**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-KSB**


**(Amendment
            No. 1)**




(Mark
      One)


x
            Annual
                report under Section 13 or 15(d) of the Securities Exchange Act of
                1934
                for the fiscal year ended January 1,
                2006





o
            Transition
                report under Section 13 or 15(d) of the
                Securities


Exchange
      Act of 1934 for the transition period from ____ to______.








Commission
      file number: 000-49862





PROCERA
                NETWORKS, INC.(Name
                of small business issuer in its charter)








Nevada
            
            33-0974674(State
                or other jurisdiction of incorporation or organization)
            
            (IRS
                Employer Identification No.)








100
                Cooper Court, Los Gatos, California
            
            95032(Address
                of principal executive offices)
            
            (Zip
                Code)





Issuer's
                telephone Number
            (408)
                354-7200


Securities
      registered under Section 12(b) of the Exchange Act:





Common
                Stock, $0.001 par value Common
            
            OTCBB(Title
                of class)
            
            (Name
                of exchange on which registered)





Check
      whether the issuer is not required to file reports pursuant to Section 13 or
      15
      (d) of the Exchange Act. o





Check
      whether the issuer: (1) filed all reports required to be filed by Section 13
      or
      15(d) of the Exchange Act during the past 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





Check
      if
      there is no disclosure of delinquent filers in response to Item 405 of
      Regulation S-B contained in this form, and no disclosure will be contained,
      to
      the best of registrant’s knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-KSB or any
      amendment to this form 10-KSB. o





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





State
      issuer’s revenue for its most recent fiscal year: $254,800 for the fiscal year
      ended January 1, 2006.





The
      aggregate market value of common shares of voting and non-voting common shares
      held by non-affiliates, based on the average of the bid and asked price of
      the
      common stock as of March 30, 2006, was $21,954,505. Shares of common stock
      held
      by each officer, director and holder of 5% or more of the outstanding common
      stock have been excluded in that such persons’ may be deemed to be affiliates.
      This determination of affiliate status is not necessarily a conclusive
      determination for other purposes.




State
      the
      number of shares outstanding of each of the issuer's classes of common equity,
      as of the latest practicable date: The registrant had 45,965,342 shares of
      common stock outstanding as of March 30, 2006.




DOCUMENTS
      INCORPORATED BY REFERENCE: None





Transitional
      Small Business Disclosure Format (Check one):     Yes o ;      
      No x










**TABLE
      OF CONTENTS**





PagePART
                IItem
                1
            Description
                of Business
            4Item
                2
            Description
                of Property
            14Item
                3
            Legal
                Proceedings
            14Item
                4
            Submission
                of Matters to a Vote of Security
                Holders
            15PART
                IIItem
                5
            Market
                for Common Equity and Related Stockholder
                Matters
            15Item
                6
            Management's
                Discussion and Analysis of Financial Condition and
                Results of Operation
            17Item
                7
            Financial
                Statements
            24Item
                8
            Changes
                in and Disagreements with Accountants on Accounting and
                Financial Disclosures
            52Item
                8A
            Controls
                and Procedures
            53Item
                8B
            Other
                Information
            53PART
                IIIItem
                9
            Directors,
                Executive Officers, Promoters and Control Persons;
                Compliance with Section 16(A) of the Exchange Act
            53Item
                10
            Executive
                Compensation
            56Item
                11
            Security
                Ownership of Certain Beneficial Owners and Management
                and Related Stockholder Matters
            57Item
                12
            Certain
                Relationships and Related
                Transactions
            58Item
                13
            Exhibits
            58Item
                14
            Principal
                Accountant Fees and Services
            58Signatures
            60Index
                to Exhibits
            61Certification




**PART
      I**




This
      report contains forward-looking statements within the meaning of Section 21E
      of
      the Securities Exchange Act of 1934 (the "Exchange Act"). We have based these
      forward-looking statements largely on our current expectations and projections
      about future events and financial trends affecting the financial condition
      of
      our business. These forward-looking statements are subject to a number of risks,
      uncertainties and assumptions, including, among other things:





-
            general
                economic and business conditions, both nationally and in our
                markets,


-
            our
                history of losses,


-
            our
                expectations and estimates concerning future financial performance,
                financing plans and the impact of
                competition,


-
            our
                ability to implement our growth
                strategy,


-
            anticipated
                trends in our business,





3
 *Table
            of Contents*





-
            advances
                in technologies, and


-
            other
                risk factors set forth under "Risk Factors" in this
                prospectus.





In
      addition, in this report, we use words such as "anticipates," "believes,"
      "plans," "expects," "future," "intends," and similar expressions to identify
      forward-looking statements.





Procera
      Networks, Inc. (“Procera” or the “Company”) undertakes no obligation to update
      publicly or revise any forward-looking statements, whether as a result of new
      information, future events or otherwise after the date of this prospectus.
      In
      light of these risks and uncertainties, the forward-looking events and
      circumstances discussed in this prospectus may not occur and actual results
      could differ materially from those anticipated or implied in the forward-looking
      statements.





**ITEM1.**
            **BUSINESS**





**History**





Procera
      Networks, Inc., a Delaware corporation (“PNI”), was incorporated on May 1, 2002
      to provide the corporate structure for a spinout of a small team of
      technologists, intellectual property and experienced managers led by Douglas
      J.
      Glader from Digi International of Eden Prairie, Minnesota (“Digi”). PNI’s
      intended business was developing and marketing intelligent network products
      that
      provide a non-intrusive, wire-speed network overlay to protect, control and
      optimize IP-based network traffic. Initial operations were partially financed
      by
      Digi.





On
      October 16, 2003, PNI merged with Zowcom, Inc., a Nevada corporation previously
      founded on July 11, 2001, in a stock-for-stock transaction. After the merger,
      Zowcom was the surviving corporation and assumed the operations and the business
      plan of PNI and the stockholders of PNI became the stockholders of Zowcom.
      Zowcom changed its name to Procera Networks, Inc. (“Procera” or the “Company”).
      Procera’s trading symbol is: OTC: BB:PRNW.OB





Procera
      spent the years of 2002 through 2004 refining its product vision and
      implementing the first two commercial products that embodied its vision. These
      products were the OptimIPTM 2402 (“2402”) and the OptimIPTM 12012 (“12012”). Thus,
      by the end of 2004, Procera was ready to take its first two products to market.





The
      first
      significant action taken by Procera to prepare to take its current and new
      products to market was to recruit Mr. Gary Johnson as Senior Vice President
      of
      Sales and Marketing in November 2004. In the first half of 2005, Mr. Johnson
      hired and trained a sales team in North America, Latin America, Japan and
      Europe. Over the course of the second half of 2005, the sales team in
      conjunction with the Company’s technical staff worked closely with prospective
      customers to find the particular niches that were served best by the Company’s
      initial offerings of products. While the Company gained some attention in
      certain vertical markets/applications it did not in others. In general, the
      vertical markets that were most receptive to the Company’s product offerings,
      such as hospitality, multi-tenant residential and commercial, and wireless
      infrastructure, were looking for solutions that the 2402 and 12012 could fill
      with a very minimum of customization and systems integration work. The vertical
      markets that were least receptive to the Company’s initial products were those
      that had requirements that were too demanding for the 2402 and 12012 products.
      That is, the Company learned that its initial product offerings while built
      on
      the right concept, did not have sufficient value relative to entrenched
      competition to be useful in all applications originally envisioned by the
      Company. The 2402 and 12012 products were the first products to embody the
      Company’s vision, and contained many but not all of the product features needed
      to address all applications/vertical markets where the Company’s concept will
      ultimately be beneficial. As a result of this market feedback in 2005, the
      Company took two significant actions.





**First** ,
      the
      Company commenced development of its next generation product, the converged
      platform product known as the 3600 family of products (the ‘3600’). This product
      tightly integrates a generic server with the Company’s intelligent switching
      capability. The integration is facilitated by using an XML transition layer
      that
      is operating system agnostic. The 3600 will run any number of “best of breed”
software point products normally found in server based network appliances.
      By
      tightly coupling the functionality of software only products to Procera’s policy
      driven intelligent switching fabric, only packets that need to be processed
      by
      the software running on the server are processed at the slow server speeds.
      All
      other packets can be passed through the 3600 switch fabric at wire speed. This
      has the effect of vastly increasing the throughput and scalability of the
      software running in the 3600. The 3600 product has been reviewed by Gartner
      Group, the Yankee Group, Frost and Sullivan, a large system integrator and
      several small software companies, and all strongly affirmed the product concept.
      The first 3600 product to be extensively tested is being delivered for
      particular applications found extensively in Japan. This version of the 3600
      is
      running third party software that can block a particularly invasive peer-to-peer
      software prevalent in Japan and was extensively tested at IT-4 Labs in Japan
      under the supervision of two large Japanese distributors in the summer and
      fall
      of 2005. We
      hope
      to enter into a business relationship with one of these Japanese distributors
      in
      the near term and discussions are progressing at the second distributor.A second version of the 3600 product running third party software that
      provides true two-factor authentication for ultra secure internet transactions
      such as on line banking was released in January 2006.





4
 *Table
            of Contents*





**Second** ,
      the
      Company has focused its sales effort for the 2402 and 12012 products on a
      substantially more select group of customers than in the past. The Company
      learned in 2005 that the 2402 and the 12012 have most if not all of the
      functionality needed to provide a compelling value proposition for many
      functions in the hospitality and multi-tenant environments and in some wireless
      installations. In these applications, many users are competing for limited
      bandwidth. For example in today’s hotel operations, internet connection is
      provided to all guests at a fixed price regardless of how much bandwidth a
      particular guest ends up using. Yet there is a fixed bandwidth for all users
      in
      the hotel. In this environment, some users can “hog” the bandwidth by getting on
      the network and running applications, such as downloading movies, which use
      up
      most of the available bandwidth. The 2402 and 12012 allow hoteliers to customize
      the bandwidth received by each guest and allows the hotel operators, if they
      choose, to charge different amounts for different bandwidth availability. The
      situation is much the same in wireless “hot spots”.




**Industry
      Background**





The
      explosive growth of the Internet over the past decade has had many benefits
      for
      end users and the economy generally. Yet along with all of the good, some
      hitherto unimaginable problems have materialized. Corporations are faced with
      an
      ever-increasing need to protect their network from threats, which can compromise
      the integrity of the network. For example, in today’s work environment, the
      Internet has enabled a significant amount of computer network usage completely
      unrelated to the business of the employer. The misuse and abuse of the corporate
      network asset is rampant and poses significant legal liabilities as employees
      play video games, download music, buy and sell stocks, visit gambling and
      pornographic websites, check their personal e-mail and use their employer's
      computer network for many other purposes unrelated to their employment or the
      business of their employer. Another “revolutionary” industry changing phenomenon
      has been the recently mandated requirement for public corporations to manage,
      and meet Sarbanes-Oxley compliance. The combination of these factors has driven
      the need for new levels of intelligence ‘inside’ the network to eliminate,
      control or secure the content being passed through the corporate network. The
      costs of bandwidth, network management, lost productivity, and network misuse
      and abuse far outweigh the initial costs of the application and networking
      infrastructure. Following are some of the foremost problems that companies
      face
      in today’s network-enabled business environments:





·
            Compliance
                with government regulatory requirements and corporate policies requires
                archiving and retention of business communications. A network-driven
                compliance strategy can keep executives out of legal jeopardy while
                ensuring storage systems are not filled with junk
                data.


·
            Network
                misuse and abuse causes significant costs from lost productivity
                and lost
                business. The average 100-employee firm loses over $750,000 per year
                from
                network misuse and abuse.


·
            Companies
                may be liable for non-business and inappropriate use of network resources
                such as peer-to-peer music downloading, pornography, etc. Controlling
                or
                eliminating non-business usage has become a business
                imperative.


·
            Most
                business networks are secured from the outside in, leaving corporate
                LANs,
                WANs and WLANs relatively open to attacks from the inside and insider
                misuse. Additional network security behind the firewall is required
                to
                control insider fraud as well as the introduction of viruses, worms
                and
                other network-borne abuse.


·
            LAN/WAN
                speeds are miss-matched: WAN-width is more expensive than LAN-width,
                so
                many companies have implemented WAN-facing optimization schemes.
                However,
                real-world network performance is largely dependent on the latency
                and
                congestion of the underlying LAN/WAN
                infrastructure.


·
            IP-based
                networks are being deployed as converged topologies for data, streaming,
                video and mission-critical business applications. Delay-sensitive
                and
                time-constrained applications such as VOIP (voice over IP), audio/video
                streaming media, etc. require high bandwidth and consistent performance.
                Meanwhile, the performance and response time of transactional ERP,
                database and Citrix applications are subject to network congestion
                and
                bottlenecks. Network optimization systems are required to intelligently
                optimize, prioritize and control these converged networks and the
                applications that run on them.


·
            The
                cost and management complexity of network solutions to enable compliance,
                control content, provide security and optimize performance are increasing.
                Integrated solutions are required instead of disparate
                products.





5
 *Table
            of Contents*





As
      a
      result of these problems, many business applications do not perform efficiently
      or even reliably over IP-based networks without massive over-provisioning.





**The
      Procera Product Vision**





The
      foregoing problems represent the business opportunity that Procera identified
      early in its life and is now building out a series of progressively more
      sophisticated products to address. The Procera vision is to design and sell
      a
      family of products that identify application traffic being carried over a
      network at wire speed through hardware based deep-packet inspection of each
      packet and offer the user the ability to route and process each packet based
      on
      policies that can be revised in real time. The vision calls for products that
      seamlessly integrate with existing network infrastructures and
      equipment.





**Procera’s
      Initial Product Offerings**





Procera’s
      initial products combine wire-speed, port based networking hardware, with
      Procera’s software modules, available in a range of configurations for usage
      control, internal protection, archiving, compliance and application
      acceleration. The 2402 “edge product” provides up to 8.4 Gbps of throughput,
      while the 12012 gigabit “core product”, provides up to 24 Gbps of throughput.
      The proprietary value added for those products lies to some considerable degree
      in Procera’s three software modules that are sold in conjunction with the 2402
      and the 12012. The OptimIPTM Application Accelerator, OptimIPTM Network Protector
      and the OptimIPTM Compliance Executive feature sets are each described below. All
      products are managed through an intuitive graphical user interface that can
      implement and match companies’ corporate content and security policies into
      their network.





***OptimIPTM
      Application Accelerator:*** The
      OptimIPTM Application Accelerator works harmoniously with WAN network
      optimization and bandwidth-management systems enabling IT groups to
      transparently manage overall quality of service, bandwidth, and application
      prioritization to maximize the ROI of existing corporate and campus networks.





The
      OptimIPTM Application Accelerator helps existing Ethernet networks run mission
      critical applications more efficiently when bandwidth is constrained within
      the
      LAN. Besides better business based usage of the network, it also has significant
      cost savings to organizations which can prioritize vital business data, instead
      of purchasing additional bandwidth. The OptimIPTM solution enables multiple
      applications with different performance characteristics to work efficiently
      and
      interdependently. This ensures that internal networks perform with greatly
      reduced latency with existing bandwidth and equipment. Delay-sensitive and
      time-constrained applications such as VoIP and multimedia streaming require
      timely delivery and consistent network services. Additionally, ERP, CRM,
      database, Citrix, and other business applications are particularly sensitive
      to
      network congestion and thus dependent on the effective allocation of bandwidth.
      The OptimIPTM Application Accelerator ensures that business-critical applications
      receive appropriate network priority, while less important network traffic
      can
      be rate limited in order to align the network usage with the organization’s
      priorities (i.e. mission critical applications get top priority).


***OptimIPTM
        Network Protector:*** The
        OptimIPTM Network Protector restricts the misuse of personal applications,
        controls network bandwidth abuse, and ensures that mission-critical
        applications, such as VoIP, Citrix, database and ERP systems, execute
        consistently and reliably with highest possible performance.
 
 Procera's
        new OptimIPTM Network Protector can process up to 24 Gbps of sustained throughput
        at network speeds without introducing latency and provide guaranteed service
        levels for VoIP, streaming media and business-critical applications, such
        as
        ERP/MRP, database and other transaction-intensive applications -- all using
        existing bandwidth, LAN topologies and network equipment.
 
 Procera's
        OptimIPTM Network Protector provides LAN/WAN bandwidth management through rate
        limiting, with granular flow control down to 64 Kbit increments, eight priority
        queues, and managed bandwidth for latency- and congestion-sensitive
        applications, quality of service compatible with 802.1p, TOS, and DiffServ
        QoS
        topologies, and per-port and per-flow expert policy control -- all easily
        configurable from a graphical dashboard.
 
 ***OptimIPTM
        Compliance Executive:*** The
        OptimIPTM Compliance Executive includes the functionality of the OptimIP
        Application Accelerator and the Network Protector and adds selective
        surveillance, data retention and archiving to facilitate meeting the new
        regulatory and governmental compliance regulations. The OptimIPTM Compliance
        Executive allows corporations to:
 
 ·
              Archive
                  business data and communications for compliance with government
                  regulations and business policies;
 ·
              Implement
                  selective and cloaked surveillance of potential internal fraud
                  or other
                  breaches of corporate policies and retain critical information
                  required
                  for evidence and prosecution.
 
 Procera’s
        OptimIP Compliance Executive is a powerful software set that provides network
        administrators with the ability to define high-level policies for traffic
        mirroring to network analyzers, log servers, Intrusion Detection Systems,
        etc.
        Businesses can record everything employees do online with the OptimIPTM
Compliance Executive, including Websites visited, emails, and instant messages.
        Policies define which traffic to forward to the designated monitor port.
        The
        OptimIP filters traffic at wire-speed, so no latency is introduced and policies
        operate transparently to applications and users. Using the intuitive graphical
        user interface for Procera’s OptimIP Compliance Executive, even a non-technical
        administrator can define policies down to the packet, user, or application
        level
        to provide a new level of security and compliance.




***The
      Converged Platform family of Products*** :
      As
      alluded to in the history section above, the OptimANA Convergence Platform
      Series, the CP3600, tightly couples Procera’s OptimIP intelligent networking
      routing and switching hardware with a standard Intel Zeon-based server. The
      new
      converged platform architecture integrates, in the standard 2U form factor,
      the
      intelligence and deep-packet inspection capabilities of server-based application
      software with the wire-speed performance and granular port-level control of
      Procera’s proprietary networking hardware. Procera has also produced the
      OptimANA XML APL which enables vendors of server software, security gateways
      and
      network appliances to increase the functionality of their software. The API
      can
      take calls specified by the application software to automatically translate
      and
      implement network policies, in hardware, to block, prioritize, or provide
      specific bandwidth management usage levels for data flowing within the LAN.
      The
      OtimANA platform is targeted at the rapidly emerging multi-billion dollar market
      for Application Oriented Networking.





The
      CP3600 comes in an easy-to-deploy and manage system that extends the
      functionality, performance and market research of server-based software vendors
      without requiring them to develop expensive ASIC-based systems or retooling
      their application architectures to work on proprietary platforms.





Applications





Procera’s
      core technology of wire-speed information processing, based on the contents
      of
      the data packets, can be used as the foundation of many solutions - e.g., IT
      security, network performance management, storage archiving, hierarchical
      storage management, network traffic shaping, etc. Presently, the application
      that Procera is focused on is bandwidth management, particularly for hotels
      and
      multi-tenant (residential and commercial) facilities and for wireless
      infrastructure.





6
 *Table
            of Contents*





Distribution





Procera
      substantially modified its product distribution during the second half of 2005.
      Based on the results of its directly employed sales staff and its experience
      with VAR’s, Systems Integrators, and the like (“third party resellers”), Procera
      is now working with a substantially smaller group of third party resellers,
      but
      such resellers are very well connected in a particular vertical market. The
      vertical markets are hospitality, multi-tenant housing, and wireless
      infrastructure for its 12012 and 2404 products. For its converged platform
      products. Procera is partnering with several “best of breed” software point
      solution companies (solutions that were originally intended to run solely on
      servers).





Competition


Procera’s
        products and technology cut across several networking, security, and bandwidth
        management market segments, including servers and networking hardware devices
        that control how, when and where voice, data and video are transmitted and
        received. Thus, the OptimIPTM and the OptimANA network products provide similar
        functionality as the major networking brand leaders such as Cisco Systems,
        Inc.,
        Foundry Networks and Extreme Networks, Inc. Procera’s products enable its
        customers to customize their networks to include functionality previously
        offered only on server based network appliances at much higher prices and
        much
        lower throughput rates.
  Procera’s
        core technology also offers functionality similar to that of some point solution
        software companies such as ServeGate, Packeteer and Surf Control. Procera’s
        products can be deployed in most LAN infrastructures without any design changes
        to the LAN, resulting in a simple plug and play model.  The products also
        process traffic using an embedded chip that provides processing capacity
        in the
        multi-gigabit range.  This allows for wire speed inspection of each
        Ethernet packet without the addition of any network latency.  This
        contrasts with server based software solutions that have to use a standard
        processor to inspect each packet, which inherently has lower capacity for
        traffic handling and introduces significant latency in the data path.  The
        result is that server based companies can offer hundreds of megabits per
        second
        of throughput while Procera is capable of delivering multi-gigabits per
        second.


Manufacturing





Procera
      utilizes a hybrid manufacturing model that provides tremendous flexibility
      and
      control while offering quick turn around for prototype and small production
      lots
      through contract manufacturing companies located in the San Francisco Bay Area.
      This local capability also offers Procera quick turn repsonse capability to
      any
      custom requirements that are often required by OEM customers and some foreign
      market opportunities. Procera utilizes two turn-key off shore manufacturing
      companies located in the People’s Republic of China and the Republic of
      Singapore. These operations are fully ISO9000 certified and have a history
      of
      producing very high quality products of a similar complexity. Procera has
      received 100% tested product from both manufacturers and has established gold
      standard models. By having two suppliers, located in different parts of the
      Pacific Rim, Procera has protection from any potential work stoppage or
      localized political situation that might arise. Procera also has the proven
      capacity to address rapid expansion of its business. These manufacturers are
      known for their quality and competitiveness and have the proven capital
      resources to sustain and grow their businesses as might be
      required.





INTELLECTUAL
      PROPERTY





Procera
      designed and developed what it believes was the industry’s first hardware engine
      that can process network data based on deep packet inspection at wire-speed.
      A
      patent application was filed in May 2002 with the US Patent and Trademark Office
      covering the intellectual property (design, architecture and algorithms) of
      the
      Company’s core technology. A second patent application was filed in August 2002
      to cover further aspects and details of the core technology and certain
      applications of that technology. Procera’s management believes that the claims
      filed on these applications, if allowed, will cover a very rich combination
      of
      design and algorithms that will be fundamental to future solutions in the areas
      of IT security, network performance management, capacity planning, storage
      processing and archiving, and security surveillance.





Procera
      currently requires all employees to sign confidentiality agreements as well
      as
      proprietary information and invention assignment agreements. All the Company’s
      design and architecture work is done at its headquarters in Los Gatos,
      California. Whereas, low-level protocol testing is outsourced to India to take
      advantage of low labor costs.





**EMPLOYEES**





As
      of
      January 1, 2006, Procera employed 26 people, of which 12 were employed in
      engineering, 4 in operations, 7 in sales and marketing, and 3 in management
      and
      administration. None of Procera’s employees are members of a labor union.
      Management believes that relations with its employees are good.





7
 *Table
            of Contents*





**RISK
      FACTORS**





Any
      of
      the following risks could materially adversely affect Procera’s business,
      financial condition, or operating results.




**PROCERA
      IS AN EARLY STAGE COMPANY AND THE PRODUCT OF A RECENT MERGER, AND HAVE A LIMITED
      OPERATING HISTORY ON WHICH TO EVALUATE ITS POTENTIAL FOR FUTURE
      SUCCESS.**





Procera
      was formed as a result of a merger of two separate companies, Procera Networks,
      Inc., a Delaware corporation ("PNI") and Zowcom, Inc., a Nevada corporation
      ("Zowcom"), in October 2003, and to date have only two fiscal years of combined
      operations. In addition, both Zowcom and PNI had only a limited operating
      history prior to the merger. Therefore, Procera has only a limited operating
      history upon which you can evaluate its business and prospects, and it has
      yet
      to develop sufficient experience regarding actual revenues to be received from
      its combined operations.





Procera
      has only recently launched many of the products and services described herein
      and therefore is a start-up company. You must consider the risks and
      uncertainties frequently encountered by early stage companies in new and rapidly
      evolving markets. If Procera is unsuccessful in addressing these risks and
      uncertainties, its business, results of operations and financial condition
      will
      be materially and adversely affected.




**WE
          HAVE REPORTED MATERIAL WEAKNESSES IN OUR INTERNAL CONTROL OVER FINANCIAL
          REPORTING.**
 
 A
          material weakness is a control deficiency, or combination of control
          deficiencies, that results in more than a remote likelihood that a material
          misstatement of the annual or interim financial statements will not be
          prevented
          or detected. We reported material weaknesses in our internal control over
          financial reporting that, if not remedied, could adversely affect our internal
          controls. We have assessed the effectiveness of our internal control over
          financial reporting. Based on this assessment, management have identified
          the
          material weaknesses as set forth in Article 3 of this Quarterly Report
          -
          Controls and Procedures.
 
 During
          2006, we plan to take additional steps to remediate these internal control
          weaknesses, including but not limited to hiring accounting personnel and
          engaging outside contractors with technical accounting expertise.
          Notwithstanding the foregoing, we may not be able to maintain effective
          internal
          controls over financial reporting in the future. In addition, deficiencies
          in
          our internal controls may be discovered in the future. Any failure to remediate
          the reported material weaknesses, or to implement new or improved controls,
          or
          difficulties encountered in their implementation, could harm our operating
          results, cause us to fail to meet our reporting obligations or result in
          material misstatements in our financial statements. Any such failure also
          could
          affect the ability of our management to certify in our 2006 Forms 10-KSB
          and
          10-QSB’s that our internal controls are effective when it provides an assessment
          of our internal control over financial reporting, and could affect the
          results
          of our independent registered public accounting firm's related attestation
          report regarding our management's assessment. Ineffective internal controls
          could also cause investors to lose confidence in our reported financial
          information, which could have a negative effect on the trading price of
          our
 securities.




**PROCERA
      EXPECTS LOSSES FOR THE FORSEEABLE FUTURE.**





For
      the
      year ended January 1, 2006, Procera had losses from operations of $6,738,915.
      Procera will continue to incur losses from operations for the foreseeable
      future. These losses will result primarily from costs related to product
      development and substantial sales and marketing expenses. In addition, Procera
      plans to invest heavily in marketing and promotion, to hire additional
      employees, and to enhance its network content and management technologies.
      Procera’s management believes these expenditures are necessary to build and
      maintain hardware and software technology and to penetrate the markets for
      Procera’s products. If Procera’s revenue growth is slower than anticipate or its
      operating expenses exceed expectations, its losses will be significantly
      greater. It may never achieve profitability.




**PROCERA
      MAY NEED FURTHER CAPITAL.**





Based
      on
      current reserves and anticipated cash flow from operations, Procera currently
      anticipates that the available funds, following the closing of its financing
      transaction on February 28, 2006 (the “February Placement”), will be sufficient
      to meet its anticipated needs for working capital, capital expenditures and
      business expansion through December 2006. Thereafter, it will need to raise
      additional funds. If any of its assumptions is incorrect, Procera may need
      to
      raise capital before the end of December 2006. If additional funds are raised
      through the issuance of equity or convertible debt securities, the percentage
      ownership of its stockholders will be reduced, stockholders may experience
      additional dilution and such securities may have rights, preferences and
      privileges senior to those of our common stock. There can be no assurance that
      additional financing will be available on terms favorable to Procera or at
      all.
      If adequate funds are not available on acceptable terms, Procera may not be
      able
      to fund expansion, take advantage of unanticipated acquisition opportunities,
      develop or enhance services or products or respond to competitive pressures.
      In
      addition, we may be required to cancel product development programs and/or
      lay-off employees. Such inability could have a material adverse effect on its
      business, results of operations and financial condition.




**HOLDERS
      OF PROCERA’S COMMON STOCK MAY BE DILUTED IN THE FUTURE.**





Procera
      is authorized to issue up to 100,000,000 shares of common stock and to the
      extent of such authorization, its Board of Directors will have the ability,
      without seeking stockholder approval, to issue additional shares of common
      stock
      in the future for such consideration as its Board of Directors may consider
      sufficient. The issuance of additional common stock in the future will reduce
      the proportionate ownership and voting power of its common stock held by
      existing stockholders. At January 1, 2006, there were 30,945,317 shares of
      common stock outstanding, common stock subscriptions for 3,545,833 shares,
      warrants to purchase 7,213,178 shares of common stock, stock options to purchase
      3,916,970 shares of common stock, and rights to purchase 292,100 shares of
      common stock. Further, after the February Placement and as of March 30, 2006,
      there were 45,965,342 shares of common stock outstanding, common stock
      subscriptions for 183,332 shares of common stock, warrants to purchase 8,713,178
      shares of common stock, stock options to purchase 3,916,970 shares of common
      stock, and right to purchase 150,000 shares of common stock.





