Table of Contents

 

 

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

**FORM 10-Q**

 
| **x** | **Quarterly Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934** |
|-------|--------------------------------------------------------------------------------------------------------|

 

**For thequarterly period ended March 31, 2009**

 

**or**

 
| **o** | **Transition Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934** |
|-------|--------------------------------------------------------------------------------------------------------------|

 

**For thetransition periodfrom           to          **

 

**Commissionfile number 000-51995**

 

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**ETELOS, INC.**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                                                   | ** ** | **77-0407364**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization) |       | (I.R.S. Employer Identification No.) |
| ** **                                                     | ** ** | ** **                           |
| **26828  Maple Valley Highway-#297  Maple Valley, WA**         | ** ** | **98038**                            |
| (Address of principal executive offices)                       |       | (Zip Code)                           |

 

**(425)458-4510**

(Registrant’s telephone number, including area code)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period thatthe registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.   Yes    x  No    o

 

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

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seethe definitions of “large accelerated filer”, “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 
| Large accelerated filer o | Accelerated filer o         |
|--------------------------------|----------------------------------|
|                           |                             |
| Non-accelerated filer o   | Smaller reporting company x |

 

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

 

Asof March 31, 2009, 24,069,291 shares of the issuer’s common stock, parvalue $0.01 per share, and 843,333 shares of the issuer’s Series Apreferred stock were outstanding.

 

** **

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** **

**EXPLANATORY NOTE**

** **

On February 8, 2007, Tripath Technology Inc., aDelaware corporation (“Tripath”) filed a voluntary petition for relief underChapter 11 of the Bankruptcy Code. On February 1, 2008, the bankruptcycourt issued an order confirming approval of the Plan of Reorganization, includingthe merger and the transfer of all of Tripath’s existing assets into a separatebankruptcy estate and the discharge of all of Tripath’s liabilities.  The Plan of Reorganization also contemplatedthe merger of Etelos, Incorporated, a Washington corporation (“Etelos-WA”) withTripath.   The overall impact of theconfirmed Plan of Reorganization was for Tripath to emerge from the bankruptcyproceeding with no assets and no liabilities as a shell corporation and for allissued and outstanding securities of and interests in Tripath, includingdebentures, stock options (including, but not limited to, all stock optionsgranted to employees), warrants, and other shares of common stock to becanceled and extinguished.

 

On April 23, 2008, Tripath filed a Current Reporton Form 8-K announcing, among other things, that Etelos-WA, merged withand into Tripath, and that the surviving corporation changed its name to Etelos, Inc.and its fiscal year end to December 31. The effective date of the merger was April 22, 2008, and Etelos, Inc.,as the surviving corporation, will conduct the business and operationspreviously conducted by Etelos-WA.  Inconnection with the merger, all outstanding shares of Etelos-WA common stockwere converted into shares of Etelos, Inc. common stock on a three for oneratio: one share of Etelos, Inc. common stock for every three shares ofcommon stock of Etelos-WA.  Also inconnection with the merger, (i) all outstanding shares of preferred stockof Etelos-WA were converted into shares of common stock of Etelos, Inc., (ii) Etelos, Inc.issued an aggregate of 5,010,000 shares of its common stock to the secured andunsecured creditors of Tripath and (iii) all the shares of Tripath werecancelled.  Prior to the merger, Tripathwas a shell corporation and in accordance with the Plan of Reorganization hadno assets or liabilities.  While Tripathacquired all the outstanding preferred and common stock of Etelos-WA, foraccounting purposes, the acquisition has been treated as a recapitalization of Etelos-WAwith Etelos-WA as the acquirer (a reverse acquisition).  The historical financial statements prior to April 22,2008, are those of Etelos-WA and the description of the business contained inthis report as well as the one contained in the financial statements reflectthe operations of Etelos-WA for the twelve month periods ended December 31,2008 and 2007.

