three months ended September 30, 2009.   Revenues improved as we increased penetration in our target markets and shifted revenue producing assets from the United States to International markets, principally Mexico.





Gross Profit.  Gross profit increased by $0.5 million (87%) to $1.0 million for the three months ended September 30, 2010 as compared to $0.6 million for the three months ended September 30, 2009.  The increase in gross profit was primarily attributable to improved asset utilization and reduced depreciation and amortization.






13





Selling, General and Administrative Expenses.   Selling, general and administrative expenses (“SG&A”) increased by $0.1 million (9%) to $1.2 million for the three months ended September 30, 2010 as compared to $1.1 million for the three months ended September 30, 2009. SG&A has been essentially flat following expense reductions in 2008 and early 2009.  As a percentage of total revenues, SG&A expenses were 83% of total revenues for the three months ended September 30, 2010, compared with 84% of total revenues for the comparable period in 2009.





Research and Development Expenses.  Research and development expenses decreased by $8,054 (3%) to $264,703 for the three months ended September 30, 2010 as compared to $272,757 for the three months ended September 30, 2009. We continue to invest in software and hardware development to improve PokerPro and to develop our new ProCore platform. However, our cost reduction initiatives favorably impacted research and development expenses.





Depreciation. Depreciation decreased by $13,460 (28%) for the three months ended September 30, 2010 to $33,916 from $47,376 for the comparable period in 2009.  The decrease in depreciation was primarily attributable to certain assets being fully depreciated.





Interest Expense, net. Interest expense decreased $42,430 (56%) for the three months ended September 30, 2010 to $33,973 from $76,403 for the three months ended September 30, 2009.  The decrease was primarily attributable to the reduction in the principal balance of our Founders’ Loan from $2.0 million to $0.8 million on September 10, 2009, combined with lower interest rates. Interest expense for the three months ended September 30, 2010 was composed of the following items: Founders’ Loan interest of $18,148; loan origination and unused line fees associated with the credit line from Silicon Valley Bank totaling $13,358; and interest on our capital lease of $2,467.





Income Taxes. Income tax provision was $14,188 for the three months ended September 30, 2010 and $19,117 in the comparable period of 2009.  The decrease in income tax provision was attributable to reduced withholdings in foreign jurisdictions.




Net Loss from continuing operations. Net loss from continuing operations for the three months ended September 30, 2010 was $0.7 million, an improvement of $0.5 million (43%) from $1.2 million for the three months ended September 30, 2009.  Net loss from continuing operations per share, basic and diluted, was $0.05 per share for the three months ended September 30, 2010, an improvement of $0.05 (55%) per share from net loss per share, basic and diluted, compared to $0.10 for the comparable period of 2009. The decrease in net loss was attributable to improved revenue and margins and stable operating expenses.





Net Income from discontinued operations. Net income from discontinued operations for the three months ended September 30, 2010 was $32,215, an improvement of $135,118 (131%) from  a net loss of $102,903 for the three months ended September 30, 2009.  Net income from discontinued operations per share, basic and diluted, was $0.00 for the three months ended September 30, 2010, an improvement of $0.01 (125%) per share from net loss per share, basic and diluted, compared to $0.01 for the comparable period of 2009.





Net Loss. Net loss for the three months ended September 30, 2010 was $0.6 million, an improvement of $0.6 million (50%) from $1.3 million for the three months ended September 30, 2009.    Net loss per share, basic and diluted, was $0.04 per share for the three months ended September 30, 2010, an improvement of $0.07 (61%) per share from net loss per share, basic and diluted, of $0.11 for the comparable period of 2009. The decrease in net loss was attributable to our improved results from continuing gaming business.





Results of Operations for the Nine Months Ended September 30, 2010 Compared to the Nine Months Ended September 30, 2009





Revenues. Revenues increased by $0.3 million (6%) to $4.3 million for the nine months ended September 30, 2010 as compared to $4.0 million for the nine months ended September 30, 2009. Revenues improved as we increased penetration in our target markets and shifted revenue producing assets from the United States to International markets, principally Mexico.