8
 *Table
            of Contents*





**COMPETITION
      FOR EXPERIENCED PERSONNEL IS INTENSE AND PROCERA’S INABILITY TO ATTRACT AND
      RETAIN QUALIFIED PERSONNEL COULD SIGNIFICANTLY INTERRUPT ITS BUSINESS
      OPERATIONS.**





Procera’s
      future success will depend, to a significant extent, on the ability of its
      management to operate effectively, both individually and as a group. Given
      its
      early stage of development, Procera is dependent on its ability to attract,
      retain and motivate high caliber key personnel. Procera has recently expanded
      its sales force, and it is actively searching for systems engineers, research
      and development engineers and sales and marketing personnel, all of whom are
      in
      short supply. Procera currently has a small indirect channel partner and
      end-user service and support organization and will need to increase its staff
      to
      support new indirect channel partners and end users and the expanding needs
      of
      existing indirect channel partners and end users. Additionally, Procera relies
      on qualified systems engineers and service and support personnel to provide
      pre-
      and post-sales technical support for its products. Competition for qualified
      personnel in the networking industry, including systems engineers, sales and
      service and support personnel, is intense, and Procera may not be successful
      in
      attracting and retaining such personnel. There may be only a limited number
      of
      persons with the requisite skills to serve in these key positions and it may
      become increasingly difficult to hire such persons. Procera’s business will
      suffer if it encounters delays in hiring these additional
      personnel.





Procera’s
      performance is substantially dependent on the continued services and on the
      performance of its executive officers and other key employees, particularly
      Douglas J. Glader, its Chief Executive Officer, Anil Sahai, its Chief Technical
      Officer, and Gary J. Johnson, its Senior Vice President of Sales and Marketing.
      The loss of the services of any of its executive officers or key employees
      could
      materially and adversely affect Procera’s business. Additionally, Procera
      believes it will need to attract, retain and motivate talented management and
      other highly skilled employees to be successful. It may be unable to retain
      our
      key employees or attract, assimilate and retain other highly qualified employees
      in the future. Competitors and others have in the past, and may in the future,
      attempt to recruit Procera’s employees. Procera does not have employment
      contracts with any of its personnel. Procera currently does not have key person
      insurance in place. If Procera loses one of the key officers, Procera must
      attract, hire, and retain an equally competent person to take his place. There
      is no assurance that Procera would be able to find such an employee. If Procera
      fails to find one or find one timely, its product development may slow down
      or
      stop. Procera could fail to implement its strategy or lose the sales and
      marketing momentum.





**PROCERA
      MAY BE UNABLE TO COMPETE EFFECTIVELY WITH OTHER COMPANIES IN ITS MARKET SECTOR
      WHO ARE SUBSTANTIALLY LARGER AND MORE ESTABLISHED AND HAVE SIGNIFICANTLY GREATER
      RESOURCES.**





Procera
      competes in a new, rapidly evolving and highly competitive sector of the
      networking technology market. It expects competition to persist and intensify
      in
      the future from a number of different sources. Increased competition could
      result in reduced prices and gross margins for Procera’s products and could
      require increased spending by it on research and development, sales and
      marketing and customer support, any of which could have a negative financial
      impact on its business. Procera competes with Cisco Systems, Inc., Packeteer,
      Inc., Foundry Networks, Inc. and Extreme Networks, Inc., which sell products
      incorporating competing technologies. Procera also competes with several small
      private companies that utilize competing technologies to provide bandwidth
      management. In addition, its products and technology compete for information
      technology budget allocations with products that offer monitoring capabilities,
      such as probes and related software. Lastly, Procera faces indirect competition
      from companies that offer enterprises and service providers increased bandwidth
      and infrastructure upgrades that increase the capacity of their networks, which
      may lessen or delay the need for bandwidth management solutions.





Many
      of
      Procera’s competitors are substantially larger than it is and have significantly
      greater financial, sales and marketing, technical, manufacturing and other
      resources and more established distribution channels. These competitors may
      be
      able to respond more rapidly to new or emerging technologies and changes in
      customer requirements or devote greater resources to the development, promotion
      and sale of their products than it can. Procera has encountered, and expect
      to
      encounter, customers who are extremely confident in and committed to the product
      offerings of its competitors. Furthermore, some of its competitors may make
      strategic acquisitions or establish cooperative relationships among themselves
      or with third parties to increase their ability to rapidly gain market share
      by
      addressing the needs of its prospective customers. These competitors may enter
      Procera’s existing or future markets with solutions that may be less expensive,
      provide higher performance or additional features or be introduced earlier
      than
      its solutions. Given the market opportunity in the bandwidth management
      solutions market, Procera also expects that other companies may enter our market
      with alternative products and technologies, which could reduce the sales or
      market acceptance of its products and services, perpetuate intense price
      competition or make its products obsolete. If any technology that is competing
      with Procera’s is or becomes more reliable, higher performing, less expensive or
      has other advantages over our technology, then the demand for its products
      and
      services would decrease, which would harm its business.





9
 *Table
            of Contents*





**THE
      PROCERA FAMILY OF PRODUCTS IS CURRENTLY ITS ONLY SUITE OF PRODUCTS, AND ALL
      OF
      ITS CURRENT REVENUES AND A SIGNIFICANT PORTION OF ITS FUTURE GROWTH DEPENDS
      ON
      THEIR COMMERCIAL SUCCESS.**





All
      of
      Procera’s current revenues and a significant portion of its future growth depend
      on the commercial success of its family of products, which are the only products
      that it currently offers. If its target customers do not widely adopt, purchase
      and successfully deploy the Procera switching family of products, its revenues
      will not grow significantly.





**THE
      MARKET IN WHICH PROCERA COMPETES IS SUBJECT TO RAPID TECHNOLOGICAL PROGRESS
      AND
      TO COMPETE IT MUST CONTINUALLY INTRODUCE NEW PRODUCTS THAT ACHIEVE BROAD MARKET
      ACCEPTANCE.**





The
      network equipment market is characterized by rapid technological progress,
      frequent new product introductions, changes in customer requirements and
      evolving industry standards. If Procera does not regularly introduce new
      products in this dynamic environment, its product lines will become obsolete.
      Developments in routers and routing software could also significantly reduce
      demand for its products. Alternative technologies could achieve widespread
      market acceptance and displace the technology on which Procera has based its
      product architecture. Procera cannot assure you that its technological approach
      will achieve broad market acceptance or that other technologies or devices
      will
      not supplant its own products and technology.





**IF
      THE BANDWIDTH MANAGEMENT SOLUTIONS MARKET FAILS TO GROW, PROCERA’S BUSINESS WILL
      FAIL.**





The
      market for bandwidth management solutions is in an early stage of development
      and its success is not guaranteed. Therefore, Procera cannot accurately assess
      the size of the market, the products needed to address the market, the optimal
      distribution strategy, or the competitive environment that will develop. In
      order for it to be successful, its potential customers must recognize the value
      of more sophisticated bandwidth management solutions, decide to invest in the
      management of their networks and the performance of important business software
      applications and, in particular, adopt Procera’s bandwidth management solutions.
      The growth of the bandwidth management solutions market also depends upon a
      number of factors, including the availability of inexpensive bandwidth,
      especially in international markets, and the growth of wide area networks.
      The
      failure of the market to rapidly grow would adversely affect Procera’s sales and
      sales prospects leading to sustained financial losses.





**FUTURE
      PERFORMANCE WILL DEPEND ON THE INTRODUCTION AND ACCEPTANCE OF NEW
      PRODUCTS.**





Procera’s
      future performance will also depend on the successful development, introduction
      and market acceptance of new and enhanced products that address customer
      requirements in a timely and cost-effective manner. In the past, Procera has
      experienced delays in product development and such delays may occur in the
      future. The introduction of new and enhanced products may cause Procera’s
      customers to defer or cancel orders for existing products. Such actions would
      substantially hurt sales and negatively affect future
      profitability.




**INTRODUCTION
      OF PROCERA’S NEW PRODUCTS MAY CAUSE CUSTOMERS TO DEFER PURCHASES OF ITS EXISTING
      PRODUCTS WHICH COULD HARM ITS OPERATING RESULTS**





When
      Procera announces new products or product enhancements that have the potential
      to replace or shorten the life cycle of its existing products, customers may
      defer purchasing its existing products. These actions could harm Procera’s
      operating results by unexpectedly decreasing sales, increasing inventory levels
      of older products and exposing it to greater risk of product
      obsolescence.





**IF
      PROCERA IS UNABLE TO EFFECTIVELY MANAGE ITS GROWTH, IT MAY EXPERIENCE OPERATING
      INEFFICIENCIES AND HAVE DIFFICULTY MEETING DEMAND FOR ITS
      PRODUCTS.**





Procera
      has been careful to regulate its growth due to capital requirements. If
      Procera’s customer base and market grow rapidly, Procera would need to expand to
      meet this demand. This expansion could place a significant strain on Procera’s
      management, products and support operations, sales and marketing personnel
      and
      other resources, which could harm its business.





In
      the
      future, Procera may experience difficulties meeting the demand for its products
      and services. The installation and use of Procera’s products requires training.
      If it is unable to provide training and support for its products, the
      implementation process will be longer and customer satisfaction may be lower.
      In
      addition, Procera’s management team may not be able to achieve the rapid
      execution necessary to fully exploit the market for Procera’s products and
      services. Procera cannot assure you that its systems, procedures or controls
      will be adequate to support the anticipated growth in its operations. The
      failure to meet the challenges presented by rapid customer and market expansion
      would cause Procera to miss sales opportunities and otherwise have a negative
      impact on its sales and profitability.





10
 *Table
          of Contents*




Procera
      may not be able to install management information and control systems in an
      efficient and timely manner, and its current or planned personnel, systems,
      procedures and controls may not be adequate to support its future
      operations.





**PROCERA’S
      LIMITED ABILITY TO PROTECT ITS INTELLECTUAL PROPERTY AND DEFEND AGAINST CLAIMS
      MAY ADVERSELY AFFECT ITS ABILITY TO COMPETE.**





Procera
      relies on a combination of patent, copyright, trademark and trade secret laws
      and restrictions on disclosure to protect its intellectual property rights.
      However, it cannot assure you that the actions it has taken will adequately
      protect its intellectual property rights or that other parties will not
      independently develop similar or competing products that do not infringe on
      its
      patents. Procera enters into confidentiality or license agreements with its
      employees, consultants and corporate partners, and controls access to and
      distribution of its software, documentation and other proprietary information.
      Despite Procera’s efforts to protect its proprietary rights, unauthorized
      parties may attempt to copy or otherwise misappropriate or use its products
      or
      technology.





Procera’s
      industry is characterized by the existence of a large number of patents and
      frequent claims and related litigation regarding patent and other intellectual
      property rights. If Procera is found to infringe the proprietary rights of
      others, or if it otherwise settles such claims, it could be compelled to pay
      damages or royalties and either obtain a license to those intellectual property
      rights or alter its products so that they no longer infringe upon such
      proprietary rights. Any license could be very expensive to obtain or may not
      be
      available at all. Similarly, changing its products or processes to avoid
      infringing the rights of others may be costly or impractical. Litigation
      resulting from claims that we are infringing the proprietary rights of others
      could result in substantial costs and a diversion of resources, and could have
      a
      material adverse effect on its business, financial condition and results of
      operations.





**PROCERA’S
      DEPENDENCE ON CONTRACT MANUFACTURERS FOR SUBSTANTIALLY ALL OF ITS MANUFACTURING
      REQUIREMENTS COULD HARM ITS OPERATING RESULTS.**





If
      the
      demand for Procera’s products grows, it will need to increase its material
      purchases, contract manufacturing capacity, and internal test and quality
      functions. Any disruptions in product flow could limit its revenue, adversely
      affect its competitive position and reputation, and result in additional costs
      or cancellation of orders under agreements with its customers.





Procera
      relies on independent contractors to manufacture its products. Procera does
      not
      have long-term contracts with any of these manufacturers. Delays in product
      shipments from contract manufacturers are not unusual. Similar or other problems
      may arise in the future, such as inferior quality, insufficient quantity of
      products, or the interruption or discontinuance of operations of a manufacturer,
      any of which could have a material adverse effect on Procera’s business and
      operating results.





Procera
      does not know whether it will effectively manage its contract manufacturers
      or
      that these manufacturers will meet its future requirements for timely delivery
      of products of sufficient quality and quantity. Procera intends to transition
      the manufacture of some of its products from one contract manufacturer to
      another. Procera also intends to regularly introduce new products and product
      enhancements, which will require that it rapidly achieves volume production
      by
      coordinating its efforts with those of its suppliers and contract manufacturers.
      The inability of Procera’s contract manufacturers to provide it with adequate
      supplies of high-quality products or a reduction in the number of contract
      manufacturers may cause a delay in its ability to fulfill orders and may have
      a
      material adverse effect on its business, operating results and financial
      condition.





As
      part
      of Procera’s cost-reduction efforts, it will need to realize lower per unit
      product costs from its contract manufacturers by means of volume efficiencies
      and the utilization of manufacturing sites in lower-cost geographies. However,
      Procera cannot be certain when or if such price reductions will occur. The
      failure to obtain such price reductions would adversely affect Procera’s gross
      margins and operating results.




**IF
      PROCERA’S PRODUCTS CONTAIN UNDETECTED SOFTWARE OR HARDWARE ERRORS, IT COULD
      INCUR SIGNIFICANT UNEXPECTED EXPENSES AND LOSE SALES.**





11
 *Table
          of Contents*




Network
      products frequently contain undetected software or hardware errors when new
      products or new versions or updates of existing products are first released
      to
      the marketplace. In the past, Procera has experienced such errors in connection
      with new products and product upgrades. Procera expects that such errors or
      component failures will be found from time to time in the future in new or
      existing products, including the components incorporated therein, after the
      commencement of commercial shipments. These problems may have a material adverse
      effect on Procera’s business by causing it to incur significant warranty and
      repair costs, diverting the attention of its engineering personnel from new
      product development efforts, delaying the recognition of revenue and causing
      significant customer relations problems. Further, if Procera’s product is not
      accepted by customers due to defects, and such returns exceed the amount it
      accrued for defect returns based on its historical experience, its operating
      results would be adversely affected.





Procera’s
      products must successfully interface with products from other vendors. As a
      result, when problems occur in a computer or communications network, it may
      be
      difficult to identify the sources of these problems. The occurrence of hardware
      and software errors, whether or not caused by Procera’s products, could result
      in the delay or loss of market acceptance of its products and any necessary
      revisions may cause it to incur significant expenses. The occurrence of any
      such
      problems would likely have a material adverse effect on Procera’s business,
      operating results and financial condition.





**PROCERA
      EXPECTS THE AVERAGE SELLING PRICES OF ITS PRODUCTS TO DECREASE, WHICH MAY REDUCE
      GROSS MARGIN OR REVENUE.**





The
      network equipment industry has traditionally experienced a rapid erosion of
      average selling prices due to a number of factors, including competitive pricing
      pressures, promotional pricing, technological progress and a slowdown in the
      economy that has resulted in excess inventory and lower prices as companies
      attempt to liquidate this inventory. We anticipate that the average selling
      prices of its products will decrease in the future in response to competitive
      pricing pressures, excess inventories, increased sales discounts and new product
      introductions by it or its competitors. Procera may experience substantial
      decreases in future operating results due to the erosion of its average selling
      prices.





**SOME
      OF PROCERA’S CUSTOMERS MAY NOT HAVE THE RESOURCES TO PAY FOR ITS PRODUCTS AS A
      RESULT OF THE CURRENT ECONOMIC ENVIRONMENT.**





With
      the
      current economic slowdown, some of Procera’s customers are forecasting that
      their revenue for the foreseeable future will generally be lower than originally
      anticipated. Some of these customers are experiencing, or are likely to
      experience, serious cash flow problems and, as a result, find it increasingly
      difficult to obtain financing, if at all. If some of these customers are not
      successful in generating sufficient revenue or securing alternate financing
      arrangements, they may not be able to pay, or may delay payment for, the amounts
      that they owe Procera. Furthermore, they may not order as many products from
      Procera as forecast, or cancel orders entirely. The inability of some of
      Procera’s potential customers to pay it for its products may adversely affect
      its cash flow, the timing of its revenue recognition and the amount of revenue,
      which may cause its stock price to decline.





**LEGISLATIVE
      ACTIONS, HIGHER INSURANCE COSTS AND POTENTIAL NEW ACCOUNTING PRONOUNCEMENTS
      ARE
      LIKELY TO IMPACT PROCERA’S FUTURE FINANCIAL POSITION AND RESULTS OF
      OPERATIONS.**





Recent
      regulatory changes, including the Sarbanes-Oxley Act of 2002, and future
      accounting pronouncements and regulatory changes, will have an impact on
      Procera’s future financial position and results of operations. These changes and
      proposed legislative initiatives are likely to increase Procera’s general and
      administrative costs. In addition, insurance costs, including health and
      workers' compensation insurance premiums, have been dramatically increasing
      and
      likely to continue to increase in the future as a result of high claims rates
      over the past year. Further, proposed initiatives could result in changes in
      accounting rules, including legislative and other proposals to account for
      employee stock options as an expense. These and other potential changes could
      materially increase the expenses Procera reports under generally accepted
      accounting principles, and adversely affect its operating results.





**PROCERA’S
      PRODUCTS MUST COMPLY WITH EVOLVING INDUSTRY STANDARDS AND COMPLEX GOVERNMENT
      REGULATIONS OR ELSE ITS PRODUCTS MAY NOT BE WIDELY ACCEPTED, WHICH MAY PREVENT
      IT FROM GROWING ITS NET REVENUE OR ACHIEVING
      PROFITABILITY.**





The
      market for network equipment products is characterized by the need to support
      industry standards as different standards emerge, evolve and achieve acceptance.
      Procera will not be competitive unless it continually introduces new products
      and product enhancements that meet these emerging standards. In the past,
      Procera has introduced new products that were not compatible with certain
      technological standards, and in the future it may not be able to effectively
      address the compatibility and interoperability issues that arise as a result
      of
      technological changes and evolving industry standards. Procera’s products must
      comply with various United States federal government requirements and
      regulations and standards defined by agencies such as the Federal Communications
      Commission, in addition to standards established by governmental authorities
      in
      various foreign countries and recommendations of the International
      Telecommunication Union. If Procera does not comply with existing or evolving
      industry standards or if it fails to obtain timely domestic or foreign
      regulatory approvals or certificates it will not be able to sell its products
      where these standards or regulations apply, which may prevent it from sustaining
      its net revenue or achieving profitability.





12
 *Table
          of Contents*




**FAILURE
      TO SUCCESSFULLY EXPAND PROCERA’S SALES AND SUPPORT TEAMS OR EDUCATE THEM ABOUT
      TECHNOLOGIES AND PROCERA’S PRODUCT FAMILIES MAY HARM PROCERA’S OPERATING
      RESULTS.**





The
      sale
      of Procera’s products and services requires a concerted effort that is
      frequently targeted at several levels within a prospective customer's
      organization. Procera may not be able to increase net revenue unless it expands
      its sales and support teams in order to address all of the customer requirements
      necessary to sell its products.





Procera
      cannot assure you that it will be able to successfully integrate employees
      into
      its company or to educate current and future employees in regard to rapidly
      evolving technologies and its product families. A failure to do so may hurt
      Procera’s revenue growth and operating results.





**PROCERA
      MUST CONTINUE TO DEVELOP AND INCREASE THE PRODUCTIVITY OF ITS INDIRECT
      DISTRIBUTION CHANNELS TO INCREASE NET REVENUE AND IMPROVE ITS OPERATING
      RESULTS.**





Procera’s
      distribution strategy focuses primarily on developing and increasing the
      productivity of its indirect distribution channels through resellers and
      distributors. If Procera fails to develop and cultivate relationships with
      significant resellers, or if these resellers are not successful in their sales
      efforts, sales of Procera’s products may decrease and its operating results
      could suffer. Many of Procera’s resellers also sell products from other vendors
      that compete with Procera’s products. Procera cannot assure you that it will be
      able to enter into additional reseller and/or distribution agreements or that
      it
      will be able to successfully manage its product sales channels. Procera’s
      failure to do any of these could limit its ability to grow or sustain revenue.
      In addition, Procera’s operating results will likely fluctuate significantly
      depending on the timing and amount of orders from its resellers. Procera cannot
      assure you that its resellers and/or distributors will continue to market or
      sell its products effectively or continue to devote the resources necessary
      to
      provide it with effective sales, marketing and technical support. Such failure
      would negatively affect revenue and profitability.





**PROCERA’S
      HEADQUARTERS ARE LOCATED IN NORTHERN CALIFORNIA WHERE DISASTERS MAY OCCUR THAT
      COULD DISRUPT ITS OPERATIONS AND HARM ITS BUSINESS** .





Procera’s
      corporate headquarters are located in Silicon Valley in Northern California.
      Historically, this region has been vulnerable to natural disasters and other
      risks, such as earthquakes, which at times have disrupted the local economy
      and
      posed physical risks to Procera and its manufacturers' property.





In
      addition, terrorist acts or acts of war targeted at the United States, and
      specifically Silicon Valley, could cause damage or disruption to Procera, its
      employees, facilities, partners, suppliers, distributors and resellers, and
      customers, which could have a material adverse effect on its operations and
      financial results. Procera currently does not have redundant, multiple site
      capacity in the event of a natural disaster or catastrophic event. In the event
      of such an occurrence, Procera’s business would suffer.





**ACQUISITIONS
      MAY DISRUPT OR OTHERWISE HAVE A NEGATIVE IMPACT ON PROCERA’S
      BUSINESS.**





Procera
      may acquire or make investments in complementary businesses, products, services
      or technologies on an opportunistic basis when it believes they will assist
      it
      in carrying out its business strategy. Growth through acquisitions has been
      a
      successful strategy used by other network control and management technology
      companies. Procera does not have any present understanding, nor is it having
      any
      discussions relating to any such acquisition or investment. If Procera buys
      a
      company, then it could have difficulty in assimilating that company's personnel
      and operations. In addition, the key personnel of the acquired company may
      decide not to work for Procera. An acquisition could distract Procera’s
      management and employees and increase its expenses. Furthermore, Procera may
      have to incur debt or issue equity securities to pay for any future
      acquisitions, the issuance of which could be dilutive to its existing
      shareholders.





13
 *Table
          of Contents*




**ANTI-TAKEOVER
      PROVISIONS AND PROCERA’S RIGHT TO ISSUE PREFERRED STOCK COULD MAKE A THIRD-PARTY
      ACQUISITION OF IT DIFFICULT.**





Procera
      a
      Nevada corporation. Anti-takeover provisions of Nevada law could make it more
      difficult for a third party to acquire control of Procera, even if such change
      in control would be beneficial to stockholders. Procera’s articles of
      incorporation provide that its Board of Directors may issue preferred stock
      without stockholder approval. The issuance of preferred stock could make it
      more
      difficult for a third party to acquire Procera. All of the foregoing could
      adversely affect prevailing market prices for Procera’s common
      stock.




**PROCERA’S
      COMMON STOCK PRICE IS LIKELY TO BE HIGHLY VOLATILE.**





The
      market price of Procera’s common stock is likely to be highly volatile as the
      stock market in general, and the market for small cap and micro cap technology
      companies in particular, has been highly volatile. Investors may not be able
      to
      resell their shares of Procera’s common stock following periods of volatility
      because of the market's adverse reaction to volatility. Procera cannot assure
      you that its stock will trade at the same levels of other stocks in its industry
      or that industry stocks, in general, will sustain their current market prices.
      Factors that could cause such volatility may include, among other
      things:





-
            actual
                or anticipated fluctuations in Procera’s quarterly operating
                results;


-
            announcements
                of technological innovations;


-
            changes
                in financial estimates by securities
                analysts;


-
            conditions
                or trends in the network control and management
                industry;


-
            changes
                in the market valuations of other such industry related companies;
                and


-
            the
                acceptance of market makers and institutional investors of Procera
                and its
                stock.





In
      addition, Procera’s stock is currently traded on the NASD O-T-C Market and it is
      uncertain that it will be able to successfully apply for listing on the American
      Stock Exchange or the NASDAQ National Market or SmallCap market in the
      foreseeable future due to the trading price for its Common Stock, market
      capitalization, its working capital and revenue history. Failure to list its
      shares on the American Stock Exchange or the National or SmallCap Markets will
      impair the liquidity for Procera’s common stock.





**SHARES
      ELIGIBLE FOR FUTURE SALE BY PROCERA’S CURRENT STOCKHOLDERS MAY ADVERSELY AFFECT
      ITS STOCK PRICE.**





To
      date,
      Procera has had a very limited trading volume in its common stock. Sales of
      substantial amounts of common stock, including shares issued upon the exercise
      of outstanding options and warrants, under Securities and Exchange Commission
      Rule 144 or otherwise could adversely affect the prevailing market price of
      Procera’s common stock and could impair Procera’s ability to raise capital at
      that time through the sale of its securities. See "Market For Common Equity
      and
      Related Stockholder Matters".





**ADDITIONAL
      SHARES HELD BY EXISTING STOCKHOLDERS MAY BE SOLD INTO THE PUBLIC MARKET IN
      THE
      FUTURE, WHICH MAY CAUSE PROCERA’S STOCK PRICE TO DECLINE.**





Sales
      of
      a substantial number of shares of common stock after the date of this report
      could adversely affect the market price of Procera’s common stock and could
      impair its ability to raise capital through the sale of additional equity
      securities. As of January 1, 2006, Procera had 30,945,317 shares of common
      stock
      outstanding. After the February placement and as of March 30, 2006, Procera
      had
      45,965,342 shares of common stock outstanding.





**ITEM
                2.**
            **DESCRIPTION
                OF PROPERTY**





Procera’s
      headquarters is located at 100 Cooper Court, Los Gatos, California, 95032.
      Procera has a 37-month lease starting from June 1, 2005 and the rent is $12,949
      per month for the first year, $14,126 per month for the second year, and $15,304
      per month for the third year for 11,772 square feet. Procera believes that
      its
      facilities are adequate for its needs and that additional suitable space will
      be
      available on acceptable terms as required.





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





None.




14
 *Table
          of Contents*


**ITEM4.**
              **SUBMISSION
                  OF MATTERS TO A VOTE OF SECURITY
                  HOLDERS**


At
      Procera’s Annual Meeting of Stockholders held on October 12, 2005, the following
      individuals were elected to the Board of Directors to serve until the next
      Annual Meeting of Stockholders:





SharesVoted
                For
            
            Shares
                VotedAgainst
            
            SharesAbstaining
            
            Shares
                NoVote
            
            TotalSharesDouglas
                J. Glader
            
            
            28,883,567
            
            
            0
            
            
            0
            
            
            1,896,750
            
            
            30,780,317Tom
                Williams
            
            
            28,883,567
            
            
            0
            
            
            0
            
            
            1,896,750
            
            
            30,780,317





The
      following proposals were also approved at Procera’s Annual Meeting of
      Stockholders:





SharesVoted
                For
            
            Shares
                VotedAgainst
            
            SharesAbstaining
            
            Shares
                NoVote
            
            TotalSharesApprove
                the ratification of the appointment of Burr, Pilger & Mayer LLP as the
                Company’s independent accountants for the fiscal year ending January 1,
                2006
            
            
            28,551,565
            
            
            17,800
            
            
            375,800
            
            
            1,835,152
            
            
            30,780,317Approve
                the ratification to increase
              the
                authorized shares of capital stock from 50,000,000 to 100,000,000
                shares
                of common stock and from 5,000,000 to 15,000,000 shares of preferred
                stock
            
            
            16,104,461
            
            
            485,789
            
            
            373,250
            
            
            13,816,817
            
            
            30,780,317Approve
                the ratification to increase the number of shares of common stock
                reserved
                for the 2004 Stock Option Plan from 2,500,000 to 5,000,000
            
            
            16,213,721
            
            
            371,528
            
            
            378,250
            
            
            13,816,818
            
            
            30,780,317








**PART
      II**




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





**MARKET
      FOR COMMON EQUITY**





Procera’s
      common stock is quoted on the OTC Bulletin Board under the symbol "PRNW".
      Procera’s common stock has been traded on the OTC Bulletin Board since June 24,
      2003. Prior to that date, Procera’s common stock was not actively traded in the
      public market. For the periods indicated, the following table sets forth the
      high and low bid prices per share of common stock as stated in the Over the
      Counter Bulletin Board Quarterly Trade and Quote Summary Report for the year
      ended January 1, 2006. These prices represent inter-dealer quotations without
      retail markup, markdown, or commission and may not necessarily represent actual
      transactions.







HIGH
                BID
            
            LOW
                BIDFirst
                Quarter 2004
            
            $
            3.74
            
            $
            2.10Second
                Quarter 2004
            
            $
            3.20
            
            $
            1.58Third
                Quarter 2004
            
            $
            1.83
            
            $
            1.26Fourth
                Quarter 2004
            
            $
            2.09
            
            $
            0.49First
                Quarter 2005
            
            $
            2.47
            
            $
            1.22Second
                Quarter 2005
            
            $
            2.16
            
            $
            0.88Third
                Quarter 2005
            
            $
            1.19
            
            $
            0.42Fourth
                Quarter 2005
            
            $
            0.66
            
            $
            0.35





On
      January 1, 2006, the closing price of Procera’s common stock on the OTCBB was
      $0.50.