 

Also, on April 23, 2008, Etelos, Inc.,formerly Tripath, amended its certificate of incorporation with the state ofDelaware to change its total authorized shares of stock to 300,000,000 shares,of which 250,000,000 shares are designated “common stock” with a par value of$0.01 per share and 50,000,000 shares are designated “preferred stock” with apar value of $0.01 per share.  Thepreferred stock may be issued from time to time in one or more series, each ofsuch series to consist of such number of shares and to have such terms, rights,powers and preferences, and the qualifications and limitations with respectthereto, as stated in the resolutions providing for the issue of such seriesadopted by the board of directors.

 

Information concerning number of shares outstandingfor Etelos, Inc. including the conversion prices and number of sharesissuable upon conversion of convertible securities and exercise prices ofwarrants and stock options and the number of shares issuable upon exercise ofsuch options and warrants, has been adjusted to reflect the three for oneconversion ratio effected in connection with the merger as if it had occurredfor all periods presented.

 

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**Etelos, Inc.**

 

**QuarterlyReport on Form 10-Q**

 

**For theThree Months Ended March 31, 2009**

 

TABLE OF CONTENTS

 
| ** **                                  | ** **                                                                                  | **Page** |
|---------------------------------------------|---------------------------------------------------------------------------------------------|----------|
|                                        |                                                                                        |     |
| **FORWARD  LOOKING STATEMENTS**             | 1                                                                                           |
|                                        |                                                                                        |     |
| **PART I—FINANCIAL  INFORMATION** | 2                                                                                           |
|                                        |                                                                                        |     |
| Item 1.                                     | FINANCIAL  STATEMENTS (UNAUDITED)                                                           | 2        |
|                                        |                                                                                        |     |
| Item  2.                                    | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 21       |
|                                        |                                                                                        |     |
| Item  3.                                    | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                 | 31       |
|                                        |                                                                                        |     |
| Item 4.                                     | CONTROLS AND  PROCEDURES                                                                    | 31       |
|                                        |                                                                                        |     |
| **PART II—OTHER  INFORMATION**    | 32                                                                                          |
|                                        |                                                                                        |     |
| Item 1.                                     | LEGAL PROCEEDINGS                                                                           | 32       |
|                                        |                                                                                        |     |
| Item 1A.                                    | RISK  FACTORS                                                                               | 33       |
|                                        |                                                                                        |     |
| Item  2.                                    | UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                | 48       |
|                                        |                                                                                        |     |
| Item  3.                                    | DEFAULTS  UPON SENIOR SECURITIES                                                            | 48       |
|                                        |                                                                                        |     |
| Item  4.                                    | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                        | 48       |
|                                        |                                                                                        |     |
| Item 5.                                     | OTHER INFORMATION                                                                           | 48       |
|                                        |                                                                                        |     |
| Item 6.                                     | EXHIBITS                                                                                    | 48       |
|                                        |                                                                                        |     |
| SIGNATURES                                  | 49                                                                                          |
|                                        |                                                                                        |     |
| EXHIBIT INDEX                               | 50                                                                                          |

 

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**FORWARD LOOKING STATEMENTS**

 

In this report, unless the context indicatesotherwise, the terms “Etelos,” “Company,” “we,” “us,” and “our” refer to Etelos, Inc.,a Delaware corporation.

 

This Quarterly Report on Form 10-Q containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, or the “Securities Act,” and Section 21E of theSecurities Exchange Act of 1934 or the “Exchange Act.”  These forward-looking statements are subjectto certain risks and uncertainties that could cause actual results to differmaterially from historical results or anticipated results, including those setforth under the heading “Risk Factors” and elsewhere in, or incorporated byreference into, this report.

 

In some cases, you can identify forward lookingstatements by terms such as “may,” “intend,” “might,” “will,” “should,” “could,”“would,” “expect,” “believe,” “anticipate,” “estimate,” “predict,” “potential,”or the negative of these terms.  Theseterms and similar expressions are intended to identify forward-lookingstatements.  Such statements are subjectto certain risks and uncertainties, which could cause actual results to differmaterially from those projected.  Theforward-looking statements in this report are based upon management’s currentexpectations and belief, which management believes are reasonable.  In addition, we cannot assess the impact ofeach factor on our business or the extent to which any factor or combination offactors, or factors we are aware of, may cause actual results to differmaterially from those contained in any forward looking statements.  You are cautioned not to place undue relianceon any forward-looking statements.  Thesestatements represent our estimates and assumptions only as of the date of thisreport.  Except to the extent required byfederal securities laws, we undertake no obligation to update anyforward-looking statement to reflect events or circumstances after the datehereof or to reflect the occurrence of unanticipated events.

