UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549




FORM
10-Q




x
            
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES
      EXCHANGE ACT OF 1934For
      the quarterly period ended June 30, 2009OR ̈
            
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES
      EXCHANGE ACT OF 1934For
      the transition period from ________________ to
      ________________





Commission
file number:  000-25755





WORLDGATE
COMMUNICATIONS, INC.


(Exact
name of registrant as specified in its charter)





Delaware
            
            23-2866697(State
      or other jurisdiction of
            
            (I.R.S.
      Employerincorporation
      or organization)
            
            Identification
      No.)3190
      Tremont Avenue
              Trevose,
      Pennsylvania
            
            19053(Address
      of principal executive offices)
            
            (Zip
      Code)





(215)
354-5100


(Registrant’s
telephone number, including area code)





[None]


(Former
name, former address and former fiscal year, if changed since last
report)





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.


Yes x                  No   ̈





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files).


Yes  ̈                  No   ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting
company.  See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Securities Exchange Act of 1934.





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





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Securities Exchange Act of
1934).  Yes  ̈No  x





Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date.





Class
            
            Outstanding
      at August 11, 2009Common
      Stock, $0.01 par value per share
            
            333,773,787
      shares










WORLDGATE
COMMUNICATIONS, INC.





QUARTERLY
REPORT ON FORM 10-Q


FOR
THE THREE MONTHS ENDED JUNE 30, 2009





TABLE
OF CONTENTS





PART
      I. FINANCIAL INFORMATION
              3ITEM
      1.  FINANCIAL STATEMENTS
              3ITEM
      2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
      AND RESULTS OF OPERATIONS
              23ITEM
      3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK
              31ITEM
      4T.  CONTROLS AND PROCEDURES.
              31PART
      II. OTHER INFORMATION
              32ITEM
      1.  LEGAL PROCEEDINGS.
              32ITEM
      2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
      PROCEEDS.
              32ITEM
      3.  DEFAULTS UPON SENIOR SECURITIES.
              32ITEM
      4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS.
              32ITEM
      5.  OTHER INFORMATION.
              33ITEM
      6.  EXHIBITS.
              33




2


PART
I. FINANCIAL INFORMATION


ITEM
1.  FINANCIAL STATEMENTS





WORLDGATE
COMMUNICATIONS, INC.


CONDENSED
CONSOLIDATED BALANCE SHEETS


(Dollars
In Thousands, Except Share Amounts)





June 30,
                  2009
              
              
              December 31,
                  2008 *(Unaudited)ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              $
              1,209
              
              
              $
              429Trade
      accounts receivables, less allowance for doubtful accounts of $157 at June
      30, 2009 and $0 at December 31, 2008
              
              
              918
              
              
              
              1,019Other
      receivables
              
              
              1
              
              
              
              1Inventory,
      net
              
              
              1,048
              
              
              
              1,176Prepaid
      and other current assets
              
              
              282
              
              
              
              160Revenue
      incentive asset - current  portion (See Note 8)
              
              
              4,200
              
              
              
              0Total
      current assets
              
              
              7,658
              
              
              
              2,785Property
      and equipment, net
              
              
              869
              
              
              
              234Deposits
      and other assets
              
              
              0
              
              
              
              66Revenue
      incentive asset – long term portion (See Note 8)
              
              
              55,800
              
              
              
              0Total
      assets
              
              $
              64,327
              
              
              $
              3,085LIABILITIES
      AND STOCKHOLDERS’ EQUITY (DEFICIENCY)Current
      liabilities :Accounts
      payable
              
              $
              2,311
              
              
              $
              1,750Accrued
      expenses
              
              
              657
              
              
              
              1,420Accrued
      compensation and benefits
              
              
              91
              
              
              
              173Accrued
      severance
              
              
              690
              
              
              
              0Detachable
      warrants
              
              
              413
              
              
              
              4,360Warranty
      reserve
              
              
              18
              
              
              
              17Deferred
      revenues and income
              
              
              2,201
              
              
              
              1,762Notes
      Payable
              
              
              96
              
              
              
              0Convertible
      debentures payable (net of unamortized discount of $0 at June 30, 2009 and
      $2,287 at December 31, 2008
              
              
              0
              
              
              
              1,793Total
      current liabilities
              
              
              6,477
              
              
              
              11,275Commitments
      and contingenciesStockholders’
      equity (deficiency):Preferred
      Stock, $.01 par value, 13,492,450 shares authorized; 0 shares issued at
      June 30, 2009 and December 31, 2008
              
              
              0
              
              
              
              0Common
      Stock, $.01 par value; 700,000,000 and 200,000,000 shares authorized at
      June 30, 2009 and December 31, 2008, respectively; and 325,048,500 shares
      issued and outstanding at June 30,2009 and 118,906,345 at December 31,
      2008..
              
              
              3,251
              
              
              
              1,189Additional
      paid-in capital
              
              
              340,545
              
              
              
              261,478Accumulated
      deficit
              
              
              (285,946
              )
              
              
              (270,857
              )Total
      stockholders’ equity (deficiency)
              
              
              57,850
              
              
              
              (8,190
              )Total
      liabilities and stockholders’ equity (deficiency)
              
              $
              64,327
              
              
              $
              3,085





*
Condensed from audited financial statement





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


3





WORLDGATE
COMMUNICATIONS, INC.


CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


(Unaudited)


(Dollars
In Thousands, Except Share And Per Share Amounts)





Three Months ended June 30,
                              
                              
                              Six Months ended June 30,2009
                              
                              
                              2008
                              
                              
                              2009
                              
                              
                              2008Net
      revenues:Product
      revenues
                              
                              $
                              16
                              
                              
                              $
                              812
                              
                              
                              $
                              365
                              
                              
                              $
                              831Service
      revenues
                              
                              
                              89
                              
                              
                              
                              164
                              
                              
                              
                              182
                              
                              
                              
                              259Other
      revenues
                              
                              
                              38
                              
                              
                              
                              279
                              
                              
                              
                              833
                              
                              
                              
                              279Total
      net revenues
                              
                              
                              143
                              
                              
                              
                              1,255
                              
                              
                              
                              1,380
                              
                              
                              
                              1,369Cost
      of revenues
                              
                              
                              5
                              
                              
                              
                              837
                              
                              
                              
                              919
                              
                              
                              
                              875Gross
      margin
                              
                              
                              138
                              
                              
                              
                              418
                              
                              
                              
                              461
                              
                              
                              
                              494Engineering
      and development (excluding depreciation and amortization amounts of $65
      and $43 for the three months ended June 30, 2009 and 2008, respectively,
      and $90 and $93 for the six months ended June 30, 2009 and 2008,
      respectively).
                              
                              
                              763
                              
                              
                              
                              498
                              
                              
                              
                              1,405
                              
                              
                              
                              1,075Sales
      and marketing (excluding depreciation and amortization amounts of $9 and
      $13 for the three months ended June 30, 2009 and 2008, respectively, and
      $17 and $28 for the six months ended June 30, 2009 and 2008,
      respectively).
                              
                              
                              67
                              
                              
                              
                              140
                              
                              
                              
                              105
                              
                              
                              
                              359General
      and administrative (excluding depreciation and amortization amounts of $6
      and $25 for the three months ended June 30, 2009 and 2008, respectively,
      and $12 and $59 for the six months ended June 30, 2009 and 2008,
      respectively).
                              
                              
                              1,576
                              
                              
                              
                              978
                              
                              
                              
                              2,441
                              
                              
                              
                              1,877Excess
      fair value transferred to WGI (See Note 8)
                              
                              
                              14,463
                              
                              
                              
                              0
                              
                              
                              
                              14,463
                              
                              
                              
                              0Depreciation
      and amortization
                              
                              
                              80
                              
                              
                              
                              81
                              
                              
                              
                              119
                              
                              
                              
                              180Total
      expenses from operations
                              
                              
                              16,949
                              
                              
                              
                              1,697
                              
                              
                              
                              18,533
                              
                              
                              
                              3,491Loss
      from operations
                              
                              
                              (16,811
                              )
                              
                              
                              (1,279
                              )
                              
                              
                              (18,072
                              )
                              
                              
                              (2,997
                              )Other
      Income (expense)Interest
      and other income
                              
                              
                              0
                              
                              
                              
                              4
                              
                              
                              
                              8
                              
                              
                              
                              10Change
      in fair value of derivative warrants and conversion
options
                              
                              
                              284
                              
                              
                              
                              (1,674
                              )
                              
                              
                              4,209
                              
                              
                              
                              (1,807
                              )Income
      from service fee contract termination
                              
                              
                              0
                              
                              
                              
                              1,056
                              
                              
                              
                              348
                              
                              
                              
                              1,056Amortization
      of debt discount
                              
                              
                              (2,235
                              )
                              
                              
                              (707
                              )
                              
                              
                              (2,918
                              )
                              
                              
                              (926
                              )Loss
      on equipment disposal
                              
                              
                              0
                              
                              
                              
                              (295
                              )
                              
                              
                              0
                              
                              
                              
                              (295
                              )Interest
      and other expense
                              
                              
                              (40
                              )
                              
                              
                              (99
                              )
                              
                              
                              (113
                              )
                              
                              
                              (186
                              )Total
      other (expense) income, net
                              
                              
                              (1,991
                              )
                              
                              
                              (1,715
                              )
                              
                              
                              1,534
                              
                              
                              
                              (2,148
                              )Net
      loss
                              
                              $
                              (18,802
                              )
                              
                              $
                              (2,994
                              )
                              
                              $
                              (16,538
                              )
                              
                              $
                              (5,145
                              )Net
      loss per common share:Basic
      and Fully Diluted
                              
                              $
                              (0.06
                              )
                              
                              $
                              (0.05
                              )
                              
                              $
                              (0.08
                              )
                              
                              $
                              (0.09
                              )Weighted
      average common shares outstanding:Basic
      and Fully Diluted
                              
                              
                              308,302,424
                              
                              
                              
                              58,740,660
                              
                              
                              
                              214,127,578
                              
                              
                              
                              57,844,501





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


4





WORLDGATE
COMMUNICATIONS, INC.


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)


(in
Thousands)





Six Months ended June 30,2009
              
              
              2008Cash
      flows from operating activities:Net
      loss
              
              $
              (16,538
              )
              
              $
              (5,145
              )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
              
              
              119
              
              
              
              180Amortization
      of debt discount
              
              
              2,918
              
              
              
              926Excess
      fair value transferred to WGI (See Note 8)
              
              
              14,463
              
              
              
              0Bad
      debt expense
              
              
              157
              
              
              
              0Change
      in fair value of derivative warrants and conversion
options
              
              
              (4,209
              )
              
              
              1,807Loss
      on disposal of fixed assets
              
              
              1
              
              
              
              295Inventory
      reserve
              
              
              600
              
              
              
              0Non-cash
      stock based compensation
              
              
              290
              
              
              
              251Changes
      in operating assets and liabilities:Trade
      accounts receivable
              
              
              (56
              )
              
              
              75Other
      receivables
              
              
              1
              
              
              
              603Inventory
              
              
              (472
              )
              
              
              351Prepaid
      and other current assets
              
              
              (122
              )
              
              
              (108
              )Deposits
      and other assets
              
              
              66
              
              
              
              55Accounts
      payable
              
              
              60
              
              
              
              529Accrued
      expenses and other current liabilities
              
              
              283
              
              
              
              (732
              )Accrued
      severance
              
              
              690
              
              
              
              0Accrued
      compensation and benefits
              
              
              (82
              )
              
              
              67Warranty
      reserve
              
              
              1
              
              
              
              (21
              )Deferred
      revenues and other income
              
              
              439
              
              
              
              213Net
      cash used in operating activities
              
              
              (1,391
              )
              
              
              (654
              )Cash
      flows used in investing activities:Capital
      expenditures
              
              
              (256
              )
              
              
              0Proceeds
      from the sale of fixed assets
              
              
              0
              
              
              
              4Net
      cash (used in) provided by investing activities
              
              
              (256
              )
              
              
              4Cash
      flows from financing activities:Proceeds
      from issuance of common stock
              
              
              1,581
              
              
              
              1Proceeds
      from the issuance of notes
              
              
              846
              
              
              
              0Net
      cash provided by financing activities
              
              
              2,427
              
              
              
              1Net
      increase (decrease) in cash and cash equivalents
              
              
              780
              
              
              
              (649
              )Cash
      and cash equivalents, beginning of period
              
              
              429
              
              
              
              1,081Cash
      and cash equivalents, end of period
              
              $
              1,209
              
              
              $
              432Non-cash
      investing and financing activities:Cumulative
      effect on a change in accounting principle on (See Note
6):Detachable
      warrants
              
              $
              885
              
              
              $
              0Additional
      Paid in Capital
              
              
              (1,751
              )
              
              
              0Accumulated
      deficit
              
              
              1,449
              
              
              
              0Conversion
      of convertible debenture to common stock
              
              
              0
              
              
              
              648Common
      stock issued in payment of convertible debentures
              
              
              4,080
              
              
              
              0Common
      stock issued in payment of accrued interest
              
              
              1,046
              
              
              
              0Common
      stock issued in payment of warrant derivative
              
              
              623
              
              
              
              0Common
      stock issued in payment of notes
              
              
              750
              
              
              
              0Revenue
      incentive asset
              
              
              60,000
              
              
              
              0





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


5


WORLDGATE
COMMUNICATIONS, INC.


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)


(Dollars
In Thousands, Except share and per Share Amounts)





1.
            Basis
      of Presentation.




The
unaudited condensed consolidated financial statements of WorldGate
Communications, Inc. (“WorldGate” or the “Company”) for the three and six months
ended June 30, 2009 and 2008 presented herein have been prepared by the Company
pursuant to the rules and regulations of the Securities and Exchange Commission
for quarterly reports on Form 10-Q.  Certain information and footnote
disclosures normally included in financial statements prepared in accordance
with United States generally accepted accounting principles (“GAAP”) have been
condensed or omitted pursuant to such rules and regulations.  In
addition, the December 31, 2008 condensed consolidated balance sheet was derived
from the audited financial statements, but does not include all disclosures
required by GAAP.  These financial statements should be read in
conjunction with the audited financial statements for the year ended December
31, 2008 and the notes thereto included in the Company’s Annual Report on Form
10-K.  The accounting policies used in preparing these unaudited
condensed consolidated financial statements are materially consistent with those
described in the audited December 31, 2008 financial statements.




The
financial information in this Report reflects, in the opinion of management, all
adjustments of a normal recurring nature necessary to present fairly the results
for the interim periods. Quarterly operating results are not necessarily
indicative of the results that may be expected for other interim periods or the
year ending December 31, 2009.




The preparation of financial statements
in conformity with accounting principles generally accepted in the United States
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities, as of the date of the financial statements, and the reported amount
of revenues and expenses during the reporting period.   Actual
results could differ from those estimates.  Judgments and estimates of
uncertainties are required in applying the Company’s accounting policies in many
areas.  Following are some of the areas requiring significant
judgments and estimates: revenue recognition, inventory valuation, deferred
revenues, stock-based compensation, valuation of derivative liabilities, related
warrants and deferred tax asset valuation allowance.




2.
            Liquidity
      and Going Concern Considerations.




Cash and Cash
Flow.  As of June 30, 2009, the Company had cash and cash
equivalents of $1,209.   The Company’s cash used in operations was $529 and
$1,391, respectively, during the three and six months ended June 30, 2009. The
$2,650 of aggregate funds the Company received as a result of (a) the closing on
April 6, 2009 of the transactions contemplated by the Securities Purchase
Agreement, dated December 12, 2008 (“ Securities Purchase Agreement”), between
WGI Investor LLC (“WGI”) and the Company and (b) the Commercial Relationship
with ACN Digital Phone Service, LLC (“ACN”) described below, including $1,200 of
payments received for development efforts, and the net proceeds from the
exercise of certain warrants totaling $881 contributed to the generation of
funds during the three months ended June 30, 2009 and have provided financing
for the on-going operations of the Company.




Liabilities.  The
Company had $6,477 of liabilities and none of its assets are pledged as
collateral as of June 30, 2009.  These liabilities include $2,968 of
accounts payable and accrued expenses, $690 of accrued severance, $2,201 of
deferred revenues and income, and $413 of detachable warrants related to the
Company’s private placement of preferred stock in June 2004.




Short Term Cash
Requirements.  At June 30, 2009, the Company’s short term cash
requirements and obligations include payment for finished, excess and obsolete
inventory, accounts payable from continuing operations and operating
expenses.  During the quarter ended June 30, 2009, the Company’s
convertible debt and the interest related to this convertible debt was converted
to equity pursuant to the closing on April 6, 2009 of the transactions
contemplated by the Securities Purchase Agreement.




Net Losses and Impact on
Operations.  The Company has incurred recurring net losses and
has an accumulated deficit of $285,946, stockholders’ equity of $57,850 and
working capital of $1,181 as of June 30, 2009.  During 2007 the
Company experienced severe cash shortfalls, deferred payment of some of its
operating expenses, and elected to shut down its operations for a period of time
during the first quarter of 2008. Further curtailments of its operations may be
necessary in the future.  These factors raise substantial doubt about
the Company’s ability to continue as a going concern as of June 30,
2009.  The financial statements do not include any adjustments that
might be necessary should the Company be unable to continue as a going
concern.