**HOLDERS**





As
      of
      January 1, 2006, Procera had approximately 79 holders of its common stock.
      The
      number of record holders was determined from the records of Procera’s transfer
      agent and does not include beneficial owners of common stock whose shares are
      held in the names of various security brokers, dealers, and registered clearing
      agencies. The transfer agent of Procera’s common stock is Pacific Stock Transfer
      Company, 500 East Warm Springs Road, Suite 240, Las Vegas, Nevada
      89119.





15
 *Table
          of Contents*




**DIVIDEND
      POLICY**





Procera
      has not declared or paid any cash dividends on its common stock or other
      securities and does not anticipate paying any cash dividends in the foreseeable
      future. Any future determination to pay cash dividends will be at the discretion
      of the Board of Directors and will be dependent upon Procera’s financial
      condition, results of operations, capital requirements, and such other factors
      as the Board of Directors deem relevant.





**DESCRIPTION
      OF SECURITIES**





The
      descriptions in this section and in other sections of this annual report of
      Procera’s securities and various provisions of the Company’s articles of
      incorporation and its bylaws are limited solely to descriptions of the material
      terms of its securities, articles of incorporation and bylaws. Procera’s
      articles of incorporation and bylaws have been filed with the SEC as exhibits
      to
      this annual report.





Procera’s
      authorized capital stock consists of 100,000,000 shares of common stock, par
      value $0.001 per share, and 15,000,000 shares of preferred stock, par value
      $0.001 per share. As of January 1, 2006, 30,945,317 shares of Procera’s common
      stock and no shares of its preferred stock were issued and outstanding. This
      excludes an aggregate of 14,968,081 shares of common stock reserved for issuance
      upon exercise of common stock subscription agreements, stock options, stock
      purchase rights and warrants. After the February Placement and as of March
      30,
      2006, 45,965,342 shares of Procera’s common stock and no shares of its preferred
      stock were issued and outstanding. This excludes an aggregate of 12,963,480
      shares of common stock reserved for issuance upon exercise of common stock
      subscription agreements, stock options, stock purchase rights and
      warrants.





**COMMON
      STOCK**





The
      holders of Procera’s common stock are entitled to equal dividends and
      distributions per share with respect to the common stock when, and if declared
      by the Board of Directors from funds legally available therefore. No holder
      of
      any shares of Procera’s common stock has a pre-emptive right to subscribe for
      any of the Company’s securities, nor are any common stock subject to redemption
      or convertible into other of its securities. Upon liquidation, dissolution
      or
      winding up of the Company, and after payment of creditors and preferred
      stockholders the assets will be divided pro-rata on a share-for-share basis
      among the holders of the shares of common stock. All shares of common stock
      now
      outstanding are fully paid, validly issued and non-assessable.





Each
      share of common stock is entitled to one vote with respect to the election
      of
      any Director or any other matter upon which stockholders are required or
      permitted to vote. Holders of the common stock do not have cumulative voting
      rights, so the holders of more than 50% of the combined shares voting for the
      election of Directors may elect all of the Directors if they choose to do so,
      and, in that event, the holders of the remaining shares will not be able to
      elect any members to the Board of Directors.





**PREFERRED
      STOCK**





Procera
      may issue shares of preferred stock in one or more classes or series within
      a
      class as may be determined by its Board of Directors, who may establish, from
      time to time, the number of shares to be included in each class or series,
      may
      fix the designation, powers, preferences and rights of the shares of each such
      class or series and any qualifications, limitations or restrictions thereof,
      and
      may increase or decrease the number of shares of any such class or series
      without any further vote or action by the stockholders. Any preferred stock
      so
      issued by the Board of Directors may rank senior to the common stock with
      respect to the payment of dividends or amounts upon liquidation, dissolution
      or
      winding up of Procera, or both. In addition, any such shares of preferred stock
      may have class or series voting rights. Moreover, under certain circumstances,
      the issuance of preferred stock or the existence of the unissued preferred
      stock
      might tend to discourage or render more difficult a merger or other change
      in
      control of Procera.





No
      shares
      of preferred stock are currently outstanding. The issuance of preferred stock,
      while providing desirable flexibility in connection with possible acquisitions
      and other corporate purposes, could have the effect of making it more difficult
      for a third party to acquire, or of discouraging a third party from acquiring,
      a
      majority of Procera’s outstanding voting stock.




16
 *Table
          of Contents*


**ITEM6.**
              **MANAGEMENT'S
                  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                  OPERATIONS**


**OVERVIEW** .





Headquartered
      in Los Gatos, CA, Procera Networks, Inc. ("Procera" or the "Company") develops
      intelligent network appliances that provide a non-intrusive, wire-speed network
      overlay to protect, control and optimize internal IP-based networks. Procera's
      OptimIP(TM) family of network appliances enables businesses of every size and
      type to regain control over their internal networks.





Procera
      was formed as a result of a merger and plan of reorganization (the "Merger")
      between Zowcom, Inc. ("Zowcom"), a Nevada corporation incorporated on July
      11,
      2001, and Procera Networks, Inc. ("PNI"), a Delaware corporation incorporated
      on
      May 1, 2002. On October 16, 2003, PNI merged into Zowcom in a stock-for-stock
      transaction. As a result of the Merger, Zowcom continued as the surviving
      corporation, assumed the operations and business plan of PNI, the stockholders
      of PNI became stockholders of Zowcom, and Zowcom changed its name to Procera
      Networks, Inc. ("Procera" or the "Company")(trading symbol OTC: BB:
      PRNW.OB).





Financial
      information for the period from May 1, 2002 (date of inception) to December
      31,
      2002 is the historical financial information of PNI. Financial information
      for
      the year ended December 28, 2003 is the historical financial information of
      PNI
      and Zowcom combined. Financial information for the year ended January 2, 2005
      and thereafter are the historical financial information of Procera.





**RECENT
      DEVELOPMENT**





On
      February 28, 2006, Procera completed the sale of 15,000,025 shares of its
      restricted common stock for $0.40 per share for a total of $6,000,010 to
      thirty-three accredited investors (the “February 2006 Investors”). Chadbourn
      Securities served as the lead placement agent for the transaction. The February
      2006 Investors purchased the shares pursuant to subscription agreements (each
      a
“Subscription Agreement”). In conjunction with the transaction, Procera also
      issued warrants to Chadbourn Securities and other placement agents to purchase
      an aggregate of 1,500,000 shares of its common stock at a per share price of
      $0.40. The warrants are exercisable, in whole or in part, for three years
      following the effectiveness of the registration statement. Procera’s Board of
      Directors accepted the terms for the sale of the shares after pursuing all
      financing alternatives and based upon advice from its lead placement agent.
      Each
      February 2006 Investor completed a subscription agreement and a registration
      rights agreement. The February 2006 Investors and the placement agents also
      received registration rights with respect to the shares of common stock issued
      and to the shares of common stock underlying the warrants, and the filing of
      its
      registration statement satisfies Procera’s obligations.





**RESULTS
      OF OPERATIONS FOR THE YEAR ENDED JANUARY 1, 2006 AND THE YEAR ENDED JANUARY
      2,
      2005**





**Revenues**





From
      the
      date of its inception on May 1, 2002 through January 1, 2006, Procera has
      operated as a development stage company, devoting all of its efforts and
      resources to developing and testing new products and preparing for introduction
      of its products into the market place. Accordingly, Procera has generated
      insignificant revenues from actual sales of its products during fiscal years
      ended January 2, 2005 and January 1, 2006, respectively.





During
      the fiscal year ended January 2, 2005, Procera recognized revenues of $97,611
      from: (a) sales of 28 of its MLS-XP product at an average selling price of
      $2,234; (b) sales of 3 of its new and improved 12012 product, which it
      introduced in the fourth quarter of 2004, at an average selling price of $3,700;
      (c) sales of third party products totaling of $12,783; and (d) sales of product
      accessories totaling $11,176. During the fiscal year ended January 1, 2006,
      Procera recognized revenues of $254,809 from: (a) Sales of 12 of its OptimIP
      2402 product at an average selling price of $3,093; (b) Sales of 13 of its
      OptimIP 12012 product at an average selling price of $6,755; (c) sales of 415
      of
      its OptimIP 1000 product at an average selling price of $287; and (d) sales
      of
      Product accessories totaling $17,046; offset by an allowance for sales returns
      of $6,271.





**Cost
      of Sales**





Cost
      of
      sales of $307,799 and $160,383 reported for the fiscal years ended January
      1,
      2006 and January 2, 2005, respectively, include: (a) the direct cost of
      materials for products sold; (b) charges to write-down the value of Procera's
      inventories;(c) transportation in costs; and (d) cost of warranty allowance
      for
      products sold. Procera follows the accounting policy of valuing inventories
      at
      the lower of cost or market, with standard FIFO cost used to determine inventory
      cost. Standard costs are evaluated at the end of each fiscal quarter and are
      adjusted, if necessary, to equate to actual costs. As a result of adjusting
      standard costs to equate with actual costs, cost of sales was charged $19,129
      and 23,276 during the fiscal years ended January 1, 2006, and January 2, 2005,
      respectively.





17
 *Table
          of Contents*




Procera
      follows the accounting policy of charging cost of goods sold for an estimated
      inventory reserve against consigned inventory for products shipped to end users
      for evaluation purposes. For evaluation shipments, the end user has 30 days
      in
      which to decide to keep the consigned products and pay billed price for them
      or
      return them to Procera. If such products are returned to Procera, they are
      recorded as used inventory and are placed in the pool of products which may
      be
      used for future evaluation trials. Inventory reserve amounts of $59,229 and
      $101,217 where charged to cost of sales during the fiscal years ended January
      1,
      2006 and January 2, 2005, respectively.





Because
      volume sales have not been achieved, the majority of fixed and variable overhead
      costs have been expensed and reported as engineering operating expenses. During
      the fiscal year which ended January 1, 2006, one-half of labor charges for
      receiving and storekeeping, as well as facilities expenses related to square
      footage occupied by receiving and storekeeping totaling $36,531, were charged
      to
      cost of sales. No such charges were included in cost of sales in prior fiscal
      years. When volume sales are achieved, reported cost of sales will include
      100%
      of fixed and variable manufacturing overhead costs.





**Gross
      Losses and Margins**





Gross
      losses reported for the fiscal years ended January 1, 2006 and January 2, 2005
      were ($52,990) and ($62,772), respectively. These gross margins are not
      representative of margins expected by Procera when sales of its products in
      volume are achieved. Excluding inventory write-downs and reserves, which are
      not
      expected to occur on a regular basis, margins for the fiscal years ended January
      1, 2006 and January 2, 2005 were 10% and 63%, respectively. During the fiscal
      year ended January 1, 2006, in anticipation of receiving multiple orders of
      product from an identified customer prospect, Procera purchased products from
      an
      outside vendor for re-work and re-sale to this prospect as OptimIP 1000. After
      shipping an initial order of 415 OptimIp 1000 units to this prospect, Procera
      failed to receive any further orders for this product during 2005. Due to its
      low volume sales of the OptimIp 1000 product, Procera lost a purchase discount
      of $20,000 and was required to pay for non-recurring engineering charges of
      $30,000 on t his
      product; resulting in a gross loss of ($13,449) on the OptimIP 1000 transaction.




Fiscal
                Year EndedJanuary
                1,
            
            January
                2,2006
            
            2005Revenues
            
            $
            254,809
            
            $
            97,611Cost
                of sales:Direct
                material cost
            
            
            184,878
            
            
            30,237Inventory
                write-downs
            
            
            19,129
            
            
            23,276Inventory
                reserves
            
            
            59,229
            
            
            101,217Applied
                manufacturing overhead
            
            
            36,531
            
            
            0Warranty
                allowance
            
            
            8,032
            
            
            5,653Total
                cost of sales
            
            
            307,799
            
            
            160,383Gross
                Profit
            
            $
            (52,990
            )
            $
            (62,772
            )Gross
                margin
            
            
            -21
            %
            
            -64
            %Gross
                margin (excluding inventory write-downs and reserves)
            
            
            10
            %
            
            63
            %





**Operating
      Expenses**





Operating
      expenses for the fiscal year ended January 1, 2006 totaled $6,696,503 as
      compared to $6,285,048 incurred during the fiscal year ended January 2, 2005.
      These expenses increased by $411,000 during 2005 as a result of the
      following:




(a)
            Increase
                in headcount during 2005
            505,000(b)
            Decrease
                in employee stock based compensation
            (202,000)(c)
            Decrease
                in use of outside services
            (142,000)(d)
            Increase
                in travel & entertainment expenses
            113,000(e)
            Increase
                in sales and marketing expenses
            53,000(f)
            Increase
                in facilities expenses
            92,000(g)
            Increase
                in bad debt expense
            118,000(h)
            Decrease
                in amortization of intellectual property
            (178,000)(i)
            Increase
                in audit & legal expenses
            20,000(j)
            Increase
                in administrative expenses
            32,000Net
                increase in operating expenses
            $411,000




18
 *Table
            of Contents*





(a) 
      During 2005, Procera employed the equivalent of 32 full-time employees and
      4
      independent sales contractors. Whereas, in 2004, the Company employed only
      24
      full-time employees and no independent sales contractors. This increase in
      headcount resulted in an increase of personnel expenses of $505,000 during
      the
      fiscal year ended January 1, 2006.





(b) 
      Employee stock based non-cash compensation expense decreased by approximately
      $202,000 during the fiscal year ended January 1, 2006 as a result of vesting
      amortization and employee turnover.





(c) 
      Outside service expenses decreased by approximately $142,000 as a result of
      the
      Company reducing the amount of outsourced hardware and software design services
      required during the fiscal year ended January 1, 2006.





(d) 
      Due to increased sales activities of the newly hired sales representatives
      and
      newly retained independent sales contractors, travel & entertainment
      expenses during the fiscal year ended January 1, 2006 increased by approximately
      $113,000.





(e) 
      Sales and marketing expenses increased approximately $53,000 to support the
      sales efforts of its newly hired and contracted sales representatives during
      the
      fiscal year ended January 1, 2006.





(f) 
      Until May 2005, Procera subleased 6,500 sq. ft. of facility space from a tenant
      in Campbell, CA at a cost of approximately $7,808 per month. Due to expiration
      of its sublease, in June 2005 Procera moved to a larger facility of 11,000
      sq.
      ft. in Los Gatos, CA, at a cost of approximately $21,000 per month. Moving
      to
      the new facility cost the Company approximately $9,100. As a result, the
      Company’s facilities expenses for the fiscal year which ended January 1, 2006
      totaled $195,291, an increase of $91,838 over the prior fiscal year.





(g) 
      During 2005, Procera shipped products on open account to 2 customers in Mexico
      who have not paid for their purchases, totaling approximately $118,000. The
      Company believes collection of these amounts is doubtful and has charged this
      amount to bad debt expense for the fiscal year ended January 1,
      2006.





(h) 
      In 2004, Procera acquired intellectual property from Ezyte, Inc. in exchange
      for
      65,000 shares of Procera’s common stock, which was valued at said stock’s market
      value at the time of acquisition of approximately $178,000. This amount was
      amortized and expensed in its entirety during 2004. There was no similar expense
      item in 2005.





(i) 
       Legal and audit services expenses increased approximately $20,000 during
      the fiscal year which ended January 1, 2006, as a result of Procera's filing
      an
      S-3 Registration Statement and a subsequent SB-2 Registration Statement with
      the
      Securities and Exchange Commission relating to its private placement financing
      transaction which closed in December 2004.





(j)
        Administrative expenses increased by approximately $32,000 during the
      fiscal year ended January 1, 2006 primarily as a result of an increase in
      telephone expenses to support the Company’s expanded sales efforts during
      2005.





**Interest
      and Other Expense**




During
      the fiscal year which ended January 1, 2006, Procera earned interest income
      of
      $11,724 on cash balances deposited in a money market account, compared to
      interest income of $6,176 earned on similar deposits during the prior fiscal
      year. During the fiscal year which ended January 2, 2005, Procera reported
      $21,725 of other expense resulting from a 1% penalty paid to shareholders.
      The
      Company had no such charges during the fiscal year which ended January 1, 2006.
      During the fiscal year which ended January 1, 2006, Procera accrued interest
      expense totaling $1,076 on two outstanding short-term notes payable in principal
      amounts of $90,000 and $150,000, respectively, which bear interest at the rate
      of 6% per annum. One of these notes, with a principal amount of $90,000, was
      paid in its entirety, together with interest of $562, on January 6, 2006. On
      February 28, 2006, at the option of the note holder, principal amount of
      $130,000 was used to purchase 325,000 shares of the Company’s common stock at a
      price of $0.40 per share. The remaining principal amount of $20,000 was paid
      in
      its entirety, plus accrued interest of $1,978, on March 24, 2006. Procera had
      no
      loans outstanding as of January 2, 2005.





19
 *Table
            of Contents*





**Net
      Loss**





Procera
      incurred a net loss of $6,738,915 for the fiscal year ended January 1, 2006,
      compared to a net loss of $6,363,169 for the fiscal year ended January 2, 2005.
      During its continuing development phase, Procera has sustained operating losses
      and it expects such losses to continue through most of the fiscal year of 2006.
      Procera plans to introduce new and improved versions of its hardware platform
      products during the first quarter of 2006 and it is optimistic that it will
      generate revenues from selling of these new products in the remainder of
      2006.





**Liquidity
      and Capital Resources**





From
      its
      date of inception (May 1, 2002) through December 31, 2002, Procera obtained
      the
      majority of its cash resources from the issuance of convertible notes payable,
      totaling $1,080,000. The remainder of its cash resources came from sales of
      $175,368, and the sale of stock to its founders for $8,115.





During
      the first four months of 2003, Procera obtained cash resources from additional
      convertible loans, totaling $275,000.





In
      May
      2003, the outstanding amount of unpaid salary of $560,194 owed to former
      employees was converted into 1,120,388 shares of Procera’s restricted common
      stock.





In
      June
      2003, Procera completed a private placement of 808,000 shares of PNI restricted
      common stock at $0.50 per share and issued warrants to purchase 404,000 shares
      of restricted common stock at a purchase price of $0.75 per share, raising
      an
      aggregate of $404,000 in gross proceeds. The warrants are exercisable
      immediately and expire in June 2008.





In
      July
      2003, the outstanding principal amount of the convertible notes payable of
      $1,355,000 and accrued interest and loan fees of $258,833 were converted into
      3,227,666 shares of Procera’s restricted common stock using a conversion rate of
      $0.50 per share. In addition, 361,893 shares of Procera’s restricted common
      stock were issued to note holders in accordance with the terms of their
      agreements.





In
      August
      2003, Procera completed a private placement sale of 1,695,000 shares of its
      restricted common stock at $1.00 per share, raising an aggregate of $1,695,000
      in gross proceeds.





In
      October 2003, Procera issued an unsecured convertible promissory note in the
      amount of $500,000 to an investor, and a warrant to purchase 31,250 shares
      of
      its restricted common stock with an exercise price of $2.00 per share. The
      warrant is exercisable immediately and expires in October 2006. In December
      2003, the outstanding principal amount of the convertible note payable and
      accrued interest of $5,918 were converted into 252,959 shares of Procera’s
      restricted common stock, using a conversion rate of $2.00 per
      share.





In
      December 2003, Procera completed a brokered private placement (the "Placement")
      of 2,172,500 shares of common stock. Procera raised a total of $4,345,000 in
      the
      Placement, receiving $2,172,500 in gross proceeds from the sale of 1,086,250
      shares of common stock at $2.00 per share, and $2,172,500 from the sale of
      1,086,250 shares of common stock to certain existing stockholders pursuant
      to
      the execution of special warrants in May 2004.





On
      May
      24, 2004, Procera completed a private placement transaction with one of its
      shareholders, who purchased 250,000 shares of Procera’s common stock at $2.00
      per share, providing Procera with additional gross proceeds of
      $500,000.





In
      December 2004, Procera completed a private placement of 5,762,500 shares of
      restricted common stock to 23 institutional and accredited investors (the
      "December 2004 Investors") at a price of $0.80 per share, providing Procera
      with
      gross proceeds of $4,610,000. In connection with this private placement, Procera
      granted warrants to purchase an aggregate of 1,728,750 shares of its common
      stock at a per share exercise price of $1.25 and warrants to purchase an
      aggregate of 1,728,750 shares of its common stock at a per share exercise price
      of $1.37. The warrants are exercisable, in whole or in part, for three years
      following the effectiveness of the registration statement that Procera filed
      in
      January 2005. The Seidler Companies and PacificWave Capital served as placement
      agents for the transaction. The agents received a total of $228,125 in cash,
      warrants to purchase 346,409 shares of Procera’s common stock, and 17,473 shares
      of Procera’s common stock as compensation to their services.





20
 *Table
            of Contents*




On
        February 28, 2006, Procera completed the sale of 15,000,025 shares of its
        restricted common stock for $0.40 per share for a total of $6,000,010 to
        thirty-three accredited investors (the “February 2006 Investors”). Chadbourn
        Securities served as the lead placement agent for the transaction. The February
        2006 Investors purchased the shares pursuant to subscription agreements (each
        a
“Subscription Agreement”). In conjunction with the transaction, Procera also
        issued warrants to Chadbourn Securities and other placement agents to purchase
        an aggregate of 1,500,000 shares of its common stock at a per share price
        of
        $0.40. The warrants are exercisable, in whole or in part, for three years
        following the effectiveness of the registration statement. Procera’s Board of
        Directors accepted the terms for the sale of the shares after pursuing all
        financing alternatives and based upon advice from its lead placement agent.
        Each
        February 2006 Investor completed a subscription agreement and a registration
        rights agreement. The February 2006 Investors and the placement agents also
        received registration rights with respect to the shares of common stock issued
        and to the shares of common stock underlying the warrants, and the filing
        of its
        registration statement satisfies Procera’s obligations.


Procera's
      balance of cash and cash equivalents of $1,254,831 at January 1, 2006 represents
      primarily the net proceeds of $1,288,000 from the private placement sales of
      common stock to five accredited investors. Procera’s private placement sales
      commenced on December 19, 2005 and closed on February 28, 2006 with total net
      proceeds of $5,520,010 being received by the Company from a total of
      thirty-three accredited investors. Chadbourn Securities served as lead placement
      agent, along with several other participating agents, for the transactions.
      The
      placement agents received a total of $480,000 in cash and warrants to purchase
      1,500,000 shares of Procera’s common stock as compensation for their
      services.





Procera
      projects that cash and cash equivalents on hand at January 1, 2006, together
      with additional net proceeds of $4,232,010 received through February 28, 2006
      will be sufficient to support its operations growth through December 2006,
      without relying on incoming revenue from sales to customers. Procera expects
      that additional funds, from customer sales or equity financing, will need to
      be
      generated or located in order to sustain its operations beyond December
      2006.





**Material
      Commitments of Capital**





Procera
      uses third-party contract manufacturers to assemble and test its products.
      In
      order to reduce manufacturing lead-times and ensure an adequate supply of
      inventories, Procera's agreements with some of these manufacturers allow them
      to
      procure long lead-time component inventory on its behalf based on a rolling
      production forecast provided by Procera. Procera may be contractually obligated
      to purchase long lead-time component inventory procured by certain manufacturers
      in accordance with its forecasts. In addition, Procera issues purchase orders
      to
      its third-party manufacturers that may not be cancelable at any time. As of
      January 1, 2006, Procera had no open non-cancelable purchase orders with its
      third-party manufacturers compared to $92,353 of open non-cancelable purchase
      orders as of January 2, 2005.





**Off-Balance
      Sheet Arrangements**





As
      of
      January 1, 2006, the Company had no off-balance sheet items as described by
      Item
      303(a)(4)(ii) of Securities and Exchange Commission Regulation S-K.





**CRITICAL
      ACCOUNTING POLICIES AND ESTIMATES**





Procera's
      financial statements have been prepared in accordance with accounting principles
      generally accepted in the United States of America. The preparation of these
      financial statements requires Procera to make significant estimates and
      judgments that affect the reported amounts of assets, liabilities, revenues
      and
      expenses and related disclosure of contingent assets and liabilities. Procera
      evaluates estimates, including those related to bad debts, inventories and
      income taxes, on an ongoing basis. Procera bases its estimates on historical
      experience and on various other assumptions that are believed to be reasonable
      under the circumstances, the results of which form the basis for making
      judgments about the carrying values of assets and liabilities that are not
      readily apparent from other sources. Actual results may differ from these
      estimates under different assumptions or conditions.





Procera
      believes the following critical accounting policies, among others, involve
      the
      more significant judgments and estimates used in the preparation of its
      financial statements:





**REVENUE**





Procera
      recognizes revenue in accordance with SEC Staff Accounting Bulletin No. 104,
      "Revenue Recognition in Financial Statements" (SAB 104). Under SAB 104, revenue
      is recognized when the title and risk of loss have passed to the customer,
      there
      is persuasive evidence of an arrangement, delivery has occurred or services
      have
      been rendered, the sales price is fixed or determinable and collectibility
      is
      reasonably assured. Procera recognizes revenue from product sales upon shipment
      to the customer provided no significant obligations remain and collection of
      the
      receivable is probable. Upon shipment, Procera provides for estimated product
      returns and discounts.





Procera
      also provides a provision for estimated customer returns at the time product
      revenue is recognized. Its provision is based on best estimate at the time
      of
      sale and its return policies. Procera's resellers generally do not have a right
      of return, except for approved stock rotations of excess inventory which must
      be
      accompanied by a new order for products which is equivalent in amount to the
      products being returned. Procera’s contracts with original equipment
      manufacturers only provide for rights of return in the event Procera's products
      do not meet specifications or there is an epidemic failure, as defined in the
      contracts. If historical data used by Procera to calculate estimated sales
      returns do not reasonably approximate future returns, revenue in future periods
      could be affected. For accounting arrangements that have multiple revenue
      generating activities, the Company recognized revenue from product shipments
      at
      the time of shipment under the terms of SAB 104.





21
 *Table
            of Contents*





**ALLOWANCE
      FOR DOUBTFUL ACCOUNTS**





Procera
      maintains an allowance for doubtful accounts for estimated bad debts. If the
      financial condition of its customers were to deteriorate, resulting in an
      impairment of their ability to make payments, additional allowances might be
      required.





**INVENTORIES**





Inventories
      are recorded at the lower of cost or market on a first-in, first-out basis.
      On
      an ongoing basis, Procera reviews for estimated obsolete or excess inventories
      and writes down its inventories to their estimated net realizable value based
      upon its projections of future product demand and product lifecycle and product
      development plans. These write downs are reflected in Procera's cost of revenue.
      Actual product demand may differ from Procera's projections, in which case
      it
      may have understated or overstated the provision for excess and obsolete
      inventory, which would have an impact on its operating results.





**WARRANTY
      RESERVE**





Procera
      generally warrants its products for a specific period of time, usually three
      months for software and twelve months for hardware, against material defects.
      Procera provides for the estimated future costs of warranty obligations in
      costs
      of goods sold when the related revenue is recognized. The accrued warranty
      costs
      represent Procera's best estimate at the time of sale of the total costs that
      it
      will incur to repair or replace product parts, which fail while still under
      warranty. Actual warranty costs could differ from the estimate amounts. On
      a
      quarterly basis, Procera reviews the accrued balances and updates the historical
      warranty cost trends. If Procera were required to accrue additional warranty
      cost in the future, it would negatively affect operating results.





**DEFERRED
      TAX VALUATION ALLOWANCE**





The
      carrying value of Procera's deferred tax assets are dependent upon its ability
      to generate sufficient future taxable income in certain tax jurisdictions.
      Should Procera determines that it would not be able to realize all or part
      of
      our deferred tax assets in the future, an adjustment to the deferred tax assets
      would be charged to income in the period such determination was made. Currently,
      Procera's deferred tax assets are fully reserved.





**RECENT
      ACCOUNTING PRONOUNCEMENTS**





In
      November 2004, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards No. 151, “Inventory Costs - An
      Amendment of ARB No. 43, Chapter 4” (“SFAS 151”). SFAS 151 amends the guidance
      in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for
      abnormal amounts of idle facility expense, freight, handling costs, and wasted
      material (spoilage). Among other provisions, the new rule requires that items
      such as idle facility expense, excessive spoilage, double freight and
      re-handling costs must be recognized as current-period charges regardless of
      whether they meet the criterion of “so abnormal” as stated in ARB No. 43.
      Additionally, SFAS 151 requires that the allocation of fixed production
      overheads to the costs of conversion be based on the normal capacity of the
      production facilities. SFAS 151 is effective for fiscal years beginning after
      June 15, 2005 and is required to be adopted by the Company in the first quarter
      of 2006, beginning on January 2, 2006. The Company does not expect SFAS 151
      to
      have a material financial statement impact.