 

You should be aware that our actual results coulddiffer materially from those contained in the forward-looking statements due toa number of factors, including:

 

·              our ability to obtain futurefinancing or funds when needed;

·              new competitors are likely toemerge and new technologies may further increase competition;

·              our operating costs may increasebeyond our current expectations and we may be unable to fully implement ourcurrent business plan;

·              our ability to successfully obtaina diverse customer base;

·              our ability to protect ourintellectual property through patents, trademarks, copyrights andconfidentiality agreements;

·              our ability to attract and retaina qualified employee base;

·              our ability to respond to newdevelopments in technology and new applications of existing technology beforeour competitors;

·              acquisitions, businesscombinations, strategic partnerships, divestures, and other significanttransactions may involve additional uncertainties;

·              our ability to maintain andexecute a successful business strategy; and

·              we face other risks described fromtime to time in periodic and current reports we file with the United StatesSecurities and Exchange Commission, or the “SEC.”

 

Other risks and uncertainties include such factors asmarket acceptance and market demand for our products and services, pricing, thechanging regulatory environment, the effect of our accounting policies,potential seasonality, industry trends, adequacy of our financial resources toexecute our business plan, our ability to attract, retain and motivate keytechnical, marketing and management personnel, possible disruption incommercial activities occasioned by terrorist activity and armed conflict, andother risk factors detailed in this report and our other SEC filings.  You should consider carefully the statementsunder “Item 1A. Risk Factors” in Part II and other sections of thisreport, which address additional factors that could cause our actual results todiffer from those set forth in the forward-looking statements and could materiallyand adversely affect our business, operating results and financialcondition.  All subsequent written andoral forward-looking statements attributable to us or persons acting on ourbehalf are expressly qualified in their entirety by the applicable cautionarystatements.

 

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**PART I**—**FINANCIAL INFORMATION**

 

**Item 1.****           FINANCIALSTATEMENTS (Unaudited)**

 

**ETELOS,INC.**

**CONDENSED BALANCE SHEETS**

(in thousands,except share data)

(Unaudited)