6


Aequus.  In October
2008, Aequus Technologies Corp. (“Aequus”) failed to pay to WorldGate $953 owed
to WorldGate for the purchase of video phones, and as a result the Company
terminated its reseller agreement with Aequus.  The Company has most
of the units sold to Aequus in its possession and will attempt to sell the units
elsewhere to recover the $953 while continuing to resolve its dispute with
Aequus.  There can be no assurance that WorldGate will be able to sell
the units and recover the $953 owed by Aequus.  The Company continues
to believe that the Video Relay Services and Video Remote Interpreting markets
provide an attractive opportunity for the sale of video phones and has initiated
shipments of video phones with other Video Relay Services / Video Remote
Interpreting service providers.




On
January 27, 2009, the Company resolved the outstanding NRE Arbitration with
Aequus, and in full satisfaction of the outstanding arbitration claim Aequus
agreed to terminate any obligation on the Company’s part to provide certain
prepaid engineering services pursuant to the March 31, 2008 Agreement with
Aequus (Aequus had prepaid approximately $900 for these engineering services of
which $725 was allocated to the settlement).





Vendor Payable.  On
January 28, 2009, in exchange for a vendor’s agreement to reduce an outstanding
obligation to the vendor, the Company issued a promissory note in the amount of
$30, to this vendor.  $20 of this note was paid on April 1, 2009 and
$10 of the note was paid on July 15, 2009.




Advance of Purchase Price by WGI
Investor.  On February 4, 2009 and March 24, 2009, the Company,
in exchange for cash received, issued promissory notes for $550 and $200
respectively to WGI. Both notes were an advance of the cash consideration
payable by WGI at the closing of the transactions contemplated by the Securities
Purchase Agreement.   The notes had a maturity date of May 1,
2009 and had interest payable at six percent per annum.  On April 6,
2009, upon closing of the transactions contemplated by the Securities Purchase
Agreement, the two notes were cancelled pursuant to their terms.




WGI and ACN
Transactions.  On April 6, 2009, the Company completed a
private placement of securities to WGI pursuant to the terms of the Securities
Purchase Agreement.  In connection with the transaction, the Company
issued to WGI an aggregate of 202,462,155 shares of its common stock, par value
of $0.01 per share (“Common Stock”) , representing approximately 63% of the
total number of issued and outstanding shares of ’Common Stock,, as well as a
warrant to purchase up to approximately 140.0 million shares of Common Stock in
certain circumstances (the “Anti-Dilution Warrant”) in exchange for (i) cash
consideration of $1,450 (of which $750 had been previously advanced to the
Company by WGI), (ii) the cancellation of convertible debentures held by WGI
under which approximately $5,100 in principal and accrued interest was
outstanding and (iii) the cancellation of certain outstanding warrants held by
WGI.  In December 2008, WGI had acquired from YA Global Investments,
L.P. (“YA Global”) the convertible debentures that the Company had previously
issued to YA Global and the outstanding warrants to purchase Common Stock then
held by YA Global.  The Company expects to use the proceeds from the
closing on April 6, 2009 of the transactions contemplated by the Securities
Purchase Agreement primarily for working capital purposes.





The
Anti-Dilution Warrant entitles WGI to purchase up to 140.0 million shares of
Common Stock at an exercise price of $0.01 per share to the extent the Company
issues any capital stock upon the exercise or conversion of (i) any warrants,
options and other purchase rights that were outstanding as of April 6, 2009
(“Existing Contingent Equity”), (ii) up to 19.7 million shares underlying future
options, warrants or other purchase rights issued by the Company after April 6,
2009 (“Future Contingent Equity”), or (iii) the ACN Warrant described
below.  The Anti-Dilution Warrant is designed to ensure that WGI may
maintain 63% of the issued and outstanding shares of the Company’s capital stock
in the event that any of the Company’s capital stock is issued in respect to the
Existing Contingent Equity, the Future Contingent Equity or the ACN Warrant as
defined below.  The term of the Anti-Dilution Warrant is ten years
from the date of issuance, and the shares subject to the Anti-Dilution Warrant
will be decreased proportionally upon the expiration of Existing Contingent
Equity, Future Contingent Equity and the ACN Warrant.





WGI is a
private investment fund whose ownership includes owners of ACN, a direct seller
of telecommunications services and a distributor of video
phones.  Concurrently with the closing on April 6, 2009 of the
transactions contemplated by the Securities Purchase Agreement, the Company
entered into a commercial relationship with ACN pursuant to which the Company
will design and sell video phones to ACN (the “Commercial
Relationship”).  As part of the Commercial Relationship, the Company
entered into two agreements, a Master Purchase Agreement pursuant to which ACN
has committed to purchase three hundred thousand videophones over a two-year
period and a Software Development and Integration and Manufacturing Assistance
Agreement pursuant to which ACN has committed to provide the Company with $1,200
to fund certain software development costs.   During the quarter ended
June 30, 2009, the Company received the $1,200 for software development costs
from ACN.  In connection with the Commercial Relationship, the Company
granted ACN a warrant to purchase up to approximately 38.2 million shares of its
Common Stock at an exercise price of $0.0425 per share (the “ACN
Warrant”).  The ACN Warrant will vest incrementally based on ACN’s
purchases of video phones under the Commercial Relationship.


7





Exercise of
Warrants.On June 23, 2009, the Company amended the exercise
price and other provisions of certain Series A Warrants to Purchase Common Stock
of WorldGate Communications, Inc. issued June 23, 2004 and certain Series B
Warrants to Purchase Common Stock of WorldGate Communications, Inc. issued June
23, 2004 (collectively, the “2004 Warrants”),
representing rights to purchase, in the aggregate, 8,771,955 shares of Common
Stock and that would have expired on June 23, 2009.  The exercise
price of the 2004 Warrants was amended to $0.25 per share of Common Stock and
the expiration date of the 2004 Warrants was amended to August 7,
2009.





On June
23, 2009, the Company also amended the exercise price and other provisions of
certain Warrants to Purchase Common Stock of WorldGate Communications, Inc.
issued August 3, 2005 (collectively, the “2005 Warrants”), representing rights
to purchase, in the aggregate, 513,333 shares of Common Stock and that expire on
August 3, 2010.  The exercise price of the 2005 Warrants was amended
to $0.25 per share of Common Stock.




As of
June 30, 2009, 3,166,667 of the 2004 Warrants and all of the 2005 Warrants were
exercised, resulting in the Company issuing 3,680,000 shares of Common Stock and
in return the Company received $920 in gross aggregate cash proceeds ($881 net
proceeds).  After June 30, 2009 and through August 7, 2009, additional
2004 Warrants were exercised (including a significant number of 2004 Warrants
held by an affiliate of Antonio Tomasello) resulting in the Company issuing
5,525,288 shares of Common Stock and in return the Company received $1,401 in
cash proceeds.  The Company incurred $39 of fees pursuant to the
transfer of the 2004 Warrants and 2005 Warrants from the original warrant
holders that were not interested in exercising the warrants to new warrant
holders. As of August 7, 2009, all 2004 Warrants had either expired or been
exercised.  As of August 7, 2009, 879,359 of the warrants issued
August 3, 2005 remain outstanding.




WGI
Warrant.  Upon closing on April 6, 2009 of the transactions
contemplated by the Securities Purchase Agreement, the Company issued to WGI a
warrant to purchase up to 140.0 million shares of Common Stock (the
“Anti-Dilution Warrant”), at an exercise price of $0.01 per share under certain
circumstances, including if the Company issues any capital stock upon the
exercise or conversion of any warrants that were outstanding as of April 6, 2009
(“Existing Contingent Equity”).   As of June 30, 2009, the
3,680,000 shares of Common Stock issued in connection with the exercise of the
2004 Warrants and 2005 Warrants resulted in WGI having the right to purchase an
aggregate of 6,265,946 shares of Common Stock at an exercise price of $0.01 per
share under the Anti-Dilution Warrant.   After June 30, 2009 and
through August 7, 2009, the additional 5,525,288 shares of Common Stock issued
in connection with the exercise of the 2004 Warrants and 2005 Warrants resulted
in WGI having the right to purchase in aggregate 9,544,138 of additional shares
of Common Stock at an exercise price of $0.01 per share under the Anti-Dilution
Warrant.




Employment
Agreements.  In connection with the closing on April 6, 2009 of
the transactions contemplated by the Securities Purchase Agreement, the Company
also entered into employment agreements with members of senior management,
including Hal Krisbergh, Randall Gort, Joel Boyarski and James McLoughlin.The
employment agreements entered into with the Company’s executive officers have a
term of one year (unless terminated earlier by either party) and provide for the
execution by the employee of a non-compete and confidentiality agreement with
the Company.  The employment agreements set an annual base salary of
$336 for Mr. Krisbergh, $200 for Mr. Gort, $195 for Mr. Boyarski and $190 for
Mr. McLoughlin.  The agreements also provide for the payment of
quarterly bonuses during the period of employment, based on individual
performance objectives to be set by the Company’s compensation committee, with
100% of the target quarterly bonus amounts guaranteed for Q2 2009 and 50%
guaranteed for Q3 2009, with the remaining amounts for Q3 and Q4 2009 earned to
the extent that the individual performance objectives have been
met.  The employment agreements also contemplate a future grant of
options under a new stock incentive plan, as and when such plan is adopted by
the board of directors, in the following anticipated amounts: Hal Krisbergh:
1,080,000 shares; Randall Gort: 1,080,000 shares; Joel Boyarski: 900,000 shares;
and James McLoughlin: 900,000 shares.  While the employment
arrangements under these agreements are “at-will,” the agreements provide
that in the event the employee is terminated by the Company without cause, upon
the execution by the employee of a general release in a form acceptable to the
Company, the employee will be entitled to certain continued health benefits as
well as severance in the amount equal to the greater of (i) the employee’s
monthly base salary amount, plus any cash bonus amounts (including guaranteed
amounts earned or accrued through the termination date), multiplied by the
number of months remaining in the term or (ii) the employee’s monthly base
salary amount, plus any cash bonus amounts (including guaranteed amounts earned
or accrued through the termination date), multiplied by six.




Departure of
Officers.  On April 9, 2009, Harold M. Krisbergh tendered his
resignation as Chief Executive Officer and as a director of the Company and
Randall J. Gort tendered his resignation as Senior Vice President, Chief Legal
Officer and Secretary of the Company. On May 15, 2009 James McLoughlin tendered
his resignation as Senior Vice President, Sales and Marketing.  In
connection with their respective resignations, the Company entered into
severance agreements with each of Messrs. Krisbergh, Gort, and McLoughlin
pursuant to which the Company agreed to provide them with certain severance
benefits, including continuation of their salary through April 6, 2010, payment
of accrued bonus amounts, continuation of certain health benefits for the
severance period, and an extension of the period during which vested options may
be exercised.  These severance agreements provide a general release in
favor of the Company and its affiliates.


8




Increase in Officer’s
Compensation.As of June 30, 2009, the Company increased its
annual compensation obligations for officers and senior executives of the
Company by $605 as a result of hiring additional members of senior management
and the termination and severance payments of Messrs. Krisbergh, Gort, and
McLoughlin described above.  In August 2009, the Company added an
additional officer increasing the annual compensation by $220.  The
severance compensation for Messrs. Krisbergh, Gort, and McLoughlin will cease on
April 7, 2010.  As of June 30, 2009, the Company accrued $626 in
officer’s compensation and severance.




Mototech
Agreement.On July 8, 2009, the Company entered into a letter
agreement with Mototech, Inc. (“Mototech”) to settle
all past due obligations owed by the Company to
Mototech.  Mototech had performed various services for the Company,
including manufacturing and engineering development, through various historical
transactions, which resulted in a claim by Mototech for approximately $1,400 in
unpaid fees and expenses from the Company.  Pursuant to the letter
agreement,




·
            all
      obligations of the Company to Mototech were terminated and the Company was
      released from all liabilities or obligations to Mototech, including all
      amounts due or owing to Mototech;




·
            the
      Company agreed to pay $600 in cash to Mototech pursuant to the following
      payment schedule: (a) $50 was paid on July 20, 2009; (b) $100 to be paid
      on or prior to August 30, 2009; (c) $150 to be paid on or prior to
      September 30, 2009; and (d) $300 to be paid on or prior to October 30,
      2009;




·
            the
      Company issued to Mototech 3,200,000 unregistered shares of Common Stock,
      subject to the following conditions: (a) no such shares can be sold prior
      to the date that is 9 months after the issuance of such shares and (b)
      when such shares are permitted to be sold, no more than 25,000 of such
      shares may be sold in any single day;
and




·
            the Company issued to Mototech an
      unregistered warrant to purchase 1,000,000 shares of Common Stock (the
      “Mototech Warrant”) with the following terms: (a) exercise price of $0.35
      per share; (b) immediate vesting of the entire warrant; and (c) expiration
      date of the earlier of (i) July 8, 2014, (ii) a change of control of the
      Company or (iii) the twentieth (20th) day following the Company’s delivery
      of notice to Mototech of the occurrence of a period of ten (10)
      consecutive trading days during which the quoted bid price of the Common
      Stock has been greater than a price equal to one hundred fifty percent
      (150%) of the exercise price of the
  warrant.




As a
result of the Mototech transaction the Company reduced its accounts payable by
$1,439, recorded accrued expenses of $600 for the cash to be paid and increased
stockholder equity by $839 for the common stock and warrants
issued.




Future Cash Flows and
Financings.  The Company’s ability to generate cash is
dependent upon the sale of its products and services and on obtaining cash
through the private or public issuance of debt or equity securities.  Given
that the Company’s video phone business involves the development of a new
product line with no market penetration in an underdeveloped market sector, no
assurances can be given that sufficient sales, if any, will materialize. The
lack of success of the Company’s sales efforts could also have an adverse
ability to raise additional financing.




Based on
management’s internal forecasts and assumptions regarding its short term cash
requirements, the Company currently believes that it will have sufficient cash
on hand to meet its obligations into the fourth quarter of
2009.  However, there can be no assurance given that these assumptions
are correct or that the revenue projections associated with product sales and
services to ACN will materialize to a level that will provide the Company with
sufficient capital to operate its business.




The
Company continues to evaluate possibilities to obtain additional financing
through public or private equity or debt offerings or from other
sources.  In addition, the Company plans to explore additional service
and distribution sales opportunities. There can be no assurance given, however,
that the Company’s efforts will be successful or that any additional financing
will be available and can be consummated on terms acceptable to the Company, if
at all. There can also be no assurance given that any additional sales can
be achieved through additional service and distribution
opportunities.  If the Company is unable to obtain sufficient funds,
the Company may be required to reduce the size of the organization or suspend
operations which could have a material adverse impact on its business
prospects.


9




3.
            Recent
      Accounting Pronouncements.


In
December 2007, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standard (“SFAS”) No. 141R, “Business
Combinations,” which replaces SFAS No. 141, “Business
Combinations.”  SFAS No. 141R establishes principles and requirements
for determining how an enterprise recognizes and measures the fair value of
certain assets and liabilities acquired in a business combination, including
noncontrolling interests, contingent considerations, and certain acquired
contingencies. SFAS No. 141R also requires acquisition-related transaction
expenses and restructuring costs to be expensed as incurred rather than
capitalized as a component of the business combination. SFAS No. 141R is
applicable prospectively to business combinations for which the acquisition date
is on or after January 1, 2009. The adoption of SFAS No. 141R will have an
impact on accounting for businesses acquired after the effective date of this
pronouncement.




In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements—An Amendment of ARB No. 51.”  SFAS
No. 160 establishes accounting and reporting standards for the noncontrolling
interest in a subsidiary (previously referred to as minority
interests).  SFAS 160 also requires that a retained
noncontrolling interest upon the deconsolidation of a subsidiary be initially
measured at its fair value. Upon the adoption of SFAS No. 160, the Company will
be required to report any noncontrolling interests as a separate component of
consolidated stockholders’ equity. The Company will also be required to present
any net income allocable to noncontrolling interest and net income attributable
to the stockholders of the Company separately in its consolidated statements of
operations. SFAS No. 160 is effective for fiscal years, and interim periods
within those fiscal years, beginning on or after January 1,
2009.  The implementation of SFAS No. 160 would require retroactive
adoption of the presentation and disclosure requirements for existing minority
interests, with all other requirements of SFAS No. 160 to be applied
prospectively. As the Company does not have noncontrolling interests in any
subsidiary, the adoption of SFAS No. 160 did not have any impact upon the
Company’s consolidated financial position or results of operations.




In March
2008, the FASB issued SFAS 161, “Disclosures about Derivative Instruments
and Hedging Activities: an amendment of FASB Statement No. 133,” which amends
and expands the disclosure requirements of SFAS 133 to require qualitative
disclosure about objectives and strategies for using derivatives, quantitative
disclosures about fair value amounts of and gains and losses on derivative
instruments, and disclosures about credit-risk-related contingent features in
derivative agreements. This statement is effective beginning January 1,
2009. The adoption of SFAS 161 did not have a material impact upon the Company’s
consolidated financial position or results of operations.




In June
2008, the FASB ratified EITF No. 07-5, “Determining Whether an Instrument (or an
Embedded Feature) is Indexed to an Entity’s Own Stock” (“EITF
07-5”).  EITF 07-5 provides that an entity should use a two-step
approach to evaluate whether an equity-linked financial instrument (or embedded
feature) is indexed to its own stock, including evaluating the instrument’s
contingent exercise and settlement provisions.  EITF 07-5 is effective
for financial statements issued for fiscal years beginning after December 15,
2008. Early application is not permitted. Upon adoption of EITF 07-5 on January
1, 2009, the Company has determined that certain warrants issued on August 11,
2006 and October 13, 2006 were not equity-linked financial instruments, and
accordingly, were derivative instruments.  The Company has recorded
the fair value of these instruments and the resulting cumulative effect of this
change in accounting method, as of January 1, 2009 (See Note 6).