In
      December 2004, the FASB issued Statement of Financial Accounting Standards
      No.
      153, “Exchanges of Non-monetary Assets - An Amendment of APB Opinion No. 29”
(“SFAS 153”). SFAS 153 eliminates the exception from fair value measurement for
      non-monetary exchanges of similar productive assets in paragraph 21(b) of APB
      Opinion No. 29, “Accounting for Non-monetary Transactions,” and replaces it with
      the exception for exchanges that do not have commercial substance. SFAS 153
      specifies that a non-monetary exchange has commercial substance if the future
      cash flows of the entity are expected to change significantly as a result of
      the
      exchange. SFAS 153 is effective for the fiscal periods beginning after June
      15,
      2005 and is required to be adopted by the Company in the first quarter of fiscal
      2006, beginning on January 2, 2006. The Company does not expect it to have
      a
      material financial statement impact.





In
      December 2004, the FASB issued Statement of Financial Accounting Standards
      No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which
      requires the measurement of all share-based payments to employees, including
      grants of stock options, using a fair-value-based method and the recording
      of
      such expense in the consolidated statements of operations. The accounting
      provisions of SFAS 123R were originally effective for all reporting periods
      beginning after June 15, 2005. The pro forma disclosures previously
      permitted under SFAS 123 no longer will be an alternative to financial
      statement recognition. See “Stock-Based Compensation” above for the pro forma
      net income (loss) and net income (loss) per share amounts, as if the Company
      had
      used a fair-value-based method similar to the methods required under
      SFAS 123R to measure compensation expense for employee stock incentive
      awards.





22
 *Table
            of Contents*





In
      March
      2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107, providing
      supplemental implementation guidance for SFAS 123R. In April 2005, the
      Securities and Exchange Commission approved a rule that delayed the effective
      date of SFAS 123R to the first annual reporting period beginning after December
      15, 2005 for companies that file as small business issuers. Although the Company
      has not yet determined whether the adoption of SFAS 123R will result in
      amounts that are similar to the current pro forma disclosures under
      SFAS 123, it is evaluating the requirements under SFAS 123R and SAB
      107 and expects the adoption to have a significant adverse impact on the
      Company’s consolidated statements of operations and net loss per share. SFAS
      123R will be effective for the Company beginning with the first quarter of
      2006.





In
      May
      2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections—a
      replacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS
      154”). SFAS 154 changes the requirements for the accounting for and reporting of
      a change in accounting principle, and applies to all voluntary changes in
      accounting principle. It also applies to changes required by an accounting
      pronouncement in the unusual instance that the pronouncement does not include
      specific transition provisions. This statement requires retrospective
      application to prior periods’ financial statements of changes in accounting
      principle, unless it is impracticable to determine either the period-specific
      effects or the cumulative effect of the change. SFAS 154 is effective for
      accounting changes made in fiscal years beginning after December 15, 2005.
      The Company does not expect the adoption of this statement will have a material
      impact on our results of operations or financial condition.




23
 *Table
            of Contents*





**ITEM
              7.**
            **FINANCIAL
                STATEMENTS**





PROCERA
      NETWORKS, INC.


(a
      development stage enterprise)







Contents





PageReport
                of Independent Registered Public Accounting Firm
            
            25Audited
                Financial Statements:Balance
                Sheet
            
            26Statements
                of Operations
            
            27Statements
                of Stockholders' Equity (Deficit)
            
            28
                - 29Statements
                of Cash Flows
            
            30Notes
                to Financial Statements
            
            31-52




24
 *Table
            of Contents*





REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM











The
      Board
      of Directors and Stockholders


of
      Procera Networks, Inc.








We
      have
      audited the accompanying balance sheet of Procera Networks, Inc. (a development
      stage enterprise) as of January 1, 2006 and the related statements of
      operations, stockholders' equity (deficit), and cash flows for each of the
      years
      in the two year period ended January 1, 2006, and for the period from May 1,
      2002 (date of inception) to January 1, 2006. These financial statements are
      the
      responsibility of the Company's management. Our responsibility is to express
      an
      opinion on these financial statements based on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Oversight Board (United States). Those standards require that we plan and
      perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles used
      and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.





In
      our
      opinion, the financial statements referred to above present fairly, in all
      material respects, the financial position of Procera Networks, Inc. as of
      January 1, 2006, and the results of its operations and its cash flows for each
      of the years in the two year period ended January 1, 2006, and for the period
      from May 1, 2002 (date of inception) to January 1, 2006, in conformity with
      accounting principles generally accepted in the United States of
      America.





The
      accompanying financial statements have been prepared assuming Procera Networks,
      Inc. will continue as a going concern. As more fully described in Note 2, the
      Company has incurred net losses since its inception and has experienced severe
      liquidity problems. These conditions raise substantial doubt about the Company's
      ability to continue as a going concern. Management's plans in regard to these
      matters are also described in Note 2. The financial statements do not include
      any adjustments that might result from the outcome of this
      uncertainty.








/s/
      Burr,
      Pilger & Mayer LLP





Palo
      Alto, California


February
      13, 2006




25
 *Table
            of Contents*





PROCERA
      NETWORKS, INC.


(a
      development stage enterprise)





BALANCE
      SHEET





January
      1, 2006





**ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            1,254,831Accounts
                receivable, net
            
            
            8,733Inventories,
                net
            
            
            139,816Prepaid
                expenses and other current assets
            
            
            160,941Total
                current assets
            
            
            1,564,321Property
                and equipment, net
            
            
            37,291Other
                assets
            
            
            95,919Total
                assets
            
            $
            1,697,531**LIABILITIES
                AND STOCKHOLDERS' EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            291,034Deferred
                revenue
            
            
            7,319Accrued
                liabilities
            
            
            291,975Notes
                payable - related party
            
            
            240,000Total
                current liabilities
            
            
            830,328Long
              Term LiabilitiesDeferred
                rent
            
            
            16,229Commitments
                and contingenciesStockholders'
                equity:Preferred
                stock, $0.001 par value; 15,000,000 shares authorized; none issued
                and
                outstanding at January 1, 2006
            
            
            -Common
                stock, $0.001 par value, 100,000,000 shares authorized; 30,945,317
                shares
                issued and outstanding at January 1, 2006
            
            
            30,945Common
                stock subscriptions
            
            
            1,310,917Additional
                paid-in-capital
            
            
            17,362,468Deficit
                accumulated during the development stage
            
            
            (17,853,356
            )Total
                stockholders' equity
            
            
            850,974Total
                liabilities and stockholders' equity
            
            $
            1,697,531





The
      accompanying notes are an integral part of these financial
      statements





26
 *Table
            of Contents*





PROCERA
      NETWORKS, INC.


(a
      development stage enterprise)





STATEMENTS
      OF OPERATIONS








CumulativePeriod
                fromMay
                1, 2002Twelve
                Months Ended
            
            (Date
                of Inception)January
                1,
            
            January
                2,
            
            To2006
            
            2005
            
            January
                1, 2006_____________Sales
            
            $
            254,809
            
            $
            97,611
            
            $
            559,873Cost
                of sales
            
            
            307,799
            
            
            160,383
            
            
            619,929Gross
                profit
            
            
            (52,990
            )
            
            (62,772
            )
            
            (60,056
            )Operating
                expenses:Engineering
            
            
            2,604,897
            
            
            2,156,998
            
            
            6,692,452Sales
                and marketing
            
            
            1,752,886
            
            
            900,952
            
            
            3,318,988General
                and administrative
            
            
            2,338,720
            
            
            3,227,098
            
            
            7,355,927Total
                operating expenses
            
            
            6,696,503
            
            
            6,285,048
            
            
            17,367,367Loss
                from operations
            
            
            (6,749,493
            )
            
            (6,347,820
            )
            
            (17,427,423
            )Interest
                and other income
            
            
            11,724
            
            
            6,376
            
            
            30,462Interest
                and other expense
            
            
            (1,146
            )
            
            (21,725
            )
            
            (456,395
            )Net
                loss
            
            $
            (6,738,915
            )
            $
            (6,363,169
            )
            $
            (17,853,356
            )Net
                loss per share - basic and diluted
            
            $
            (0.22
            )
            $
            (0.27
            )Shares
                used in computing net loss per share-basic and diluted
            
            
            30,445,423
            
            
            23,592,522




The
      accompanying notes are an integral part
      of
      these financial statements




27
 *Table
            of Contents*





(a
      development stage enterprise)





STATEMENTS
      OF STOCKHOLDERS' EQUITY (DEFICIT)





Period
      from May 1, 2002 (date of inception) to January 1, 2006





**Additional****Common
                Stock**
            
            **paid-in**
            
            **Common
                stock subscriptions****Shares**
            
            **Amount**
            
            **capital**
            
            **Shares**
            
            **Amount**Issuance
                of common stock to founders at $0.001 per share from May - October
                2002
            
            
            8,115,000
            
            $
            8,115
            
            $
            -
            
            
            -
            
            $
            -Common
                stock subscription issued in connection with advisory agreement at
                $0.001
                per share in May 2002
            
            
            
            
            
            
            
            
            
            
            
            1,200,000
            
            
            1,200Common
                stock subscription issued in connection with convertible notes payable
                at
                $0.001 and $0.01 per share from June - December 2002
            
            
            
            
            
            
            
            
            
            
            
            190,360
            
            
            1,004Net
                lossBalances,
                December 31, 2002
            
            
            8,115,000
            
            
            8,115
            
            
            -
            
            
            1,390,360
            
            
            2,204Issuance
                of common stock to founders at $0.001 per share from January - August
                2003
            
            
            3,750,000
            
            
            3,750
            
            
            
            
            
            (1,200,000
            )
            
            (1,200
            )Issuance
                of common stock to former employees for conversion of unpaid salary
                at
                $0.01 per share in May 2003
            
            
            1,120,388
            
            
            1,120
            
            
            10,084Issuance
                of common stock for cash at $0.50 per share in June 2003, less issuance
                costs of $7,500
            
            
            808,000
            
            
            808
            
            
            395,692Issuance
                of common stock for cash at $0.001 per share upon exercise of warrants
                in
                June 2003
            
            
            500,000
            
            
            500Issuance
                of common stock upon conversion of notes payable at $0.50 per share
                in
                July 2003
            
            
            3,227,666
            
            
            3,228
            
            
            1,610,605Issuance
                of common stock to noteholders at $0.001 - $0.50 per share in January
                -
                July 2003
            
            
            361,893
            
            
            362
            
            
            28,915
            
            
            (190,360
            )
            
            (1,004
            )Issuance
                of common stock for services provided at $0.50 per share in July
                2003
            
            
            40,000
            
            
            40
            
            
            19,960Issuance
                of common stock for cash at $1.00 per share in August 2003, less
                issuance
                costs of $5,500
            
            
            1,695,000
            
            
            1,695
            
            
            1,687,805Issuance
                of common stock in connection with merger with Zowcom at $0.001 in
                October
                2003
            
            
            1,610,000
            
            
            1,610
            
            
            (1,610
            )Issuance
                of common stock for cash at $0.001 per share upon exercise of warrants
                in
                November 2003
            
            
            5,000
            
            
            5Issuance
                of common stock upon conversion of notes payable at $2.00 per share
                in
                December 2003
            
            
            252,959
            
            
            253
            
            
            505,665Issuance
                of common stock for cash at $2.00 per share in December 2003, less
                issuance costs of $299,109
            
            
            1,086,250
            
            
            1,086
            
            
            1,872,305Fair
                value of common stock warrants issued to non-employees
            
            
            
            
            
            
            
            
            324,852Issuance
                of unsecured convertible promissory note with Beneficial conversion
                feature
            
            
            
            
            
            
            
            
            69,470Stock
                based employee compensation
            
            
            
            
            
            
            
            
            84,688Net
                lossBalances,
                December 28, 2003
            
            
            22,572,156
            
            
            22,572
            
            
            6,608,431
            
            
            -
            
            
            -Issuance
                of common stock for cash at $0.075 per share upon exercise of warrants
                in
                January 2004
            
            
            50,000
            
            
            50
            
            
            3,700Additional
                stock issuance costs
            
            
            
            
            
            
            
            
            (2,104
            )Issuance
                of common stock to purchase EZ2, Inc. at $2.05 per share in April
                2004
            
            
            35,000
            
            
            35
            
            
            71,715Issuance
                of common stock for cash at $2.00 per share upon exercise of special
                warrants in April & May 2004, less issuance cost of $172,054
            
            
            1,086,250
            
            
            1,086
            
            
            1,999,360Issuance
                of common stock for cash at $2.00 per share in May 2004
            
            
            250,000
            
            
            250
            
            
            499,750Issuance
                of common stock for cash at $0.075 per share upon exercise of warrants
                in
                May 2004
            
            
            26,000
            
            
            26
            
            
            1,924Issuance
                of common stock to purchase intellectual property of Ezyte, Inc.
                at $1.64
                per share in May 2004
            
            
            65,000
            
            
            65
            
            
            106,535Issuance
                of common stock in connection with private placement at $0.001 in
                June
                2004
            
            
            20,000
            
            
            20
            
            
            (20
            )Issuance
                of common stock for services provided at $0.92 per share in October
                2004
            
            
            11,000
            
            
            11
            
            
            10,109Common
                stock subscription issued in connection with private placement of
                common
                stock at $0.80 per share in December 2004, less issuance costs of
                $285,625
            
            
            
            
            
            
            
            
            
            
            
            5,762,500
            
            
            4,324,375Fair
                value of common stock warrants issued to non-employees
            
            
            
            
            
            
            
            
            505,340Stock
                based employee compensation
            
            
            
            
            
            
            
            
            1,068,615Net
                lossBalances,
                January 2, 2005
            
            
            24,115,406
            
            $
            24,115
            
            $
            10,873,355
            
            
            5,762,500
            
            
            4,324,375Issuance
                of common stock in connection with private placement of common stock
                at
                $0.80 per share in December 2004, less issuance costs of
                $285,625
            
            
            5,762,500
            
            
            5,763
            
            
            4,318,612
            
            
            (5,762,500
            )
            
            (4,324,375
            )Issuance
                of common stock at $1.86 per share to charity organization in connection
                with private placement in December 2004
            
            
            17,473
            
            
            17
            
            
            32,483Issuance
                of common stock for cash at $0.075 per share upon exercise of warrants
                in
                March 2005
            
            
            100,000
            
            
            100
            
            
            7,400Issuance
                of common stock for cash at $2.00 per share upon exercise of warrants
                in
                March 2005, less issuance cost of $5,000
            
            
            50,000
            
            
            50
            
            
            94,950Issuance
                of common stock for cash at $0.075 per share upon exercise of warrants
                in
                April 2005
            
            
            75,000
            
            
            75
            
            
            5,550Issuance
                of common stock for cash at $1.50 per share upon exercise of warrants
                in
                April 2005, less issuance cost of $4,898
            
            
            557,438
            
            
            557
            
            
            830,702Issuance
                of common stock for cash at $1.40 per share upon exercise of warrants
                in
                April 2005
            
            
            102,500
            
            
            103
            
            
            143,397Issuance
                of common stock for services provided at $0.51 per share in November
                2005
            
            
            165,000
            
            
            165
            
            
            83,985Fair
                value of common stock warrants issued to non-employees
            
            
            
            
            
            
            
            
            542,648Stock
                based employee compensation
            
            
            
            
            
            
            
            
            429,386Common
                stock subscribed, net of issuance costs of $112,000
            
            
            
            
            
            
            
            
            
            
            
            3,500,000
            
            
            1,288,000Common
                stock subscribed for services to be rendered
            
            
            
            
            
            
            
            
            
            
            
            45,833
            
            
            22,917Net
                lossBalances,
                January 1, 2006
            
            
            30,945,317
            
            $
            30,945
            
            $
            17,362,468
            
            
            3,545,833
            
            $
            1,310,917




The
      accompanying notes are an integral part of these financial
      statements





28
 *Table
            of Contents*





PROCERA
      NETWORKS, INC.


(a
      development stage enterprise)





STATEMENTS
      OF STOCKHOLDERS' EQUITY (DEFICIT),(Continued)





Period
      from May 1, 2002 (date of inception) to January 1, 2006





**Receivable****for
                stock**
            
            **Deficit
                accumulated during the development****stage**
            
            **Total
                stockholders’****equity(deficit)**Issuance
                of common stock to founders at $0.001 per share from May - October
                2002
            
            $
            -
            
            $
            -
            
            $
            8,115Common
                stock subscription issued in connection with advisory agreement at
                $0.001
                per share in May 2002
            
            
            (1,200
            )Common
                stock subscription issued in connection with convertible notes payable
                at
                $0.001 and $0.01 per share from June - December 2002
            
            
            
            
            
            
            
            
            1,004Net
                loss
            
            
            
            
            
            (1,509,084
            )
            
            (1,509,084
            )Balances,
                December 31, 2002
            
            
            (1,200
            )
            
            (1,509,084
            )
            
            (1,499,965
            )Issuance
                of common stock to founders at $0.001 per share from January - August
                2003
            
            
            1,200
            
            
            
            
            
            3,750Issuance
                of common stock to former employees for conversion of unpaid salary
                at
                $0.01 per share in May 2003
            
            
            
            
            
            
            
            
            11,204Issuance
                of common stock for cash at $0.50 per share in June 2003, less issuance
                costs of $7,500
            
            
            
            
            
            
            
            
            396,500Issuance
                of common stock for cash at $0.001 per share upon exercise of warrants
                in
                June 2003
            
            
            
            
            
            
            
            
            500Issuance
                of common stock upon conversion of notes payable at $0.50 per share
                in
                July 2003
            
            
            
            
            
            
            
            
            1,613,833Issuance
                of common stock to noteholders at $0.001 - $0.50 per share in January
                -
                July 2003
            
            
            
            
            
            
            
            
            28,273Issuance
                of common stock for services provided at $0.50 per share in July
                2003
            
            
            
            
            
            
            
            
            20,000Issuance
                of common stock for cash at $1.00 per share in August 2003, less
                issuance
                costs of $5,500
            
            
            
            
            
            
            
            
            1,689,500Issuance
                of common stock in connection with merger with Zowcom at $0.001 in
                October
                2003
            
            
            
            
            
            
            
            
            -Issuance
                of common stock for cash at $0.001 per share upon exercise of warrants
                in
                November 2003
            
            
            
            
            
            
            
            
            5Issuance
                of common stock upon conversion of notes payable at $2.00 per share
                in
                December 2003
            
            
            
            
            
            
            
            
            505,918Issuance
                of common stock for cash at $2.00 per share in December 2003, less
                issuance costs of $299,109
            
            
            
            
            
            
            
            
            1,873,391Fair
                value of common stock warrants issued to non-employees
            
            
            
            
            
            
            
            
            324,852Issuance
                of unsecured convertible promissory note with Beneficial conversion
                feature
            
            
            
            
            
            
            
            
            69,470Stock
                based employee compensation
            
            
            
            
            
            
            
            
            84,688Net
                loss
            
            
            
            
            
            (3,242,188
            )
            
            (3,242,188
            )Balances,
                December 28, 2003
            
            
            -
            
            
            (4,751,272
            )
            
            1,879,731Issuance
                of common stock for cash at $0.075 per share upon exercise of warrants
                in
                January 2004
            
            
            
            
            
            
            
            
            3,750Additional
                stock issuance costs
            
            
            
            
            
            
            
            
            (2,104
            )Issuance
                of common stock to purchase EZ2, Inc. at $2.05 per share in April
                2004
            
            
            
            
            
            
            
            
            71,750Issuance
                of common stock for cash at $2.00 per share upon exercise of special
                warrants in April & May 2004, less issuance cost of $172,054
            
            
            
            
            
            
            
            
            2,000,446Issuance
                of common stock for cash at $2.00 per share in May 2004
            
            
            
            
            
            
            
            
            500,000Issuance
                of common stock for cash at $0.075 per share upon exercise of warrants
                in
                May 2004
            
            
            
            
            
            
            
            
            1,950Issuance
                of common stock to purchase intellectual property of Ezyte, Inc.
                at $1.64
                per share in May 2004
            
            
            
            
            
            
            
            
            106,600Issuance
                of common stock in connection with private placement at $0.001 in
                June
                2004
            
            
            
            
            
            
            
            
            -Issuance
                of common stock for services provided at $0.92 per share in October
                2004
            
            
            
            
            
            
            
            
            10,120Common
                stock subscription issued in connection with private placement of
                common
                stocks at $0.80 per share in December 2004, less issuance costs of
                $285,625
            
            
            
            
            
            
            
            
            4,324,375Fair
                value of common stock warrants issued to non-employees
            
            
            
            
            
            
            
            
            505,340Stock
                based employee compensation
            
            
            
            
            
            
            
            
            1,068,615Net
                loss
            
            
            
            
            
            (6,363,169
            )
            
            (6,363,169
            )Balances,
                January 2, 2005
            
            
            -
            
            
            (11,114,441
            )
            
            4,107,404Issuance
                of common stock in connection with private placement of common stocks
                at
                $0.80 per share in December 2004, less issuance costs of
                $285,625
            
            
            
            
            
            
            
            
            -Issuance
                of common stock at $1.86 per share to charity organization in connection
                with private placement in December 2004
            
            
            
            
            
            
            
            
            32,500Issuance
                of common stock for cash at $0.075 per share upon exercise of warrants
                in
                March 2005
            
            
            
            
            
            
            
            
            7,500Issuance
                of common stock for cash at $2.00 per share upon exercise of warrants
                in
                March 2005, less issuance cost of $5,000
            
            
            
            
            
            
            
            
            95,000Issuance
                of common stock for cash at $0.075 per share upon exercise of warrants
                in
                April 2005
            
            
            
            
            
            
            
            
            5,625Issuance
                of common stock for cash at $1.50 per share upon exercise of special
                warrants in April 2005, less issuance cost of $4,898
            
            
            
            
            
            
            
            
            831,259Issuance
                of common stock for cash at $1.40 per share upon exercise of special
                warrants in April 2005
            
            
            
            
            
            
            
            
            143,500Issuance
                of common stock for services provided at $0.51 per share in November
                2005
            
            
            
            
            
            
            
            
            84,150Fair
                value of common stock warrants issued to non-employees
            
            
            
            
            
            
            
            
            542,648Stock
                based employee compensation
            
            
            
            
            
            
            
            
            429,386Common
                stock subscribed, net of issuance costs of $112,000
            
            
            
            
            
            
            
            
            1,288,000Common
                stock subscribed for services to be rendered
            
            
            
            
            
            
            
            
            22,917Net
                loss
            
            
            
            
            
            (6,738,915
            )
            
            (6,738,915
            )Balances,
                January 1, 2006
            
            $
            -
            
            $
            (17,853,356
            )
            $
            850,974





The
      accompanying notes are an integral part of these financial
      statements





29
 *Table
            of Contents*





PROCERA
      NETWORKS, INC.


(a
      development stage enterprise)





STATEMENTS
      OF CASH FLOWS




Fiscal
                  Year Ended
              
              CumulativePeriod
                  from
                May
                  1, 2002(Date
                  of Inception)toJanuary
                  1, 2006
              
              January
                  2, 2005
              
              January
                  1, 2006Cash
                  flows from operating activities:Net
                  loss
              
              $
              (6,738,915
              )
              $
              (6,363,169
              )
              $
              (17,853,356
              )Adjustments
                  to reconcile net loss to net cash used in operating
                  activities:Gain
                  on disposal of property and equipment
              
              
              -
              
              
              -
              
              
              (11,796
              )Common
                  stock issued for service rendered
              
              
              84,150
              
              
              10,120
              
              
              125,474Accrued
                  interest on convertible notes payable
              
              
              -
              
              
              
              
              
              264,751Common
                  stock subscribed for services
              
              
              22,917
              
              
              -
              
              
              22,917Stock
                  based compensation
              
              
              429,387
              
              
              1,068,615
              
              
              1,582,690Fair
                  value of warrants issued to non-employee
              
              
              542,647
              
              
              505,340
              
              
              1,442,309Common
                  stocks subscriptions issued in connection with convertible notes
                  payable
              
              
              -
              
              
              -
              
              
              29,277Depreciation
              
              
              32,214
              
              
              62,850
              
              
              117,502Amortization
                  of intangibles
              
              
              -
              
              
              178,350
              
              
              178,350Changes
                  in assets and liabilities:Accounts
                  receivable
              
              
              22,872
              
              
              (31,605
              )
              
              (8,733
              )Inventory
              
              
              (13,403
              )
              
              (31,810
              )
              
              109,387Prepaid
                  expenses and other assets
              
              
              45,793
              
              
              (109,178
              )
              
              (256,860
              )Accounts
                  payable
              
              
              221,910
              
              
              37,520
              
              
              291,034Accrued
                  liabilities, deferred revenue, deferred rent
              
              
              (128,220
              )
              
              81,181
              
              
              48,023Net
                  cash used in operating activities
              
              
              (5,478,648
              )
              
              (4,591,786
              )
              
              (13,919,031
              )Cash
                  flows from investing activities:Purchase
                  of property and equipment
              
              
              (25,335
              )
              
              (34,442
              )
              
              (107,200
              )Proceeds
                  from sale of property and equipment
              
              
              -
              
              
              -
              
              
              15,000Decrease
                  (increase) in restricted cash
              
              
              -
              
              
              10,000
              
              
              -Net
                  cash used in investing activities
              
              
              (25,335
              )
              
              (24,442
              )
              
              (92,200
              )Cash
                  flows from financing activities:Proceeds
                  from issuance of common stock, net
              
              
              -
              
              
              2,500,446
              
              
              6,471,702Proceeds
                  from common stock subscription, net
              
              
              1,288,000
              
              
              4,324,375
              
              
              5,612,375Proceeds
                  from exercise of warrants
              
              
              1,082,884
              
              
              3,596
              
              
              1,086,985Proceeds
                  from convertible notes payable
              
              
              -
              
              
              -
              
              
              1,855,000Proceeds
                  from notes payable-related party
              
              
              240,000
              
              
              -
              
              
              240,000Net
                  cash provided by financing activities
              
              
              2,610,884
              
              
              6,828,417
              
              
              15,266,062Net
                  increase in cash and cash equivalents
              
              
              (2,893,099
              )
              
              2,212,189
              
              
              1,254,831Cash
                  and cash equivalents, beginning of period
              
              
              4,147,930
              
              
              1,935,741
              
              
              -Cash
                  and cash equivalents, end of period
              
              $
              1,254,831
              
              $
              4,147,930
              
              $
              1,254,831Supplemental
                  cash flow information:Cash
                  paid for income taxes
              
              $
              830
              
              $
              3,656
              
              $
              5,286Cash
                  paid for interest
              
              $
              1,076
              
              
              -
              
              $
              1,076Non
                  cash investing and financing activities:Property
                  and equipment acquired with accrued liabilities
              
              
              -
              
              
              -
              
              $
              32,040Transfer
                  of inventory to property and equipment
              
              
              -
              
              
              -
              
              $
              18,757Inventory
                  acquired with accrued liabilities
              
              
              -
              
              
              -
              
              $
              267,960Issuance
                  of common stock in exchange for convertible notes payable and accrued
                  interest
              
              
              -
              
              
              -
              
              $
              2,199,751Issuance
                  of common stock in connection with merger with Zowcom, Inc.
              
              
              -
              
              
              -
              
              $
              1,610Issuance
                  of common stock in connection with acquisition of intellectual
                  property
                  from Ezyte, Inc.
              
              
              -
              
              $
              106,600
              
              $
              106,600Issuance
                  of common stock in connection with acquisition of EZ2,
                  Inc.
              
              
              -
              
              $
              71,750
              
              $
              71,750Issuance
                  of common stock in connection with note payable
              
              
              -
              
              
              -
              
              $
              30,477Issuance
                  of common stock pursuant to common stock subscription agreements
              
              
              -
              
              
              -
              
              $
              30,477Issuance
                  of common stock to charity organization in connection with the
                  private
                  placement in December 2004
              
              $
              32,500
              
              
              -
              
              $
              32,500





The
      accompanying notes are an integral part of these financial
      statements





30
 *Table
            of Contents*








**PROCERA
      NETWORKS, INC.**


**(a
      development stage enterprise)**





**Notes
      to Financial Statements**


**___________________**








**1.**
            **FORMATION
                AND BUSINESS OF THE
                COMPANY**





Procera
      Networks, Inc. (“Procera” or the “Company”), formerly Zowcom, Inc. (“Zowcom”),
      was incorporated in Nevada on July 11, 2001. On October 16, 2003, Procera
      Networks, Inc., a Delaware corporation (“PNI”) merged into Zowcom, Inc. in a
      stock-for-stock transaction, as a result of a merger and plan of reorganization
      agreement (the “Merger”) between Zowcom and PNI. Pursuant to the Merger, Zowcom
      assumed PNI’s operations and business plan and changed its name to Procera
      Networks, Inc.




Procera
      Networks, Inc. is a development stage high techology company engaged in the
      development and marketing of a wire-speed smart switch family of products and
      a
      converged platform family of products, both for the enhancement of existing
      network performance. These products provide intelligent switching and routing
      based on deep packet inspection at wire speed and also the combination of the
      smart switching and routing with point software solutions for secure delivery
      of
      information and applications across wireless and wire line networks. The Company
      is in the development stage, devoting substantially all of its efforts to
      product development, initial sales penetration, and financing. The Company
      has
      funded its operations substantially from the proceeds from issuance of common
      stock.