 
| ** **                                                                                                                                                                         | ** ** | **March 31,  2009** | ** ** | **December 31,  2008** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                                                                                                                                                               |       |                     |       |                        |       |
| ASSETS                                                                                                                                                                             |       |                     |       |                        |       |
| Current assets:                                                                                                                                                                    |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                                                                          |       | $                        | 66         |                        | $          | 7 |   |
| Accounts receivable, net                                                                                                                                                           |       | 10                       |       | 60                          |       |
| Employee advances                                                                                                                                                                  |       | 85                       |       | —                      |       |
| Other prepaid expenses and current assets                                                                                                                                          |       | 9                        |       | 46                          |       |
| Total current assets                                                                                                                                                               |       | 170                      |       | 113                         |       |
|                                                                                                                                                                               |       |                     |       |                        |       |
| Property and equipment, net                                                                                                                                                        |       | 73                       |       | 82                          |       |
| Other assets                                                                                                                                                                       |       | 10                       |       | 10                          |       |
|                                                                                                                                                                               |       |                     |       |                        |       |
| **Total assets**                                                                                                                                                                   | ** ** | **$**                    | **253**    | ** **                  | **$**      | **205** | ** ** |
|                                                                                                                                                                               |       |                     |       |                        |       |
| LIABILITIES AND STOCKHOLDERS’ DEFICIT                                                                                                                                         |       |                     |       |                        |       |
| Current liabilities:                                                                                                                                                               |       |                     |       |                        |       |
| Accounts payable                                                                                                                                                                   |       | $                        | 988        |                        | $          | 983 |   |
| Accounts payable related parties                                                                                                                                                   |       | 17                       |       | 42                          |       |
| Accrued payroll and related expenses                                                                                                                                               |       | 797                      |       | 399                         |       |
| Accrued expenses                                                                                                                                                                   |       | 1,533                    |       | 1,381                       |       |
| Deferred revenue                                                                                                                                                                   |       | 61                       |       | 64                          |       |
| Current portion convertible notes payable, net of discounts                                                                                                                        |       | 7,264                    |       | 7,264                       |       |
| Current portion other notes payable, net of discounts                                                                                                                              |       | 236                      |       | 89                          |       |
| Current portion notes payable to related parties, net of discounts                                                                                                                 |       | 149                      |       | 132                         |       |
| Current portion capital leases                                                                                                                                                     |       | 11                       |       | 9                           |       |
| Warrant and derivative liability                                                                                                                                                   |       | 5,339                    |       | 108                         |       |
| Total current liabilities                                                                                                                                                          |       | 16,395                   |       | 10,471                      |       |
|                                                                                                                                                                               |       |                     |       |                        |       |
| Long-term notes payable to related parties, less current portion                                                                                                                   |       | 552                      |       | 552                         |       |
| Long-term capital leases                                                                                                                                                           |       | 21                       |       | 24                          |       |
|                                                                                                                                                                               |       |                     |       |                        |       |
| Total liabilities                                                                                                                                                                  |       | 16,968                   |       | 11,047                      |       |
|                                                                                                                                                                               |       |                     |       |                        |       |
| Commitments and contingencies                                                                                                                                                      |       | —                   |       | —                      |       |
|                                                                                                                                                                               |       |                     |       |                        |       |
| Stockholders’ deficit:                                                                                                                                                        |       |                     |       |                        |       |
| Preferred stock, $0.01 par value: 50,000,000 shares authorized with  liquidation preferences:                                                                                      |       |                     |       |                        |       |
| New Series A: 3,333,333 shares authorized; issued and  outstanding - 843,333 shares at March 31, 2009, and 833,333 shares at  December 31, 2008                     |       | 8                        |       | 8                           |       |
| Common stock, $0.01 par value: 250,000,000 shares authorized; issued  and outstanding - 24,069,291 shares at March 31, 2009, and 23,027,624 shares  at December 31, 2008 |       | 241                      |       | 231                         |       |
| Additional paid-in capital                                                                                                                                                         |       | 19,274                   |       | 18,722                      |       |
| Accumulated deficit                                                                                                                                                                |       | (36,238                  | )          | (29,803                     | )          |
| Total stockholders’ deficit                                                                                                                                                   |       | (16,715                  | )          | (10,842                     | )          |
|                                                                                                                                                                               |       |                     |       |                        |       |
| **Total liabilities and stockholders’ deficit**                                                                                                                               | ** ** | **$**                    | **253**    | ** **                  | **$**      | **205** | ** ** |

 

The accompanying notes are an integral part of these condensed interimfinancial statements

 

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**ETELOS,INC.**

**CONDENSED STATEMENTS OF OPERATIONS**

(in thousands,except per share data)

(Unaudited)