In
April 2009, the FASB issued FSP FAS 157-4, “Determining Fair Value When the
Volume and Level of Activity for the Asset or Liability Have Significantly
Decreased and Identifying Transactions That Are Not Orderly” (“FSP FAS 157-4”).
FSP FAS 157-4 provides guidance on estimating fair value when market activity
has decreased and on identifying transactions that are not
orderly.  Additionally, entities are required to disclose in interim
and annual periods the inputs and valuation techniques used to measure fair
value. FSP FAS 157-4 is effective for interim and annual periods ending
after June 15, 2009. The adoption of FSP FAS 157-4 did not have a material
impact on the Company’s consolidated financial position or results of
operations.





In May
2009, the FASB issued SFAS No. 165, “Subsequent Events” (“SFAS 165”), which
establishes general standards of accounting for and disclosure of events that
occur after the balance sheet date but before financial statements are issued or
are available to be issued. The Company is required to adopt SFAS 165
prospectively to both interim and annual financial periods ending after
June 15, 2009. The adoption of SFAS 165 did not have a material impact
on the Company’s consolidated financial position or results of
operations.





In June
2009, the FASB issued SFAS No. 167, “Amendments to FASB Interpretation No.
46(R)” (“SFAS No. 167”). SFAS No. 167 is intended to improve financial reporting
by enterprises involved with variable interest entities and to address (1) the
effects on certain provisions of FASB Interpretation No. 46 (revised December
2003), Consolidation of Variable Interest Entities , as a result of the
elimination of the qualifying special-purpose entity concept in SFAS No. 166,
and (2) constituent concerns about the application of certain key provisions of
Interpretation 46(R), including those in which the accounting and disclosures
under the Interpretation do not always provide timely and useful information
about an enterprise’s involvement in a variable interest entity. SFAS No. 167 is
effective as of the beginning of each reporting entity’s first annual reporting
period that begins after November 15, 2009, for interim periods within that
first annual reporting period, and for interim and annual reporting periods
thereafter. The adoption of SFAS No. 167 is not expected to have a material
impact on the Company’s consolidated financial position or results of
operations.


10





In June
2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards Codification
and the Hierarchy of Generally Accepted Accounting Principles” (“SFAS
168”). SFAS 168 establishes the FASB Accounting Standards
Codification, (“Codification”) as the single source of
authoritative GAAP to be applied by nongovernmental entities, except for
the rules and interpretive releases of the SEC under authority of federal
securities laws, which are sources of authoritative GAAP for SEC
registrants. All guidance contained in the Codification carries an equal
level of authority. SFAS 168 is effective for interim and annual periods
ending after September 15, 2009. The adoption of SFAS 168 is not expected to
have a material impact on the Company’s consolidated financial position or
results of operations.





4.
            Inventory.




The Company’s inventory consists
primarily of finished goods equipment to be sold to customers. The cost is
determined on a first-in, first-out cost basis. A periodic review of inventory
quantities on hand is performed in order to determine and record a provision for
excess and obsolete inventories. Factors related to current inventories such as
technological obsolescence and market conditions were considered in determining
estimated net realizable values. A provision is recorded to reduce the cost of
inventories to the estimated net realizable values. To motivate trials and sales
of the Ojo, which is the Company’s main product, the Company has historically
subsidized, and may in the future continue to subsidize, certain of its product
sales to customers that result in sales of inventory below cost.  Any
significant unanticipated changes in the factors noted above could have an
impact on the value of the Company’s inventory and its reported operating
results.  At June 30, 2009 and December 31, 2008, the Company’s
inventory balance was $1,048 and $1,176, respectively (net of a reserve of $600
and $0, respectively for excess and obsolete inventory that is not expected to
be utilized in the continued development of the video phone).  Under
an agreement with Aequus dated March 31, 2008, Aequus purchased $1,153 of units
which were agreed to be held by the Company until shipped to Aequus
customers.  Included in the inventory balance reported on the balance
sheet as of June 30, 2009 are remaining Aequus units not yet shipped to Aequus
customers totaling $765.




5.
            Stock
      Based Compensation.




The
Company accounts for stock based compensation in accordance with the provisions
of SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS No.
123(R)”).   SFAS No. 123(R) requires that all stock based
compensation be recognized as an expense in the financial statements, and that
such cost be measured at the fair value of the award.  SFAS No. 123(R)
also requires that excess tax benefits related to stock option exercises be
reflected as financing cash inflows instead of operating inflows.  As
a result, the Company’s net loss before taxes for the three and six months ended
June 30, 2009 included approximately $226 and $290, respectively, of stock based
compensation. The three and six months ended June 30, 2008 included
approximately $126 and $251, respectively, of stock based compensation.
 The stock based compensation expense is included in general and
administrative expense in the condensed consolidated statements of
operations.




Consistent
with the requirements of SFAS 123(R), the Company has selected a
“with-and-without” approach regarding the accounting for the tax effects of
share-based compensation awards.  This approach is consistent with
intraperiod allocation guidance in SFAS No. 109, “Accounting for Income Taxes,”
and EITF Topic D-32, “Intraperiod Tax Allocation of the Tax Effect of Pretax
Income from Continuing Operations.”




On May
26, 2009, the Company’s Board of Directors (the “Board”) approved the terms of
Amendment No. 1 (the “Amendment”) to the Company’s 2003 Equity Incentive Plan
(the “Plan”).  The Amendment, among other things, increased the
maximum number of shares of Common Stock that may be issued or transferred under
the Plan to 26,500,000 and increased the maximum amount of shares that may be
issued in any fiscal year to any single participant in the Plan underlying an
option award to 2,000,000 shares.  The Board determined that it was
advisable and in the best interests of the Company to increase the maximum
number of shares available under the Plan so as to enable the Company to be able
to provide meaningful equity incentives to eligible participants in light of the
significant increase (from 118,906,345 on March 16, 2009 to 321,368,500 on May
5, 2009) in the number of shares of Common Stock that are now outstanding as a
result of the closing on April 6, 2009 of the transactions contemplated by the
Securities Purchase Agreement.




Upon the
approval of the Amendment, pursuant to authority delegated to them, the members
of the Compensation and Stock Option Committee of the Board who are “outside
directors” as defined in Treas. Reg. Section 1.162-27(e)(3) and “non-employee
directors” as defined in Rule 16(b)-3 of the Securities and Exchange Act of
1934, as amended, approved grants of non-qualified stock options to purchase an
aggregate of 13,261,500 shares of Common Stock to certain employees and
consultants of the Company.  Each such option has an exercise price
equal to the fair market value of the underlying stock as of the date of the
grants (which was $0.28 and $0.32, respectively, per share based on the closing
price on the Over the Counter Bulletin Board on May 26, 2009 and June 30, 2009),
vests in four equal annual installments commencing on the first anniversary of
the date of grant and has a ten year term.  These options had a
weighted average grant date fair value of $0.28 per share determined
using the Black Scholes fair value option model.


11





A summary
of awards under the Company’s 2003 Equity Incentive Plan is presented below:




Stock Options
                      
                      
                      Weighted-Average
                        Exercise Price
                      
                      
                      Aggregate
                        Intrinsic ValueOutstanding,
      January 1, 2009
                      
                      
                      6,080,364
                      
                      
                      $
                      0.27
                      
                      
                      $
                      0Granted
                      
                      
                      13,261,500
                      
                      
                      $
                      0.28Exercised
                      
                      
                      0
                      
                      
                      
                      0Cancelled/forfeited
                      
                      
                      (319,431
                      )
                      
                      $
                      0.27Outstanding,
      June 30, 2009
                      
                      
                      19,022,433
                      
                      
                      $
                      0.28
                      
                      
                      $
                      1,543,493Exercisable,
      June 30, 2009
                      
                      
                      4,081,585
                      
                      
                      $
                      0.32
                      
                      
                      $
                      706,553





As of
June 30, 2009, there was a total of $3,925 of unrecognized compensation
arrangements granted under the Plan.  The cost is expected to be
recognized through 2013.




Options
granted during the six months ended June 30, 2009 vest over four years and
expire ten years from the date of grant under the Plan. The weighted-average
exercise price of the options granted was $0.28. The fair value of each option
grant is estimated on the date of grant using the Black-Scholes fair value
option valuation model. The weighted-average assumptions used for these grants
were: expected volatility of 194%; average risk-free interest rates of 2.40%;
dividend yield of 0%; and expected life of 6.25 years.




The
following table summarizes information about stock options outstanding at June
30, 2009:




Stock Options Outstanding
                    
                    
                    Stock Options ExercisableRange of Exercise Prices
                    
                    Shares
                    
                    
                    Weighted-
                      Average
                      Remaining
                      Contractual
                      Life (Years)
                    
                    
                    Weighted-
                      Average
                      Exercise
                      Price
                    
                    
                    Shares
                    
                    
                    Weighted-
                      Average
                      Exercise
                      Price$0.00
      - $0.39
                    
                    
                    18,341,441
                    
                    
                    
                    8.89
                    
                    
                    $
                    0.23
                    
                    
                    
                    3,463,093
                    
                    
                    $
                    0.11$0.40
      - $0.59
                    
                    
                    56,500
                    
                    
                    
                    7.55
                    
                    
                    
                    0.49
                    
                    
                    
                    31,500
                    
                    
                    
                    0.49$0.60
      - $0.89
                    
                    
                    289,492
                    
                    
                    
                    5.48
                    
                    
                    
                    0.60
                    
                    
                    
                    289,492
                    
                    
                    
                    0.60$0.90
      - $1.34
                    
                    
                    6,500
                    
                    
                    
                    3.07
                    
                    
                    
                    1.20
                    
                    
                    
                    6,500
                    
                    
                    
                    1.20$1.35
      - $2.01
                    
                    
                    81,500
                    
                    
                    
                    4.79
                    
                    
                    
                    1.72
                    
                    
                    
                    56,500
                    
                    
                    
                    1.78$2.02
      - $3.02
                    
                    
                    193,000
                    
                    
                    
                    3.73
                    
                    
                    
                    2.39
                    
                    
                    
                    193,000
                    
                    
                    
                    2.39$3.03
      - $4.53
                    
                    
                    54,000
                    
                    
                    
                    5.71
                    
                    
                    
                    3.60
                    
                    
                    
                    41,500
                    
                    
                    
                    3.59Total
                    
                    
                    19,022,433
                    
                    
                    
                    8.74
                    
                    
                    $
                    0.28
                    
                    
                    
                    4,081,585
                    
                    
                    $
                    0.32





An
aggregate of 1,151,000 restricted shares were granted on October 3, 2007 and
December 20, 2007 to certain senior executives that vest upon the achievement of
certain performance criteria:




·
            10%
      of the shares vest upon achieving each of a 10%, 20%, 30%, 40% and 50%
      increase for the Company in total gross revenue in a quarter over its
      third quarter 2007 total gross revenue of $1,532 as shown on its statement
      of operations as reported in the SEC
filings;




·
            25%
      of the shares vest upon the Company achieving (1) a quarterly operating
      cash break-even (defined as zero or positive “net cash provided by
      operations” consistent with or as reported on the Consolidated
      Statement  of Cash Flows and (2) a 10% net income as a percent
      of revenue.




During
2008, 318,000 of these restricted shares were forfeited, leaving a balance of
outstanding restricted shares of 833,000 at December 31, 2008 with an aggregate
fair value of $198 on their dates of grant of October 3, 2007 and December 20,
2007. The criteria for these restricted shares were amended to clarify that the
criteria is intended to refer to transactions and revenue, operating cash flow
and income generated in the ordinary course of the Company’s business, and not
to extraordinary transactions.  During the three month period ended
June 30, 2009, 525,000 additional restricted shares were forfeited by executives
whose employment with the Company ended.  As of June 30, 2009, it was
determined that it was more likely than not that the remaining 308,000
outstanding restricted shares, with a fair value of $83, would
vest.  As such, the Company began amortizing the fair value of these
shares over the expected period that they will vest and recorded compensation
expense of $9 for these grants.


12


The
following table is the summary of the Company’s nonvested restricted shares as
of June 30, 2009.


Restricted
                    SharesNonvested
      as of January 1, 2009
                  
                  
                  833,000Granted
                  
                  
                  0Vested
                  
                  
                  0Cancelled/forfeited
                  
                  
                  (525,000
                  )Nonvested
      as of June 30, 2009
                  
                  
                  308,000




6.
            Accounting
      for Secured Convertible Debentures and Related
  Warrants.




As
discussed in Note 2, the Company completed a transaction with WGI on April 6,
2009 in which the convertible debentures described below were
cancelled.




General Terms of Convertible
Debentures.  On August 11, 2006 and October 13, 2006, the
Company completed a private placement with an institutional investor of
convertible debentures in the aggregate principal amount of
$11,000.  The Company received $6,000 ($5,615, net of transaction
costs) upon the closing of the transaction on August 11, 2006 (the “First
Tranche”) and the remaining $5,000 ($4,700, net of transaction costs) was
received on October 13, 2006 (the “Second Tranche”).   The
convertible debentures had a maturity of three years, an interest rate of 6% per
annum, and were convertible at the option of the investors into Common Stock at
a conversion price equal to the lesser of $1.75 per share or 90% of the average
of the five lowest daily volume weighted closing price (“VWAP”) of the Common
Stock during the fifteen trading days immediately preceding the conversion date
(subject to adjustment in the event of stock dividends, splits and certain
distributions to stockholders, fundamental transactions, and future dilutive
equity transactions).  Interest is payable at maturity, and the
Company may elect to pay the interest amount in cash or shares of its Common
Stock.  The Company also granted the holder of convertible debentures
a security interest in substantially all of its assets.  Upon any
liquidation, dissolution or winding up of the Company, the holders of the
convertible debentures would have been entitled to receive the principal amount
of the convertible debentures, together with accrued and unpaid interest, prior
to any payment to the holders of the Company’s common and preferred
stock.




Amendment To Convertible
Debentures.  On May 18, 2007, the Company and the holder
amended the terms of the convertible debentures to remove the investor’s
ability, upon conversion of the debenture, to demand cash in lieu of shares of
Common Stock and to clarify that the Company may issue restricted shares if
there is no effective registration statement at the time of conversion. This
amendment of the terms of the convertible debenture resulted in the Company
reclassifying the derivative conversion option liability embedded in the
convertible debentures from debt to equity.




Restrictions on Convertible
Debentures.  The holder could not make any conversions below
$1.75 per share (i) which would exceed $500 in principal amount in any calendar
month or (ii) which would result in the issuance of more than 840,000 shares of
Common Stock per calendar month (provided that this maximum share limit will be
waived by the Company unless it elects to pay the holder in cash the difference
in value between 840,000 shares and the number of shares the holder wishes to
convert, up to the $500 per month conversion limit).  If the Company
was in default under the convertible debentures, these limitations would be
waived. The holder was also not restricted in making conversions at $1.75 per
share.




In no
case, however, may the holder convert the convertible debentures if it would
result in beneficial ownership by the holder of more than 9.99% of the Company’s
outstanding Common Stock (though this provision can be waived by the holder upon
65 days prior notice).




In
addition, with respect to all of the convertible debentures, the aggregate
number of shares to be issued upon conversion, exercise of the warrants
(described below), payment for commitment shares (described below), and payment
of liquidated damages (described below) has been limited to 61,111,111 shares of
Common Stock.  In December 2008, the share limitation of the aggregate
number of shares to be issued was increased to 75,368,811 shares of Common
Stock.




Accounting for Convertible
Debentures.  The Company initially accounted for conversion
options embedded in the convertible debentures in accordance with SFAS
No. 133 “Accounting for Derivative Instruments and Hedging Activities”
(“SFAS 133”) and EITF 00-19 “Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company’s Own Stock”
(“EITF 00-19”)  SFAS 133 generally requires companies to
bifurcate conversion options embedded in convertible debentures from their host
instruments and to account for them as free standing derivative financial
instruments in accordance with EITF 00-19.   EITF 00-19 states
that if the conversion option requires net cash settlement in the event of
circumstances that are not solely within the Company’s control that they should
be classified as a liability measured at fair value on the balance
sheet.


13




Effective
January 1, 2007, the Company adopted the provisions of EITF Issue No. 06-7,
“Issuer’s Accounting for a Previously Bifurcated Conversion Option in a
Convertible Debt Instrument When the Conversion Option No Longer Meets the
Bifurcation Criteria in Financial Accounting Standards Board (“FASB”) Statement
No. 133, Accounting for Derivative Instruments and Hedging Activities”
(“EITF 06-7”).  Under EITF 06-7, at the time of issuance, an embedded
conversion option in a convertible debt instrument may be required to be
bifurcated from the debt instrument and accounted for separately by the issuer
as a derivative under SFAS 133, based on the application of EITF 00-19.
Subsequent to the issuance of the convertible debt, facts may change and cause
the embedded conversion option to no longer meet the conditions for separate
accounting as a derivative instrument, such as when the bifurcated instrument
meets the conditions of Issue 00-19 to be classified in stockholders’ equity.
Under EITF 06-7, when an embedded conversion option previously accounted for as
a derivative under SFAS 133 no longer meets the bifurcation criteria under
that standard, an issuer shall disclose a description of the principal changes
causing the embedded conversion option to no longer require bifurcation under
SFAS 133 and the amount of the liability for the conversion option
reclassified to stockholders’ equity.