Gross Profit.Gross profit increased by $1.0 million (58%) to $2.8 million for the nine months ended September 30, 2010 as compared to $1.7 million for the nine months ended September 30, 2009. The increase in gross profit was primarily attributable to improved asset utilization and reduced depreciation and amortization.





Selling, General and Administrative Expenses.   SG&A decreased by $0.7 million (16%) to $3.5 million for the nine months ended September 30, 2010 as compared to $4.2 million for the nine months ended September 30, 2009. This decrease was primarily due to lower salaries and other employee-related expenses as a result of the headcount reductions and other cost reduction initiatives.  As a percentage of total revenues, SG&A expenses were 82% of total revenues for the nine months ended September 30, 2010, compared with 104% of total revenues for the comparable period in 2009 on lower product sale revenues.





Research and Development Expenses.  Research and development expenses decreased by $0.1 million (13%) to $0.8 million for the nine months ended September 30, 2010 as compared to $0.9 million for the nine months ended September 30, 2009. We continue to invest in software and hardware development to improve PokerPro and to develop our new ProCore platform. However, our cost reduction initiatives favorably impacted research and development expenses.





Depreciation. Depreciation decreased by $40,258 (27%) for the nine months ended September 30, 2010 to $107,621 from $147,879 for the comparable period in 2009.  The decrease in depreciation was due primarily to certain assets being fully depreciated.





Interest Expense, net. Interest expense, net decreased $154,128 (60%) for the nine months ended September 30, 2010 to $103,546 from $257,674 for the nine months ended September 30, 2009.   The decrease was primarily attributable to the reduction in the principal balance of our Founders’ Loan from $2.0 million to $0.8 million on September 10, 2009, combined with lower interest rates. Interest expense for the nine months ended September 30, 2010 was composed of the following items: Founders’ Loan interest of $53,852; loan origination and unused line fees associated with the credit line from Silicon Valley Bank totaling $45,732; and interest on our capital lease of $4,027.






14





Income Taxes. Income tax provision was $52,795 for the nine months ended September 30, 2010 and $83,087 for the comparable period of 2009.  The decrease in income tax provision was attributable to reduced withholdings in foreign jurisdictions.





Net Loss from continuing operations.   Net loss from continuing operations for the nine months ended September 30, 2010 was $2.4 million, an improvement of $2.1 million (47%) from $4.4 million for the nine months ended September 30, 2009.  Net loss per share, basic and diluted, was $0.16 per share for the nine months ended September 30, 2010, an improvement of $0.23 (59%) per share from net loss per share, basic and diluted, of $0.39 for the comparable period of 2009.  The decrease in net loss was attributable to improved revenue and margins and stable operating expenses.





Net Loss from discontinued operations.   Net loss from discontinued operations for the nine months ended September 30, 2010 was $1.2 million, an increase of $0.9 million (293%) from $0.3 million for the nine months ended September 30, 2009.  Net loss per share, basic and diluted, was $0.08 per share for the nine months ended September 30, 2010, a decrease of $0.05 (204%) per share from net loss per share, basic and diluted, of $0.03 for the comparable period of 2009.  The increase in net loss was primarily attributable to the $1.1 million in non-recurring charges recognized to reduce the Amusement assets to net realizable value and to recognize an unfavorable purchase commitment.





Net Loss.   Net loss for the nine months ended September 30, 2010 was $3.5 million, an improvement of $1.2 million (25%) from $4.7 million for the nine months ended September 30, 2009.  Net loss per share, basic and diluted, was $0.24 per share for the nine months ended September 30, 2010, an improvement of $0.18 (42%) per share from net loss per share, basic and diluted, of $0.42 for the comparable period of 2009.  The decrease in net loss was attributable to the improved results from continuing gaming business, partially offset by the $1.1 million in non-recurring charges from the Amusement segment.