 
| ** **                                                                                                | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                | ** ** | **March 31,**               | ** ** |
| ** **                                                                                                | ** ** | **2009**                         | ** ** | **2008** | ** ** |
|                                                                                                      |       |                             |       |   |   |
| Revenue                                                                                                   |       | $                                | 58         |   | $ | 24 |   |
| Cost of revenue                                                                                           |       | 93                               |       | 101 |   |
| Gross profit (loss)                                                                                       |       | (35                              | )          | (77 | ) |
|                                                                                                      |       |                             |       |   |   |
| Operating expenses:                                                                                       |       |                             |       |   |   |
| Research and development                                                                                  |       | 910                              |       | 1,193 |   |
| Sales and marketing                                                                                       |       | 571                              |       | 293 |   |
| General and administrative                                                                                |       | 670                              |       | 470 |   |
| Change in valuation of liability related to warrants from settlement,  financing, and consulting services |       | 2,155                            |       | — |   |
| Total operating expenses                                                                                  |       | 4,306                            |       | 1,956 |   |
|                                                                                                      |       |                             |       |   |   |
| Loss from operations                                                                                      |       | (4,341                           | )          | (2,033 | ) |
|                                                                                                      |       |                             |       |   |   |
| Interest expense, net                                                                                     |       | (127                             | )          | (134 | ) |
| Amortization of notes discount                                                                            |       | (13                              | )          | (65 | ) |
| Change in valuation of liability relating to embedded derivatives and  warrants                           |       | (1,954                           | )          | — |   |
| Total interest income (expense)                                                                           |       | (2,094                           | )          | (199 | ) |
|                                                                                                      |       |                             |       |   |   |
| Loss before taxes                                                                                         |       | (6,435                           | )          | (2,232 | ) |
|                                                                                                      |       |                             |       |   |   |
| Provision for income taxes                                                                                |       | —                           |       | — |   |
|                                                                                                      |       |                             |       |   |   |
| **Net loss**                                                                                              | ** ** | **$**                            | **(6,435** | **)** | **$** | **(2,232** | **)** |
|                                                                                                      |       |                             |       |   |   |
| Basic and diluted net loss per share                                                                      |       | $                                | (0.28      | ) | $ | (0.30 | ) |
|                                                                                                      |       |                             |       |   |   |
| Weighted average number of common shares used in computing basic and  diluted net loss per share          |       | 23,367                           |       | 7,358 |   |

 

The accompanying notes are an integral part of these condensed interimfinancial statements

 

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**ETELOS, INC.**

**CONDENSED STATEMENTS OFSTOCKHOLDERS’ DEFICIT**

(in thousands,except share data)

(Unaudited)

 
| ** **                                            | ** ** | ** **          | ** ** | ** **       | ** ** | ** **          | ** **     | ** **      | ** ** | ** **             | ** ** | ** **  | ** ** | **Total**   | ** ** |
|-------------------------------------------------------|------------|---------------------|------------|------------------|------------|---------------------|----------------|-----------------|------------|------------------------|------------|-------------|------------|-------------|------------|
| ** **                                            | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional Paid** | ** **     | **Accumulated** | ** ** | **Stockholders’** | ** ** |
| ** **                                            | ** ** | **Shares**          | ** ** | **Amount**       | ** ** | **Shares**          | ** **     | **Amount**      | ** ** | **in Capital**         | ** ** | **Deficit** | ** ** | **Deficit** | ** ** |
| **Balance at December 31, 2008**                      |       | 833,333             |       | $                | 8          |                | 23,027,624     |            | $          | 231                    |       | $           | 18,722     |        | $          | (29,803 | ) | **$** | **(10,842** | **)** |
| ** **                                            | ** ** | ** **          | ** ** | ** **       | ** ** | ** **          | ** **     | ** **      | ** ** | ** **             | ** ** | ** **  | ** ** | ** **  | ** ** |
| Issuance of Preferred New Series A Stock              |       | 10,000              |       | 0                |       |                |           |            |       | 6                      |       |        | ** ** | **6**       | ** ** |
| Issuance of common stock upon exercise of options     |       |                |       |             |       | 41,667              |           | 0               |       | 2                      |       |        | ** ** | **2**       | ** ** |
| Issuance of common stock to consultant’s service |       |                |       |             |       | 1,000,000           |           | 10              |       | 500                    |       |        | ** ** | **510**     | ** ** |
| Stock Based Compensation                              |       |                |       |             |       |                |           |            |       | 44                     |       |        | ** ** | **44**      | ** ** |
|                                                  |       |                |       |             |       |                |           |            |       |                   | ** ** | ** **  | ** ** | ** **  | ** ** |
| Net Loss                                              |       |                |       |             |       |                |           |            |       |                   |       | (6,435      | )          | **(6,435**  | **)**      |
|                                                  |       |                |       |             |       |                |           |            |       |                   |       |        |       |        |       |
| **Balance at March 31, 2009**                         | ** ** | **843,333**         | ** ** | **$**            | **8**      | ** **          | **24,069,291** | ** **      | **$**      | **241**                | ** ** | **$**       | **19,274** | ** **  | **$**      | **(36,238** | **)** | **$** | **(16,715** | **)** |
|                                                       |            |                     |            |                  |            |                     |                |                 |            |                        |            |             |            |             |            |  |  |  |  |  |  |  |  |  |  |