Prior to
the May 18, 2007 amendment of the convertible debenture, subject to the share
limitation, as discussed above, the actual number of shares of Common Stock that
would be required if a conversion of the convertible debentures was made through
the issuance of Common Stock could not be predicted.  If the Company’s
requirements to issue shares under these convertible debentures had exceeded the
share limitation, or if it was not listed or quoted for trading on the OTCBB,
the Company could have been required to settle the conversion of the convertible
debentures with cash instead of its Common Stock.




Through
May 18, 2007, the Company accounted for the conversion options using the fair
value method at the end of each quarter, with the resultant gain or loss
recognition recorded against earnings.  On May 18, 2007 the Company
and the investor amended the terms of the secured convertible debentures to
remove the investor’s ability, upon conversion of the debentures, to demand cash
in lieu of shares of Common Stock and to clarify that the Company may issue
restricted shares if there is no effective registration statement at the time of
conversion.  This amendment of the terms of the convertible debentures
permitted the Company to reclassify $5,384 of the embedded derivative conversion
option liability to stockholders’ equity.  The discount on the
convertible debentures of $5,240 was based on amortization until
October 2009.




At the
closing of the First Tranche, the sum of the fair values of the conversion
feature and the warrants was $5,714 in the aggregate, which exceeded the net
proceeds of $5,615.  The difference of $99 was charged to the
provision for fair value adjustment, upon issuance during the third quarter of
2006.   Accordingly, the Company recorded a discount equal to the
face value of the convertible debentures, which will be amortized using the
effective interest rate method over the three year term.  The Common
Stock issued as fees in the transaction was recorded at a net value of $0, as
there was no residual value remaining.




At
October 13, 2006, in connection with the closing of the Second Tranche, the
convertible feature of the convertible debentures was recorded as a derivative
liability of $3,449 and the warrants were recorded as additional paid in capital
of $230.  For the Second Tranche issuance on October 13, 2006, the
Company recorded a discount of $3,979, which is being amortized using the
effective interest method over the three year term.




From
January 1, 2009 through closing on April 6, 2009 of the transactions
contemplated by the Securities Purchase Agreement when the debentures were
cancelled, there were no conversions of the debentures. As a result during the
three and six months ended June 30, 2009 there were no issuances of Common Stock
related to the debentures.  During the three and six months ended June
30, 2008, $646 and $647, respectively in face value of the convertible
debentures was converted, resulting in the issuance of 6,116,010 and 6,116,581
shares of Common Stock, respectively.  As a result of the amortization
and conversion, $2,235 and $2,918, respectively, of the discount on the
convertible debenture has been charged to discount amortization for three and
six months ended June 30, 2009, which includes the effects of the closing on
April 6, 2009 of the transactions contemplated by the Securities Purchase
Agreement.  During the three and six months ended June 30, 2008, $707
and $926, respectively, of the discount on the convertible debenture has been
charged to discount amortization.As of June 30, 2009, there
was no debt or interest outstanding as a result of the cancellation of the
convertible debenture and interest as part of the closing on April 6, 2009 of
the transactions contemplated by the Securities Purchase Agreement.




Adoption
of EITF 07-5.On January 1,
2009, in connection with the adoption of EITF 07-5, the Company determined that
warrants issued on August 11, 2006 and October 13, 2006 were not indexed to the
Company’s own stock, as defined.  Accordingly, the Company determined
that these warrants were derivative instruments, and on January 1, 2009,
recorded derivative liabilities of $479 and $406 for each of the August 11, 2006
and October 13, 2006 warrants, respectively.  At January 1, 2009, the
Company determined the fair value of the warrant derivative liability using the
Black-Scholes valuation model, applying the actual Common Stock price on January
1, 2009 ($0.38), applicable volatility rate (242%), and the period close
risk-free interest rate (0.27%) for the instruments’ remaining contractual lives
of 2.61 years for the August 2006 tranche and 2.78 years for the October 2006
tranche.  In connection with recording the warrant derivative
liabilities, the Company determined the cumulative effect of a change in
accounting principle as if they were recorded at inception, and increased the
debt discount related to the October 13, 2006 tranche by $584, reduced
additional paid in capital by $1,752 for the previously recorded equity value of
the warrants and decreased accumulated deficit by $1,449 for inception to
adoption date mark to market and discount amortization
adjustments.


14




The
following warrants were issued under the August 2006 tranche and the October
2006 tranche and were cancelled as part of the closing on April 6, 2009
of the transactions contemplated by the Securities Purchase
Agreement:




Tranche
                      
                      Exercise Price
                      
                      
                      Warrant SharesAugust
      2006
                      
                      $
                      1.85
                      
                      
                      
                      624,545$
                      2.35
                      
                      
                      
                      600,000$
                      2.60
                      
                      
                      
                      190,909October
      2006
                      
                      $
                      1.85
                      
                      
                      
                      520,455$
                      2.35
                      
                      
                      
                      500,000$
                      2.60
                      
                      
                      
                      159,091





7.
            Accounting
      for Derivative Instruments.




The
Company accounts for certain warrants, including the warrants issued as part of
the June 2004 private placement of preferred stock and the warrants issued as
part of the August and October 2006 private placement of convertible debentures,
as a derivative liability using the fair value method at the end of each
quarter, with the resultant gain or loss recognition recorded against
earnings.  The August and October 2006 warrants were cancelled as part
of the closing on April 6, 2009 of the transactions contemplated by the
Securities Purchase Agreement (See Note 2).  The Company recognized a
total non-cash gain of $284 and $4,209, respectively, for the three and six
months ended June 30, 2009 and a non-cash expense of $1,674 and $1,807,
respectively, for the three and six months ended June 30, 2008, for these
derivative warrants, based on the following criteria, each of which impact on
the fair value of the derivative, using the Black-Scholes valuation
model:




June 2004 Private Placement
                      WarrantsCriteria
                    
                    June 30, 2009
                    
                    
                    June 30, 2008Closing
      Common Stock price
                    
                    $
                    0.32
                    
                    
                    $
                    0.19Applicable
      volatility rates
                    
                    
                    86
                    %
                    
                    
                    192
                    %Risk-free
      interest rates
                    
                    
                    0.17
                    %
                    
                    
                    2.36
                    %Contractual
      life of instrument
                    
                    0.10
      years
                    
                    
                    1.00
      years




15


The
following table summarizes the derivative instruments (warrants) liability for
the three and six months ended June 30, 2009 (See Note 6):


June 2004 Private
                        Placement
                      
                      
                      August and October
                        2006 Private Placement
                      
                      
                      TotalOutstanding,
      December 31, 2008
                      
                      $
                      4,360
                      
                      
                      $
                      0
                      
                      
                      $
                      4,360Cumulative
      effect of the change in accounting principal, January 1, 2009 (See Note
      6)
                      
                      
                      0
                      
                      
                      
                      885
                      
                      
                      
                      885Net
      cash gain in fair value:Three
      months ended March 31, 2009
                      
                      
                      (3,665
                      )
                      
                      
                      (260
                      )
                      
                      
                      (3,925
                      )Three
      months ended June 30, 2009
                      
                      
                      (282
                      )
                      
                      
                      (2
                      )
                      
                      
                      (284
                      )Total
      six months ended June 30, 2009
                      
                      
                      (3,947
                      )
                      
                      
                      (262
                      )
                      
                      
                      (4,209
                      )Cancellation
      of Warrants April 6, 2009
                      
                      
                      0
                      
                      
                      
                      (623
                      )
                      
                      
                      (623
                      )Outstanding,
      June 30, 2009
                      
                      $
                      413
                      
                      
                      $
                      0
                      )
                      
                      $
                      413





8.
            Accounting
      for the WGI / ACN transaction





The Company accounts for stock and
warrants issued to third parties, including customers, in accordance with the
provisions of the Emerging Issues Task Force (“EITF “) 96-18, “Accounting for
Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services,” and EITF 01-9, “Accounting for
Consideration Given by a Vendor to a Customer (Including a Reseller of the
Vendor’s Products)” (“EITF 01-9”).





On April 6, 2009, the Company completed
a private placement of securities to WGI pursuant to the terms of the Securities
Purchase Agreement.  In connection with the transaction, the Company
received the following elements of value (i) cash consideration of $1,450 (of
which $750 had been previously advanced to the Company by WGI as a note), (ii)
the cancellation of convertible debentures held by WGI under which $4,080 in
principal and $1,046 in accrued interest was cancelled and (iii) the
cancellation of certain outstanding warrants held by WGI with a fair value of
$623.





The total fair value of these elements
received by the Company was determined by the Company to be approximately
$7,199.  In connection with the closing on April 6, 2009 of the
transactions contemplated by the Securities Purchase Agreement, WGI received (i)
202,462,155 shares of Common Stock and (ii) a ten year Anti-Dilution Warrant,
with an exercise price of $0.01, to purchase up to approximately 140.0 million
shares of Common Stock in certain circumstances.  The fair value of
the issued shares was determined to be $58,714 based on the closing price of
$0.29 on April 6, 2009.  The fair value of the Anti-Dilution Warrant
was determined to be $22,948 based on using the Black Scholes pricing model and
certain assumptions regarding the estimated probability for the issuance of
capital stock upon the exercise or conversion of each of (i) the Existing
Contingent Equity (ii) Future Contingent Equity or (iii) the ACN Warrant (See
Note 2).  As a result, the Company has determined that the value
received by WGI exceeded the fair value received by the Company by $74,463 as
summarized below:





Fair value Received by WGI:202,462,155
      shares of Common Stock
                        
                        $
                        58,714Anti-Dilution
      Warrant
                        
                        
                        22,948Total
      fair value received by WGI
                        
                        
                        
                        
                        
                        $
                        81,662Consideration Received by the
      CompanyCash
      received
                        
                        
                        1,450Convertible
      debenture cancelled
                        
                        
                        4,080Interest
      on convertible debentures  cancelled
                        
                        
                        1,046Warrant
      derivative terminated
                        
                        
                        623Total
      consideration received by the Company
                        
                        
                        
                        
                        
                        
                        7,199Excess
      fair value transferred to WGI
                        
                        
                        
                        
                        
                        $
                        74,463




16




Since the
WGI transaction is related to the ACN Master Purchase Agreement pursuant to
which ACN has committed to purchase three hundred thousand videophones over a
two-year period, with expected revenue of $60,000, and the consideration
provided to WGI is considered to be an inducement to a vendor per EITF 96-18 and
EITF-01-9, the $74,463 in excess fair value is required to be offset as a
reduction of revenues to the extent of cumulative probable future revenue from
that customer.(there can be no assurance provided that this revenue will
materialize). However, since the excess fair value exceeds the probable future
revenues expected under the ACN Master Purchase Agreement by $14,463, EITF-01-9
requires the amount of the excess in fair value provided to a vendor over the
probable future revenue ($14,463) to be taken as an immediate non cash expense.
The amount of the excess in fair value equal to probable future revenue of
$60,000 has been recorded as a $4,200 current asset and $55,800 long-term
deferred asset (presented as “Revenue incentive asset”) in accordance with EITF
00-18 “Accounting Recognition for Certain Transactions involving Equity
Instruments Granted to Other than Employee” in the balance sheet at June 30,
2009, and will offset revenue as and when the revenue is realized.  In
future periods should the Company determine that probable future revenue would
be less than $60,000, the Company would record an immediate non cash expense for
any probable revenue shortfall.




In
addition, in connection with the Commercial Relationship entered into with ACN
on April 6, 2009, the Company granted ACN the ACN Warrant.  The ACN
Warrant will vest incrementally based on ACN’s purchases of videophones under
the Commercial Relationship.  Under the provisions of EITF 96-18, the
Company will record a charge for the fair value of the portion of the warrant
earned from the point in time when shipments of units are initiated to ACN
through the vesting date. Final determination of fair value of the warrant
occurs upon actual vesting. EITF 01-9 requires that the fair value of the
warrant be recorded as a reduction of revenue to the extent of probable
cumulative revenue recorded from that customer.




Accordingly,
the application of these accounting guidelines will require the Company’s
reported revenue from the Commercial Relationship to be reduced to reflect both
the fair value of the ACN Warrant and the excess fair value of the equity issued
on the closing on April 6, 2009 of the transactions contemplated by the
Securities Purchase Agreement.




9.
            Fair
      Value of Financial Instruments.




SFAS No.
157, “Fair Value Measurements” (“SFAS 157”), defines fair value, establishes a
framework for


measuring
fair value in accordance with generally accepted accounting principles, and
expands disclosures about the price that would be received to sell an asset, or
paid to transfer a liability in an orderly transaction between market
participants at the measurement date.  SFAS 157 applies to all assets and
liabilities that are measured and reported on a fair value basis.





SFAS 157
establishes a three-tier fair value hierarchy which prioritizes the inputs used
in measuring fair


value as
follows:





Level
1 – Observable inputs such as quoted prices in active markets;


Level
2 – Inputs, other than the quoted prices in active markets, that are observable
either directly or


indirectly;
and


Level
3 – Unobservable inputs in which there is little or no market data, which
require the reporting entity


to
develop its own assumptions.





The
Company does not have any liabilities categorized as Level 1or Level 2 as of
June 30, 2009. The Company had Level 3 derivative liabilities valued at $413 as
of June 30, 2009.




The following is a reconciliation of
the beginning and ending balances for the Company’s derivative liabilities
measured at fair value on a recurring basis using significant unobservable
inputs (Level 3) during the six months ended


June 30,
2009:





Fair Value Measurements
Using Significant Unobservable Inputs (Level 3):





Description
                  
                  DerivativesLiabilities:Balance,
      January 1, 2009
                  
                  $
                  4,360Cumulative
      effect of the change in accounting Principal, January 1, 2009 (See Note
      6)
                  
                  
                  885Cancelation
      of debenture April 6, 2009
                  
                  
                  (623
                  )Total
      gain in fair value included in operations
                  
                  
                  (4,209
                  )Balance,
      June 30, 2009
                  
                  $
                  413





The change in fair value recorded for
Level 3 liabilities for the periods above are reported in other income (expense)
on the consolidated statement of operations.


17





10.
            Commitments
      and Contingencies.




The
Company’s prior five year lease was signed on September 1, 2005 and covered
42,500 square feet at an annual rate of $11.40 per square foot with a 3%
increase annually, cancelable by either party with eight months notice, with a
termination by tenant which included a six month termination fee.  In
March 2009, the parties agreed in principle to a new lease effective retroactive
to April 1, 2008 (and the cancellation of the current lease with no termination
cost) for a smaller space within the current facility consisting of
approximately 17,000 square feet at an annual fee of $7 per square foot. The
Company relocated into this smaller space in April 2008. This new lease was
executed in April 2009 and is cancelable by either party upon 90 days
notice with no termination costs. Total rent expense for the three and six
months ended June 30, 2009 amounted to approximately $46 and $88, respectively,
and for the three and six months ended June 30, 2008 amounted to approximately
$43 and $164, respectively.




In
December 2008, the Company entered into a 60 month lease for office
equipment. As of June 30, 2009, there remains an aggregate of $39 to be paid
over the remaining period of the terms of the leases.




The future minimum contractual rental
commitments under non-cancelable leases for each of the fiscal years ending
December 31 are as follows:




2009
      (July 1 to December 31,2009)
                  
                  $
                  62010
                  
                  
                  112011
                  
                  
                  112012
                  
                  
                  11Total
                  
                  $
                  39




11.
              Net
      Loss per Share (Basic and
Diluted).




The Company displays earnings per share
in accordance with SFAS No. 128, “Earnings Per Share.”  SFAS No. 128
requires dual presentation of basic and diluted earnings per share
(“EPS”).  Basic EPS includes no dilution and is computed by dividing
net loss attributable to common shareholders by the weighted average number of
common shares outstanding for the period.  Diluted EPS includes under
the “if converted method” of SFAS No. 128 the potential dilution that could
occur if securities or other contracts to issue Common Stock were exercised or
converted into Common Stock. Outstanding stock options, warrants and other
potential stock issuances are not included in the computation when they are not
in the money and their effect would be anti-dilutive.  The following
table presents the shares used in the computation of fully diluted loss per
share for the three and six months ended June 30, 2009 and 2008:




For
      the three months ended June 30,2009
                                                                              
                                                                              
                                                                              2008Numerator
      for diluted EPS calculation:Net
      loss
                                                                              
                                                                              $
                                                                              (18,802
                                                                              )
                                                                              
                                                                              $
                                                                              (2,994
                                                                              )Denominator
      for diluted EPS calculation:Basic
      and Fully Diluted weighted average common shares
    outstanding
                                                                              
                                                                              
                                                                              308,302,424
                                                                              
                                                                              
                                                                              
                                                                              58,740,660Basic
      and Fully Diluted EPS*
                                                                              
                                                                              $
                                                                              (0.06
                                                                              )
                                                                              
                                                                              $
                                                                              (0.05
                                                                              )




17




For
      the six months ended June 30,2009
                                  
                                  
                                  2008Numerator
      for diluted EPS calculation:Net
      loss
                                  
                                  $
                                  (16,538
                                  )
                                  
                                  $
                                  (5,145
                                  )Denominator
      for diluted EPS calculation:Basic
      and Fully Dilutive weighted average common shares
    outstanding
                                  
                                  
                                  214,127,578
                                  
                                  
                                  
                                  57,844,501Basic
      and Fully Dilutive EPS*
                                  
                                  $
                                  (0.08
                                  )
                                  
                                  $
                                  (0.09
                                  )




* The
Company had net losses during the three and six month periods ended June 30,
2009 and 2008 and as such     the basic and fully
diluted earnings per share calculations use the same share amounts in
determining the earning  per share value (adding the fully dilutive
shares to the denominator would be antidilutive to the
calculations).