In
      the
      course of its development activities, the Company has sustained operating losses
      and expects such losses to continue through the foreseeable future. The Company
      will finance its operations primarily through its cash and cash equivalents,
      future financing and future revenues. However, there can be no assurance that
      such efforts will succeed or that sufficient funds will be
      available.





**FISCAL
      YEAR**





The
      Company maintains its accounting records on a 52-53 week fiscal year. The fiscal
      year ends on the Sunday nearest to December 31 and, as a result, an extra week
      is added every five or six years. Fiscal year 2005, which ended January 1,
      2006,
      had 52 weeks, whereas fiscal year 2004, which ended January 2, 2005, had 53
      weeks instead.





**2.**
            **SUMMARY
                OF SIGNIFICANT ACCOUNTING
                POLICIES**





**BASIS
      OF PRESENTATION**





The
      accompanying financial statements have been prepared in conformity with
      accounting principles generally accepted in the United States of America, which
      contemplate continuation of the Company as a going concern. However, at January
      1, 2006, the Company has an accumulated deficit of $17,853,356 and has sustained
      an operating cash flow deficiency of $13,919,031 since inception. In addition,
      the Company had insufficient cash at January 1, 2006 to fund its operations
      for
      the next fiscal year. The Company’s activities have been financed principally
      through borrowings and the issuance of equity.





The
      Company will require additional financing to fund ongoing operations. On
      February 28, 2006, the Company consummated the closure of a private placement
      financing transaction for total net proceeds of $5,520,010, of which $1,288,000
      had been received prior to January 1, 2006. This financing was received from
      thirty-three individual and institutional investors. There can be no assurance
      that any new debt or equity financing could be successfully consummated. These
      factors raise substantial doubt about the Company’s ability to continue as a
      going concern. The financial statements do not include any adjustments relating
      to the recoverability and classification of the recorded asset amounts or
      amounts and classification of liabilities that might result from the outcome
      of
      this uncertainty.





**USE
      OF ESTIMATES**





The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect certain report amounts and disclosures.
      Accordingly, actual results could differ from those estimates.





31
 *Table
            of Contents*





**PROCERA
      NETWORKS, INC.**


**(a
      development stage enterprise)**





**Notes
      to Financial Statements, continued**


**___________________**




**2.**
            **SUMMARY
                OF SIGNIFICANT ACCOUNTING POLICIES,
                continued**





**FAIR
      VALUE OF FINANCIAL INSTRUMENTS**





The
      carrying amounts of certain of the Company's financial instruments including
      cash and cash equivalents, prepaid expenses, accounts payable and accrued
      liabilities approximate fair value due to their short maturities.





**CONCENTRATION
      OF CREDIT RISK**





Financial
      instruments that potentially subject the Company to a concentration of credit
      risk consist of cash and cash equivalents and accounts receivable. Cash and
      cash
      equivalents are deposited in demand and money market accounts in one financial
      institution in the United States. Deposits held with financial institutions
      may
      exceed the amount of insurance provided on such deposits. The Company has not
      experienced any material losses on its deposits of cash and cash
      equivalents.




The
      Company’s accounts receivable are derived from revenue earned from customers
      located in the United States, Australia, Europe, Asia, Canada and the Middle
      East. There are a limited number of customers accounting for the majority of
      purchaseds in the industry worldwide. The Company maintains an allowance for
      doubtful accounts based upon the expected collection of its outstanding
      receivable balances.





On
      January 1, 2006, two customer(s) accounted for 51% and 41%, respectively, of
      total accounts receivable.





**ADVERTISING
      COSTS**





Advertising
      costs are expenses as incurred. Advertising expenses were not significant for
      the periods ended January 1, 2006 and January 2, 2005.





**CASH
      AND CASH EQUIVALENTS AND RESTRICTED CASH**





The
      Company considers all highly liquid investments to mature within three months
      or
      less to be cash equivalents. Restricted cash consists of a certificate of
      deposit in the amount of $30,000 held with a financial institution as a sales
      tax security deposit.





**ACCOUNTS
      RECEIVABLE**





Accounts
      receivable are stated at net realizable value. Customers are on cash on delivery
      until credit approval. Uncollectible receivables are recorded as bad debt
      expense when all efforts to collect have been exhausted and recoveries are
      posted as they are received.





**INVENTORY**





Inventory
      is stated at the lower of cost or market. Cost is determined on a standard
      cost
      basis which approximates actual cost on the first-in, first-out ("FIFO") method.
      Lower of cost or market is evaluated by considering obsolescence, excessive
      levels of inventory, deterioration and other factors.





**PROPERTY
      AND EQUIPMENT**





Property
      and equipment are stated at cost. Depreciation is calculated using the
      straight-line method over the estimated useful lives of the assets, which is
      three years for computer, tooling, test and office equipment and two years
      for
      software. Leasehold improvements are amortized using the straight-line method
      over the estimated useful lives of the assets or the term of the lease,
      whichever is shorter. Whenever assets are retired or otherwise disposed of,
      the
      cost and related accumulated depreciation are removed from the accounts, and
      any
      resulting gain or loss is recognized in income for the period. The cost of
      maintenance and repairs is expensed as incurred; significant improvements are
      capitalized.





32
 *Table
            of Contents*





**IMPAIRMENT
      OF LONG-LIVED ASSETS**





The
      Company evaluates its long-lived assets for indicators of possible impairment
      by
      comparison of the carrying amounts to future net undiscounted cash flows
      expected to be generated by such assets when events or changes in circumstances
      indicate the carrying amount of an asset may not be recoverable. Should an
      impairment exist, the impairment loss would be measured based on the excess
      carrying value of the asset over the asset'sfair value or discounted estimates
      of future cash flows. The Company has not identified any such impairment losses
      to date.





**STOCK
      BASED COMPENSATION**





The
      Company accounts for stock-based employee compensation using the intrinsic
      value
      method under Accounting Principles Board Opinion No. 25, "Accounting for Stock
      Issued to Employees" ("APB 25"), and related interpretations and complies with
      the disclosure provisions of Statement of Financial Accounting Standards
      ("SFAS") No. 148, "Accounting for Stock-Based Compensation, Transition and
      Disclosure - an Amendment of FASB Statement No. 123." The following table
      illustrates the effect on net loss and net loss per share if the Company had
      applied the fair market recognition provisions of SFAS No. 123, "Accounting
      for
      Stock-Based Compensation," to stock-based employee compensation.





CumulativePeriod
                    FromFiscal
                    Year Ended
                
                May
                    1, 2002(Date
                    of Inception)January
                    1
                
                January
                    2,
                
                to2006
                
                2005
                
                January
                    1, 2006__________
                
                __________
                
                _______________Net
                    loss as reported
                
                
                ($6,738,915
                )
                
                ($6,363,169
                )
                
                ($17,853,356
                )Add:
                    Stock-based employee Compensation expense included in reported
                    net loss,
                    net of related tax effects
                
                
                429,386
                
                
                1,068,615
                
                
                1,582,689Deduct:
                    Total stock-based employee compensation expense determined under
                    fair
                    value based method for all awards, net of related tax
                    effects
                
                
                (1,412,246
                )
                
                (969,854
                )
                
                (2,466,788
                )Pro
                    forma net loss
                
                
                ($7,721,775
                )
                
                ($6,264,408
                )
                
                ($18,737,455
                )Earnings
                    per share basic and diluted:As
                    reported
                
                
                ($0.22
                )
                
                ($0.27
                )Pro
                  Forma
                
                
                ($0.25
                )
                
                ($0.27
                )





**STOCK
      BASED COMPENSATION, continued**





The
      fair
      value of options granted was estimated on the date of grant using the
      Black-Scholes option pricing model with the following weighted-average
      assumptions used for grants in 2005:




2005Weighted
                average risk-free rate
            
            
            3.88
            %Expected
                life (years)
            
            
            3.89Volatility
            
            
            114.00
            %Dividend
                yield
            
            
            -




Stock
      options granted to non-employees are accounted for in accordance with SFAS
      123
      and the Emerging Issues Task Force Consensus No. 96-18, “Accounting for
      Equity Instruments That Are Issued to Other Than Employees for Acquiring, or
      in
      Conjunction with Selling Goods or Services,” which are recorded at fair value of
      the consideration received or the fair value of the equity investments issued
      and they vest over a performance period. The fair value of such options is
      determined using the Black-Scholes option pricing model.





33
 *Table
            of Contents*





**INCOME
      TAXES**





Income
      taxes are recorded under the liability method, under which deferred tax assets
      and liabilities are determined based on the difference between the financial
      statement and tax bases of assets and liabilities using enacted tax rates in
      effect for the year in which the differences are expected to affect taxable
      income. Valuation allowances are established when necessary to reduce deferred
      tax assts to the amount expected to be realized.





**REVENUE
      RECOGNITION**





Revenue
      is recognized when a purchase order has been received, the product has been
      shipped, the sales price is fixed or determinable and collection of the
      resulting receivable is probable.





Under
      standard terms, we provide products to direct customers under payment terms
      of
      net 30 days, with no right of return nor price protection provisions. Under
      standard terms, we provide initial products to indirect customers (value-added
      resellers) under payment terms of net 45 days, with the right to evaluate and
      return products in lieu of payment at the end of 45 days. Thereafter, under
      follow-on orders from value-added resellers we provide products under payment
      terms of net 30 days. Any terms other than those just described would be
      considered non-standard.





Products
      sold to an end-user customer have no rights of return, stock rotation rights,
      nor price protection rights. Products sold to an end-user customer may be
      returned for full credit or modification if, upon receipt by the customer,
      they
      do not satisfy the customer’s expectations. Warranty liabilities are established
      based on historical experience of customer returns.





**RESEARCH
      AND DEVELOPMENT**





Research
      and development costs are charged to operations as incurred.





**SHIPPING
      AND HANDLING COSTS**





The
      Company includes shipping and handling costs associated with inbound and
      outbound freight in costs of goods sold.





**PRODUCT
      DEVELOPMENT COSTS**





The
      Company accounts for internally-generated software development costs in
      accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to
      be Sold, Leased or Otherwise Marketed.” Capitalization of eligible product
      development costs begins upon the establishment of technological feasibility,
      which we have defined as completion of a working model. Internally-generated
      software related costs that were eligible for capitalization was approximately
      $75,000 of which approximately $37,500 and $26,000 has been amortized and
      charged to “Engineering” in the statements of operations for the years ended
      January 1, 2006 and January 2, 2005, respectively. For year ended December
      28,
      2003, technical feasibility had not been established and thus all products
      development costs of $402,846 was charged to “Engineering” in the statements of
      operations.





**COMPREHENSIVE
      INCOME**





The
      Company has adopted Statement of Financial Accounting Standards No. 130,
      "Reporting Comprehensive Income," which establishes standards for reporting
      comprehensive income and its components in the financial statements. To date,
      the Company's comprehensive income has equaled its net income.





**NET
      LOSS PER SHARE**





Basic
      earnings per share ("EPS") is computed by dividing net loss by the weighted
      average number of common shares outstanding for the period. Diluted EPS reflects
      the potential dilution that could occur from common shares issuable through
      stock options, warrants and other convertible securities, if
      dilutive.





The
      following table is a reconciliation of the numerator (net loss) and the
      denominator (number of shares) used in the basic and diluted EPS calculations
      and sets forth potential shares of common stock that are not included in the
      diluted net loss per share calculation as the effect is
      antidilutive:





34
 *Table
            of Contents*




Fiscal
                Year EndedJanuary
                1,
            
            January
                2,2006
            
            2005Numerator
                - Basic and diluted
            
            $
            (6,768,915
            )
            $
            (6,363,169
            )Denominator
                - basic and dilutedWeighted
                average common shares outstanding
            
            
            30,445,423
            
            
            23,592,522Weighted
                average unvested common shares subject to repurchase
            
            
            -
            
            
            -Total
            
            
            30,445,423
            
            
            23,592,522Net
                loss per share - basic and diluted
            
            $
            (0.22
            )
            $
            (0.27
            )Antidilutive
                securities:Common
                stock subscriptions
            
            
            3,545,833
            
            
            5,762,500Options
            
            
            3,916,970
            
            
            3,173,000Warrants
            
            
            7,213,178
            
            
            8,808,160Rights
                to purchase common stock
            
            
            292,100
            
            
            325,000





**2.**
            **SUMMARY
                OF SIGNIFICANT ACCOUNTING POLICIES,
                continued**





**RECENT
      ACCOUNTING PRONOUNCEMENTS**





In
      November 2004, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards No. 151, “Inventory Costs - An
      Amendment of ARB No. 43, Chapter 4” (“SFAS 151”). SFAS 151 amends the guidance
      in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for
      abnormal amounts of idle facility expense, freight, handling costs, and wasted
      material (spoilage). Among other provisions, the new rule requires that items
      such as idle facility expense, excessive spoilage, double freight and
      re-handling costs must be recognized as current-period charges regardless of
      whether they meet the criterion of “so abnormal” as stated in ARB No. 43.
      Additionally, SFAS 151 requires that the allocation of fixed production
      overheads to the costs of conversion be based on the normal capacity of the
      production facilities. SFAS 151 is effective for fiscal years beginning after
      June 15, 2005 and is required to be adopted by the Company in the first quarter
      of 2006, beginning on January 2, 2006. The Company does not expect SFAS 151
      to
      have a material financial statement impact.





In
      December 2004, the FASB issued Statement of Financial Accounting Standards
      No.
      153, “Exchanges of Non-monetary Assets - An Amendment of APB Opinion No. 29”
(“SFAS 153”). SFAS 153 eliminates the exception from fair value measurement for
      non-monetary exchanges of similar productive assets in paragraph 21(b) of APB
      Opinion No. 29, “Accounting for Non-monetary Transactions,” and replaces it with
      the exception for exchanges that do not have commercial substance. SFAS 153
      specifies that a non-monetary exchange has commercial substance if the future
      cash flows of the entity are expected to change significantly as a result of
      the
      exchange. SFAS 153 is effective for the fiscal periods beginning after June
      15,
      2005 and is required to be adopted by the Company in the first quarter of fiscal
      2006, beginning on January 2, 2006. The Company does not expect it to have
      a
      material financial statement impact.





In
      December 2004, the FASB issued Statement of Financial Accounting Standards
      No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which
      requires the measurement of all share-based payments to employees, including
      grants of stock options, using a fair-value-based method and the recording
      of
      such expense in the consolidated statements of operations. The accounting
      provisions of SFAS 123R were originally effective for all reporting periods
      beginning after June 15, 2005. The pro forma disclosures previously
      permitted under SFAS 123 no longer will be an alternative to financial
      statement recognition. See “Stock-Based Compensation” above for the pro forma
      net income (loss) and net income (loss) per share amounts, as if the Company
      had
      used a fair-value-based method similar to the methods required under
      SFAS 123R to measure compensation expense for employee stock incentive
      awards.





In
      March
      2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107, providing
      supplemental implementation guidance for SFAS 123R. In April 2005, the
      Securities and Exchange Commission approved a rule that delayed the effective
      date of SFAS 123R to the first annual reporting period beginning after December
      15, 2005 for companies that file as small business issuers. Although the Company
      has not yet determined whether the adoption of SFAS 123R will result in
      amounts that are similar to the current pro forma disclosures under
      SFAS 123, it is evaluating the requirements under SFAS 123R and SAB
      107 and expects the adoption to have a significant adverse impact on the
      Company’s consolidated statements of operations and net loss per share. SFAS
      123R will be effective for the Company beginning with the first quarter of
      2006.





35
 *Table
            of Contents*





In
      May
      2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections—a
      replacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS
      154”). SFAS 154 changes the requirements for the accounting for and reporting of
      a change in accounting principle, and applies to all voluntary changes in
      accounting principle. It also applies to changes required by an accounting
      pronouncement in the unusual instance that the pronouncement does not include
      specific transition provisions. This statement requires retrospective
      application to prior periods’ financial statements of changes in accounting
      principle, unless it is impracticable to determine either the period-specific
      effects or the cumulative effect of the change. SFAS 154 is effective for
      accounting changes made in fiscal years beginning after December 15, 2005.
      The Company does not expect the adoption of this statement will have a material
      impact on our results of operations or financial condition.


.


**3.**
            **MERGER
                WITH ZOWCOM, INC.**





On
      October 16, 2003, Zowcom, Inc., a Nevada corporation and public shell
      ("Zowcom"), merged with Procera Networks, Inc. a Delaware corporation ("PNI")
      (the "Merger") pursuant to an Agreement and Plan of Merger between Zowcom and
      PNI (the "Agreement").





In
      the
      Merger, Zowcom issued 19,617,947 shares of its restricted common stock and
      warrants to purchase 1,479,000 shares of its restricted common stock to the
      stockholders of PNI in exchange for 100% of PNI's issued and outstanding shares
      of common stock and warrants. In addition, Zowcom's management, which held
      6,000,000 shares of Zowcom's restricted common stock, tendered all of their
      shares for redemption by Zowcom in exchange for $88,000.





As
      a
      result of the Merger, Zowcom continued as the surviving corporation, assumed
      the
      operations and business plan of PNI, the stockholders of PNI became stockholders
      of Zowcom and Zowcom changed its name to Procera Networks, Inc.
      ("Procera").





For
      accounting purposes, the merger is considered a capital transaction rather
      than
      a business combination and a recapitalization of PNI since Zowcom has only
      a
      minor amount of net assets and no operations. The transaction was valued based
      on the value of Zowcom's net tangible assets, with no goodwill recognized.
      The
      net tangible asset value was zero as Procera did not receive any of the assets
      or assume any of the liabilities of Zowcom. The statement of stockholder's
      equity (deficit) reflects the issuance of 1,610,000 shares of common stock
      which
      represents the outstanding shares of Zowcom's common stock at the time of the
      merger. The historical financial statements prior to October 16, 2003 are those
      of PNI.





The
      following unaudited pro forma summary is provided for illustrative purposes
      only
      and is not necessarily indicative of the consolidated results of operations
      for
      future periods or that actually would have been realized had Zowcom and PNI been
      a consolidated entity during the periods presented. The summary combines the
      results of operations as if the merger between Zowcom and PNI had taken place
      as
      of the beginning of the periods presented.




2003
            
            2002SALES
            
            $
            32,085
            
            $
            177,413NET
                LOSS
            
            $
            (3,284,163
            )
            $
            (1,590,276
            )NET
                LOSS PER SHARE - BASIC AND DILUTED
            
            $
            (0.27
            )
            $
            (0.38
            )








**4.**
            **BALANCE
                SHEET DETAILS**





Accounts
      receivable consist of the following at January 1, 2006:





Accounts
                receivable
            
            $
            133,520Less:
                allowance for bad debts
            
            
            (124,787
            )Accounts
                receivable, net
            
            $
            8,733




Inventory
      consist of the following at January 1, 2006:





Raw
                Material
            
            $
            3,375WIP
                inventory
            
            
            22,996Finished
                goods inventory
            
            
            139,428Consignment
                inventory
            
            
            134,463Less:
                inventory reserve for obsolescence
            
            
            (160,446
            )Inventories,
                net
            
            $
            139,816








36
 *Table
            of Contents*





Prepaid
      expenses and other current assets consist of the following at January 1,
      2006:





Prepaid
                insurance premiums
            
            $
            34,299Prepaid
                software licenses
            
            
            55,319Prepaid
                maintenance
            
            
            27,686Other
                receivables
            
            
            43,637Total
                prepaid expenses and other current assets
            
            $
            160,941




Property
      and equipment consists of the following at January 1, 2006:





Tooling
                and test equipment
            
            $
            27,826Office
                equipment
            
            
            33,898Computer
                equipment
            
            
            71,296Software
            
            
            19,686Furniture
                and fixtures
            
            
            2,085Total
            
            
            154,791Less:
                accumulated depreciation
            
            
            (117,500
            )Property
                and equipment, net
            
            $
            37,291





Other
      assets consist of the following at January 1, 2006:





Security
                deposit - HR and payroll services
            
            $
            50,615Security
                deposit - Sales taxes collateral
            
            
            30,000Security
                deposit - Facility lease
            
            
            15,304Total
                other assets
            
            $
            95,919




Accrued
      liabilities consist of the following at January 1, 2006:





Payroll
                and related expenses
            
            $
            95,038Accrued
                audit, tax & legal fees
            
            
            64,124Accrued
                stock issuance cost
            
            
            112,000Contingent
                warranty liability
            
            
            14,237Other
                accrued expenses
            
            
            6,576Total
                accrued liabilities
            
            $
            291,975





**5.**
            **ASSET
                PURCHASES**





On
      April
      22, 2004, the Company completed the acquisition of 100% of the outstanding
      stock
      of EZ2, Inc. ("EZ2"), a development stage company located in Saratoga,
      California, for 35,000 shares of the Company's restricted common stock valued
      at
      $71,750. EZ2 has been designing and developing a switching platform for XML
      (Extensible Mark-up Language) and Web Services based applications. XML is a
      mark-up language or mechanism that identifies structured information in a data
      format, such as a document, graph, equation, or e-commerce transaction.
      Structured information contains both content (for example, words or pictures)
      and some indication of what role that content plays (for example, a heading,
      footnote, caption, or table). The Company plans to develop products for the
      XML
      market by taking advantage of the core technology of the EZ-2-XML platform
      to
      perform as a wire-speed packet processing engine. The acquisition has been
      accounted for as an asset purchase since EZ2 did not meet the criteria of a
      business as defined in Statement of Financial accounting Standards No. 141,
      Business Combinations, and Emerging Issues Task Force No. 98-3, Determining
      Whether a Nonmonetary Transaction Involves Receipt of Productive Assets of
      a
      Business. The purchase price has been allocated to purchased technology as
      EZ2
      had no tangible assets and has been fully amortized as of January 2,
      2005.





On
      May
      20, 2004, the Company completed the acquisition of the intellectual property
      of
      Ezyte, Inc. ("Ezyte"), a system performance management company located in
      Saratoga, California for 65,000 shares of the Company's restricted common stock
      valued at $106,600. Ezyte offered products and services for system performance
      management of packet switching networks, high performance routers, Internet
      architecture, wireless Internet and storage systems. Ezyte has developed high
      performance algorithms and architectures for storage systems like RAID
      (redundant array of disks), SAN (storage area network), Remote Copy, Disaster
      Recovery, Cache Servers, etc. Procera plans to use Ezyte's technology to
      expedite new offerings for storage applications and content filtering. The
      acquisition has been accounted for as an asset purchase since Ezyte did not
      meet
      the criteria of a business as defined in Statement of Financial accounting
      Standards No. 141, Business Combinations, and Emerging Issues Task Force No.
      98-3, Determining Whether a Nonmonetary Transaction Involves Receipt of
      Productive Assets of a Business. The purchase price has been allocated to
      purchased technology and has been fully amortized as of January 2,
      2005.





37
 *Table
            of Contents*





**6.**
            **INTANGIBLE
                ASSETS, NET**





Intangible
      assets consist of the following at January 1, 2006:





Gross
            
            
            
            NetIntangible
            
            Accumulated
            
            IntangibleAssets
            
            Amortization
            
            AssetsPurchased
                technology acquired from EZ2, Inc.
            
            $
            71,750
            
            $
            (71,750
            )
            $
            -Purchased
                technology acquired from Ezyte, Inc.
            
            
            106,600
            
            
            (106,600
            )
            
            -Total
                intangible assets
            
            $
            178,350
            
            $
            (178,350
            )
            $
            -





Amortization
      expense for those intangible assets still required to be amortized under
      Statement of Financial Accounting Standards No. 142, Goodwill and Other
      Intangible Assets, was zero for fiscal year ended January 1, 2006 and $178,350
      for the fiscal year ended January 2, 2005.





**7.**
            **NOTES
                PAYABLE**





**Convertible
      Notes Payable**





The
      convertible notes payable disclosure is presented due to the development stage
      nature of the Company and requirements to show the historical equity
      transactions since inception.





In
      May,
      June, July, September and November 2002, the Company issued $1,080,000 in
      convertible notes payable to certain investors. The principal amount of the
      convertible notes payable, together with interest at 0.5% per month is due
      and
      payable upon demand by the holders of the note on or after March 31, 2003.
      The
      outstanding principal and accrued interest of the notes are convertible, at
      the
      option of the holders, into Series B preferred stock at the purchase price
      paid
      for the Series B preferred stock at the first closing. The Company must also
      pay
      a monthly fee of 1.5% of the outstanding principal amount of the note.
      Additionally, the holders of the notes are entitled to 2% of the outstanding
      principal amount of each note per month in shares of the Company's common stock.
      For example, this provision provides for two shares of common stock to be earned
      for each $100 of principal outstanding each month. These notes are
      collateralized by a senior security interest in all of the assets of the
      Company, held pro rata with the other outstanding senior secured creditors
      and
      solely subordinate to senior bank financing or senior secured financing from
      a
      corporate strategic partner of the Company.





In
      connection with the convertible notes payable issued in November 2002, the
      Company granted warrants to purchase common stock (Note 10).





In
      January 2003, the Company issued a convertible note payable in the amount of
      $25,000 to an investor. The principal amount of the convertible note payable,
      together with interest at 0.5% per month is due and payable upon demand by
      the
      holders of the note on or after March 31, 2003. The outstanding principal and
      accrued interest of the note is convertible, at the option of the holder, into
      Series B preferred stock at the purchase price paid for the Series B preferred
      stock at the first closing. The Company must also pay a monthly fee of 1.5%
      of
      the outstanding principal amount of the note. Additionally, the holder of the
      note is entitled to 2% of the outstanding principal amount of the note per
      month
      in shares of the Company's common stock.





The
      note
      is collateralized by a senior security interest in all of the assets of the
      Company, held pro rata with the other outstanding senior secured creditors
      and
      solely subordinate to senior bank financing or senior secured financing from
      a
      corporate strategic partner of the Company.





In
      April
      2003, the Company issued a convertible note payable in the amount of $250,000
      to
      an investor. The principal amount of the convertible note payable, together
      with
      interest at 0.5% per month is due and payable on or after March 31, 2004. The
      outstanding principal and accrued interest of the note is convertible, at the
      option of the holder, into Series B preferred stock at the purchase price paid
      for the Series B preferred stock at the first closing. The note is
      collateralized by a senior security interest in all of the assets of the
      Company, held pro rata with the other outstanding senior secured creditors
      and
      solely subordinate to senior bank financing or senior secured financing from
      a
      corporate strategic partner of the Company.





38
 *Table
          of Contents*




In
      July
      2003, the outstanding principal amount of the convertible notes payable of
      $1,355,000 and accrued interest and loan fees of $258,833 was converted into
      3,227,666 shares of common stock using a conversion rate of $0.50 per share.
      Additionally, the Company issued 361,893 shares of common stock to the note
      holders in accordance with the agreements. In October 2003, the Company issued
      an unsecured convertible promissory note in the amount of $500,000 to an
      investor. The principal amount of the convertible note payable, together with
      interest at 8% per annum, was originally due and payable on April 22, 2004.
      The
      outstanding principal and accrued interest of the note is convertible, at the
      option of the holder, into common stock at a conversion rate of $2.00 per share.
      In connection with the unsecured convertible promissory note, the Company
      granted warrants to purchase common stock (Note 10). The Company has accounted
      for a beneficial conversion feature embedded in the unsecured convertible
      promissory note in accordance with the provisions of Emerging Issues Task Force
      No. 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments.
      The
      beneficial conversion feature, amounting to $69,470, represents an additional
      interest yield on the debt which may be converted at any time at the option
      of
      the holder into common stock. Accordingly, the beneficial conversion feature
      has
      been recorded as an immediate charge to interest expense in October 2003. In
      determining the amount of the beneficial conversion feature, the Company first
      allocated the gross proceeds from the unsecured convertible promissory note
      and
      the warrants based on their relative fair values; resulting in $430,530 of
      the
      proceeds assigned to the unsecured convertible promissory note and $69,470
      assigned to the warrants. The warrants were valued at the issuance date using
      the Black Scholes option pricing model. Interest expense of $69,470 relating
      to
      the discount on the unsecured convertible promissory note associated with the
      warrants was recognized as interest expense over the period that the unsecured
      convertible promissory note was outstanding.





In
      December 2003, the outstanding principal amount of the unsecured convertible
      note payable of $500,000 and accrued interest of $5,918 was converted into
      252,959 shares of common stock at $2.00 per share.





At
      January 1, 2006, the Company has no long-term or convertible debt
      outstanding.





**Notes
      Payable-Related Party**





On
      November 29, 2005, the Company received loan proceeds of $90,000 from Cagan
      McAfee Capital Partners, a related party, and issued a promissory note in that
      amount, bearing interest of 6% per annum, and maturing on April 1, 2006. This
      loan, together with accrued interest of $562, was paid in full on January 6,
      2006.





On
      December 13, 2005, the Company received loan proceeds of $150,000 from Laird
      Cagan, a related party who is a partner with Chadbourn Securities, Inc., and
      issued a promissory note in that amount, bearing interest of 6% per annum,
      and
      maturing on April 1, 2006. On February 28, 2006, Mr. Cagan requested that
      $130,000 of the loan principal owed to him by the Company be converted to a
      purchase of 325,000 shares of the Company’s common stock in conjunction with the
      private placement sales the company’s common stock that closed on this date. The
      remaining loan principal of $20,000, together with accrued interest of $1,971,
      was paid in full by the Company on March 22, 2006.