 

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

 

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**ETELOS,INC.**

**CONDENSED STATEMENTS OF CASH FLOWS**

(in thousands)

(Unaudited)

 
| ** **                                                                                 | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                 | ** ** | **March 31,**          | ** ** |
| ** **                                                                                 | ** ** | **2009**                    | ** ** | **2008** | ** ** |
|                                                                                       |       |                        |       |   |   |
| **Cash flows from operating activities:**                                                  |       |                        |       |   |   |
| Net loss                                                                                   |       | $                           | (6,435     | ) | $ | (2,232 | ) |
| Adjustments to reconcile net loss to net cash provided by (used in)  operating activities: |       |                        |       |   |   |
| Depreciation and amortization                                                              |       | 10                          |       | 5 |   |
| Amortization of notes discount                                                             |       | 13                          |       | 65 |   |
| Stock based compensation                                                                   |       | 44                          |       | — |   |
| Consulting expenses paid through issuance of common stock and  warrants                    |       | 1,511                       |       | — |   |
| Change in valuation of liability relating to embedded derivatives and  warrants            |       | 4,110                       |       | — |   |
| Changes in operating assets and liabilities:                                               |       |                        |       |   |   |
| Accounts receivable, net                                                                   |       | 50                          |       | (12 | ) |
| Prepaid expenses and other current assets                                                  |       | (49                         | )          | (290 | ) |
| Other assets                                                                               |       | —                      |       | (78 | ) |
| Accounts payable                                                                           |       | 6                           |       | 89 |   |
| Accounts payable related parties                                                           |       | (25                         | )          | (54 | ) |
| Accrued payroll and related expenses                                                       |       | 398                         |       | 135 |   |
| Other accrued expenses                                                                     |       | 152                         |       | 118 |   |
| Deferred revenue                                                                           |       | (3                          | )          | — |   |
|                                                                                       |       |                        |       |   |   |
| **Net cash used in operating activities**                                                  | ** ** | **(218**                    | **)**      | **(2,254** | **)** |
|                                                                                       |       |                        |       |   |   |
| **Cash flows from investing activities:**                                                  |       |                        |       |   |   |
| Purchases of property and equipment                                                        |       | (—                     | )          | (34 | ) |
|                                                                                       |       |                        |       |   |   |
| **Net cash used in investing activities**                                                  | ** ** | **—**                  | ** ** | **(34** | **)** |
|                                                                                       |       |                        |       |   |   |
| **Cash flows from financing activity:**                                                    |       |                        |       |   |   |
| Proceeds from notes payable                                                                |       | 170                         |       | 2,000 |   |
| Proceeds from notes payable to related parties                                             |       | 100                         |       | — |   |
| Proceeds from issuance of preferred stock                                                  |       | 7                           |       | — |   |
| Proceeds from issuance of common stock                                                     |       | 2                           |       | 460 |   |
| Payments of notes payable                                                                  |       | —                      |       | (111 | ) |
| Payments of notes payable to related parties                                               |       | —                      |       | (70 | ) |
| Payment of capital leases                                                                  |       | (2                          | )          | (3 | ) |
|                                                                                       |       |                        |       |   |   |
| **Net cash provided by financing activities**                                              | ** ** | **277**                     | ** ** | **2,276** | ** ** |
|                                                                                       |       |                        |       |   |   |
| **Net increase (decrease) in cash and cash  equivalents**                                  | ** ** | **59**                      | ** ** | **(12** | **)** |
|                                                                                       |       |                        |       |   |   |
| **Cash, and cash equivalents, beginning of period**                                        | ** ** | **7**                       | ** ** | **928** | ** ** |
|                                                                                       |       |                        |       |   |   |
| **Cash, and cash equivalents, end of period**                                              | ** ** | **$**                       | **66**     | ** ** | **$** | **916** | ** ** |
|                                                                                       |       |                        |       |   |   |
| **Supplemental disclosure of cash flow  information:**                                     |       |                        |       |   |   |
| Cash paid for income taxes                                                                 |       | $                           | —     |   | $ | — |   |
| Cash paid for interest                                                                     |       | $                           | —     |   | $ | 20 |   |
|                                                                                       |       |                        |       |   |   |
| **Supplemental disclosure of non-cash financing  activities:**                             |       |                        |       |   |   |
| Issuance of detachable warrants                                                            |       | $                           | —     |   | $ | 76 |   |
| Reclassification of accounts payable to notes payable                                      |       | $                           | —     |   | $ | 29 |   |
| Record warrants and embedded derivatives as liabilities                                    |       | $                           | 120        |   | $ | — |   |