Potential
common shares excluded from net loss per share for the three and
six  months ended June 30, 2009, were 206,971,328 and 71,477,947 for
the three and six months ended June 30, 2008 because their effect would be
anti-dilutive.  Potential common shares comprise shares of Common
Stock issuable upon the exercise of stock options, unvested restricted stock and
warrants, and upon the conversion of convertible debentures irrespective of
whether such securities are in the money.





12.
            Warrants.





A summary
of the Company’s warrant activity for the three months ended June 30, 2009 is as
follows:





Warrants
                                      
                                      
                                      Weighted Average
                                        Exercise Price
                                      
                                      
                                      Weighted
                                        Average
                                        Remaining
                                        Contract
                                        LifeOutstanding,
      April 1, 2009
                                      
                                      
                                      20,035,811
                                      
                                      
                                      $
                                      0.94
                                      
                                      
                                      
                                      1.02GrantedWGI
      Anti-Dilution Warrant
                                      
                                      
                                      140,009,750
                                      
                                      
                                      
                                      0.01ACN
      Warrant
                                      
                                      
                                      38,219,897
                                      
                                      
                                      
                                      0.0425Total
      Granted
                                      
                                      
                                      178,229,647
                                      
                                      
                                      
                                      0.02Expired/cancelled
                                      
                                      
                                      (6,944,563
                                      )
                                      
                                      
                                      (1.06
                                      )Exercised
                                      
                                      
                                      (3,680,000
                                      )
                                      
                                      
                                      (0.25
                                      )Outstanding,
      June 30, 2009
                                      
                                      
                                      187,640,895
                                      
                                      
                                      $
                                      0.06
                                      
                                      
                                      
                                      9.33Exercisable,
      June 30, 2009
                                      
                                      
                                      9,411,248





13.
            Stockholders’
      Equity (Deficiency).




The following summarizes the
transactions in stockholders’ equity (deficiency) from January 1, 2009 through
June 30, 2009:





Common
                    Stock
                  
                  
                  Additional
                    Paidin
                    Capital
                  
                  
                  Accumulated
                    Deficit
                  
                  
                  TotalBalance
      as of January 1, 2009
                  
                  $
                  1,189
                  
                  
                  $
                  261,478
                  
                  
                  $
                  (270,857
                  )
                  
                  $
                  (8,190
                  )Cumulative
      effect of a change in accounting principle
                  
                  
                  0
                  
                  
                  
                  (1,751
                  )
                  
                  
                  1,449
                  
                  
                  
                  (302
                  )Balance
      as of January 1, 2009
                  
                  
                  1,189
                  
                  
                  
                  259,727
                  
                  
                  
                  (269,408
                  )
                  
                  
                  (8,492
                  )Non-cash
      stock based compensation
                  
                  
                  
                  
                  
                  
                  290
                  
                  
                  
                  
                  
                  
                  
                  290Issuance
      of Common Stock upon exercise of warrants
                  
                  
                  37
                  
                  
                  
                  844
                  
                  
                  
                  
                  
                  
                  
                  881April
      6, 2009 Issuance of Common Stock and Anti-Dilution Warrant
                  
                  
                  2,025
                  
                  
                  
                  72,438
                  
                  
                  
                  
                  
                  
                  
                  74,463April
      6, 2009 Cancellation of convertible debt and accrued
    interest
                  
                  
                  
                  
                  
                  
                  6,623
                  
                  
                  
                  
                  
                  
                  
                  6,623April
      6, 2009 Cancellation of the derivative warrants
                  
                  
                  
                  
                  
                  
                  623
                  
                  
                  
                  
                  
                  
                  
                  623Net
      loss for the six months ended June 30, 2009
                  
                  
                  0
                  
                  
                  
                  0
                  
                  
                  
                  (16,538
                  )
                  
                  
                  (16,538
                  )Balance
      as of June 30, 2009
                  
                  $
                  3,251
                  
                  
                  $
                  340,545
                  
                  
                  $
                  (285,946
                  )
                  
                  $
                  57,850




18




14.         Revenue
Recognition.




Revenue
is recognized when persuasive evidence of an arrangement exists, the price is
fixed or determinable, the collectibility is reasonably assured, and the
delivery and acceptance of the equipment has occurred or services have been
rendered.  Management exercises judgment in evaluating these factors in
light of the terms and conditions of its customer contracts and other existing
facts and circumstances to determine appropriate revenue recognition. Due to the
Company’s limited commercial sales history, its ability to evaluate the
collectibility of customer accounts requires significant judgment. The Company
continually evaluates accounts of its equipment customers and service customers
for collectibility at the date of sale and on an ongoing basis.




Revenues
are also offset by a reserve for any price refunds and consumer rebates
consistent with the EITF Issue 01-9, “Accounting for Consideration Given by a
Vendor to a Customer.”




Video Phone Sales.
During the three and six months ended June 30, 2009, the Company did not ship
any product to customers with a right of return.  During the three and
six months ended June 30, 2008, the Company shipped approximately 0 and 9 units,
respectively, with a sales value of $0 and $2, respectively, to customers with a
right of return.  These customers may exercise their right of return
only if they do not sell the units to their respective
customers.  Revenue and cost for these units were deferred in
accordance with SFAS 48 “Revenue Recognition when a Right of Return
Exists.”




Aequus
Revenue.  From June 2007 through March 2008 the Company shipped
its video phone product to Aequus.  As part of its June 2007 agreement
with Aequus, the Company began to recognize product revenue at the time of
shipment of its video phone. In addition, the Company also began to receive
service fee revenues based on a percentage of the fees earned by Aequus and for
which the customer has received service. The Company recognizes this service fee
revenue upon confirmation from Aequus of the fees they have
earned.   The Company also receives service fee revenues from end
consumers which are recognized after the services have been
performed.




On March
31, 2008, the Company entered into a new agreement with Aequus and Snap
Telecommunications Inc. (“Snap!VRS”). This new agreement provides for the (i)
resolution of a dispute with Aequus regarding amounts the Company claimed were
owed to the Company by Aequus and the termination by the Company of video phone
service to Aequus, (ii) payment to the Company by Aequus of approximately $5,000
in scheduled payments over ten months commencing March 31, 2008, (iii) agreement
to arbitrate approximately $1,354 claimed by the Company to be owed by Aequus
and (iv) purchase of an additional $1,475 of video phones by
Aequus.




·
            $5,000 of Payments to the
      Company.  The $5,000 of payments in the agreement are
      related to multiple deliverables to Aequus that have standalone value with
      objective and reliable evidence of fair value, and include the following:
      (i) a specified amount of non recurring engineering (“NRE”, with a fair
      value of $900), (ii) support and transition training to Aequus to operate
      its own data center (“Training,” with an estimated fair value of $358),
      (iii) continued use of the WorldGate video phone service center during the
      transition (with an estimated fair value of $230), and (iv) the
      elimination of  previously agreed service fees (“contract termination
      fee”, with a residual fair value of $3,512). These deliverables are all
      separate units of accounting in accordance with EITF No. 00-21, “Revenue
      Arrangements with Multiple
Deliverables.”




19




The
Company recognized revenue for the NRE and training and support as the service
was provided. For the three and six months ended June 30, 2009 such revenue was
$0 and $796, respectively. For the three and six months ended June 30, 2008,
revenue of $279 was recognized for NRE and training and support.  The
revenue of $796 in the quarter ended June 30, 2009 includes $725 related to the
settlement of the dispute with Aequus wherein the settlement eliminated $725 of
the Company’s $900 obligation to provide NRE to Aequus and was credited to NRE
services provided under a previous agreement with Aequus.  The
Training was expected to be performed over approximately 7 months. Revenue from
the use of the video phone service center was recognized on a straight-line
basis over the expected period of use, which was approximately 7 months. 
Since collectibility was not reasonably assured, the contract termination fee
was recognized as other income on a straight line basis over the ten months that
the $5,000 was paid.  For the three months ended June 30, 2009 and
2008, other income was recorded for the contract termination fee of $0 and
$1,056, respectively.  For the six months ended June 30, 2009 and
2008, other income was recorded for the contract termination fee of $348 and
$1,056, respectively.  The Company had received payment of $1,475
toward the purchase of video phone units and all of the $5,000 agreed payments
in 2008 and the first quarter of 2009.




·
            Arbitration.  On
      January 27, 2009, the Company resolved the outstanding arbitration with
      Aequus, and in full satisfaction of the outstanding arbitration claim
      Aequus agreed to terminate any obligation on the part of the Company to
      provide certain prepaid engineering services pursuant to the March 31,
      2008 Agreement with Aequus (Aequus had prepaid approximately $900 for
      these engineering services of which $725 was allocated to the settlement
      which is recorded as revenue during the three months ended March 31,
      2009).




·
            Purchase of
      Units.  Units purchased per the March 31, 2008 agreement
      with Aequus are initially held by the Company pending shipment to Aequus
      customers.  Revenue for these units held by the Company pending
      shipment to the ultimate customer is deferred, per the SEC Staff
      Accounting Bulletin Topic 13A(3)(a) (Bill and Hold
      Arrangements).  Revenue for the units held is recognized as and
      when the units are shipped to the Aequus customers.  For the
      three months ended June 30, 2009 and 2008, the Company shipped $0 and
      $790, respectively, to Aequus customers. For the six months ended June 30,
      2009 and 2008, the Company shipped $0 and $790, respectively, to Aequus
      customers.




ACN
Revenues.  On April 6, 2009, the Company entered into a
Software Development and Integration and Manufacturing Assistance Agreement
pursuant to which ACN has committed to provide the Company with $1,200 to fund
certain software development costs.   During the quarter ended June
30, 2009 the Company received the $1,200 from ACN.  The Company
recorded these funds as deferred revenue as of June 30, 2009, pursuant to the
Software Development and Integration and Manufacturing Assistance Agreement’s
terms which partially compensates the Company for its development of a video
phone and licensing thereof.  The Company will recognize revenue from
this funding upon completion of the development in accordance with SOP 81-1
“Accounting for Performance of Construction Type and Certain Production Type
Contracts.”




15.        Risks
and uncertainties.




The
Company depends on relationships with third parties such as contract
manufacturing companies, chip design companies and others who may be sole source
providers of key components and services critical for the product the Company is
developing in its video phone business.  The components and raw
materials used in the Company’s Ojo video phone product, as well as the vendors
providing the parts necessary for the Ojo, are constantly changing which may
continue to result in the discontinuation and/or the unavailability of certain
parts possibly resulting in significant additional product development to
accommodate changes in vendor and replacement parts and may render some parts as
excess and obsolete.  This could increase the risk of additional
obsolescence and or development cost for the Company in pursuing large volume
customers.  Parts are sourced based, among other factors, on
reliability, price and availability.




At
the present time Mototech is the Company’s sole manufacturer of its video
phones.  If Mototech or other providers of components and/or
manufacturing services do not produce these components or provide their services
on a timely basis, if the components or services do not meet the Company’s
specifications and quality control standards, or if the components or services
are otherwise flawed, the Company may have to delay product delivery, or recall
or replace unacceptable products. In addition, such failures could damage the
Company’s reputation and could adversely affect its operating results. As a
result, the Company could lose potential customers and any revenues that it may
have at that time may decline dramatically.




16.         Accounting
for the Uncertainty in Income Taxes.




The
Company has adopted the provisions of FASB Interpretation No. 48, “Accounting
for Uncertainty in Income Taxes - an interpretation of FASB Statement No.
109”(“FIN 48”), on January 1, 2007.  FIN 48 clarifies the accounting
for uncertainty in income taxes recognized in an enterprise’s financial
statements in accordance with SFAS No. 109, “Accounting for Income Taxes,” and
prescribes a recognition threshold and measurement process for financial
statement recognition and measurement of a tax position taken or expected to be
taken in a tax return.  FIN 48 also provides guidance on recognition,
classification, interest and penalties, accounting in interim periods,
disclosure and transition.


20




The
Company has identified its federal tax return and its state tax return in
Pennsylvania as “major” tax jurisdictions, as defined in FIN
48.  Based on the Company’s evaluation, it concluded that there are no
significant uncertain tax positions requiring recognition in the Company’s
financial statements.  The Company’s evaluation was performed for tax
years ended 2005 through 2008, the only periods subject to
examination.  The Company believes that its income tax positions and
deductions would be sustained on audit and does not anticipate any adjustments
that would result in a material change to its financial position.




The
Company’s policy for recording interest and penalties associated with audits is
not to record such items as a component of income before income
taxes.  Penalties are recorded in other expense and interest paid or
received is recorded in interest expense or interest income, respectively, in
the statement of operations.  There were no amounts accrued for
penalties or interest as of or during the three and six months ended June 30,
2009 and 2008.  The Company does not expect its unrecognized tax
benefit position to change during the next twelve months.  Management
is currently unaware of any issues under review that could result in significant
payments, accruals or material deviations from its position.




17.   Net
Operating Losses and Changes of Ownership




The
Company’s ability to utilize its net operating loss carryforwards and credit
carryforwards will be subject to annual limitations as a result of prior,
current or future changes in ownership and tax law as defined under
Section 382 of the Internal Revenue Code (IRC) of 1986. Such limitations
are based on the Company’s market value at the time of an ownership change
multiplied by the long-term tax-exempt rate supplied by the Internal Revenue
Service.




October 2008 Change of
Control.  Upon completing an analysis as required by IRC
Section 382, it was determined that during October 2008, as a result of the
aggregation of shares related to the conversion of the convertible debenture
into shares of Common Stock by the convertible debenture holder, the Company
experienced a change of ownership as defined in Section 382.  Prior to
the change, the Company had a net operating loss carryforward (NOL) of
approximately $237,441. Due to the annual limitations imposed by Section 382,
the Company will be unable to utilize approximately $234,952 of this net
operating loss and the remaining amount of approximately $2,489 will be subject
to an annual utilization limitation of approximately $124 for 20
years.  The total NOL available to offset future taxable income as of
December 31, 2008 is approximately $2,754, which includes losses incurred for
the period up to the change of control of approximately $2,489 (subject to
annual limitations) and losses incurred subsequent to the change in control to
December 31, 2008 of approximately $265, which will likely not be subject to an
annual limitation.




April 2009 Change of
Control.  Upon completing an analysis as required by Section
382, it was determined that during April 2009, as a result of the private
placement pursuant to which WGI acquired shares of Common Stock representing 63%
of the outstanding Common Stock, the Company experienced a second change of
ownership as defined in Section 382.  As a result of the second
change, the NOL limitation attributable to the first change of approximately
$124 annually will remain in place limiting approximately $2,489 of NOL. The
post October 2008 change of control loss of approximately $265 would be able to
be fully utilized going forward with no likely limitations.




The state
net operating loss projected to be lost is approximately $187,356 resulting in
approximately $2,754 remaining to be carried forward subject to similar annual
limitations. The state net operating losses are also limited by state law and
subject to maximum utilization limits. The federal research and experimentation
credit (R&D), which provides tax credit for certain R&D efforts, will
also be subject to an annual limitation.  Due to the limitation
pursuant to Section 382, all but approximately $25 of the credit is
lost.  The federal credits remaining will expire in
2028.  All state research and experimentation credit carryovers have
been refunded and no state credit remains.




Results
of the Company’s net operating and credit carryforwards are expressed within the
table below:




FEDERAL
                    
                    
                    STATE
                    
                    
                    FEDERALNOL
                    
                    
                    NOL
                    
                    
                    R&DNOL
      and credit prior to October change
                    
                    
                    237,441
                    
                    
                    
                    189,845
                    
                    
                    
                    4111Unavailable
      losses/credit as a result of the October 2008 change in
      control
                    
                    
                    234,952
                    
                    
                    
                    187,356
                    
                    
                    
                    4111Loss/credit
      Available after October change subject to annual
    limitations
                    
                    
                    2,489
                    
                    
                    
                    2,489
                    
                    
                    noneNOL/Credit
      attributable to period subsequent to October change in
    control
                    
                    
                    265
                    
                    
                    
                    265
                    
                    
                    
                    25Total  NOL
      and credits subject to limitation
                    
                    
                    2,754
                    
                    
                    
                    2754
                    
                    
                    
                    25




21




Future
issuances of Common Stock and subsequent losses may further affect this analysis
which might cause an additional limitation on our ability to utilize the
remaining net operating loss carryforwards.




18.         Subsequent
Events




Mototech
Agreement.On July 8, 2009, the Company entered into a letter
agreement with Mototech, Inc. (“Mototech”) to settle
all past due obligations owed by the Company to
Mototech.  Mototech had performed various services for the Company,
including manufacturing and engineering development, through various historical
transactions, which resulted in a claim by Mototech for approximately $1,400 in
unpaid fees and expenses from the Company.  Pursuant to the letter
agreement,




·
            all
      obligations of the Company to Mototech were terminated and the Company was
      released from all liabilities or obligations to Mototech, including all
      amounts due or owing to Mototech;




·
            the
      Company agreed to pay $600 in cash to Mototech pursuant to the following
      payment schedule: (a) $50 was paid on July 20, 2009; (b) $100 to be paid
      on or prior to August 30, 2009; (c) $150 to be paid on or prior to
      September 30, 2009; and (d) $300 to be paid on or prior to October 30,
      2009;




·
            the
      Company issued to Mototech 3,200,000 unregistered shares of Common Stock,,
      subject to the following conditions: (a) no such shares can be sold prior
      to the date that is 9 months after the issuance of such shares and (b)
      when such shares are permitted to be sold, no more than 25,000 of such
      shares may be sold in any single day;
and




·
            the
      Company issued to Mototech an unregistered warrant to purchase 1,000,000
      shares of Common Stock (the “Mototech Warrant”) with the following terms:
      (a) exercise price of $0.35 per share; (b) immediate vesting of the entire
      warrant; and (c) expiration date of the earlier of (i) July 8, 2014, (ii)
      a change of control of the Company or (iii) the twentieth (20th) day
      following the Company’s delivery of notice to Mototech of the occurrence
      of a period of ten (10) consecutive trading days during which the quoted
      bid price of the Common Stock has been greater than a price equal to one
      hundred fifty percent (150%) of the exercise price of the
      warrant.