**8.**
            **COMMITMENTS
                AND CONTINGENCIES**





In
      June
      2003, the Company entered into a six month agreement for the sublease of 3,200
      square feet of space for $1.00 per square foot plus $2,300 in monthly common
      area expenses and a one time deposit of $3,200. Upon expiration, the sublease
      will renew monthly, therefore there are no future minimum payments under this
      lease. In January 2004, the Company reached an agreement with the sub landlord
      to sublease an additional 1,332 square feet of space for $1.00 per square foot.
      The monthly rent increased to $4,532 plus $2,300 in monthly common area
      expenses. In July 2004, the Company subleased an additional 1,000 square feet
      of
      space for $1.00 per square foot from the sub landlord. The monthly rent
      increased to $5,532 plus $2,800 in monthly common area expenses.





On
      May
      31, 2005, the Company terminated its sublease of 5,532 square feet of space
      in
      Campbell, California, at a monthly rental of $5,532 plus $2,800 of monthly
      common area expenses. On June 1, 2005, the Company entered into a 37-month
      lease
      for 11,772 square feet of space in Los Gatos, California at a rent expense
      of
      $12,949 per month for the first 12 months, $14,126 per month for the second
      12
      months, and $15,304 per month for the third 12 months, with the first month’s
      rent under the lease at no charge. Rent expense for the year ended January
      1,
      2006, the year ended January 2, 2005 and for the cumulative period from May
      1,
      2002 (date of inception) to January 1, 2006 was $127,521, $61,297, and $374,294,
      respectively.





39
 *Table
            of Contents*





**9.**
            **GUARANTEES**





**INDEMNIFICATION
      AGREEMENTS**





The
      Company enters into standard indemnification arrangements in our ordinary course
      of business. Pursuant to these arrangements, the Company indemnifies, holds
      harmless, and agrees to reimburse the indemnified parties for losses suffered
      or
      incurred by the indemnified party, generally our business partners or customers,
      in connection with any U.S. patent, or any copyright or other intellectual
      property infringement claim by any third party with respect to our products.
      The
      term of these indemnification agreements is generally perpetual anytime after
      the execution of the agreement. The maximum potential amount of future payments
      the Company could be required to make under these agreements is unlimited.
      The
      Company has never incurred costs to defend lawsuits or settle claims related
      to
      these indemnification agreements. As a result, the Company believes the
      estimated fair value of these agreements is minimal.





The
      Company has entered into indemnification agreements with its directors and
      officers that may require the Company: to indemnify its directors and officers
      against liabilities that may arise by reason of their status or service as
      directors or officers, other than liabilities arising from willful misconduct
      of
      a culpable nature; to advance their expenses incurred as a result of any
      proceeding against them as to which they could be indemnified; and to obtain
      directors' and officers' insurance if available on reasonable terms, which
      the
      Company currently has in place.





**PRODUCT
      WARRANTY**





The
      Company warrants its products for a specific period of time, generally twelve
      months, against material defects. The Company provides for the estimated future
      costs of warranty obligations in cost of sales when the related revenue is
      recognized. The accrued warranty costs represents the best estimate at the
      time
      of sale of the total costs that the Company expects to incur to repair or
      replace product parts, which fail while still under warranty. The amount of
      accrued estimated warranty costs are primarily based on current information
      on
      repair costs. The Company periodically reviews the accrued balances and updates
      the historical warranty cost trends. The following table reflects the change
      in
      the Company's warranty accrual during the year ended January 1,
      2006:





Warranty
                accrual, January 2, 2005
            
            $
            6,206Charged
                to cost of sales
            
            
            8,031Actual
                warranty expenditures
            
            
            0Warranty
                accrual, January 1, 2006
            
            $
            14,237




**10.**
            **STOCKHOLDERS'
                EQUITY (DEFICIT)**




**COMMON
      STOCK**





During
      2002, the Company issued 8,115,000 shares of its common stock to founders and
      certain employees for cash under stock purchase agreements, some of which
      contain repurchase provisions. During 2003, the Company issued 3,750,000 shares
      of its common stock to certain directors, consultants and employees under stock
      purchase agreements, some of which contain repurchase provisions. These shares
      are generally released from repurchase provisions ratably over three
      years.





In
      connection with the termination and rehiring of employees all restricted shares
      were vested.





In
      June
      2003, the Company completed a private placement of 808,000 shares of the
      Company's common stock at $0.50 per share. The Company received net proceeds
      of
      $396,500 after deducting the offering expenses. In connection with the private
      placement, the Company granted warrants to purchase common stock (Note 10 -
      Warrants).




In
      July
      2003, the Company issued 40,000 shares of common stock to a professional advisor
      for services rendered. The Company recorded a charge of $20,000 for the
      estimated fair value of the common stock on the date of issuance.





40
 *Table
          of Contents*




In
      August
      2003, the Company completed a private placement of 1,695,00 shares of the
      Company's common stock at $1.00 per share. The Company received net proceeds
      of
      $1,689,500 after deducting the offering expenses.





In
      December 2003, the Company completed a brokered private placement of 1,086,250
      shares of the Company's common stock at $2.00 per share. The Company received
      net proceeds of $1,873,391 after deducting the offering expenses. In connection
      with the private placement, the Company granted warrants and special warrants
      to
      purchase common stock (Note 10 - Warrants and Special Warrants).





On
      April
      26, 2004, the registration statement filed with the Securities and Exchange
      Commission covering the shares issued in the December 2003 private placement
      is
      declared effective by the Securities and Exchange Commission. Certain investors
      exercised the special warrants to purchase 1,086,250 shares of common stock
      at
      $2.00 per share. The Company received net proceeds of $2,000,446 after deducting
      the offering expenses. In connection with the exercise of Special Warrants,
      the
      Company granted warrants to purchase common stock (Note 10 -
      Warrants).





In
      May
      2004, the Company completed a private placement of 250,000 shares of common
      stock for $2.00 per share. The Company received proceeds of $500,000. In
      connection with the private placement, the Company granted warrants to purchase
      common stock (Note 10 - Warrants).





In
      March
      2005, Procera issued 17,473 shares of the Company’s common stock to a charity
      organization in connection with the private placement of December
      2004.





In
      November, 2005, Procera issued 165,000 shares of its restricted common stock
      for
      services provided for $0.51 per share.





**COMMON
      STOCK SUBSCRIPTIONS**





In
      connection with the convertible notes payable (Note 7), the Company agreed
      to
      issue 190,360 shares of common stock in 2002 and 171,533 shares of common stock
      in 2003 to the holders of the notes. The Company has recorded the earned shares
      as a common stock subscription which resulted in a charge to interest expense
      of
      $1,004 in 2002 and $28,273 in 2003. In May 2002, the Company entered into an
      advisory agreement with a director and agreed to issue 1,200,000 shares of
      common stock at $0.001 per share.





In
      August
      and September 2003, the Company issued 1,200,000 shares and 361,893 shares
      of
      common stock in satisfaction of the common stock subscriptions, respectively.





In
      December 2004, 23 institutional and accredited investors (the "December 2004
      Investors"), each signed a Subscription Agreement, applied to purchase a total
      of 5,762,500 shares of the Company’s restricted common stock for $0.80 per share
      for a total of $4,324,375, net of issuance cost of $285,625. Under the
      Subscription Agreements, the Company granted warrants to purchase common stock
      (Note 10 - Warrants).





In
      January 2005, the Company issued 5,762,500 shares of common stock in
      satisfaction of the common stock subscriptions.





In
      December 2005, five accredited investors each signed a Subscription Agreement,
      applied to purchase a total of 3,500,000 shares of the Company’s restricted
      common stock for $0.40 per share for a total of $1,288,000, net of issuance
      costs of $112,000.





In
      November 2005, the Company agreed to issue 825,000 shares of its restricted
      common stock to a financial adviser as compensation for services to be provided
      over 18 months, beginning in December 2005 and vests ratably over the service
      term. At January 1, 2006, the Company recognized and reported as common stock
      subscriptions 45,833 shares of its restricted common stock as compensation
      for
      financial services for the month of December 2005.





**WARRANTS**





In
      November 2002, the Company issued warrants to purchase 50,000 and 20,000 shares
      of common stock with an exercise price of $0.075 per share, respectively, in
      connection with the convertible notes payable (Note 7). The warrants are
      exercisable immediately and expire in November 2007. Warrants to purchase 50,000
      shares of common stock were exercised and the shares were purchased in December
      2003 at an exercise price of $0.075 per share. The fair value of warrants
      calculated using the Black-Scholes option pricing model was not considered
      material, and accordingly, no value was ascribed to them for financial reporting
      purposes.





41
 *Table
            of Contents*





In
      December 2002, the Company issued warrants to purchase 100,000 shares and 75,000
      shares of common stock to two advisory board members with an exercise price
      of
      $0.075 per share. The vesting terms of the warrants are based on completion
      of
      service on the advisory board over a two year period, with the initial vesting
      occurring upon signing of the agreement. The warrants expire in December 2007.
      One of the agreements was signed in 2002 and the other in 2003. The fair value
      of the warrants will be calculated quarterly using the Black-Scholes option
      pricing model and the Company will record quarterly charges over the vesting
      period of the warrants. During the year ended January 1, 2006, warrants to
      purchase 100,000 shares and 75,000 shares were exercised and the shares were
      purchased for a price of $0.075 per share. The company did not record any
      charges relating to these warrants in 2005. For the year ended January 2, 2005,
      the Company recorded charges of $(8,840) and $(386) relating to these warrants.
      For the year ended December 28, 2003, the Company recorded charges of $135,975
      and $104,340 relating to these warrants. The fair value of the warrants was
      not
      considered material in 2002, and accordingly, the Company did not record any
      charges relating to these warrants in 2002.





In
      December 2002, the Company issued warrants to purchase 400,000 shares of common
      stock for advisory services with an exercise price of $0.01 per share. The
      vesting terms of the warrant are based on completion of advisory services and
      the attainment of certain milestones relating to OEM customers. The warrants
      expire in June 2004 unless the advisor has not exercised his vested warrant
      then
      the advisor shall have an additional three years to exercise the vested
      warrants. At January 1, 2006, warrants to purchase 301,268 shares had vested
      and
      warrants to purchase 98,732 shares were cancelled. The Company calculated the
      fair value of the vested warrants using the Black-Scholes option pricing model
      and recorded a charge of $151,243. At December 28, 2003, 200,000 of the warrants
      had vested in connection with advisory services. The Company calculated the
      fair
      value of the vested warrants using the Black-Scholes option pricing model and
      recorded a charge of $1,075 relating to this warrant.





In
      June
      and July 2003, the Company issued warrants to purchase 770,000 shares and 6,000
      shares of common stock with exercise prices between $0.001 and $0.075 per share
      to placement agents in connection with the private placement of common stock
      in
      June 2003. The warrants are exercisable immediately and expire in June and
      July
      2008. The fair value of warrants calculated using the Black-Scholes option
      pricing model was $319,083 and has been recorded as additional issuance costs
      of
      the transaction. In June 2003, warrants to purchase 500,000 shares of common
      stock were exercised for $500. In December 2003, warrants to purchase 250,000
      shares of common stock were cancelled. In April 2004, warrants to purchase
      20,000 shares and 6,000 shares, repsectively, were exercised and said shares
      were purchased for a price of $0.075 per share.





In
      June
      2003, the Company issued warrants to purchase 50,000 shares of common stock
      with
      an exercise price of $0.50 per share to a legal firm in connection with their
      engagement to provide legal services to the Company. The warrants are
      exercisable immediately and expire in June 2008. The fair value of the warrants
      calculated using the Black-Scholes option pricing model was $13,992 and was
      recognized as legal fees in the year ended December 28, 2003.





In
      June
      2003, the Company issued warrants to purchase 404,000 shares of common stock
      with an exercise price of $0.75 per share to certain investors in connection
      with the private placement in June 2003. The warrants are exercisable
      immediately and expire in June 2008. The fair value of the warrants calculated
      using the Black-Scholes option pricing model was $93,663. Since the warrants
      related to capital raising activities, there was no charge recorded in the
      financial statements for these warrants.





In
      October 2003, the Company issued warrants to purchase 6,125 shares of common
      stock for advisory services with an exercise price of $2.00 per share. The
      warrants are exercisable immediately and expire in October 2006. The fair value
      of warrants calculated using the Black-Scholes option pricing model was $27,232
      and has been recorded as additional issuance costs of the
      transaction.





In
      October 2003, the Company issued warrants to purchase 31,250 shares of common
      stock with an exercise price of $2.00 per share in connection with the unsecured
      convertible notes payable (Note 7). The warrants are exercisable immediately
      and
      expire in October 2006. The fair value of warrants calculated using the
      Black-Scholes option pricing model was $69,470 and was recorded as a discount
      on
      the debt and amortized to interest expense over the life of the debt. During
      the
      year ended December 28, 2003, $138,940 was charged to interest
      expense.





In
      December 2003, the Company issued warrants to purchase 110,188 shares of common
      stock with an exercise price of $2.00 per share to the placement gents in
      connection with the private placement in December 2003. The warrants are
      exercisable immediately and expire one year following the date on which the
      registration statement for the shares has been declared effective by the
      Securities and Exchange Commission. The fair value of warrants calculated using
      the Black-Scholes option pricing model was $207,553 and has been recorded as
      additional issuance costs of the transaction. In April 2005, warrants to
      purchase 47,438 shares of common stock were exercised and said shares were
      purchased at a reduced price of $1.50 per share and warrants to purchase 62,750
      shares of common stock expired.





42
 *Table
          of Contents*




In
      December 2003, the Company issued warrants to purchase 2,172,500 shares of
      common stock with an exercise price of $2.00 per share to certain investors
      in
      connection with the private placement in December 2003. The warrants are
      exercisable immediately and expire one year following the date on which the
      registration statement for the shares has been declared effective by the
      Securities and Exchange Commission. The fair value of warrants calculated using
      the Black-Scholes option pricing model was $4,109,900. Since the warrants
      related to capital raising activities, there was no charge recorded in the
      financial statements for these warrants. In May 2004, special warrants to
      purchase 1,086,250 shares of common stock were exercised and said shares were
      purchased for a price of $2.00 per share. In April 2005, warrants to purchase
      560,000 shares of common stock were exercised and said shares were purchased
      at
      a reduced price of $1.50 per share and warrants to purchase 526,250 of common
      stock expired.




In
      April
      2004, the Company issued warrants to purchase 15,000 shares of the Company's
      restricted common stock at a price of $2.05 per share to an independent
      contractor as additional compensation to perform sales and marketing services.
      The warrants were 50% exercisable on July 15, 2004 and the remaining 50% were
      exercisable on January 15, 2005. The warrants expire on January 5, 2007. The
      fair value of vested warrants calculated using the Black-Scholes option pricing
      model was $16,219 and has been recorded as expense for consulting service for
      the year ended January 2, 2005.





In
      May
      2004, the Company issued warrants to purchase 250,000 shares of common stock
      with an exercise price of $2.00 per share to a certain investor in connection
      with the private placement in May 2004. The warrants are exercisable immediately
      and expire on June 30, 2006. The fair value of warrants calculated using the
      Black-Scholes option pricing model was $82,171. Since the warrants related
      to
      capital raising activities, there was no charge recorded in the financial
      statements for these warrants.




In
      May
      2004, the Company issued warrants to purchase 1,086,250 shares of common stock
      with an exercise price of $2.00 per share to certain investors in connection
      with the exercise of Special Warrants in May 2004. The warrants are exercisable
      immediately and expire on June 30, 2006, which is two years following the date
      on which the registration statement for the shares was declared effective by
      the
      Securities and Exchange Commission. The fair value of warrants calculated using
      the Black-Scholes option pricing model was $539,691. Since the warrants related
      to capital raising activities, there was no charge recorded in the financial
      statements for these warrants. In April 2005, warrants to purchase 102,500
      shares of common stock were exercised and said shares were purchased for a
      reduced price of $1.40 per share.





In
      May
      2004, the Company issued warrants to purchase 110,188 shares of common stock
      with an exercise price of $2.00 per share to the placement agents in connection
      with the exercise of Special Warrants in May 2004. The warrants are exercisable
      immediately and expire on June 30, 2006, which is two years following the date
      on which the registration statement for the shares was declared effective by
      the
      Securities and Exchange Commission. The fair value of warrants calculated using
      the Black-Scholes option pricing model was $55,516 and has been recorded as
      additional issuance costs of the transaction.





In
      August
      2004, the Company issued warrants to purchase 400,000 shares of the Company's
      restricted common stock at a price of $1.40 per share to a financial
      communication firm, as compensation to perform marketing and promotional
      services. The warrants are exercisable in one-third increments, the initial
      33%
      were exercisable on August 2, 2004, the second 33% were exercisable on November
      2, 2004, and the remaining warrants were exercisable on February 2, 2005. The
      warrants expire on August 2, 2006. The fair value of warrants calculated using
      the Black-Scholes option pricing model have been recorded as consulting expenses
      in the amount of $195,351 and $253,144 for the years ended January 1, 2006
      January 2, 2005, respectively.





In
      August
      2004, the Company issued warrants to purchase 100,000 shares of the Company's
      restricted common stock at a price of $1.56 per share to a consulting firm,
      as
      compensation to perform marketing and promotional services. The warrants are
      exercisable immediately and expire on August 12, 2007. The fair value of
      warrants calculated using the Black-Scholes option pricing model was $76,094
      and
      has been recorded as consulting expenses for the year ended January 2,
      2005.





43
 *Table
            of Contents*





In
      August
      2004, the Company issued warrants to purchase 60,000 shares of the Company's
      restricted common stock at a price of $1.60 per share to consulting firm, as
      additional compensation to perform marketing and promotional services. The
      warrants vest over a five-month period with the initial 50% occurring in
      September 2004, 25% in October 2004 and 25% in December 2004. The warrants
      expire on August 4, 2006. The fair value of warrants calculated using the
      Black-Scholes option pricing model was $54,026 and has been recorded as
      consulting expenses for the year ended January 2, 2005.





In
      August
      2004, the Company issued the following warrants: (a) a warrant to purchase
      300,000 shares of the Company's restricted common stock at a price of $1.50
      per
      share, with a net exercise option, exercisable on or before September 1, 2006;
      (b) a warrant to purchase 200,000 shares of the Company’s restricted common
      stock at a price of $2.50 per share, exercisable on or before September 1,
      2005;
      and (c) a warrant to purchase 200,000 shares of the Company’s restricted common
      stock at a price of $3.00 per share, exercisable on or before September 1,
      2005
      to a consulting firm, as compensation to perform marketing and promotional
      services over a twelve month period. The fair value of warrants calculated
      using
      the Black-Scholes option pricing model was $132,207 and has been recorded as
      consulting expenses for the year ended January 2, 2005. As of September 1,
      2005,
      warrants to purchase 400,000 shares of the Company’s restricted common stock
      have expired.





In
      December 2004, the Company issued warrants to purchase 1,728,750 shares of
      the
      common stock at a per share exercise price of $1.25 and warrants to purchase
      1,728,750 shares of the common stock at a per share exercise price of $1.37
      to
      certain investors in connection with the private placement in December 2004.
      The
      warrants are exercisable immediately and expire July 15, 2008, which is three
      years following the date on which the registration statement for the shares
      was
      declared effective by the Securities and Exchange Commission. The fair value
      of
      warrants calculated using the Black-Scholes option pricing model was $4,873,580.
      Since the warrants related to capital raising activities, there was no charge
      recorded in the financial statements for these warrants.





In
      December 2004, the Company issued warrants to purchase 173,206 shares of common
      stock with an exercise price of $1.25 per share and warrants to purchase 175,891
      shares of common stock with an exercise price of $1.37 per share to the
      placement agents in connection with the private placement in December 2004.
      The
      warrants are exercisable immediately and expire three years following the date
      on which the registration statement for the shares has been declared effective
      by the Securities and Exchange Commission. The fair value of warrants calculated
      using the Black-Scholes option pricing model was $488,287 and has been recorded
      as additional issuance costs of the transaction.





In
      February 2005, the Company issued warrants to purchase 100,000 shares of common
      stock with an exercise price of $1.78 per share to independent sales
      representative number one as an incentive to secure orders from prospective
      customers to purchase Company products. The warrants are exercisable in relation
      to cash payments received by the Company from customers who have purchased
      Company products under orders secured by the independent representative. The
      warrants expire on February 23, 2010. Since there were no cash collections
      relating to these warrants during 2005, there was no charge recorded in the
      financial statements for these warrants.





In
      February 2005, the Company issued warrants to purchase 100,000 shares of common
      stock with an exercise price of $1.78 per share to independent sales
      representative number two as an incentive to secure orders from prospective
      customers to purchase Company products. The warrants are exercisable in relation
      to cash payments received by the Company from customers who have purchased
      Company products under orders secured by the independent representative. The
      warrants expire on February 23, 2010. The fair value of warrants calculated
      using the Black-Scholes option pricing model was $42 and has been recorded
      as
      marketing consulting expenses for the year ended January 1, 2006.





In
      February 2005, the Company issued warrants to purchase 50,000 shares of common
      stock with an exercise price of $1.78 per share to independent sales
      representative number three as an incentive to secure orders from prospective
      customers to purchase Company products. The warrants are exercisable in relation
      to cash payments received by the Company from customers who have purchased
      Company products under orders secured by the independent representative. The
      warrants expire on February 23, 2010. Since there were no cash collections
      relating to these warrants during 2005, there was no charge recorded in the
      financial statements for these warrants.





44
 *Table
            of Contents*





In
      February 2005, the Company issued warrants to purchase 50,000 shares of common
      stock with an exercise price of $1.78 per share to independent sales
      representative number four as an incentive to secure orders from prospective
      customers to purchase Company products. The warrants are exercisable in relation
      to cash payments received by the Company from customers who have purchased
      Company products under orders secured by the independent representative. In
      April 2005, the Company terminated its agreement with the independent sales
      representative and the warrants to purchase 50,000 shares of common stock were
      cancelled. Since there were no cash collections relating to these warrants
      during 2005, there was no charge recorded in the financial statements for these
      warrants.





In
      April
      2005, the Company issued warrants to purchase 10,000 shares of common stock
      with
      an exercise price of $1.86 per share to one of the Company’s directors for
      successfully directing and completing an equity raising initiative on behalf
      of
      the Company. The warrants are exercisable immediately and expire on April 13,
      2008. The fair value of warrants calculated using the Black-Scholes option
      pricing model was $14,854 and has been recorded as administrative consulting
      expenses for the year ended January 1, 2006.





In
      May
      2005, the Company issued warrants to purchase 25,000 shares of common stock
      at a
      price of $1.22 per share to its landlord as compensation for assisting the
      Company in securing a facility lease that satisfies the Company’s current
      requirements at a reasonably competitive cost. The warrants vested immediately
      and expire 36 months from the date that the shares supporting these warrants
      are
      declared effectively registered by the Securities and Exchange Commission.
      The
      fair value of warrants calculated using the Black-Scholes option pricing model
      was $22,569. The Company will record quarterly charges over the 37-month term
      of
      the lease and $4,595 has been recorded as an addition to rent expenses for
      the
      year ended January 1, 2006.





In
      June
      2005, the Company issued warrants to purchase 75,000 shares of common stock
      with
      an exercise price of $1.42 per share to one of the Company’s directors as
      partial compensation for successfully directing and coordinating activities
      to
      complete a strategic business relationship with a high profile partner(s) and/or
      investors. Fifty percent of the warrants became exercisable on October 14,
      2005
      and the remainder will vest upon completion of a PIPE or strategic investment
      with a minimum value of five million dollars. The warrants expire on June 14,
      2008. The fair value of warrants calculated using the Black-Scholes option
      pricing model was $8,102 and has been recorded as administrative consulting
      expenses for the year ended January 1, 2006.




In
      September 2005, the Company issued warrants to purchase 15,000 shares of common
      stock with an exercise price of $0.68 per share to independent sales
      representative number five as compensation for assisting the Company in
      finalizing the specification and definition of a new Company product and other
      services. The warrants vest upon completion of mutually agreed upon milestones.
      As of January 1, 2006, milestones have not been completed and no warrant shares
      have vested. The warrants expire 36 months from the date that the shares
      supporting these warrants are declared effectively registered by the Securities
      and Exchange Commission.





In
      December 2005, the Company received subscriptions from five accredited investors
      to purchase 3,500,000 shares of the Company’s common stock at a price of $0.40
      per share as part of the Company’s private placement sale of common shares which
      closed on February 28, 2006. As partial compensation to placement agents for
      obtaining these December subscriptions, as of January 1, 2006 the Company is
      obligated to issue warrants to said agents to purchase 350,000 shares of the
      Company’s common stock at a price of $0.40 per share. These warrants vest
      immediately upon issuance and expire on February 28, 2011.




At
      January 1, 2006, warrants to purchase 7,213,178 shares of common stock are
      outstanding.





The
      following table sets forth the key terms of these outstanding
      warrants:




DATE
                OF GRANT
            
            UNDERLYING
                SECURITY
            
            SHARES
                OUTSTANDING
            
            
            
            VESTING
                OF GRANT
            
            EXPIRATION
                DATE
            
            WEIGHTED
                AVERAGE EXERCISE PRICE
            
            REASONS
                FOR GRANT OF WARRANTS11/2002
            
            Common
                stock
            
            20,000
            
            (1)
            
            Immediate
            
            11/2007
            
            $             0.075
            
            Raising
                capital12/2002
            
            Common
                stock
            
            301,268
            
            (2)
            
            Milestones
            
            06/2007
            
            $            
                0.010
            
            Customer
                base06/2003
            
            Common
                stock
            
            404,000
            
            (3)
            
            Immediate
            
            06/2008
            
            $            
                0.750
            
            Raising
                capital06/2003
            
            Common
                stock
            
            50,000
            
            (4)
            
            Immediate
            
            06/2008
            
            $            
                0.500
            
            Legal
                services10/2003
            
            Common
                stock
            
            6,125
            
            (5)
            
            Immediate
            
            10/2006
            
            $             2.000
            
            Raising
                capital10/2003
            
            Common
                stock
            
            31,250
            
            (6)
            
            Immediate
            
            10/2006
            
            $             2.000
            
            Raising
                capital04/2004
            
            Common
                stock
            
            15,000
            
            (7)
            
            Over
                9 months period
            
            01/2007
            
            $             2.050
            
            Consulting
                services05/2004
            
            Common
                stock
            
            1,093,938
            
            (8)
            
            Immediate
            
            06/2006
            
            $             2.000
            
            Raising
                capital05/2004
            
            Common
                stock
            
            250,000
            
            (9)
            
            Immediate
            
            06/2006
            
            $             2.000
            
            Raising
                capital08/2004
            
            Common
                stock
            
            400,000
            
            (10)
            
            Over
                6 months period
            
            08/2006
            
            $             1.400
            
            Investor/Public
                Relations services08/2004
            
            Common
                stock
            
            60,000
            
            (11)
            
            Over
                5 months period
            
            08/2006
            
            $             1.600
            
            Investor/Public
                Relations services08/2004
            
            Common
                stock
            
            100,000
            
            (12)
            
            Immediate
            
            08/2007
            
            $             1.560
            
            Investor/Public
                Relations services08/2004
            
            Common
                stock
            
            300,000
            
            (13)
            
            Immediate
            
            09/2006
            
            $             1.500
            
            Investor/Public
                Relations services12/2004
            
            Common
                stock
            
            1,901,956
            
            (14)
            
            Immediate
            
            07/2008
            
            $             1.250
            
            Raising
                capital12/2004
            
            Common
                stock
            
            1,904,641
            
            (15)
            
            Immediate
            
            07/2008
            
            $             1.370
            
            Raising
                capital02/2005
            
            Common
                stock
            
            100,000
            
            (16)
            
            Based
                on sales performance
            
            02/2010
            
            $            
                1.78
            
            Sales
                services02/2005
            
            Common
                stock
            
            100,000
            
            (17)
            
            Based
                on sales performance
            
            02/2010
            
            $             1.78
            
            Sales
                services02/2005
            
            Common
                stock
            
            50,000
            
            (18)
            
            Based
                on sales performance
            
            02/2010
            
            $             1.78
            
            Sales
                services04/2005
            
            Common
                stock
            
            10,000
            
            (19)
            
            Immediate
            
            04/2008
            
            $             1.86
            
            Raising
                capital05/2005
            
            Common
                stock
            
            25,000
            
            (20)
            
            Immediate
            
            3
                years after effective date of SB-2
            
            $             1.22
            
            Real
                estate services06/2005
            
            Common
                stock
            
            75,000
            
            (21)
            
            Milestones
            
            06/2008
            
            $             1.42
            
            Strategic
                investment09/2005
            
            Common
                stock
            
            15,000
            
            (22)
            
            Milestones
            
            3
                years after effective date of SB-2
            
            $             0.68
            
            Sales
                services7,213,178




45
 *Table
            of Contents*





(1)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $0.01 per share; (ii) exercise price
      of
      $0.075 per share; (iii) expected life of five years; (iv) volatility of 65%;
      (v)
      risk-free rate of 3.05%; and (vi) annual dividend of 0%.