Liquidity and Capital Resources





We have incurred net operating losses since inception and operating expenses may continue to exceed revenues. We have typically funded our operating costs, research and development activities, working capital investments and capital expenditures associated with our growth strategy with proceeds from the issuances of our common stock, as well as through credit arrangements from financial institutions and a loan from certain members of our Board of Directors.




Discussion of Statement of Cash Flows Nine Months Ended September 30,2010


2009


ChangeNet cash used in operating activities

$
(70,875
)

$
(1,887,457
)

$
1,816,582Net cash provided by (used in) investing activities


(2,883
)


3,898,529



(3,901,412
)Net cash provided by (used in) financing activities


259,410



(2,383,075
)


2,642,485Net increase (decrease) in cash and cash equivalents


185,652



(372,003
)


557,655Cash and cash equivalents, beginning of year


636,374



1,481,530Cash and cash equivalents, end of period

$
822,026


$
1,109,527





For the nine months ended September 30, 2010, net cash used in operating activities was $0.1 million, as compared to $1.9 million for the nine months ended September 30, 2009, a decrease of $1.8 million.  The improvement in cash used in operating activities was primarily due to the reduction in net loss and management of working capital spending.





Net cash used in investing activities was $2,883 for the nine months ended September 30, 2010, compared to cash provided by investing activities of $3.9 million for the nine months ended September 30, 2009.  During 2010, net cash used in investing activities is attributable to minor capital expenditures.  During 2009, net cash provided by investing activities was primarily investments and redemptions of our auction rate securities (“ARS”) portfolio.





Net cash provided by financing activities was $0.3 million for the nine months ended September 30, 2010 compared to net cash used in financing activities of $2.4 million for the nine months ended September 30, 2009.  During 2010, we entered into a private placement resulting in net proceeds of $260,000 and also entered into a Purchase Agreement, as amended, with Lincoln Park Capital Fund LLC (“LPC”) resulting in initial cash proceeds of $100,000. We incurred expenses related to the LPC agreement of $75,885.  The proceeds from issuances of common stock were partially offset by payments on capital lease obligations totaling $24,705. During 2009, we liquidated our UBS Credit Facility in connection with the sale of our ARS investment.






15





We have $0.8 million of debt outstanding under our Founder’s Loan following the issuance of 1,445,784 shares of common stock to liquidate $1.2 million of the original $2.0 million loan.  The remaining $0.8 million has a maturity date of March 21, 2012 and provides that monthly interest payments, at the election of the holder, may be made in our common stock at a 13% annual interest rate pursuant to a formula or cash at a 9% annual interest rate.




We have a credit facility with Silicon Valley Bank to provide working capital financing.  The credit facility has a maturity date of October 20, 2011 and a Facility Limit of $0.9 million with maximum advances determined based on the composition of our eligible accounts receivable.  The credit facility bears interest at an annual rate equal to the greater of prime plus 6.5% or prime plus 2.0%.  There were no amounts drawn on the SVB Credit Facility as of September 3, 2010.





We have the ability to impact the timing and extent of our cash needs primarily by managing the pace of growth and managing our operating expenses. However, we also have significant contractual obligations and our ability to control both the timing and extent of the cash needs of the business is not unlimited, particularly in light of the current economic climate and the capital intensive nature of the PokerPro business. As we expand our international business, we may also incur additional import duties, taxes, legal, professional fees, overhead costs, and working capital needs that could impact our ability to grow and manage liquidity.





Our intent is to balance revenue growth with operating expense and working capital management, while carefully monitoring the impact of growth on our cash needs and cash balances. Accordingly, reductions in our working capital investments or declines in demand for our products or continued deterioration in general economic conditions could impact our ability to grow or to effectively manage our liquidity needs.