As part
of closing on April 6, 2009 of the transactions contemplated by the Securities
Purchase Agreement (See note 2), the
Company issued to WGI a warrant to purchase up to 140.0 million shares of Common
Stock (the “Anti-DilutionWarrant”), at an
exercise price of $0.01 per share under certain circumstances, including if the
Company issues any capital stock upon the exercise or conversion of up to 19.7
million shares underlying options, warrants or other purchase rights issued by
the Company after April 6, 2009 (“Future Contingent Equity”).  Any
shares of Common Stock issued in connection with any exercise of the Mototech
Warrant would result in shares becoming exercisable under the Anti-Dilution
Warrant equaling 1.7027027 multiplied by the number of shares of Common Stock
issued in connection with any exercise of the Mototech Warrant.





Warrant
Amendment.  On July 15, 2009, the Company amended the
exercise price of the Warrant to Purchase Common Stock of WorldGate
Communications, Inc., dated September 24, 2007 (the “2007 Warrant”),
representing rights to purchase 2,564,102 shares of Common Stock, held by
Antonio Tomasello and that expires on September 23, 2012.




The
exercise price of the 2007 Warrant was amended from $0.49 per share to (a) $0.25
per share of Common Stock if the 2007 Warrant is exercised in full prior to
September 15, 2009, (b) $0.31 per share of Common Stock if the 2007 Warrant is
exercised in full on or after September 15, 2009 but prior to November 15, 2009,
or (c) $0.39 per share of Common Stock if the 2007 Warrant is exercised in full
on or after November 15, 2009 or is exercised in part at any time.





Appointment of new Chief Executive
Officer and President.  On July 31, 2009, the Company entered
into a letter agreement (the “Letter Agreement”) with George E. Daddis Jr.,
pursuant to which Mr. Daddis agreed to serve as Chief Executive Officer and
President of the Company, effective August 3, 2009.




Pursuant
to the Letter Agreement, the Company agreed (1) to pay Mr. Daddis $220,000 per
year , (2) to grant Mr. Daddis an option to purchase 2,000,000 shares of Common
Stock of the Company at an exercise price of $0.34 per share and which vests 25%
per year beginning on July 31, 2010, and (3) to pay Mr. Daddis severance
payments in the amount of six (6) months’ salary and benefits continuation
should (i) the Company terminate his employment for any reason without Cause as
defined or (ii) Mr. Daddis terminates his employment with the Company for Good
Reason as defined.




On August
3, 2009, Robert Stevanovski resigned as the Company’s interim Chief Executive
and President effective immediately.


22





The Company has evaluated events that
occurred subsequent to June 30, 2009 through August 14, 2009, the date of which
the financial statements for the period ended June 30, 2009 were
issued.  Except as disclosed above, management concluded that no other
events required disclosure in these financial statements.





ITEM
2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
(Dollar amounts contained in this Item 2 are in thousands, except for share and
per share amounts)




FORWARD-LOOKING
AND CAUTIONARY STATEMENTS





We may
from time to time make written or oral forward-looking statements, including
those contained in the following Management’s Discussion and Analysis of
Financial Condition and Results of Operations.  The words “estimate,”
“project,” “believe,” “intend,” “expect,” and similar expressions are intended
to identify forward-looking statements, although not all forward-looking
statements contain these identifying words.  In order to take advantage of
the “safe harbor” provisions of the Private Securities Litigation Reform Act of
1995, we are hereby identifying certain important factors that could cause our
actual results, performance or achievement to differ materially from those that
may be contained in or implied by any forward-looking statement made by or on
our behalf.  The factors, individually or in the aggregate, that could
cause such forward-looking statements not to be realized include, without
limitation, the following: (1) difficulty in developing and implementing
marketing and business plans, (2) industry competition factors and other
uncertainty that a market for our products will develop, (3) challenges
associated with distribution channels, including both the retail distribution
channel and  high speed data operators (e.g., uncertainty that they
will offer our products, inability to predict the manner in which they will
market and price our products and existence of potential conflicts of interests
and contractual limitations impeding their ability to offer our products),
(4) continued losses, (5) difficulty or inability to raise additional
financing on terms acceptable to us, (6) departure of one or more key
persons, (7) changes in regulatory requirements, (8) delisting of our
Common Stock, par value $0.01 per share (“Common Stock”) from the OTCBB and
(9) other risks identified in our filings with the Securities and Exchange
Commission, including the risks identified in “Item 1A. Risk Factors” in our
Annual Report on Form 10-K for the fiscal year ended December 31, 2008.  We
caution you that the foregoing list of important factors is not intended to be,
and is not, exhaustive.  We do not undertake to update any forward-looking
statement that may be made from time to time by us or on our behalf, other than
as required by the federal securities law.





General




We are
currently in the process of transforming the Company from a manufacturer of high
quality consumer video phones, into a service operating company that also
provides “turn-key” digital video phone services (meaning a complete,
ready-to-use digital video phone services solution) directly to end using
customers.  Inherent in this strategy is a monthly recurring revenue
stream that would be based on the particular services provided by us to each
company we partner with.   Also key to this strategy is that it
enables many non-traditional companies and organizations who have a very broad
distribution reach, but do not have an infrastructure to provide telephone and
video services, to provide their distribution networks with a video phone
service solution.  We are currently in the process of developing a new
video phone needed for the transition to a digital video phone serviceand will make
the video phone available to ACN as well as all of our customers. The first
prototypes are expected be available in the fourth quarter of 2009 with customer
availability expected in the second quarter of 2010.





We expect
some companies will look to us to wholesale to them select services from the
platform as they are already providing services such as billing, customer care
and customer order entry.  Our wholesale offering will include our
video phone, provisioning, network and technical support services. Our platform
will be modular so customers can choose the services that best fit their
needs.




While we
expect revenues related to the new business model to begin in late 2009, or
early next year, the extent and timing of future revenues for our digital video
phone services  depends on several factors, including the rate of
market acceptance of our products, the degree of competition from similar
products, and our ability to access funding necessary to provide the time runway
to roll out product and services.  We cannot predict to what extent our
service business will produce revenues, or when, or if, we will reach
profitability.





Relationship with
AequusTechnologies.  In the spring of 2006, we entered into a
multiyear agreement with Aequus Technologies Corp. (“Aequus”) to purchase Ojo
video phones through its wholly owned subsidiary Snap Telecommunications Inc.
(“Snap!VRS”), a provider of Video Relay Services (“VRS”) and Video Remote
Interpreting (“VRI”) services for the deaf and hard of hearing.  In
the spring of 2007, we announced an expansion of our relationship with Aequus
and Snap!VRS agreeing to work collaboratively to develop the preferred VRS phone
for the VRS community.  From 2006, we were reliant on the Aequus
relationship as our primary customer relationship.


23





On
February 4, 2008, we disclosed that we were in a dispute with Aequus over the
payment of significant monies that we believed Aequus owed to us.  The
refusal by Aequus to pay such monies had contributed to a shortfall in our
available operating cash needed to continue operations, and accordingly, on
January 30, 2008, we shut down our operations. This was a first step to winding
down our business, which would occur if we were not able to secure payment of
the monies believed to be owed to us by Aequus and/or secure new
financing.





On March
31, 2008, we entered into a new agreement with Aequus and Snap!VRS. This new
agreement provides for the (i) resolution of a dispute with Aequus regarding
amounts we claimed were owed to us by Aequus and the termination by us of video
phone service to Aequus, (ii) payment to us by Aequus of approximately $5,000 in
scheduled payments over ten months commencing March 31, 2008, (iii) agreement to
arbitrate approximately $1,354 claimed by us to be owed by Aequus and (iv)
purchase of an additional $1,475 of video phones by Aequus.




In
October 2008, Aequus failed to pay $953 owed to us for the purchase of video
phones, and as a result we terminated our reseller agreement with
Aequus.  We have most of the units sold to Aequus in our possession
and we are attempting to sell the units elsewhere to recover the $953while continuing to
resolve our dispute with Aequus.  We continue to believe that the VRS
and VRI markets provide an attractive opportunity for the sale of video phones
and have initiated shipments of video phones to other VRS/VRI
providers.   In addition, on January 27, 2009, we resolved
arbitration proceedings with Aequus, and in full satisfaction of the outstanding
$1,354 arbitration claim, Aequus agreed to terminate any obligation on our part
to provide certain prepaid engineering services pursuant to a previous agreement
with Aequus.  As a result of the arbitration, we retained $725 of the
approximately $900 prepaid by Aequus for these engineering
services.




Relationship with WGI and
ACN.   On April 6, 2009, we completed a private placement
of securities to WGI Investor LLC (“WGI”), pursuant to the terms of a Securities
Purchase Agreement, dated December 12, 2008 (the “Securities Purchase
Agreement”), between WGI and the Company.  In connection with the
closing on April 6, 2009 of the transactions contemplated by the Securities
Purchase Agreement, we issued to WGI an aggregate of 202,462,155 shares of our
Common Stock, representing approximately 63% of the total number of issued and
outstanding shares of our Common Stock, as well as a warrant to purchase up to
approximately 140.0 million shares of our Common Stock in certain circumstances
(the “Anti-Dilution Warrant”) in exchange for (i) cash consideration of $1,450
(of which $750 had been previously advanced to us by WGI), (ii) the cancellation
of convertible debentures held by WGI under which approximately $5,100 in
principal and accrued interest was outstanding, and (iii) the cancellation of
certain outstanding warrants held by WGI. In December 2008, WGI had acquired
from YA Global Investments, L.P. (“YA Global”) the convertible debentures that
we had previously issued to YA Global and the outstanding warrants to purchase
our Common Stock then held by YA Global.  We expect to use the
proceeds from the closing on April 6, 2009 of the transactions contemplated by
the Securities Purchase Agreement primarily for working capital
purposes.




The
Anti-Dilution Warrant entitles WGI to purchase up to 140.0 million shares of
Common Stock at an exercise price of $0.01 per share to the extent the Company
issues any capital stock upon the exercise or conversion of (i) any warrants,
options and other purchase rights that were outstanding as of April 6, 2009
(“Existing Contingent Equity”), (ii) up to 19.7 million shares underlying future
options, warrants or other purchase rights issued by the Company after April 6,
2009 (“Future Contingent Equity”), or (iii) the ACN Warrant described
below.  The Anti-Dilution Warrant is designed to ensure that WGI may
maintain 63% of the issued and outstanding shares of the Company’s capital stock
in the event that any of the Company’s capital stock is issued in respect to the
Existing Contingent Equity, the Future Contingent Equity or the ACN
Warrant.  The term of the Anti-Dilution Warrant is ten years from the
date of issuance, and the shares subject to the Anti-Dilution Warrant will be
decreased proportionally upon the expiration of Existing Contingent Equity,
Future Contingent Equity and the ACN Warrant.




WGI is a private investment fund whose
ownership includes owners of ACN Digital Phone Service, LLC (“ACN”), a direct
seller of telecommunications services and a distributor of video
phones.  Concurrently with the closing of the closing on April 6, 2009
of the transactions contemplated by the Securities Purchase Agreement, we
entered into a commercial relationship with ACN pursuant to which we will design
and sell video phones to ACN (the “Commercial Relationship”).  As part
of the Commercial Relationship, we entered into two agreements, a Master
Purchase Agreement pursuant to which ACN has committed to purchase three hundred
thousand videophones over a two-year period and a Software Development and
Integration and Manufacturing Assistance Agreement pursuant to which ACN
committed and paid $1,200 to fund certain software development
costs.  In connection with the Commercial Relationship, we granted ACN
a warrant to purchase up to approximately 38.2 million shares of our Common
Stock at an exercise price of $0.0425 per share (the “ACN
Warrant”).  The ACN Warrant will vest incrementally based on ACN’s
purchases of video phones under the Commercial Relationship.




24





Critical
Accounting Policies and Estimates.





Our condensed consolidated financial
statements have been prepared in accordance with accounting principles generally
accepted in the United States.  These generally accepted accounting
principles require management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of net revenues and expenses during the reporting period.  Actual
results could differ from those estimates.





Our significant accounting policies are
described in the Management’s Discussion and Analysis section and the notes to
the consolidated financial statements included in our annual report on Form 10-K
for the fiscal year ended December 31, 2008.  Judgments and estimates
of uncertainties are required in applying our accounting policies in many
areas.  Following are some of the areas requiring significant
judgments and estimates:  revenue recognition, inventory valuation,
stock based compensation, deferred revenues, deferred tax asset valuation
allowances and valuation of derivative liabilities and related
warrants.  Management has discussed the development and selection of
these policies with the Audit Committee of our Board of Directors, and the Audit
Committee of the Board of Directors has reviewed our disclosures of these
policies.  There have been no material changes to the critical
accounting policies or estimates reported in the Management’s Discussion and
Analysis section or the audited financial statements for the year ended December
31, 2008 as filed with the Securities and Exchange Commission.





Results
of Operations:




Three and Six Months Ended June 30,
2009 and June 30, 2008.




Revenues.





For the three months ended June 30,
                        
                        
                        For the six months ended June 30,2009
                        
                        
                        2008
                        
                        
                        Change
                        
                        
                        2009
                        
                        
                        2008
                        
                        
                        ChangeProduct
      revenues
                        
                        $
                        16
                        
                        
                        $
                        812
                        
                        
                        $
                        (796
                        )
                        
                        
                        (98
                        )%
                        
                        $
                        365
                        
                        
                        $
                        831
                        
                        
                        $
                        (466
                        )
                        
                        
                        (56
                        )%Service
      revenues
                        
                        $
                        89
                        
                        
                        $
                        164
                        
                        
                        $
                        (75
                        )
                        
                        
                        (46
                        )%
                        
                        $
                        182
                        
                        
                        $
                        259
                        
                        
                        $
                        (77
                        )
                        
                        
                        (30
                        )%Other
      revenues
                        
                        $
                        38
                        
                        
                        $
                        279
                        
                        
                        $
                        (241
                        )
                        
                        
                        (86
                        )%
                        
                        $
                        833
                        
                        
                        $
                        279
                        
                        
                        $
                        554
                        
                        
                        
                        199
                        %Total
      net revenues
                        
                        $
                        143
                        
                        
                        $
                        1,255
                        
                        
                        $
                        (1,112
                        )
                        
                        
                        (89
                        )%
                        
                        $
                        1,380
                        
                        
                        $
                        1,369
                        
                        
                        $
                        11
                        
                        
                        
                        1
                        %





Product
Revenue.  Product revenue consists of the sale of Ojo video
phones.  For the three months ended June 30, 2009 compared with
the three months ended June 30, 2008, the decrease in product revenue
primarily reflects reduced shipments of product to Aequus.  For the
six months ended June 30, 2009 compared with the six months ended
June 30, 2008, the decrease in product revenue primarily reflects reduced
shipments of product to Aequus, partially offset by $322 of product shipments to
another customer during the six months ended June 30, 2009.





Service
Revenue.  Service revenue consists of subscription service
revenues and service provided to service operators. For the three and six months
ended June 30, 2009 compared with the three and six months ended
June 30, 2008, the decrease in service revenue primarily reflects the
reduction in service provided to Aequus.





Other
Revenue.  Other revenue consists of non-recurring engineering
and other non recurring services.  For the three months ended
June 30, 2009 compared with the three months ended June 30, 2008, the
decrease in other revenue primarily reflects the reduction in realized revenues
from non recurring engineering services, support and transition training and
service center usage provided to Aequus under the March 31, 2008
agreement.  For the six months ended June 30, 2009 compared with
the six months ended June 30, 2008, the increase in other revenue primarily
reflects the increased revenue in the quarter ended March 31, 2009 that included
$725 related to the settlement of a dispute with Aequus wherein the settlement
eliminated $725 of the Company’s $900 obligation to provide NRE to Aequus and
that was credited to NRE services provided under the March 31, 2008 agreement
with Aequus.





Net
Revenue.  For the three months ended June 30, 2009
compared with the three months ended June 30, 2008, the decrease in net
revenue primarily reflects the decrease in product, service and other revenues
related to revenue realized from Aequus.  For the six months ended
June 30, 2009 compared with the six months ended June 30, 2008, the
increase in other revenue primarily reflects the increased revenue in the
quarter ended March 31, 2009 that included $725 related to the settlement of a
dispute with Aequus which was partially offset by the decrease in product and
service revenue from Aequus as noted above which was the result of the
conclusion of the March 31, 2008 agreement in January 2009.