 

The accompanying notes are an integral part of these condensed interimfinancial statements

 

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NOTES TO FINANCIALSTATEMENTS

(Unaudited)

 

***1. Organization***

 

OnFebruary 8, 2007, Tripath Technology Inc., a Delaware corporation (“Tripath”)filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code.On February 1, 2008, the bankruptcy court issued an order confirmingapproval of the Plan of Reorganization, including the merger and the transferof all of Tripath’s existing assets into a separate bankruptcy estate and thedischarge of all of Tripath’s liabilities.  The Plan of Reorganizationalso contemplated the merger of Etelos, Incorporated, a Washington corporation(“Etelos-WA”) with Tripath.  The overall impact of the confirmed Planof Reorganization was for Tripath to emerge from the bankruptcy proceeding withno assets and no liabilities as a shell corporation and for all issued andoutstanding securities of and interests in Tripath, including debentures, stockoptions (including, but not limited to, all stock options granted toemployees), warrants, and other shares of common stock to be canceled andextinguished.

 

OnApril 23, 2008, Tripath filed a Current Report on Form 8-Kannouncing, among other things, that Etelos-WA, merged with and into Tripath(the “Merger”), and that the surviving corporation changed its name to Etelos, Inc.and its fiscal year end to December 31.  The effective date of theMerger was April 22, 2008, and Etelos, Inc., as the survivingcorporation, will conduct the business and operations previously conducted byEtelos-WA.  In connection with the Merger, all outstanding shares ofEtelos-WA common stock were converted into shares of Etelos, Inc. commonstock on a three for one ratio: one share of Etelos Inc. common stock for everythree shares of common stock of Etelos-WA.  Also in connection with theMerger, (i) all outstanding shares of preferred stock of Etelos-WA wereconverted into shares of common stock of Etelos, Inc., (ii) Etelos, Inc.issued an aggregate of 5,010,000 shares of its common stock to the secured andunsecured creditors of Tripath and (iii) all the shares of TripathTechnology were cancelled. Also on April 23, 2008, Etelos, Inc.,formerly Tripath, amended its articles of incorporation with the state ofDelaware to change its total authorized shares of stock to 300,000,000 shares,of which 250,000,000 shares are designated “Common Stock” with a par value of$0.01 per share and 50,000,000 shares are designated “Preferred Stock” with apar value of $0.01 per share.  The Preferred Stock may be issued from timeto time in one or more series, each of such series to consist of such number ofshares and to have such terms, rights, powers and preferences, and thequalifications and limitations with respect thereto, as stated in theresolutions providing for the issue of such series adopted by the board ofdirectors.

 

Priorto the Merger, Tripath was a shell corporation and in accordance with the Planof Reorganization had no assets or liabilities.  While Tripath acquiredall the outstanding preferred and common stock of Etelos-WA, for accountingpurposes, the acquisition has been treated as a recapitalization of Etelos-WAwith Etelos-WA as the acquirer (a reverse acquisition).  The historicalfinancial statements prior to April 22, 2008, are those of Etelos-WA andreflect the operations of Etelos-WA for the year ended December 31,2007.  Proforma financial information giving effect to the acquisition asif the acquisition took place on January 1, 2007, have not been presentedbecause Etelos-WA acquired no tangible or intangible assets, liabilities or anyof the business operations of Tripath prior to its emergence from bankruptcyand therefore, the historical operations of Tripath are not an indicator of thefuture operations of Etelos, Inc.  The operations of Etelos, Inc.subsequent to the Merger include only those of Etelos-WA.