Based on our current capital structure and our anticipated growth plans, we may continue to explore various alternatives to fund our growth, which may include raising additional funds through public or private offerings of our securities, obtaining additional credit facilities, converting our debt, or seeking alternative sources of financing, which may or may not be available on favorable terms, if at all. If such sources of capital are not available, we may seek other avenues to fund the business, including sale/leaseback arrangements, transitioning our products from a capital intensive leasing strategy to a product sale strategy, seeking to sell our assets, or reducing our operations. If we decide to raise additional capital in the equity markets or take other actions, shareholders could incur significant dilution, or, if we are unable to raise capital, our ability to effectively operate our business could be impaired.





Contractual Obligations





The table below sets forth our known contractual obligations as of September 30, 2010: Total


Less than

1 year


1 - 3 years


3 - 5 years


More than

5 yearsDebt obligations(1)

$
908,000


$
72,000


$
836,000


$
-


$
-Operating lease obligations(2)


139,786



139,786



-



-



-Capital lease obligations(3)


51,005



51,005



-



-



-Purchase obligations(4)


244,837



244,837



-



-



-Other long-term liabilities(5)


396,500



19,500



377,000



-



-Total

$
1,740,128


$
527,128


$
1,213,000


$
-


$
-






(1)
Represents the outstanding principal amount and interest on our Founder’s Loan.(2)
Represents operating lease agreements for office and storage facilities and office equipment.(3)
Represents outstanding principal and interest payable under capital lease obligations related to our purchase of internal-use ERP system and gaming equipment.(4)
Represents open purchase orders with our vendors, primarily purchase obligations for gaming inventory.(5)
Represents purchase of gaming inventory from Aristocrat.


Contractual obligations decreased to $1.7 million as of September 30, 2010 from $2.1 million as of December 31, 2009 due principally to a decrease in the level of inventory purchase commitments and lease obligations.





Customer Dependence





As of September 30, 2010, five of our customers made up approximately 59% of our total revenues.  The loss of any of these customers or changes in our relationship with them could have a material adverse effect on our business.






16





Critical Accounting Policies





We follow accounting principles generally accepted in the United States in preparing our financial statements, which require us to make certain estimates and apply judgments that affect our financial position and results of operations. We continually review our accounting policies and financial information disclosures. A summary of our significant accounting policies that require the use of estimates and judgments in preparing the financial statements was provided in our Annual Report on Form 10-K for the year ended December 31, 2009. During the nine months ended September 30, 2010 there were no material changes to the accounting policies and assumptions previously disclosed.





Recent Accounting Pronouncements





In January 2010, the FASB issued an amendment to the fair value measurement and disclosure standard improving disclosures about fair value measurements. This amended guidance requires separate disclosure of significant transfers in and out of Levels 1 and 2 and the reasons for the transfers. The amended guidance also requires that in the Level 3 reconciliation, the information about purchases, sales, issuances and settlements be disclosed separately on a gross basis rather than as one net number. The guidance for the Level 1 and 2 disclosures was adopted on January 1, 2010, and did not have an impact on our consolidated financial position, results of operations or cash flows. The guidance for the activity in Level 3 disclosures is effective January 1, 2011, and will not have an impact on our consolidated financial position, results of operations or cash flows as the amended guidance provides only disclosure requirements. We had no transfers between Level 1, 2, or 3 inputs during the nine months ended September 30, 2010.





In February 2010, the FASB issued amended guidance on subsequent events. Under this amended guidance, SEC filers are no longer required to disclose the date through which subsequent events have been evaluated in originally issued and revised financial statements. This guidance was effective immediately, and we adopted these new requirements for the quarter ended March 31, 2010.





Subsequent Events





On October 27, 2010, we entered into amendments to the SVB Credit Facility, which extended the maturity date for the facility to October 20, 2011, adjusted the facility amount to have a Facility Limit of $900,000 with maximum advances determined based on the composition of our eligible accounts receivable and inventory balances and modified certain other provisions of the facility.