25





Cost of Revenues and Gross
Margin





For the three months ended June 30,
                        
                        
                        For the six months ended June 30,2009
                        
                        
                        2008
                        
                        
                        Change
                        
                        
                        2009
                        
                        
                        2008
                        
                        
                        ChangeTotal
      net revenues
                        
                        $
                        143
                        
                        
                        $
                        1,255
                        
                        
                        $
                        (1,112
                        )
                        
                        
                        (89
                        )%
                        
                        $
                        1,380
                        
                        
                        $
                        1,369
                        
                        
                        $
                        11
                        
                        
                        
                        1
                        %Cost
      of product revenues
                        
                        $
                        5
                        
                        
                        $
                        678
                        
                        
                        $
                        (673
                        )
                        
                        
                        (99
                        )%
                        
                        $
                        919
                        
                        
                        $
                        716
                        
                        
                        $
                        203
                        
                        
                        
                        28
                        %Cost
      of service revenues
                        
                        $
                        0
                        
                        
                        $
                        0
                        
                        
                        $
                        0
                        
                        
                        
                        N/A
                        
                        
                        $
                        0
                        
                        
                        $
                        0
                        
                        
                        $
                        0
                        
                        
                        
                        N/ACost
      of other revenues
                        
                        $
                        0
                        
                        
                        $
                        159
                        
                        
                        $
                        (159
                        )
                        
                        
                        (100
                        )%
                        
                        $
                        0
                        
                        
                        $
                        159
                        
                        
                        $
                        (159
                        )
                        
                        
                        (100
                        )%Total
      cost of revenues
                        
                        $
                        5
                        
                        
                        $
                        837
                        
                        
                        $
                        (832
                        )
                        
                        
                        (99
                        )%
                        
                        $
                        919
                        
                        
                        $
                        875
                        
                        
                        $
                        44
                        
                        
                        
                        5
                        %Gross
      margin
                        
                        $
                        138
                        
                        
                        $
                        418
                        
                        
                        $
                        (280
                        )
                        
                        
                        (67
                        )%
                        
                        $
                        461
                        
                        
                        $
                        494
                        
                        
                        $
                        (33
                        )
                        
                        
                        (7
                        )%





Cost of
Revenues.  The cost of revenues consists of product and
delivery costs relating to the deliveries of video phones, and direct costs
related to non-recurring engineering services revenues.  For the three
months ended June 30, 2009 compared with the three months ended
June 30, 2008, the decrease in cost of revenues primarily reflects
decreased costs related to reduced product shipments of $674, and decreased
other revenue engineering services costs of $159.  For the six months
ended June 30, 2009 compared with the six months ended June 30, 2008,
the increase in cost of revenues primarily reflects the recording of a $600
inventory reserve for certain excess and obsolete inventory that may not be
utilized in the future development of our video phones.





Gross
Margin.  For the three months ended June 30, 2009 compared
with the three months ended June 30, 2008, the decrease in gross margin
primarily reflects the reduction of product revenues and the decrease in
engineering services, partially offset by the result of an improved product mix
to higher margin service and engineering service revenues.  For the
six months ended June 30, 2009 compared with the six months ended
June 30, 2008, gross margin was reduced by $600 relating to the
establishment of an inventory reserve for certain excess and obsolete
inventory.  Before this adjustment, gross margin for the six months
ended June 30, 2009 was $1,061, or 77%, compared to $494, or 36%, for the same
period in 2008.  This improvement in gross margin was primarily the
result of the increase in revenue from the non-recurring engineering , training
and service center usage revenues recognized from our agreement with Aequus,
with the respective costs of these increased revenues having been previously
incurred and recorded in 2008 (See Note 14 of the accompanying financial
statements), engineering services provided to ACN for software development (See
Note 14 of the accompanying financial statements), and increased selling prices
and lower unit costs of the product shipped during the six months ended June 30,
2009 compared to the same period in 2008.





Expenses From Operations.





For the three months ended June 30,
                        
                        
                        For the six months ended June 30,2009
                        
                        
                        2008
                        
                        
                        Change
                        
                        
                        2009
                        
                        
                        2008
                        
                        
                        ChangeEngineering
      and development
                        
                        $
                        763
                        
                        
                        $
                        498
                        
                        
                        $
                        265
                        
                        
                        
                        53
                        %
                        
                        $
                        1,405
                        
                        
                        $
                        1,075
                        
                        
                        $
                        330
                        
                        
                        
                        31
                        %Sales
      and marketing
                        
                        $
                        67
                        
                        
                        $
                        140
                        
                        
                        $
                        (73
                        )
                        
                        
                        (52
                        )%
                        
                        $
                        105
                        
                        
                        $
                        359
                        
                        
                        $
                        (254
                        )
                        
                        
                        (71
                        )%General
      and administrative
                        
                        $
                        1,576
                        
                        
                        $
                        978
                        
                        
                        $
                        598
                        
                        
                        
                        61
                        %
                        
                        $
                        2,441
                        
                        
                        $
                        1,877
                        
                        
                        $
                        564
                        
                        
                        
                        30
                        %Excess
      fair value Transferred to WGI
                        
                        $
                        14,463
                        
                        
                        $
                        0
                        
                        
                        $
                        14,463
                        
                        
                        
                        100
                        %
                        
                        $
                        14,463
                        
                        
                        $
                        0
                        
                        
                        $
                        14,463
                        
                        
                        
                        100
                        %Depreciation
      and amortization
                        
                        $
                        80
                        
                        
                        $
                        81
                        
                        
                        $
                        (1
                        )
                        
                        
                        (1
                        )%
                        
                        $
                        119
                        
                        
                        $
                        180
                        
                        
                        $
                        (61
                        )
                        
                        
                        (34
                        )%





Engineering and
Development.  Engineering and development expenses primarily
consist of compensation, and the cost of design, programming, testing,
documentation and support of our video phone product.  For the three
and six months ended June 30, 2009 compared with the three and six months
ended June 30, 2008, the increase in engineering and development expenses
primarily reflects that in 2008 certain direct engineering development costs
charged to cost of revenues that were related to revenues reported for NRE
services performed for Aequus during the three and six months ended June 30,
2008 for non recurring engineering services, support and transition training and
service center usage provided to Aequus under the March 31, 2008 agreement
..





Sales and
Marketing.  Sales and marketing expenses consist primarily of
compensation (which includes compensation to manufacturer’s representatives and
distributors), attendance at conferences and trade shows, travel costs,
advertising, promotions and other marketing programs (which include expenditures
for co-op advertising and new market development) related to the continued sales
of our video phone product   For the three and six months ended
June 30, 2009 compared with the three and months ended June 30, 2008,
the decrease in sales and marketing expenses is primarily the result of reduced
marketing, customer service and promotional expenditures and reduced
compensation costs.


26





General and
Administrative.  General and administrative expenses consist
primarily of expenditures for administration, office and facility operations, as
well as finance and general management activities, including legal, accounting
and professional fees.  For the three and six months ended
June 30, 2009 compared with the three and six months ended June 30,
2008, the increase in general and administrative expenses is primarily the
result of the accrual of $626 in compensation and severance expenses related to
officers that were terminated.   The terminated officer’s
compensation will cease on April 7, 2010.  In addition the six months
ended June 30, 2009, included a bad debt reserve of $157 relating to certain
product shipped and invoiced to a customer that has not been paid.




Excess Fair Value
Transferred to WGI.  As a result of the value of the shares and
antidilution warrants received by WGI on the closing on April 6, 2009 of the
transactions contemplated by the Securities Purchase Agreement, the Company has
determined that the value received by WGI exceeded the fair value received by
the Company by $74,463.  Since the WGI transaction is related to the
ACN purchase agreement whereby ACN agreed to purchase 300,000 video phones, the
excess in fair value was deemed to be an inducement to a vendor per Emerging
Issues Task Force 96-18 and EITF-01-9 and accordingly the excess above fair
value is requires to be offset as a reduction of revenues to the extent of
cumulative revenue recorded from that customer. However, since the excess in
fair value exceeds the expected future revenues of the ACN transaction by
$14,463 EITF-01-9 requires the amount of the excess in fair value provided to a
vendor over the expected revenue ($14,463) to be recorded as a non-cash expense
against operations.  The amount of the excess in fair value equal to
expected future revenue of $60,000 has been recorded as a $4,200 current asset
and $55,800 long-term deferred asset (presented as “Revenue incentive asset”) in
the balance sheet at June 30, 2009, and will offset revenue when the revenue is
realized. (See Note 8 of the accompanying condensed consolidated financial
statements)





Other Income and Expenses.





For the three months ended June 30,
                  
                  
                  For the six months ended June 30,2009
                  
                  
                  2008
                  
                  
                  Change
                  
                  
                  2009
                  
                  
                  2008
                  
                  
                  ChangeInterest
      and other income
                  
                  $
                  0
                  
                  
                  $
                  4
                  
                  
                  $
                  (4
                  )
                  
                  
                  (100
                  )%
                  
                  $
                  8
                  
                  
                  $
                  10
                  
                  
                  $
                  (2
                  )
                  
                  
                  (20
                  )%Change
      in fair value of derivative warrants and conversion
options
                  
                  $
                  284
                  
                  
                  $
                  (1,674
                  )
                  
                  $
                  1,958
                  
                  
                  
                  117
                  %
                  
                  $
                  4,209
                  
                  
                  $
                  (1,807
                  )
                  
                  $
                  6,016
                  
                  
                  
                  333
                  %Income
      from service fee contract termination
                  
                  $
                  0
                  
                  
                  $
                  1,056
                  
                  
                  $
                  (1,056
                  )
                  
                  
                  (100
                  )%
                  
                  $
                  348
                  
                  
                  $
                  1,056
                  
                  
                  $
                  (708
                  )
                  
                  
                  (67
                  )%Amortization
      of debt discount
                  
                  $
                  (2,235
                  )
                  
                  $
                  (707
                  )
                  
                  $
                  1528
                  
                  
                  
                  216
                  %
                  
                  $
                  (2,918
                  )
                  
                  $
                  (926
                  )
                  
                  $
                  1,992
                  
                  
                  
                  215
                  %Loss
      on equipment disposal
                  
                  $
                  0
                  
                  
                  $
                  (295
                  )
                  
                  $
                  (295
                  )
                  
                  
                  (100
                  )%
                  
                  $
                  0
                  
                  
                  $
                  (295
                  )
                  
                  $
                  (295
                  )
                  
                  
                  (100
                  )%Interest
      and other expense
                  
                  
                  (40
                  )
                  
                  
                  (99
                  )
                  
                  $
                  (59
                  )
                  
                  
                  (60
                  )%
                  
                  
                  (113
                  )
                  
                  
                  (186
                  )
                  
                  $
                  (73
                  )
                  
                  
                  (39
                  )%





Interest and Other
Income.  Interest and other income consisted of interest earned
on cash and cash equivalents.  During the three and six months ended
June 30, 2009, we earned interest on an average cash balance of approximately
$732 and $576, respectively.  During the three and six months ended
June 30, 2008, we earned interest on an average cash balance of approximately
$490 and $562, respectively.





Change in fair value of
derivative warrants and conversion options.  The fair value
adjustments of our derivative warrants and conversion options issued in our June
2004 private placement of our Series A Convertible Preferred Stock and Warrants
and our August 11, 2006 and October 13, 2006 private placements of secured
convertible debentures and warrants are primarily a result of changes in our
common stock price during each reporting period and anti-dilution provisions
that increased the number of outstanding warrants and reduced the warrant
exercise price as of June 30, 2008 (See Note 7 of the accompanying financial
statements).





Income from Service Fee
Contract Termination.Income from
service fee contract termination consists of payments from Aequus for the
elimination of previously agreed service fees with Aequus, which we realized
over a ten month period ending January 2009 (See Note 14 of the accompanying
financial statements).





Amortization of Debt
Discount.  Amortization of debt discount consists of the
amortization of the secured convertible debentures issued in the August 11, 2006
and October 13, 2006 private placements.  The increase of amortization
of debt discount for the three and six months ended June 30, 2009, when compared
to the same periods in 2008, is primarily the result of the application of the
effective interest rate method to determine the monthly amortization of the
discount over the term of the convertible debentures.  This method
increases the periodic amortization charged as the convertible debentures reach
maturity (See Note 6 of the accompanying financial statements).  On
the closing on April 6, 2009 of the transactions contemplated by the Securities
Purchase Agreement, the convertible debentures were terminated and the remaining
unamortized discount on the convertible debentures of $2,235 was charged to
income and included in amortization of debt discount expense.


27





Loss on Equipment
Disposal.  During the three months ended June 30, 2008, certain
equipment, furniture and fixtures were sold and disposed of during the Company’s
move to smaller facilities.  The net loss realized during the three
and six months ended June 30, 2008 was $295.  There was no loss or
gain realized during the three and six months ended June 30, 2009.




Interest and Other
Expense.  The reduction in
interest expense for the three and six months ended June 30, 2009, when compared
to the same periods in 2008, primarily consisted of the elimination in 2009 of
accrued interest ($1,046) on the secured convertible debentures issued in the
August 11, 2006 and October 13, 2006 private placements upon the closing on
April 6, 2009 of the transactions contemplated by the Securities Purchase
Agreement (See Note 2 of the accompanying financial statements).





Income
Taxes.  We have incurred net operating losses since inception
and accordingly had no current income tax provision and have not recorded any
income tax benefit for those losses, since realization of such benefit is
currently uncertain.





Liquidity
and Capital Resources





Sources of
Liquidity.  As of June 30, 2009, our primary sources of
liquidity consisted of proceeds from notes issued, the sale of Common Stock and
the exercise of warrants, the sale of Ojo video phones and engineering
development services.  Cash and cash equivalents are invested in
investments that are highly liquid, are of high quality investment grade and
have original maturities of less than three months.  As of June 30,
2009, we had cash and cash equivalents of $1,209.





Cash Used in
Operations.  We utilized cash from operations of $529 and
$1,391, respectively, during the three and six months ended June 30, 2009 and
$132 and $654, respectively, during the three and six months ended June 30,
2008.  Our short term cash requirements and obligations include
inventory, accounts payable and capital expenditures from continuing operations
and operating expenses during these periods in 2009 and 2008.





Cash Used in Investing
Activities.  Cash used in investing activities for the three
and six months ended June 30, 2009 was primarily a result of capital
expenditures of $229 and $256, respectively,  for investments in
equipment for product development and manufacture.  Cash used in
investing activities for the three and six months ended June 30, 2008 was
primarily a result of capital expenditures of $4 and $4, respectively for
investments in equipment for product development and manufacture.





Cash Provided by Financing
Activities.  Cash provided by financing activities during the
three and six months ended June 30, 2009 was $1,647 and $2,427,
respectively.  Cash provided by financing activities during the three
and six months ended June 30, 2008 was $0 and $1,
respectively.   During the three months ended June 30, 2009, we
received cash of $1,450 from stock issuances and $881 from the exercise of
warrants (See Note 2 of the accompanying financial statements).





Operations and Liquidity.




We have
incurred recurring net losses and have an accumulated deficit of $285,946,
stockholder’s equity of $57,850 and a working capital of $1,818 as of June 30,
2009.  We have also experienced severe cash shortfalls, deferred
payment of some of our operating expenses, and shut down operations for a period
of time in early 2008 to conserve our cash.  At least in the short
term we do not expect to generate sufficient cash from operations and will
likely need to secure additional cash financing and to increase product
sales.  No assurances can be given that we will be able to obtain the
necessary cash for us to continue as a going concern.  These factors
raise substantial doubt about our ability to continue as a going
concern.  The accompanying financial statements do not include any
adjustments that might be necessary should we be unable to continue as a going
concern.





We had
$6,477 of liabilities and none of our assets are pledged as collateral as of
June 30, 2009.  These liabilities include $2,968 of accounts payable
and accrued expenses, $2,201 of deferred revenues and income, and $413 of
detachable warrants related to the Company’s private placement of preferred
stock in June 2004 which were extended to August 7, 2009.





In
December 2008, WGI acquired from YA Global Investments, L.P. (“YA Global”) the
secured convertible debentures we previously issued to YA Global and the
outstanding warrants to purchase our Common Stock then held by YA
Global.  On the closing on April 6, 2009 of the transactions
contemplated by the Securities Purchase Agreement we issued and sold to WGI a
total of 202,462,155 shares of our Common Stock, representing approximately 63%
of our outstanding stock, as well as a warrant to purchase up to approximately
140.0 million shares of our Common Stock in certain circumstances, in exchange
for (i) total cash consideration of $1,450, (ii) the cancellation of debentures
held by WGI under which approximately $5,100 in principal and accrued interest
was outstanding at June 30, 2009, and (iii) the cancellation of certain of our
outstanding warrants to purchase an aggregate of 2,595,000 shares of our Common
Stock held by WGI.


28





In
October 2008, Aequus Technologies Corp. (“Aequus”) failed to pay to us $953 owed
to us for the purchase of video phones, and as a result we terminated our
reseller agreement with Aequus.  We have most of the units sold to
Aequus in our possession and we are attempting to sell the units elsewhere to
recover the $953while
continuing to resolve our dispute with Aequus. There can be no assurance that we
will be able to sell the units and recover the $953 owed by
Aequus.  We continue to believe that the VRS and VRI markets provide
an attractive opportunity for the sale of video phones and have initiated sales
with other VRS/VRI service providers.





On
January 27, 2009, we resolved the outstanding NRE Arbitration with Aequus, and
in full satisfaction of the outstanding arbitration claim Aequus agreed to
terminate any obligation on our part to provide certain prepaid engineering
services pursuant to the March 31, 2008 Agreement with Aequus (Aequus had
prepaid approximately $900 for these engineering services of which $725 was
allocated to the settlement).




Our
ability to generate cash is dependent upon the sale of our Ojo product, our
ability to enter into arrangements to provide services, and on obtaining cash
through the private or public issuance of debt or equity securities.  Given
that our video phone business involves the development of a new video phone
necessary for the digital video phone service with no market penetration in an
underdeveloped market sector, no assurances can be given that sufficient sales,
if any, will materialize. The lack of success of our sales efforts could also
have an adverse ability to raise additional financing.