(2)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $0.01 per share; (ii) exercise price
      of
      $0.01 per share; (iii) expected life of four and half years; (iv) volatility
      of
      65%; (v) risk-free rate of 2.70%; and (vi) annual dividend of 0%.





(3)
      The
      fair value of the warrants granted was estimated on the date of grant using
the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: i) current stock price of $0.50 per share; (ii) exercise price
      of
      $0.75 per share; (iii) expected life of five years; (iv) volatility of 65%;
      (v)
      risk-free rate of 2.28%; and (vi) annual dividend of 0%.





(4)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $0.50 per share; (ii) exercise price
      of
      $0.50 per share; (iii) expected life of five years; (iv) volatility of 65%;
      (v)
      risk-free rate of 2.35%; and (vi) annual dividend of 0%.





(5)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $6.05 per share; (ii) exercise price
      of
      $2.00 per share; (iii) expected life of three years; (iv) volatility of 65%;
      (v)
      risk-free rate of 2.35%; and (vi) annual dividend of 0%.





(6)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $2.00 per share; (ii) exercise price
      of
      $2.00 per share; (iii) expected life of three years; (iv) volatility of 65%;
      (v)
      risk-free rate of 2.35%; and (vi) annual dividend of 0%.





(7)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $1.64 per share; (ii) exercise price
      of
      $2.05 per share; (iii) expected life of three years; (iv) volatility of 92%;
      (v)
      risk-free rate of 2.37%; and (vi) annual dividend of 0%. ****





46
 *Table
            of Contents*





(8)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $1.95 per share; (ii) exercise price
      of
      $2.00 per share; (iii) expected life of one year; (iv) volatility of 65%; (v)
      risk-free rate of 2.33%; and (vi) annual dividend of 0%. ****





(9)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $1.66 per share; (ii) exercise price
      of
      $2.00 per share; (iii) expected life of one year; (iv) volatility of 65%; (v)
      risk-free rate of 2.59%; and (vi) annual dividend of 0%. ****





(10)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $1.63 per share; (ii) exercise price
      of
      $1.40 per share; (iii) expected life of two years; (iv) volatility of 103%;
      (v)
      risk-free rate of 2.78%; and (vi) annual dividend of 0%. ****





(11)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $1.63 per share; (ii) exercise price
      of
      $1.60 per share; (iii) expected life of two years; (iv) volatility of 103%;
      (v)
      risk-free rate of 2.78%; and (vi) annual dividend of 0%. ****





(12)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $1.40 per share; (ii) exercise price
      of
      $1.56 per share; (iii) expected life of three years; (iv) volatility of 87%;
      (v)
      risk-free rate of 2.85%; and (vi) annual dividend of 0%. ****





(13)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $1.40 per share; (ii) exercise price
      of
      $1.50 per share; (iii) expected life of two years; (iv) volatility of 87%;
      (v)
      risk-free rate of 2.48%; and (vi) annual dividend of 0%. ****





(14)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $1.86 per share; (ii) exercise price
      of
      $1.25 per share; (iii) expected life of three years; (iv) volatility of 118%;
      (v) risk-free rate of 3.25; and (vi) annual dividend of 0%.





(15)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $1.86 per share; (ii) exercise price
      of
      $1.37 per share; (iii) expected life of three years; (iv) volatility of 118%;
      (v) risk-free rate of 3.25; and (vi) annual dividend of 0%.





(16)
      Because no warrants vested during 2005, no charges were recorded on the
      financial statements for the year ended January 1, 2006.




(17)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $0.69 per share; (ii) exercise price
      of
      $1.78 per share; (iii) expected life of five years; (iv) volatility of 111%;
      (v)
      risk-free rate of 4.18%; and (vi) annual dividend of 0%.





(18)
      Because no warrants vested during 2005, no charges were recorded on the
      financial statements for the year ended January 1, 2006.





(19)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $1.86 per share; (ii) exercise price
      of
      $1.86 per share; (iii) expected life of three years; (iv) volatility of 109%;
      (v) risk-free rate of 4.03%; and (vi) annual dividend of 0%.





(20)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $1.34 per share; (ii) exercise price
      of
      $1.22 per share; (iii) expected life of five years; (iv) volatility of 109%;
      (v)
      risk-free rate of 3.88%; and (vi) annual dividend of 0%.





47
 *Table
            of Contents*





(21)
      The
      fair value of the warrants granted was estimated on the date of grant using
      the
      Black-Scholes option pricing model with the following weighted-average
      assumptions: (i) current stock price of $0.46 per share; (ii) exercise price
      of
      $1.42 per share; (iii) expected life of three years; (iv) volatility of 109%;
      (v) risk-free rate of 4.30%; and (vi) annual dividend of 0%.





(22) Because
      no warrants vested during 2005, no charges were recorded on the financial statements
      for the year ended January 1, 2006.





In
      December 2003, the Company issued special warrants to purchase 1,086,250 shares
      of common stock with an exercise price of $2.00 per share to certain investors
      in connection with the private placement of common stock in December 2003.
      The
      special warrants were to be automatically exercised immediately upon the
      declaration of the effectiveness of the Company's registration statement filed
      with the Securities and Exchange Commission covering the shares issued in the
      December 2003 private placement. The special warrants were to terminate if
      the
      effective date for the registration statement occurred after June 6, 2004.





On
      April
      26, 2004, the registration statement filed with the Securities and Exchange
      Commission covering the shares issued in the December 2003 private placement
      was
      declared effective by the Securities and Exchange Commission. Certain investors
      exercised the special warrants to purchase 1,086,250 shares of common stock
      at
      $2.00 per share. The Company received net proceeds of $2,000,446 after deducting
      the offering expenses. In connection with the exercise of Special Warrants,
      the
      Company granted warrants to purchase common stock (Note 10 -
      Warrants).





On
      March
      30, 2005, the Board of Directors approved an offer by the Company to amend
      the
      1,177,688 shares of investor warrants issued on December 9, 2003, to reduce
      the
      exercise price of such warrants from $2.00 to $1.50 per share, and to change
      the
      expiration date of such warrants from April 26, 2005 to April 13, 2005. In
      addition, the Company offered to amend 1,446,438 investor warrants issued on
      June 27, 2004, to reduce the exercise price of such warrants from $2.00 to
      $1.40
      per share and to change the expiration date of such warrants from June 30,
      2006
      to April 13, 2005. On or about April 13, 2005, certain holders of the Company’s
      December 2003 Warrants and June 2004 Warrants exercised warrants to purchase
      557,438 and 102,500 shares of its common stock at $1.50 and $1.40 per share,
      respectively, and the Company received net proceeds of $974,759 from the
      exercise of such exchange warrants. The Black-Scholes fair value of the warrant
      re-pricing is estimated to be $1,926,330.





At
      January 1, 2006, there are no special warrants outstanding.





**RIGHT
      TO PURCHASE COMMON STOCK**





In
      July,
      August and September 2003, the Company granted the right to purchase 250,000
      shares, 175,000 shares and 150,000 shares with exercise prices of $0.075, $0.10
      and $0.25 per share, respectively, to employees in connection with employment
      agreements. The rights vest over a three year period and expire in July, August
      and September 2006. The Company will record stock compensation expense for
      the
      excess of the deemed fair market value over the exercise price at the date
      of
      issuance. The compensation expense is being recognized over the vesting period
      of three years using the straight line method. For the years ended January
      1,
      2006, January 2, 2005 and December 28, 2003, the Company recorded stock
      compensation expense of $429,387, $1,068,615 and $84,688,
      respectively.





In
      September 2004, one employee terminated his employment with the Company and
      119,800 shares of unvested rights to purchase common stock expired. In November
      2004, sixty days after the termination of employment for this employee, 130,200
      shares of vested rights to purchase common stock expired.





In
      November 2005, a second employee terminated his employment with the Company
      and
      32,900 additional shares of unvested rights to purchase common stock expired.
      At
      January 1, 2006, this employee had vested the right to purchase 142,100 shares
      of the Company’s common stock at a price of $0.10 per share, provided such
      purchase be made on or before January 17, 2006. On January 13, 2006 the employee
      purchased 20,000 shares of the Company’s common stock at $0.10 per share and on
      January 17, 2006 rights to purchase 122,100 shares expired.





Stock
      compensation to be recorded in future periods will be $18,750 in 2006. The
      amount of stock compensation expense to be recorded in future periods could
      decrease if the stock purchase rights do not fully vest.





48
 *Table
            of Contents*





At
      January 1, 2006, there are 292,100 shares of the above rights to purchase common
      stock outstanding.





**TRANSACTIONS
      WITH EMPLOYEES**





Due
      to
      the Company's cash position and lack of ability to obtain additional financing,
      the Company was forced to terminate all of its employees on March 31, 2003.
      In
      April 2003, the Company rehired its chief executive officer and its chief
      financial officer to restart its operations and to continue to search for
      financing or a possible merger transaction.





In
      April
      2003, the Company reached agreement with its former employees and executed
      Settlement and Release Agreements whereby the former employees gave up their
      right to their accrued unpaid salary in exchange for common stock of the Company
      equal to two times their accrued salary with a fair value of $0.01 per share.
      For example, for each dollar of accrued salary the employee earned, they
      received 2 shares of common stock with a fairvalue of $0.01 per share. In July
      2003, the Company issued 1,120,388 shares of its common stock to former
      employees for their unpaid accrued salary through March 2003. The value of
      the
      common stock issued was $11,204. In addition, all shares of restricted common
      stock were vested upon rehire.





**STOCK
      OPTION PLANS**





Under
      the
      Company's 2003 Stock Option Plan and its 2004 Stock Option Plan (the "Option
      Plans"), 7,500,000 shares of Common Stock are authorized for issuance to
      employees, officers, consultants, and directors of the Company. Stock options
      are granted at fair market value on the date of grant with terms up to ten
      years. Under the terms of the Option Plans, 16.7% of the stock options granted
      to employees will vest six months after the date of employment, and the
      remaining stock options will continue to vest ratably over the remainder of
      the
      three-year vesting period. Certain grants of options to employees after the
      initial grant of options to employees vest over three years. Stock option grants
      to members of the Company’s Board of Directors in compensation for their
      services vest over four calendar quarters.








The
      following table summarizes stock option activity:





Options
                OutstandingShares
                Available for Grant
            
            Number
                of Shares
            
            Weighted
                Average Exercise PriceBalance
                at December 31, 2002
            
            
            -
            
            
            -
            
            
            -Authorized
            
            
            2,500,000
            
            
            -
            
            
            -Granted
            
            
            -
            
            
            -
            
            
            -Exercised
            
            
            -
            
            
            -
            
            
            -Canceled
            
            
            -
            
            
            -
            
            
            -Balance
                at December 28, 2003
            
            
            2,500,000
            
            
            -
            
            
            -Authorized
            
            
            2,500,000
            
            
            -
            
            
            -Granted
            
            
            (3,173,000
            )
            
            3,173,000
            
            $
            1.41Exercised
            
            
            -
            
            
            -
            
            
            -Cancelled
            
            
            -
            
            
            -
            
            
            -Balance
                at January 2, 2005
            
            
            1,827,000
            
            
            3,173,000
            
            $
            1.41Authorized
            
            
            2,500,000Granted
            
            
            (1,263,000
            )
            
            1,263,000
            
            $
            1.27Exercised
            
            
            -
            
            
            -
            
            
            -Cancelled
            
            
            519,030
            
            
            (519,030
            )
            $
            1.36Balance
                at January 1, 2006
            
            
            3,583,030
            
            
            3,916,970
            
            $
            1.38




49
 *Table
            of Contents*





The
      following table summarizes outstanding and exercisable options at January 1,
      2006:





Options
                Outstanding
            
            Options
                ExercisableExercise
                Prices
            
            Number
                of Options Outstanding
            
            Weighted
                Average Remaining Life in Years
            
            Weighted
                Average Exercise Price
            
            Number
                of Options Exercisable
            
            Weighted
                Average Exercise Price$0.45
                to $1.00
            
            
            1,102,776
            
            
            9.21
            
            $
            0.82
            
            
            272,515
            
            $
            0.90$1.01
                to $2.00
            
            
            2,669,194
            
            
            8.44
            
            $
            1.54
            
            
            1,910,442
            
            $
            1.53$2.01
                to $3.00
            
            
            85,000
            
            
            8.81
            
            $
            2.21
            
            
            34,303
            
            $
            2.16$3.01
                to $4.00
            
            
            60,000
            
            
            8.18
            
            $
            3.35
            
            
            60,000
            
            $
            3.35$0.92
                to $4.00
            
            
            3,916,970
            
            
            8.66
            
            $
            1.38
            
            
            2,277,260
            
            $
            1.51





During
      fiscal years ended January 1, 2006 and January 2, 2005, the Company granted
      options with a weighted-average fair value of approximately $0.98 and $1.97
      per
      share, respectively.





**11.**
            **INCOME
                TAXES**





There
      is
      no provision for income taxes because the Company has incurred operating losses.
      Deferred income taxes reflect the net tax effects of net operating loss and
      tax
      credit carryovers and temporary differences between the carrying amounts of
      assets and liabilities for financial reporting purposes and the amounts used
      for
      income tax purposes. Significant components of the Company's deferred tax assets
      are as follows:





Fiscal
                Year EndedJanuary
                1,
            
            January
                2,2006
            
            2005Deferred
                tax assets:Federal
                and state net operating losses
            
            $
            5,468,362
            
            $
            3,449,120Research
                credits
            
            
            529,974
            
            
            382,803Non-deductible
                accrued expenses
            
            
            1,209,378
            
            
            976,895Other
            
            
            -
            
            
            -Total
                deferred tax assets
            
            
            7,207,714
            
            
            4,808,818Valuation
                allowance
            
            
            (7,207,714
            )
            
            (4,808,818
            )Net
                deferred tax assets
            
            $
            -
            
            $
            -





As
      of
      January 1, 2006, the Company had net operating loss carryforwards for federal
      income tax purposes of approximately $14,260,462 which expires beginning after
      the year 2020. The Company also has California net operating loss carryforwards
      of approximately $10,631,305 which expire beginning after the year 2012. The
      Company also has federal and California research and development tax credits
      of
      $255,132 and $274,842. The federal research credits will begin to expire in
      the
      year 2021 and the California research credits have no expiration
      date.





The
      change in the valuation allowance was a net increase of $2,398,896 and
      $2,737,110 for the years ended January 1, 2006 and January 2, 2005,
      respectively.




Utilization
      of the Company’s net operating loss may be subject to substantial annual
      limitation due to the ownership change limitations provided by the Internal
      Revenue Code and similar state provisions. Such an annual limitation could
      result in the expiration of the net operating loss before
      utilization.





**12.**
            **RELATED
                PARTY TRANSACTIONS**





On
      May 1,
      2002, the Company entered into an Advisory Agreement with an individual, a
      partner in a company, located in Cupertino, CA. The individual was also serving
      as a Director on the Company’s Board of Directors. The initial term of the
      Agreement was May 1, 2002 through October 31, 2002 and was subsequently extended
      for a period of six months, as was provided for in the Agreement, through April
      30, 2003.





In
      his
      capacity as Advisor, the individual agreed to provide the Company with the
      following advisory services:





50
 *Table
            of Contents*





●
            Advisory
                services related to the structure of financings by the Company, including
                the initial funding;


●
            Introductions
                to potential individual, corporate, and institutional
                investors.


●
            Introductions
                to investment banking and private equity
                firms;


●
            Introductions
                and advice related to the recruitment of Board members and advisory
                board
                members;


●
            Introductions
                and advice related to the Company’s engagement of accounting and law firms
                as the CEO shall direct from time to
                time;


●
            Advice
                in the preparation of a Form S-1 and other documents required for
                an
                initial public offering of the
                Company;


●
            Advice
                related to a merger of the Company with an existing public company,
                if
                such transaction is sought by the CEO;
                and


●
            Such
                other matters as may be required from time-to-time by the President/CEO
                with the consent of Advisor, provided that such consent shall not
                be
                unreasonably withheld.




As
      part
      of his compensation for Advisory Services rendered under the Agreement, the
      Advisor was permitted to purchase from the Company 1,200,000 founder’s common
      shares at a price of $.001 per share which was deemed fair value of the stock
      at
      the time the agreement was executed. The number of shares granted were
      determined based on the nature of services being provided.





In
      August
      2003, the individual exercised the common stock subscription to purchase
      1,200,000 shares of common stock at $0.001 per share. Additionally, the
      individual held a convertible note payable in the amount of $150,000, which
      is
      included in the convertible notes payable amount of $1,355,000 that was
      converted into the Company's common stock in July 2003.





In
      May
      2003, the Company entered into an advisory agreement with Cagan McAfee Capital
      Partners, LLC ("CMCP") to assist in a $5,000,000 financing. One of the owners
      of
      CMCP is a director of the Company. In connection with the advisory agreement,
      the Company agreed to sell CMCP 2,000,000 shares of its common stock at $0.001
      per share, which was purchased in August 2003 by CMCP. This amount was recorded
      as part of common stock issued to founders for $2,000 and charged to
      miscellaneous expense.





In
      August
      2003, the Company entered into an Assignment and Assumption Agreement with
      Douglas J. Glader, the Company's president and chief executive officer, whereby
      Douglas J. Glader assigned his option to purchase certain tangible property,
      finished goods inventory, furniture, capital e quipment
      and intellectual property rights from Digi International, Inc. ("Digi") to
      the
      Company with the consent of Digi (Note 13).





On
      November 29, 2005, the Company received loan proceeds of $90,000 from Cagan
      McAfee Capital Partners, a related party, and issued a promissory note in that
      amount, bearing interest of 6% per annum, and maturing on April 1, 2006. This
      loan, together with accrued interest of $562, was paid in full on January 6,
      2006.





On
      December 13, 2005, the Company received loan proceeds of $150,000 from Laird
      Cagan, a related party who is a partner with Chadbourn Securities, Inc., and
      issued a promissory note in that amount, bearing interest of 6% per annum,
      and
      maturing on April 1, 2006. On February 28, 2006, Mr. Cagan requested that
      $130,000 of the loan principal owed to him by the Company be converted to a
      purchase of 325,000 shares of the Company’s common stock in conjunction with the
      private placement sales the company’s common stock that closed on this date. The
      remaining loan principal of $20,000, together with accrued interest of $1,971,
      was paid in full by the Company on March 22, 2006.





**13.**
            **TRANSACTIONS
                WITH DIGI INTERNATIONAL,
                INC.**





In
      May
      2002, the Company entered into a Purchase and License Agreement with Digi
      whereby the Company desired to acquire or license all of Digi’s tangible and
      intangible assets, intellectual property and personal property related to the
      business of layer 2 through layer 7 switches in exchange for issuing shares
      of
      the Company’s stock, representing 19.9% of the fully diluted capitalization of
      the Company, to Digi. The Agreement was set to close on July 31, 2002 but was
      amended to close on March 31, 2003. As the Company did not have an equity
      financing, no shares were issued to Digi. However, the Company did have full
      use
      of the related assets and intellectual property.





In
      May
      2002, the Company entered into a Distribution Agreement with Digi whereby the
      Company became the exclusive, worldwide distributor of Digi’s product, as
      defined.





In
      March
      2003, Digi and Douglas J. Glader entered into an Option and License Agreement
      whereby Digi terminated its Purchase and License Agreement with the Company
      and
      granted Douglas J. Glader the right to purchase the right, title and interest
      in
      the tangible and intangible assets, intellectual property and personal property
      related to the business which was previously covered by the Purchase Agreement
      between the Company and Digi for $300,000.





51
 *Table
            of Contents*





In
      August
      2003, the Company entered into an Assignment and Assumption Agreement with
      Douglas J. Glader whereby Douglas J. Glader assigned his option to purchase
      certain tangible property, finished goods inventory, furniture, capital
      equipment and intellectual property rights from Digi to the Company with the
      consent of Digi.





In
      September 2003, the Company exercised the option and paid Digi $300,000 for
      the
      rights, title and interest in the assets described in the Assignment and
      Assumption Agreement. The $300,000 purchase price included $267,960 of inventory
      and $32,040 of fixed assets.





**14.**
            **SEGMENT
                INFORMATION**





The
      Company operates in one segment, using one measure of profitability to manage
      its business. Revenues for geographic regions are based upon the customer's
      location. The following is a summary of revenue by geographical
      region:




Year
                Ended
            
            Cumulative
                Periodfrom
                May 1, 2002January
                1,
            
            January
                2,
            
            (date
                of inception)2006
            
            2005
            
            to
                January 1, 2006United
                States (1)
            
            $
            208,786
            
            $
            87,463
            
            $
            461,218Australia
            
            
            -
            
            
            280
            
            
            16,180Asia
            
            
            36,466
            
            
            -
            
            
            49,905Europe
            
            
            9,557
            
            
            2,273
            
            
            19,030Canada
            
            
            -
            
            
            6,795
            
            
            6,795Middle
                East
            
            
            -
            
            
            800
            
            
            6,745Total
            
            $
            254,809
            
            $
            97,611
            
            $
            559,873





(1)
      Includes Mexico and Panama.





All
      of
      the Company's long-lived assets are located in the United States.





The
      Company's accounts receivable are derived from revenue earned from customers
      located in the United States, Australia, Asia, Europe, Canada and the Middle
      East. The Company performs ongoing credit evaluations of certain customers'
      financial condition and, generally, requires no collateral from its customers.
      For the year ended January 1, 2006, two customers accounted for 46% and 15%
      of
      revenues, respectively. For the year ended January 2, 2005, three customers
      accounted for 29%, 18%, and 12% of revenues, respectively.





**15.**
            **SUBSEQUENT
                EVENTS**




On
      February 28, 2006, the Company closed private placement sales of 15,000,025
      shares of its restricted commons stock to thirty-three accredited individual
      and
      institutional investors for proceeds of $6,000,010, less financing expenses
      of
      $480,000 and warrants to purchase 1,500,000 shares of the Company’s common stock
      at a price of $0.40 per share.





On
      March
      23, 2006, the Company appointed Thomas H. Williams as its Chief Financial
      Officer, effective March 20, 2006. Mr. Williams has been a director of the
      Company since its inception in 2002. Mr. Williams’ compensation consists of a
      salary of $160,000 per annum and an option to purchase 450,000 shares of the
      Company’s common stock under the Company’s shareholder approved stock option
      plan, which options are subject to immediate vesting if there is a change of
      control of the Company and an involuntarily termination of Mr. Williams’
employment within twelve months of such change of control. In addition, Mr.
      Williams is entitled to the employee benefits available to all Company employees
      and is eligible for participation in any executive bonus program adopted by
      the
      Company’s Board of Directors.





**ITEM
                8.**
            **CHANGES
                IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
                STATEMENTS**





None.




52
 *Table
            of Contents*


**ITEM
                  8A.**
              **CONTROLS
                  AND PROCEDURES**
 ***Evaluation
              of Disclosure Controls and Procedures*** *.* The
              Securities and Exchange Commission defines the term “disclosure controls and
              procedures” to mean a company's controls and other procedures that are designed
              to ensure that information required to be disclosed in the reports
              that it files
              or submits under the Securities Exchange Act of 1934 is recorded, processed,
              summarized and reported,
              within the time periods specified in the Commission's rules and forms
              and that
              such information is accumulated and communicated to the Company’s management,
              including its Chief Executive Officer and Chief Financial Officer,
              as
              appropriate to allow timely decisions regarding required disclosure.
              Our chief
              executive officer and chief financial officer have concluded, based
              on the
              evaluation of the effectiveness of the disclosure controls and procedures
              by our
              management, with the participation of our chief executive officer and
              chief
              financial officer, as of the end of the period covered by this report,
              that our
              disclosure controls and procedures were not effective and thus there
              were
              material weaknesses in the Company’s internal control over financial
              reporting effective for this purpose, except as noted below under “Changes in Internal
              Controls.”
 
 ***Changes
              in Internal Controls*** *.*  In
              connection with its audit of our financial statements for the year
              ended January
              1, 2006, Burr, Pilger & Mayer LLP identified significant deficiencies,
              which represent material weaknesses. The material weaknesses were related
              to a
              lack of adequate segregation of duties. In addition, significant audit
              adjustments were needed within accounts receivable, deferred revenue,
              inventory
              and shareholders' equity that were the result of an insufficient quantity
              of
              experienced personnel involved with the financial reporting and year
              end/period
              end closing process resulting from the resignation of our Controller
              in November
              2005.
 
 The
              significant deficiencies that represent material weaknesses in internal
              controls
              that were identified are as follows:
 
 *Accounts
              receivable / Deferred Revenue -* The
              Company was unable to demonstrate that certain accounts receivable
              transactions
              that were recorded had met the criteria that collection was reasonably
              assured.
              Thus, the accounts receivable balance was reclassified against the
              related
              deferred revenue balance for the year ended January 1, 2006.
 
 *Inventory* -
              The
              Company was unable to demonstrate as to how much, if any, of the consigned
              inventory would be sold, resalable or reusable and therefore, had overstated
              the
              inventory balance and understated costs of goods sold during the year
              ended
              January 1, 2006.
 
 *Stockholder’s
              Equity* - The
              Company had insufficient personnel to perform the accounting for this
              accounting
              function and such personnel lacked the appropriate level of accounting
              knowledge, experience and training in the application of pertinent
              stockholders’
equity technical accounting pronouncements. The lack of sufficient
              and
              adequately trained accounting personnel resulted in certain material
              audit
              adjustments.
 
 To
              address the material weaknesses, we have retained additional experienced
              accounting personnel to oversee recent filings and further train our
              internal
              accounting personnel.
 
 The
              Company’s management has identified the steps necessary to address the material
              weaknesses described above, as follows:
 
 1)
                    Hiring
                        accounting personnel and engaging outside contractors with
                        technical
                        accounting expertise, as needed, to perform thorough analyses
                        of accounts
                        which require judgment and specific technical accounting
                        expertise.
                        Specifically, the Company has hired a new chief financial
                        officer and
                        replaced its staff accountant. In addition, the previous
                        chief financial
                        officer has assumed the role of controller. Also, the Company
                        has engaged
                        an outside consulting firm to oversee recent filings and
                        further train our
                        internal accounting personnel.
 2)
                    The
                        estimated remedial costs include the new salary of the chief
                        financial
                        officer whose salary is $160,000 annually. In addition, the
                        Company has
                        hired an outside consulting firm at the cost of $6,500 per
                        quarter to
                        oversee our recent filings. Also, the Company intends to
                        purchase stock
                        option accounting software at a cost of $20,000 to assist
                        in the
                        accounting and disclosure requirements of our stock based
                        compensation
                        arrangements.
 
 Prior
              to
              the filing of our financial statements, the Company completed the account
              reconciliations, analyses and its management reviewed such that the
              Company can
              certify that the information contained in its financial statements
              fairly
              present, in all material respects, its financial condition and results
              of
              operations.


**ITEM
                8B.**
            **OTHER
                INFORMATION**





None.





**PART
      III**




**ITEM
                9.**
            **DIRECTORS,
                EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH
                SECTION
                16 (A) OF THE EXCHANGE ACT**





The
      following table sets forth certain information regarding Procera’s directors,
      executive officers and certain key employees as of January 1, 2006:





NAME
            
            AGE
            
            POSITIONDouglas
                J. Glader
            
            62
            
            President,
                Chief Executive Officer and a DirectorAnil
                Sahai, PhD
            
            45
            
            Executive
                Vice President and CTOJay
                R. Zerfoss (1)
            
            71
            
            Chief
                Financial Officer and SecretaryGary
                J. Johnson
            
            61
            
            Senior
                Vice President of Sales and MarketingScott
                McClendon
            
            66
            
            DirectorThomas
                Saponas
            
            56
            
            DirectorThomas
                Williams (1)
            
            67
            
            Director





(1)
      Effective March 20, 2006, Jay Zerfoss resigned as the Company’s Chief Financial
      Officer. On March 23, 2006, the Company appointed Thomas H. Williams as its
      Chief financial Officer, effective March 20, 2006.





53
 *Table
            of Contents*





**DOUGLAS
      J. GLADER** has
      served as President and Chief Executive Officer and as a member of Board of
      Directors since the October 2003 merger. He served as President and Chief
      Executive Officer of PNI since founding PNI in May 2002. Prior to founding
      PNI,
      Mr. Glader served from 1996 to 2002 in key senior executive positions at Digi
      International, Inc., including Executive Vice President, Chief Operating
      Officer, Senior Vice President of Worldwide Manufacturing and Operations, and
      General Manager of Milan Technology, Digi's LAN products division. Mr. Glader
      has more than 27 years of experience in general management with firms such
      as
      Memorex, Measurex Corporation, Altus Corporation and Direct Incorporated, all
      located in the San Francisco Bay Area. In addition to co-founding Greyhawk
      Systems, Inc., a manufacturer of electronic imaging hardware and software,
      Mr.
      Glader has managed manufacturing operations in Belgium, Ireland, Mexico and
      the
      Pacific Rim. Mr. Glader serves on the board of directors of Uromedica, a
      privately held company in Plymouth, Minnesota.