The registration statement related to the LPC transaction was declared effective by the SEC on November 10, 2010, and all conditions precedent to commencement under the purchase agreement have been generally satisfied.  The Company now has the right to sell shares of common stock to LPC every two business days, as provided in the purchase agreement.




Off-Balance Sheet Arrangements





We have no off-balance sheet arrangements.




Item 3.    Quantitative and Qualitative Disclosures about Market Risk.





Reference is made to “Part II, Item 7A, Quantitative and Qualitative Disclosures about Market Risk,” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009.  There have not been significant changes in our exposure to market risk since December 31, 2009.





Item 4.   Controls and Procedures.





Disclosure Controls and Procedures





We maintain disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) that are designed to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.





As of September 30, 2010, an evaluation of the effectiveness of our disclosure controls and procedures was conducted under the supervision of, and reviewed by, our Chief Executive Officer and Chief Financial Officer. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer has concluded that our disclosure controls and procedures were effective as of September 30, 2010 to enable us to record, process, summarize, and report in a timely manner the information that we are required to disclose in our Exchange Act reports and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.






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Changes in Internal Control over Financial Reporting





We have been making changes to our internal controls during 2010 in connection with the implementation of the inventory, fixed asset, MRP and other modules of our new ERP system in order to address previously identified significant deficiencies in internal control. We have also made enhancements to our disclosure process to improve our control environment.  During 2010, we are continuing to formalize and test those new procedures and controls in connection with the transition to the new system.  Our management does not believe that these significant deficiencies are indicative of a material weakness in our internal control over financial reporting.  We believe that the changes to our internal control over financial reporting during the quarter ended September 30, 2010 have enhanced our internal control over financial reporting.  We can provide no assurance that all significant deficiencies will be resolved by the new systems and controls.  These significant deficiencies have been reported to our Audit Committee by our management and to our independent registered public accounting firm.
  PART II – OTHER INFORMATION





Item 5.     Other Information





On July 1, 2010, we received a letter from The NASDAQ Stock Market indicating that the closing bid price of our common stock had fallen below $1.00 for the 30 consecutive business days from May 19, 2010 to June 20, 2010, and therefore, we were not in compliance with NASDAQ Listing Rule 5550(a)(2) as of July 1, 2010.  NASDAQ provides an automatic 180 day grace period, through December 28, 2010, to regain compliance with the Bid Price Rule by maintaining a closing bid price of $1.00 per share for a minimum of 10 consecutive business days. At that time, if we have not regained compliance, we may receive a notice of delisting from NASDAQ, which is appealable to a hearing panel. Alternatively, we may at that time be eligible for an additional grace period of 180 days if we meet the initial listing standards, with the exception of bid price, for The NASDAQ Capital Market.





On August 5, 2010, our Board of Directors approved a plan to exit our Amusement business consisting of the manufacture and sale of Heads-Up Challenge units. Our strategic plan is to focus on expanding our higher margin gaming business. Our decision to exit the Amusement business, which has generated consistently declining revenues over the past few years and in management’s view, has a shrinking market, is consistent with this strategy. We expect to complete the exit from our Amusement business by March 31, 2011.





In connection with management’s evaluation of the Amusement business, which led to the decision to discontinue the business, management evaluated the trend of declining selling prices and margins in the first half of 2010 and determined the carrying value of the Amusement assets required adjustment to reflect those assets at the lower of cost or market. In addition, our obligation to purchase additional Amusement product was determined to be an unfavorable purchase commitment requiring recognition in the financial statements as of June 30, 2010.





Beginning with the current reporting period, the Amusement segment is treated as discontinued operations under generally accepted accounting principles, and all prior periods will be recast to reflect discontinued operations treatment.