Based
on management’s internal forecasts and assumptions, including regarding our
short term cash requirements, we currently believe that we will have sufficient
cash on hand to meet our obligations into the fourth quarter of 2009. However,
there can be no assurance given that these assumptions are correct or that the
revenue projections associated with product sales and services to ACN will
materialize to a level that will provide us with sufficient capital to operate
our business.




We
continue to evaluate possibilities to obtain additional financing through public
or private equity or debt offerings, asset securitizations, or from other
sources.  In addition the Company plans to explore additional service
and distribution sales opportunities.There
can be no assurance given, however, that our efforts will be successful or that
any additional financing will be available and can be consummated on terms
acceptable to us, if at all.There can
also be no assurance given that any additional sales can be achieved through
additional service and distribution opportunities. If we are unable to
obtain sufficient funds we may be required to further reduce the size of the
organization or suspend operations which could have a material adverse impact on
our business.





Unaudited
Non-GAAP Financial Information





The Company accounts for stock and
warrants issued to third parties, including customers, in accordance with the
provisions of the Emerging Issues Task Force (“EITF “) 96-18, “Accounting for
Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services,” and EITF 01-9, “Accounting for
Consideration Given by a Vendor to a Customer (Including a Reseller of the
Vendor’s Products)” (“EITF 01-9”).





On April 6, 2009, the Company completed
a private placement of securities to WGI pursuant to the terms of the Securities
Purchase Agreement.  In connection with the transaction, the Company
received the following elements of value (i) cash consideration of $1,450 (of
which $750 had been previously advanced to the Company by WGI as a note), (ii)
the cancellation of convertible debentures held by WGI under which $4,080 in
principal and $1,046 in accrued interest was cancelled and (iii) the
cancellation of certain outstanding warrants held by WGI with a fair value of
$623.  The total fair value of these elements received by the Company
was determined by the Company to approximately $7,199.  In connection
with the closing on April 6, 2009 of the transactions contemplated by the
Securities Purchase Agreement, WGI received (i) 202,465,155 shares of Common
Stock and (ii) a ten year Anti-Dilution Warrant, with an exercise price of
$0.01, to purchase up to approximately 140.0 million shares of Common Stock in
certain circumstances.  The fair value of the shares issues was
determined to be $58,714 based on the closing price of $0.29 on closing on April
6, 2009.  The fair value of the Anti-Dilution Warrant was determined
to be $22,948 based on certain assumptions regarding the estimated probability
for the issuance of capital stock upon the exercise or conversion of each of (i)
the Existing Contingent Equity (ii) Future Contingent Equity or (iii) the ACN
Warrant (See Note 2).  As a result The Company has determined that the
value received by WGI exceeded the fair value received by the Company by $74,463
as summarized below:


29





Fair value Received by WGI:202,462,155
      shares of Common Stock
                      
                      $
                      58,714Anti-Dilution
      Warrant
                      
                      
                      22,948Total
      fair value received by WGI
                      
                      
                      
                      
                      
                      $
                      81,662Consideration Received by the
      CompanyCash
      received
                      
                      
                      1450Convertible
      debenture cancelled
                      
                      
                      4,080Interest
      on convertible debentures  cancelled
                      
                      
                      1,046Warrant
      derivative terminated
                      
                      
                      623Total
      consideration received by the Company
                      
                      
                      
                      
                      
                      
                      7,199Excess
      fair value transferred to WGI
                      
                      
                      
                      
                      
                      $
                      74,463




Since the
WGI transaction is related to the ACN Master Purchase Agreement pursuant to
which ACN has committed to purchase three hundred thousand videophones over a
two-year period, with expected revenue of $60,000, and the consideration
provided to WGI is considered to be an inducement to a vendor per EITF 96-18 and
EITF-01-9, the $74,463 in excess fair value is required to be offset as a
reduction of revenues to the extent of cumulative probable future revenue from
that customer. However, since the fair value exceeds the probable future
revenues expected under the ACN Master Purchase Agreement by $14,463, EITF-01-9
requires the amount of the excess in fair value provided to a vendor over the
probable future revenue ($14,463) to be taken as an immediate non-cash expense
The amount of the excess in fair value equal to probable future revenue of
$60,000 has been recorded as a $4,200 current asset and $55,800 long-term
deferred asset (presented as “Revenue incentive asset”) in accordance with EITF
00-18 “Accounting Recognition for Certain Transactions involving Equity
Instruments Granted to Other than Employee” in the balance sheet at June 30,
2009, and will offset revenue as and when the revenue is realized.  In
future periods should the Company determine that probable future revenue would
be less than $60,000, the Company would record an immediate non cash expense for
any probable revenue shortfall.




In
addition, in connection with the Commercial Relationship entered into with ACN
on April 6, 2009, the Company granted ACN the ACN Warrant.  The ACN
Warrant will vest incrementally based on ACN’s purchases of videophones under
the Commercial Relationship.  Under the provisions of EITF 96-18, the
Company will record a charge for the fair value of the portion of the warrant
earned from the point in time when shipments of units are initiated to ACN
through the vesting date. Final determination of fair value of the warrant
occurs upon actual vesting. EITF 01-9 requires that the fair value of the
warrant be recorded as a reduction of revenue to the extent of probable
cumulative revenue recorded from that customer.




Accordingly,
the application of these accounting guidelines will require the Company’s
reported revenue from the Commercial Relationship to be reduced to reflect both
the fair value of the ACN Warrant and the excess fair value of the equity issued
on the closing on April 6, 2009 of the transactions contemplated by the
Securities Purchase Agreement.




The Company believes that the
accounting of the WGI and ACN transactions as noted above does not provide
indicative  period to period trends in revenues (which we are focused
on growing), expenses (which we are seeking to control and reduce) and
profitability (which is a measure that helps facilitate necessary
funding).   To appropriately review these measures and provide
management more relevant  indications of our operating performance
over time  management excludes the impact of the excess fair value and
offsets in revenue recognition from its internal financial statements in
evaluating its operating results. Accordingly the Company has excluded these
impacts in the non GAAP reporting of these financial elements.  For
management purposes we have adjusted the reported operating expenses for the
three and six months ended June 30, 2009 by eliminating the non cash expense of
$14,463 related to the excess in fair value provided to a customer over the
probable future revenue. In addition, in a similar fashion, we have adjusted the
Net Loss by eliminating the impact of the $14,463 from the Net loss thereby
reducing this loss by the $14,463. This is demonstrated in the table
below.


30





Non –GAAP
Adjustments





For the Three Months Ended June 30,
      2009Total Operating ExpensesAs
      Reported
                                      
                                      $
                                      16,949Non
      GAAP Adjustment – Excess fair value transferred to WGI
                                      
                                      
                                      (14,463
                                      )Adjusted
      Non-GAAP Operating Expense
                                      
                                      $
                                      2,486Net LossAs
      Reported
                                      
                                      $
                                      (18,802
                                      )Non
      GAAP Adjustment – Excess fair value transferred to WGI
                                      
                                      
                                      14,463Adjusted
      Non-GAAP Net Loss
                                      
                                      $
                                      (4,339
                                      )For the Six Months Ended June 30,
      2009Total Operating ExpensesAs
      Reported
                                      
                                      $
                                      18,533Non
      GAAP Adjustment – Excess fair value transferred to WGI
                                      
                                      
                                      (14,463
                                      )Adjusted
      Non-GAAP Operating Expense
                                      
                                      $
                                      4,070Net LossAs
      Reported
                                      
                                      $
                                      (16,538
                                      )Non
      GAAP Adjustment – Excess fair value transferred to WGI
                                      
                                      
                                      14,463Adjusted
      Non-GAAP Net Loss
                                      
                                      $
                                      (2,075
                                      )





ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.




Not required.





ITEM 4T.
CONTROLS AND PROCEDURES.




Evaluation of Disclosure
Controls and Procedures.





The
Company maintains disclosure controls and procedures (as defined in Rule
13a-15(e) and 15d-15(e) of Securities Exchange Act of 1934) that are designed to
ensure that information required to be disclosed in 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 Securities and
Exchange Commission’s rules and forms, and that such information is accumulated
and communicated to its management, including its Chief Executive Officer and
Chief Financial Officer, as appropriate to allow timely decisions regarding the
required disclosures. In designing and evaluating the disclosure controls and
procedures, the Company recognizes that any controls and procedures, no matter
how well designed and operated, can provide only reasonable assurance of
achieving the desired control objectives.





As
previously reported in our Form 10-K for the year ended December 31, 2008, we
carried out an evaluation, under the supervision and with the participation of
management, including our Chief Executive Officer and Chief Financial Officer,
of the effectiveness of the design and operation of its disclosure controls and
procedures as of December 31, 2008. The Company’s Chief Executive Officer and
Chief Financial Officer determined that the Company had a material weakness
related to the lack of internal GAAP expertise to assist with the accounting and
reporting of complex financial transactions. The limited Company resources as
well as the Company’s focus and efforts toward keeping the Company solvent
contributed to the material weakness. As a result, the Chief Executive Officer
and Chief Financial Officer concluded that as of December 31, 2008, its
disclosure controls and procedures were not designed properly and were not
effective in ensuring that the information required to be disclosed by the
Company in the reports that we file and submit 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.





We carried out an
evaluation, under the supervision and with the participation of management,
including our Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of our disclosure controls and
procedures as of June 30, 2009. As a result of the evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that, as of June 30,
2009, its disclosure controls and procedures were not effective as the material
weakness identified at December 31, 2008 still existed. While the Company
pursued remedies to the material weakness in accounting for complex transactions
through the engagement of external expertise, management believes that further
integration of expertise into the Company’s accounting of complex transactions
is still required.


31





Change in Internal Control
over Financial Reporting.





No change
in our internal control over financial reporting occurred during our most recent
fiscal quarter that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting. The Company is
also still in the process of implementing a financial system that it believes
will improve the internal control over financial reporting and will eliminate
any identified deficiencies.





PART
II. OTHER INFORMATION




ITEM 1.
LEGAL PROCEEDINGS.




Although
from time to time we may be involved in litigation as a routine matter in
conducting our business, we are not currently involved in any litigation which
we believe is material to our operations or balance sheet. During the three
months ended March 2008 we were involved in a dispute with Aequus Technologies.
We entered into an agreement with Aequus, effective March 31, 2008, that
provided for the resolution of a dispute with Aequus regarding amounts we
claimed were owed to us by Aequus including, (i) payment to us by Aequus of $5
million in scheduled payments over the ten months ending January 2009, (ii)
agreement to arbitrate approximately $1.4 million that we claimed were owed to
us by Aequus for NRE costs, and (iii) purchase of an additional $1.5 million of
video phones by Aequus. In October 2008, however, Aequus failed to pay us
approximately $953 that we were owed for the purchase of video phones, and as a
result we terminated our reseller agreement with Aequus. We are reviewing our
possible remedies to recover the $953, including selling Aequus inventory we
hold in our possession.




On
January 27, 2009, we resolved the outstanding NRE Arbitration with Aequus, and
in full satisfaction of the outstanding arbitration claim Aequus agreed to
terminate any obligation on our part to provide certain prepaid engineering
services pursuant to the March 31, 2008 Agreement with Aequus (Aequus had
prepaid approximately $900,000 for these engineering services of which $725,000
was allocated to the settlement).





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




On June
23, 2009, the Company amended the exercise price and other provisions of certain
Series A Warrants to Purchase Common Stock of WorldGate Communications, Inc.
issued June 23, 2004 and certain Series B Warrants to Purchase Common Stock of
WorldGate Communications, Inc. issued June 23, 2004 (collectively, the “2004
Warrants”), representing rights to purchase, in the aggregate, 8,771,955 shares
of Common Stock and that would have expired on June 23, 2009. The exercise price
of the 2004 Warrants was amended to $0.25 per share of Common Stock and the
expiration date of the 2004 Warrants was amended to August 7, 2009.




On June
23, 2009, the Company also amended the exercise price and other provisions of
certain Warrants to Purchase Common Stock of WorldGate Communications, Inc.
issued August 3, 2005 (collectively, the “2005 Warrants”), representing rights
to purchase, in the aggregate, 513,333 shares of Common Stock and that expire on
August 3, 2010. The exercise price of the 2005 Warrants was amended to $0.25 per
share of Common Stock.




As of
June 30, 2009, 3,166,667 of the 2004 Warrants and all of the 2005 Warrants were
exercised, resulting in the Company issuing 3,680,000 shares of Common Stock and
in return the Company received $920 in aggregate cash proceeds. After June 30,
2009 and through August 7, 2009, additional 2004 Warrants were exercised
(including a significant number of 2004 Warrants held by an affiliate of Antonio
Tomasello), resulting in the Company issuing 5,525,288 shares of Common Stock
and in return the Company received $1,401 in cash proceeds. The Company incurred
$39 of fees pursuant to the transfer of the 2004 Warrants and 2005 Warrants from
the original warrant holders that were not interested in exercising the warrants
to new warrant holders. The Company expects to use the aggregate net proceeds of
$2,282 from the exercise of the 2004 Warrants and 2005 Warrants primarily for
working capital purposes.




ITEM 3.
DEFAULTS UPON SENIOR SECURITIES.




None




ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.




None.


32





ITEM 5.
OTHER INFORMATION.





None.





ITEM 6.
EXHIBITS.




The
following is a list of exhibits filed as part of this report on Form 10-Q. Where
so indicated, exhibits that were previously filed are incorporated by reference.
For exhibits incorporated by reference, the location of the exhibit in the
previous filing is indicated parenthetically.




4.1
                                                  
                                                  Warrant,
      dated April 6, 2009, issued to ACN Digital Phone Service,
    LLC*4.2
                                                  
                                                  Warrant,
      dated April 6, 2009, issued to WGI Investor LLC*4.3
                                                  
                                                  Form
      of Amendment No. 1 to Warrant and Exercise Agreement with respect to the
      2004 Warrants (Incorporated by reference to Exhibit 10.1 to our Current
      Report on Form 8-K filed June 26, 2009)4.4
                                                  
                                                  Form
      of Amendment No. 1 to Warrant with respect to the 2004 Warrants
      (Incorporated by reference to Exhibit 10.2 to our Current Report on
      Form 8-K filed June 26, 2009)4.5
                                                  
                                                  Form
      of Amendment No. 1 to Warrant and Exercise Agreement with respect to the
      2005 Warrants (Incorporated by reference to Exhibit 10.3 to our Current
      Report on Form 8-K filed June 26, 2009)10.1
                                                  
                                                  Employment
      Agreement, dated April 6, 2009, between WorldGate Service, Inc. and Joel
      Boyarski*10.2
                                                  
                                                  Employment
      Agreement, dated April 6, 2009, between WorldGate Service, Inc. and Harold
      Krisbergh*10.3
                                                  
                                                  Employment
      Agreement, dated April 6, 2009, between WorldGate Service, Inc. and
      Randall J. Gort*10.4
                                                  
                                                  Employment
      Agreement, dated April 6, 2009, between WorldGate Service, Inc. and James
      McLoughlin*10.5
                                                  
                                                  Resignation
      Letter, dated as of April 8, 2009, from Harold Krisbergh to WorldGate
      Communications, Inc. *10.6
                                                  
                                                  Resignation
      Letter, dated as of April 8, 2009, from Randall J. Gort to WorldGate
      Communications, Inc.*10.7
                                                  
                                                  Resignation
      Letter, dated as of May 15, 2009, from James McLoughlin to WorldGate
      Communications, Inc.*10.8
                                                  
                                                  ACN
      Consumer Communications Equipment Master Purchase Agreement, dated as of
      April 6, 2009, between ACN Digital Phone Service, LLC and Ojo Video Phones
      LLC*10.9
                                                  
                                                  Software
      Development and Integration and Manufacturing Assistance Agreement, dated
      as of April 6, 2009, between ACN Digital Phone Service, LLC and Ojo Video
      Phones LLC*10.10
                                                  
                                                  Registration
      Rights and Governance Agreement, dated as of April 6, 2009, by and among
      WorldGate Communications, Inc., WGI Investor LLC, and ACN Digital Phone
      Service, LLC*10.11
                                                  
                                                  Amendment
      No.1 to the WorldGate Communications, Inc. 2003 Equity Incentive Plan
      (Incorporated by reference to Exhibit 10.1 to our Current Report on
      Form 8-K filed May 28, 2009)10.12
                                                  
                                                  Form
      A of the Non-Qualified Stock Option Grant (Incorporated by reference to
      Exhibit 10.2 to our Current Report on Form 8-K filed May 28,
      2009)10.13
                                                  
                                                  Form
      B of the Non-Qualified Stock Option Grant (Incorporated by reference to
      Exhibit 10.3 to our Current Report on Form 8-K filed May 28,
      2009)31.1
                                                  
                                                  Certification
      of Chief Executive Officer Pursuant to Rule 13a-14(a)*31.2
                                                  
                                                  Certification
      of Chief Financial Officer Pursuant to Rule
  13a-14(a)*




33





32.1
              
              Certification
      of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted
      by Section 906 of the Sarbanes-Oxley Act of 2002**32.2
              
              Certification
      of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted
      by Section 906 of the Sarbanes-Oxley Act of
  2002**




*
Filed herewith


**
Furnished herewith


34





SIGNATURES




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




WORLDGATE
      COMMUNICATIONS, INC.Dated:
              August
      14, 2009
              
              /s/ George E. Daddis Jr.George
      E. Daddis Jr.Chief
      Executive Officer(Principal
      Executive Officer)Dated:
              August
      14, 2009
              
              /s/ Joel BoyarskiJoel
      BoyarskiVice
      President and Chief Financial Officer(Principal
      Financial and Accounting
Officer)




35