**ANIL
      SAHAI** has
      served as Chief Technology Officer since March 2004. From 1990 until 1994,
      Dr.
      Sahai was a core member of the engineering team at Amdahl which architected
      one
      of the first Redundant Array of Independent Drives ("RAID") products for
      mainframes using Small Computer System Interface ("SCSI") drives and Enterprise
      Systems Connection ("ESCON") channels. From 1997 until 1999 at Compaq
      Corporation Dr. Sahai managed the team that was responsible for the performance
      architecture of NT servers and SAN line of products based on Servernet
      technologies. In June 2000, Dr. Sahai founded Ezyte, Inc. whose intellectual
      property he sold to Procera in May 2004. He has a PhD in computer science with
      specialization in packet switching architecture from University of California,
      Santa Cruz, and a Masters from Sloan at MIT, with specialization in new product
      development and international corporate strategies. Dr. Sahai has published
      technical papers in many journals, and presented seminars at various
      conferences, tradeshows and universities all over the world in the areas of
      high
      performance packet switching, storage architecture, wireless Internet
      architectures, system performance modeling, and international corporate
      strategies.





**JAY
      R. ZERFOSS** has
      served as Chief Financial Officer and Secretary since the October 2003 merger.
      He served as the Chief Financial Officer and Secretary of PNI from May 2002
      to
      October 2003. On March 23, 2006, Mr. Zerfoss resigned his positions as Chief
      Financial Officer and Secretary and assumed the position of Chief Accounting
      Officer. Mr. Zerfoss is an accomplished CPA with extensive experience as a
      Controller, Treasurer, Director of Finance, Vice President of Finance and
      Administration, and CFO for a variety of organizations. His areas of expertise
      include start-up high technology manufacturing companies with national and
      global concerns, rendering board of directors reporting, financial statement
      preparation, cash management reporting, planning and budgeting, policies and
      internal controls, attorney, auditor, and banking relationships. Prior to
      joining PNI, Mr. Zerfoss was Director of Finance at InnoWave Broadband Inc.
      From
      January 1998 until November 2001. From November 2001 until May 2002, Mr. Zerfoss
      was an independent financial consultant.





**GARY
      J. JOHNSON** has
      served as Senior Vice President of Sales & Marketing
      since October 2004.  Mr. Johnson has more than 25 years
      experience as an executive in the Silicon Valley high technology industry. 
He is a highly respected senior executive, who has held positions as CEO
      and president, executive vice president of sales and marketing, vice president
      of operations and numerous other senior management roles. Prior to joing
      Procera, Mr. Johnson was CEO at Force Field, Inc. From November 1999 until
      June
      2001, he served as president and CEO of Berkeley Software Design, Inc. (BSDi),
      where he pioneered the Internet server category, built the company with 1000
      percent revenue growth, orchestrated the acquisition of two companies
      leading to the acquisition of BSDi by Wind River Systems Inc. From December
      1996
      to November 1999, he served as President of Click Software Inc. an enterprise
      service scheduling software provider, where he developed their presence in
      North America, developed relationships with numerous OEM and channel
      partners, grew the customer base with dozens of significant enterprise accounts
      and positioned the firm to raise over $50 million in its NASDAQ IPO. 
Mr. Johnson also held various senior sales management positions at SCO (The
      Santa Cruz Operation, Inc.) now (Caldera/SCO), Convergent Technologies,
      now (Unisys), and Tandem Computers, now (Compaq/HP). He was also
      employed by Fairchild Semiconductor, and Measurex Corporation early in his
      career. Mr. Johnson holds a Bachelor's Degree in Business Administration from
      Michigan State University.





**SCOTT
      MCCLENDON** has
      served as a member of Board of Directors since March 1, 2004. He is currently
      a
      member of the Audit Committee. Mr. McClendon served as the President and Chief
      Executive Officer of Overland Storage, Inc. (NASDAQ: OVRL) from October 1991
      to
      March 2001, when he was named Chairman, and was an officer and employee until
      June 2001. He was employed by Hewlett-Packard Company, a global manufacturer
      of
      computing, communications and measurement products and services, for over 32
      years in various positions in engineering, manufacturing, sales and marketing.
      He last served as the General Manager of the San Diego Technical Graphics
      Division and Site Manager of Hewlett-Packard in San Diego, California. Mr.
      McClendon is a director of SpaceDev, Inc., an aerospace development company.
      Mr.
      McClendon has a BSEE and MSEE from Stanford University.





54
 *Table
            of Contents*





**THOMAS
      SAPONAS** has
      served as a member of Board of Directors since April 1, 2004. Mr. Saponas served
      as the Senior Vice President and Chief Technology Officer of Agilent
      Technologies, Inc. (NYSE: A) from August 1999 until he retired in October 2003.
      Prior to being named Chief Technology Officer, from June 1998 to April 1999,
      Mr.
      Saponas was Vice President and General Manager of Hewlett-Packard's Electronic
      Instruments Group. Mr. Saponas has held a number of positions since the time
      he
      joined Hewlett-Packard. Mr. Saponas served as General Manager of the Lake
      Stevens Division from August 1997 to June 1998 and General Manager of the
      Colorado Springs Division from August 1989 to August 1997. In 1986, he was
      a
      White House Fellow in Washington, D.C. Mr. Saponas has a BSEE/CS (Electrical
      Engineering and Computer Science) and an MSEE from the University of Colorado.
      Mr. Saponas is a director of nGimat, a nanotechnology company, a
      director of Time Domain, an ultra wideband communications company, and a
      director of Keithley Instruments (KEI on NYSE), an electronic instruments
      company. He also serves on the Visiting Committee on Advanced Technology
      at the National Institute of Standards and Technology. On March 23, 2006, Mr.
      Saponas filled the vacancy left by Tom Williams as a member of the Company’s
      Audit Committee.





**THOMAS
      H. WILLIAMS** has
      served as a member of Board of Directors since the October 2003 merger. On
      March
      23, 2006, the Company appointed Thomas H. Williams as its Chief financial
      Officer, effective March 20, 2006. He is currently a member of the Compensation
      Committee. He served as a Director of PNI from May 2002 to October 2003. Mr.
      Williams has 20 years' experience as CFO and General Counsel in start-up and
      medium-sized venture capital-backed technology companies. Mr. Williams' early
      years were spent with IBM and Shell Oil Company in engineering and legal
      positions. In 1971, Mr. Williams joined the management team of Measurex Corp.,
      a
      process control start-up, responsible for engineering project budgeting and
      patent matters as the company grew from $4 million to $50 million in revenues.
      In 1976, Mr. Williams and two partners took over management of Altus
      Corporation, guided the company through bankruptcy and raised venture capital.
      From 1984 though 1993, Mr. Williams was CFO and General Counsel for Greyhawk
      Systems, an innovator in high-resolution electronic imaging, which was sold
      in
      1993. From 1993 to 1997, Mr. Williams was in the private practice of law. In
      1997 he was appointed as CFO of IC WORKS, Inc., a venture capital-backed
      semiconductor company, on an interim basis to guide a financial turnaround.
      Within six months, the company was brought from near bankruptcy to a cash
      positive position, which allowed the company to be sold in 1998 for more than
      $100 million. Since 1999, Mr. Williams has been CFO at Bandwidth9, a company
      developing tunable lasers for the fiber optics industry. Mr. Williams holds
      a
      B.S. degree in electrical engineering, and a law degree from the University
      of
      Minnesota and a M.B.A. from the University of California at Berkeley. He is
      a
      member of the California, New York (inactive), Federal and Patent bars. On
      March
      23, 2006, Mr. Williams joined the Company’s management team as Chief Financial
      Officer and Secretary. Early in fiscal 2006, Mr. Williams resigned his position
      on the Audit Committee but will continue to perform as a Director of the
      Company.





Procera’s
      executive officers are elected by the Board of Directors on an annual basis
      and
      serve at the discretion of the Board of Directors, subject to the terms of
      any
      employment agreements with us, until their successors have been duly elected
      and
      qualified or until their earlier resignation or removal. There are no family
      relationships between any directors and executive officers.





**BOARD
      COMMITTEES**





Procera
      currently has two committees of its Board of Directors: the Audit Committee
      and
      the Compensation Committee.





The
      Audit
      Committee reviews, acts on and reports to the Board of Directors regarding
      various auditing and accounting matters, including the selection of our
      independent auditors, the monitoring of the rotation of the partners of the
      independent auditors, the review of our financial statements, the scope of
      the
      annual audits, fees to be paid to the auditors, the performance of our
      independent auditors and our accounting practices. There are currently
      two


members
      of the Audit Committee, Mr. McClendon and Mr. Saponas.





The
      Compensation Committee determines the salaries and incentive compensation of
      our
      officers and provides recommendations for the salaries and incentive
      compensation of our other employees. The Compensation Committee also administers
      our stock option plan. There is currently one member of the Compensation
      Committee, Mr. Williams. Mr. Glader, our Chief Executive Officer, participated
      in deliberations of the Board of Directors relating to his compensation.





**Audit
      Committee Financial Expert**





Procera’s
      Board of Directors has determined that it does not have an audit committee
      financial expert serving on its audit committee. Under the applicable Securities
      and Exchange Commission standard, an audit committee financial expert means
      a
      person who has the following attributes:





-
            An
                understanding of generally accepted accounting principles and financial
                statements;


-
            The
                ability to assess the general application of such principles in connection
                with the accounting for estimates, accruals and
                reserves;





55
 *Table
            of Contents*





-
            Experience
                preparing, auditing, analyzing or evaluating financial statements
                that
                present a breadth and level of complexity of accounting issues that
                are
                generally comparable to the breadth and complexity of issues that
                can
                reasonably be expected to be raised by the registrant's financial
                statements, or experience actively supervising one or more persons
                engaged
                in such activities;


-
            An
                understanding of internal controls and procedures for financial reporting;
                and


-
            An
                understanding of audit committee
                functions.





**Compliance
      with Section 16(a) of the Securities Exchange Act of 1934**





Section
      16(a)of the Exchange Act requires Procera’s officers and directors, and persons
      who own more than 10% of the its common stock, to file reports of ownership
      and
      changes of ownership of such securities with the United States Securities and
      Exchange Commission. Based solely on the copies of such forms received by
      Procera, Procera believes that during the year ended January 1, 2006, Messrs
      Magnus Hansen, Scott McClendon and Thomas Saponas did not timely file certain
      Form 4’s.





**Code
      of Ethics**





Procera
      does not have a code of ethics. The Board of Directors has decided to postpone
      the adoption of a code of ethics until the Company is able to develop a greater
      infrastructure. Once Procera has adopted a code of ethics a copy may be obtained
      by sending a written request to the Company.





**DIRECTORS'
      COMPENSATION**





Directors
      who are also Procera’s employees receive no additional compensation for serving
      on the Board. Procera reimburses non-employee Directors for all travel and
      other
      expenses incurred in connection with attending meetings of the Board of
      Directors. Procera’s Directors who are also employees may participate in other
      incentive plans described under "Item 10. Executive Compensation."




**ITEM
                10.**
            **EXECUTIVE
                COMPENSATION**





The
      following table sets forth all compensation paid in respect of the individuals
      who served, during the year ended January 1, 2006, as Procera’s Chief Executive
      Officer and the next five mostly highly compensated executive officers of the
      Company (collectively the "NAMED EXECUTIVE OFFICERS") whose total salary and
      bonus was in excess of $100,000 per annum. Except as listed below, there are
      no
      bonuses, other annual compensation, restricted stock awards or stock
      options/SARS or any other compensation paid to executive officers.





ANNUAL
                COMPENSATIONNAME
                AND PRINCIPAL POSITION
            
            YEAR
            
            SALARY
                ($)
            
            BONUS
                ($)
            
            OTHER
                ANNUAL COMPENSATION ($)Douglas
                J. Glader,
            
            
            2005
            
            $
            245,000
            
            
            0
            
            
            0CEO
            
            
            2004
            (1)
            $
            332,264
            
            
            0
            
            
            02003
            
            $
            222,203
            
            
            0
            
            
            0Anil
                Sahai
            
            
            2005
            
            $
            180,000
            
            
            0
            
            
            0Executive
                V.P. & CTO
            
            
            2004
            
            $
            143,308
            
            
            0
            
            
            02003
            
            
            0
            
            
            0
            
            
            0Jay
                Zerfoss,
            
            
            2005
            
            $
            140,000
            
            
            0
            
            
            0V.P.
                of Finance and CFO
            
            
            2004
            
            $
            140,000
            
            
            0
            
            
            02003
            
            $
            94,746
            
            
            0
            
            
            0Gary
                Johnson
            
            
            2005
            
            $
            120,000
            
            
            0
            
            
            0Sr.
                V.P. of Sales and Marketing
            
            
            2004
            
            $
            25,385
            
            
            0
            
            
            02003
            
            
            0
            
            
            0
            
            
            0




56
 *Table
            of Contents*





(1)
      Mr.
      Glader's employment letter provides that he will receive his then current base
      salary for an additional 18 months in the event that he is terminated without
      cause. There are no other severance provisions.




Option/SAR
        Grants in Last Fiscal Year
 
 There
        were no option or stock appreciation rights granted to the Named Executive
        Officer during the year ended January 1, 2006.
 
 Option
        Exercises and Year-End Option Values
 
 No
        options were exercised by the Named Executive Officer during the year ended
        January 1, 2006.
 
 Employment
        Agreements; Termination of Employment and Change of Control
        Arrangements
 
 In
        September 2003, Procera entered into an offer letter with Mr. Douglas Gladder
        employing him as its Chief Executive Officer for a minimum term of one year.
        The
        agreement provides for a base salary of $245,000 per year. In addition, Procera
        granted to Mr. Glader the right to purchase 4,000,000 shares of our common
        stock
        at a price of $0.001 per share. In addition, Mr. Glader is entitled to the
        employee benefits available to all Company employees and is eligible for
        participation in any executive bonus program adopted by the Company’s board of
        directors. Mr. Gladder's offer letter provides that he will receive his then
        current base salary for an additional 18 months in the event that he is
        terminated without cause. There are no other severance provisions.
 
 In
        May
        2002, Procera entered into an offer letter with Mr. Jay R. Zerfoss employing
        him
        as its Vice-President—Finance and CFO on an at-will basis. The agreement
        provides for a base salary of $140,000 per year. In addition, Procera granted
        to
        Mr.Zerfoss the right to purchase 600,000 shares of our common stock at a
        price
        of $0.001 per share. In addition, Mr. Zerfoss is entitled to the employee
        benefits available to all Company employees. There are no severance
        provisions.
 
 In
        March
        2004, Procera entered into an offer letter with Mr. Anil Sahai employing
        him as
        its Executive Vice-President and Chief Technical Officer (CTO) on at-will
        basis.
        The agreement , as amended, provides for a base salary of $180,000 per year.
        In
        addition, Procera granted to Mr. Sahai an incentive stock option to purchase
        2,300,000 shares of its common stock at a price of $1.50 per share. In addition,
        Mr. Sahai is entitled to the employee benefits available to all Company
        employees and is eligible for participation in any executive bonus program
        adopted by the Company’s board of directors. There are no severance provisions.
 
 In
        October 2004, Procera entered into an offer letter with Mr. Gary J. Johnson
        employing him as its Sr. Vice-President of Sales and Marketing on at-will
        basis.
        The agreement provides for a base salary of $120,000 per year and an incentive
        to earn an additional $80,000 annually in commissions based on performance.
        In
        addition, Procera granted to Mr. Johnson an incentive stock option to purchase
        500,000 shares of our common stock at a price of $0.92 per share. In addition,
        Mr. Johnson is entitled to the employee benefits available to all Company
        employees and is eligible for participation in any executive bonus program
        adopted by the Company’s board of directors. There are no severance
        provisions.
 
 STOCK
        OPTION PLAN
 
 In
        August
        2003 and October 2004 Procera’s board of directors and stockholders adopted the
        2003 Stock Option Plan and 2004 Stock Option Plan, respectively (collectively
        referred to as the "Plan"). The
        number of shares available for options under the 2003 Plan and 2004 Plan,
        as
        amended, is 2,500,000 and 5,000,000, respectively. The
        following description of our Plan is a summary and qualified in its entirety
        by
        the text of the Plan. The purpose of the Plan is to enhance our profitability
        and stockholder value by enabling us to offer stock based incentives to
        employees, directors and consultants. The Plan authorizes the grant of options
        to purchase shares of Procera’s common stock to employees, directors and
        consultants. Under the Plan, Procera may grant incentive stock options within
        the meaning of Section 422 of the Internal Revenue Code of 1986 and
        non-qualified stock options. Incentive stock options may only be granted
        to
        Procera employees.
 
 The
        number of shares available for options under the Plan is 7,500,000. As of
        January 1, 2006, 3,583,030 were shares were available for future grants.
        The
        options under the Plan vest over varying lengths of time pursuant to various
        option agreements that Procera has entered into with the grantees of such
        options. The
        Plan
        is administered by the board of directors. Subject to the provisions of the
        Plan, the board of directors has authority to determine the employees, directors
        and consultants who are to be awarded options and the terms of such awards,
        including the number of shares subject to such option, the fair market value
        of
        the common stock subject to options, the exercise price per share and other
        terms.
 
 Incentive
        stock options must have an exercise price equal to at least 100% of the fair
        market value of a share on the date of the award and generally cannot have
        a
        duration of more than 10 years. If the grant is to a stockholder holding
        more
        than 10% of our voting stock, the exercise price must be at least 110% of
        the
        fair market value on the date of grant. Terms and conditions of awards are
        set
        forth in written agreements between us and the respective option holders.
        Awards
        under the Plan may not be made after the tenth anniversary of the date of
        its
        adoption but awards granted before that date may extend beyond that
        date.
 
 Optionees
        have no rights as stockholders with respect to shares subject to option prior
        to
        the issuance of shares pursuant to the exercise thereof. An option becomes
        exercisable at such time and for such amounts as determined by the board
        of
        directors. An optionee may exercise a part of the option from the date that
        part
        first becomes exercisable until the option expires. The purchase price for
        shares to be issued to an employee upon his exercise of an option is determined
        by the board of directors on the date the option is granted. The Plan provides
        for adjustment as to the number and kinds of shares covered by the outstanding
        options and the option price therefor to give effect to any stock dividend,
        stock split, stock combination or other reorganization.


**ITEM
                11.**
            **SECURITY
                OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
                STOCKHOLDER MATTERS**





The
      following table sets forth certain information known to us with respect to
      the
      beneficial ownership of our common stock as of March 30, 2006 and (i) all
      persons who are known to us to be beneficial owners of five percent or more
      of
      the common shares, (ii) each of our Directors, (iii) the Named Executive
      Officers and (iv) all current Directors and executive officers as a
      group.





NAME
                AND ADDRESS OF BENEFICIAL OWNER
            
            SHARES
                BENEFICIALLY OWNED
            
            PERCENT
                OF CLASS BENEFICIALLY OWNEDDouglas
                Glader (1)
            
            4,148,970
            
            9.0%Linden
                Growth Partners
            
            3,252,959
            
            7.1%Anil
                Sahai (2)
            
            1,858,790
            
            4.0%Jay
                Zerfoss
            
            610,818
            
            1.3%Gary
                Johnson (3)
            
            237,223
            
            *Thomas
                Williams (4)
            
            132,000
            
            *Scott
                McClendon (5)
            
            44,000
            
            *Thomas
                Saponas (6)
            
            44,000
            
            *All
                officers and directors as a group (seven persons)
            
            7,075,801
            
            15.4%





*
      Indicates less than 1%


(1)
      Shares beneficially owned by Douglas Glader include 11,000 shares owned by
      Scott
      Glader, the son of Douglas Glader and 11,000 shares owned by Christine Glader,
      the daughter-in-law of Douglas Glader.


(2)
      Shares beneficially owned by Anil Sahai include options to purchase 1,790,000
      shares of Procera's common stock at $1.50 per share that are exercisable in
      whole or in part within 60 days of March 30, 2006, 20,790 shares issued in
      Procera's acquisition of EZ2, and 48,000 shares issued to Ezyte, Inc., which
      is
      100% owned by Anil Sahai.


(3)
      Shares beneficially owned by Gary Johnson include options to purchase 222,223
      shares of Procera's common stock at $0.92 per share and warrants to purchase
      15,000 shares of Procera’s common stock at $2.05 per share that are exercisable
      in whole or in part within 60 days of March 30, 2006.


(4)
      Shares beneficially owned by Thomas H. Williams include options to purchase
      16,000 shares of Procera's common stock at $3.35 per share and options to
      purchase 16,000 shares of Procera’s common stock at $1.67 per share that are
      exercisable in whole or in part within 60 days of March 30, 2006.


(5)
      Shares beneficially owned by Scott McClendon include options to purchase 28,000
      shares of Procera's common stock at $3.35 per share and options to purchase
      16,000 shares of Procera’s common stock at $1.67 per share that are exercisable
      in whole or in part within 60 days of March 30, 2006.


(6)
      Shares beneficially owned by Thomas Saponas include options to purchase 28,000
      shares of Procera's common stock at $1.70 per share and options to purchase
      16,000 shares of Procera’s common stock at $1.67 per share that are exercisable
      in whole or in part within 60 days of March 30, 2006.





Beneficial
      ownership is determined in accordance with the rules of the Securities and
      Exchange Commission and includes voting or investment power with respect to
      the
      securities. Common shares subject to options or warrants that are currently
      exercisable or exercisable within 60 days of March 30, 2006 are deemed to be
      outstanding and to be beneficially owned by the person or group holding such
      options or warrants for the purpose of computing the percentage ownership of
      such person or group but are not treated as outstanding for the purpose of
      computing the percentage ownership of any other person or group. Unless
      otherwise indicated, the address for each of the individuals listed in the
      table
      is care of Procera Networks, Inc., 100 Cooper Court, Los Gatos, California
      95032. Unless otherwise indicated by footnote, the persons named in the table
      have sole voting and sole investment power with respect to all common shares
      shown as beneficially owned by them, subject to applicable community property
      laws. Percentage of beneficial ownership is based on 45,965,342 shares of our
      common stock outstanding as of March 30, 2006.





57
 *Table
            of Contents*





**ITEM
                12.**
            **CERTAIN
                RELATIONSHIPS AND RELATED
                TRANSACTIONS**





Cagan
      McAfee Capital Partners ("CMCP") received rights to purchase 2,000,000 shares
      of
      Procera’s common stock for its services as a finder in the December 2003 private
      placement. Eric McAfee, as an owner of CMCP, purchased 665,000 shares at $0.001
      per share in August 2003.





Douglas
      J. Glader has an employment agreement with the Company discussed elsewhere
      in
      this annual report and included as exhibits hereto.





In
      August
      2003, Douglas J. Glader and the Company entered into an Assignment and
      Assumption Agreement discussed elsewhere in this annual report.





Procera
      believes that all of the transactions set forth above were made on terms no
      less
      favorable to the Company than could have been obtained from unaffiliated third
      parties. Procera intends that all future transactions with affiliated persons
      be
      approved by a majority of the Board of Directors, including a majority of the
      independent and disinterested outside directors on the Board of Directors,
      and
      be on terms no less favorable to it than could be obtained from unaffiliated
      third parties.




**ITEM
                13.**
            **EXHIBITS**


2.1*
                  Agreement and Plan of Merger included in our Preliminary Proxy
                  Statement
                  on Schedule 14A filed on August 25, 2003 and incorporated herein
                  by
                  reference.3.1*
                  Articles of Incorporation included as Exhibit 3.1 to our form SB-2
                  filed
                  on February 11, 2002 and incorporated herein by
                  reference.3.2*
                  Bylaws included as Exhibit 3.2 to our form SB-2 filed on February
                  11, 2002
                  and incorporated herein by reference.4.1*
                  Form of Subsc ription Agreement for February 28, 2006 offering
                  included as
                  Exhibit 10.1 to our current report on form 8-K filed on March 1,
                  2006 and
                  incorporated herein by reference.4.2*
                  Form of Registration Rights Agreement for February 2006 offering
                  included
                  as Exhibit 10.2 to our current report on Form 8-K filed on March
                  1, 2006
                  and incorporated herein by reference.10.1*
                  2003 Stock Option Plan10.2*
                  Sublease Agreement10.3*
                  Employee Offer Letter for Douglas J. Glader10.4*
                  2004 Stock Option Plan10.5*
                  Employee Offer Letter for Thomas H. Williams10.6* Employee
                Offer Letter for Jay Zerfoss10.7* Employee
                Offer Letter for Anil Sahai10.8* Employee
                  Offer Letter for Gary Johnson31.1
                  Certification of Chairman and Chief Executive Officer Pursuant
                  to Section
                  302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Sec. 1350) (transmitted
                  herewith).31.2
                  Certification of Chief Accounting Officer Pursuant to Section 302
                  of the
                  Sarbanes-Oxley Act of 2002 (18 U.S.C. Sec. 1350) (transmitted
                  herewith).32.1
                  Written Statement of Chairman and Chief Executive Officer Pursuant
                  to
                  Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section
                  1350)
                  (transmitted herewith).32.2
                  Written Statement of Chief Accounting Officer Pursuant to Section
                  906 of
                  the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350) (transmitted
                  herewith).





*
            Previously
                filed.





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





Below
      is
      the aggregate amount of fees billed for professional services rendered by
      Procera’s principal accountants with respect to the Company’s last two fiscal
      years:





58
 *Table
          of Contents*


2005
            
            2004Audit
                fees
            
            $
            71,500
            
            $
            70,380Audit-related
                fees
            
            
            49,839
            
            
            40,965Tax
                fees
            
            
            -
            
            
            -All
                other fees
            
            
            -
            
            
            -Total
            
            $
            121,339
            
            $
            111,345





All
      of
      the professional services rendered by Procera’s principal accountants for the
      audit of the Company’s annual financial statements and review of financial
      statements included in its Form 10-QSB or services that are normally provided
      by
      the accountant in connection with statutory and regulatory filings or
      engagements for last two fiscal years were approved by the Audit
      Committee.





59
 *Table
            of Contents*





**SIGNATURES**





In
      accordance with section 13 and 15 (d) 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.








Procera
      Networks, Inc.







/s/
                  Douglas J. GladerDouglas
                  J. GladerPresident
                  and CEO/DirectorAugust
                  25, 2006




60
 *Table
            of Contents*


In
          accordance with the Securities Exchange Act of 1934, this Annual Report on
          Form
          10-KSB (Amendment No. 1) has been signed below by the following persons on
          behalf of the registrant
          and in the capacities and on the dates indicated.
 
 SIGNATURE
                
                TITLE
                
                DATE/s/
                    Douglas J. Glader
                
                President,
                    Chief Executive Officer and Director
                
                August
                    25, 2006Douglas
                    J. Glader/s/
                    Jay R. Zerfoss
                
                Chief
                    Accounting Officer
                
                August
                    25, 2006Jay
                    Zerfoss/s/
                    Thomas Saponas
                
                Director
                
                August
                    25, 2006Thomas
                    Saponas/s/
                    Thomas Williams
                
                Director
                
                August
                    25, 2006Thomas
                    Williams/s/
                    Scott McClendon
                
                Director
                
                August
                    25, 2006Scott
                    McClendon
 
 EXHIBIT
          INDEX
 2.1*
                    Agreement and Plan of Merger included in our Preliminary Proxy
                    Statement
                    on Schedule 14A filed on August 25, 2003 and incorporated herein
                    by
                    reference.3.1*
                    Articles of Incorporation included as Exhibit 3.1 to our form
                    SB-2 filed
                    on February 11, 2002 and incorporated herein by
                    reference.3.2*
                    Bylaws included as Exhibit 3.2 to our form SB-2 filed on February
                    11, 2002
                    and incorporated herein by reference.4.1*
                    Form of Subsc ription Agreement for February 28, 2006 offering
                    included as
                    Exhibit 10.1 to our current report on form 8-K filed on March
                    1, 2006 and
                    incorporated herein by reference.4.2*
                    Form of Registration Rights Agreement for February 2006 offering
                    included
                    as Exhibit 10.2 to our current report on Form 8-K filed on March
                    1, 2006
                    and incorporated herein by reference.10.1*
                    2003 Stock Option Plan10.2*
                    Sublease Agreement10.3*
                    Employee Offer Letter for Douglas J. Glader10.4*
                    2004 Stock Option Plan10.5*
                    Employee Offer Letter for Thomas H. Williams10.6*
                  Employee Offer Letter for Jay Zerfoss10.7*
                  Employee Offer Letter for Anil Sahai10.8*
                    Employee Offer Letter for Gary Johnson31.1
                    Certification of Chairman and Chief Executive
                    Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of
                    2002 (18
                    U.S.C. Sec. 1350) (transmitted herewith).31.2
                    Certification of Chief Accounting Officer
                    Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18
                    U.S.C. Sec.
                    1350) (transmitted herewith).32.1
                    Written Statement of Chairman and Chief
                    Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley
                    Act of
                    2002 (18 U.S.C. Section 1350) (transmitted herewith).32.2
                    Written Statement of Chief Accounting Officer
                    Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18
                    U.S.C.
                    Section 1350) (transmitted
                    herewith).


*
            Previously
                filed.






61