Pursuant to an Amendment to Inventory Purchase Commitment, dated August 5, 2010, between us and ICP Electronics, Inc. (“ICP”), the parties agreed that our obligation to make the balance of 15 monthly payments of $39,389 in return for future deliveries of Heads-Up Challenge inventory would be terminated immediately.  As part of the Amendment, ICP agreed to complete assembly and ship the 141 Heads-Up Challenge units previously paid for by us in accordance with a shipping schedule to be mutually agreed upon by ICP and us.  In addition, since the remaining inventory held by ICP will become obsolete and ultimately be scrapped, we agreed to make the following payments to ICP: $52,617.82 on August 5, 2010; $52,617.82 on September 1, 2010; and $52,617.83 on October 1, 2010.





On August 27, 2010, we entered into the Third Amendment to our Loan and Security Agreement (the “Amendment”) with Silicon Valley Bank (“SVB”). We established this Loan and Security Agreement with SVB on July 25, 2008 (the “Credit Facility”), which was previously amended on or about December 23, 2008 and on or about July 23, 2009.





The Credit Facility, as amended, extended the maturity date for the Credit Facility to October 21, 2010, reduced the Facility Limit to One Million Two Hundred Fifty Thousand Dollars ($1,250,000) with maximum advances determined based on the composition of our eligible accounts receivable and modified certain other provisions of the Credit Facility.  Under the Loan and Security Agreement portion of the Credit Facility, we may advance up to 80% of eligible domestic accounts receivable. The total face amount of domestic accounts receivable eligible for advance may not exceed the Facility Amount of $1,250,000.





The Applicable Rate remains unchanged at the greater of Prime Rate plus 2.00% or 6.50, and the Unused Commitment Fee remains unchanged at .50% per annum of the average unused portion of the Total Commitment Amount and the Credit Facility continues to require the attainment of certain restrictive covenants, including the maintenance of an Adjusted Quick Ratio of 1.00 to 1.00.






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On September 27, 2010, we executed an Amended and Restated Purchase Agreement with Lincoln Park Capital Fund, LLC (“LPC”), amending the $5 million purchase agreement with LPC that we signed on June 24, 2010, to make clear that LPC does not have the ability to make an investment decision after the filing of our registration statement on Form S-1 and that LPC is irrevocably bound to purchase the securities underlying the put. In addition, under the amended and restated purchase agreement LPC does not have the right to terminate the agreement upon the occurrence of an event of default.





Item 6.     Exhibits.





Exhibit No.

Description10.1

Amendment to Inventory Purchase Commitment, dated August 5, 2010, between us and ICP Electronics, Inc. (incorporated by reference to Exhibit 10.1 from our Form 8-K filed on August 10, 2010).10.2

Third Amendment to Loan and Security Agreement, dated August 27, 2010, between us and Silicon Valley Bank.10.3

Amended and Restated Purchase Agreement dated as of September 27, 2010, by and between us and Lincoln Park Capital Fund, LLC (incorporated by reference to Exhibit 10.1 from our Form 8-K filed on September 28, 2010).31.1

Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1

Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.








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SIGNATURES





Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.





POKERTEK, INC.Date: November 15, 2010/s/ Mark D. RobersonMark D. RobersonChief Executive Officer and Chief FinancialOfficer(Principal Executive Officer, Principal Financial

Officer and Principal Accounting Officer)








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POKERTEK, INC.


EXHIBIT INDEX





Exhibit No.

Description10.1

Amendment to Inventory Purchase Commitment, dated August 5, 2010, between us and ICP Electronics, Inc. (incorporated by reference to Exhibit 10.1 from our Form 8-K filed on August 10, 2010).10.2

Third Amendment to Loan and Security Agreement, dated August 27, 2010, between us and Silicon Valley Bank.10.3

Amended and Restated Purchase Agreement dated as of September 27, 2010, by and between us and Lincoln Park Capital Fund, LLC (incorporated by reference to Exhibit 10.1 from our Form 8-K filed on September 28, 2010).31.1

Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1

Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.