 

The5,010,000 shares of Etelos, Inc. common stock were valued at $2.63 pershare, the estimated fair value of the common stock on the date of the Merger,which resulted in a charge to operations of $13.2 million included in thecaption Merger Related Costs in the accompanying Statement of Operations. Etelos, Inc. believes that these shares were issued primarily for pastservices provided to Etelos-WA by the secured creditors and the release of thesecured and unsecured creditors claims against Tripath.

 

Informationconcerning number of shares outstanding for Etelos, Inc. including theconversion prices and number of shares issuable upon conversion of convertiblesecurities and exercise prices of warrants and stock options and the number ofshares issuable upon exercise of the options and warrants, has been adjusted toreflect this stock split for all periods presented.  Also, the Shareholders’Deficit section of the accompanying Balance Sheet has been adjusted to reflectthe legal capital structure of Tripath adjusted for the change in authorizedshares of common and preferred stock.

 

***2. The Company and Risks and Uncertainties***

 

Asused herein, unless the context requires otherwise, the terms the “Company,” “it,”“its,” or “Etelos” refers to Etelos, Inc., the corporation that survivedthe Merger.

 

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Eteloshas a Web Application distribution platform delivering Web Applications forbusinesses.  Etelos provides aSoftware-as-a-Service (SaaS) ecosystem for building, distributing, and usingWeb Applications, including a marketplace to deploy and support them.  Unlike other cloud computing andPlatform-as-a-Service (PaaS) solutions, Etelos enables software manufacturersto migrate existing applications or create new applications, then package,distribute, host, bill, market and support their SaaS enabled applicationsthrough multiple private label applications marketplaces. Etelos has developedproducts for Web Applications, which include open standards-based tools for Webdevelopers, businesses and individual users such as the Etelos ApplicationServerTM (EASTM) and the Etelos Development EnvironmentTM (EDETM).  EAS and EDE support many common programminglanguages and also support the English Application Scripting Engine (EASETM), asimple-to-use open standards-based scripting language developed by theCompany.  In order to support broaderadoption of its products, EASE and other components of the EDE are madeavailable to developers at market appropriate pricing.  This is done to support the development ofnew Web Applications and the migration of existing Web Applications into theEtelos ecosystem where there are tools and other support mechanisms for themarketing, distribution, and support of these applications.  Etelos generally receives a transaction fee orsubscription fee for transactions that occur within the Etelos ecosystem eithervia the Etelos MarketplaceTM pursuant to Storefront Operating Agreements, or inthird-party branded Marketplaces operated by Etelos pursuant to MarketplacePartner Agreements (sometimes referred to as “an Etelos Marketplace” or,collectively, as “the Etelos Marketplaces”). Most customers in Etelos Marketplaces pay a subscription fee, whichrevenue Etelos shares with Syndication Partners and Marketplace Partners; thisrevenue share is calculated as a percentage of gross revenues from the sale ofsubscriptions to customers of Syndication Partner products and service in theEtelos Marketplaces.

 

***3. Summary of Significant Accounting Policies***

 

*Basisof Presentation*

 

The accompanying condensed financial statementsinclude our unaudited accounts as of March 31, 2009, and for the threemonths ended March 31, 2009 and 2008.  These condensed financialstatements have been prepared by management, without audit, pursuant to the rules andregulations of the Securities and Exchange Commission, or SEC. Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America have been condensed or omitted pursuant to such rules andregulations. The balance sheet at December 31, 2008, has been derived fromaudited financial statements at that date. These unaudited condensed financialstatements should be read in conjunction with the Company’s Report on Form 10-Kfor the fiscal year ended December 31, 2008.

 

In the opinion of management, all adjustments (whichconsist of normal recurring adjustments, except as disclosed herein) necessaryto fairly present the financial position, results of operations and cash flowsfor the interim periods presented have been included. The results of operationsfor the interim periods are not necessarily indicative of the results to beexpected for the full year or for any future periods.

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and reported amounts ofrevenues and expenses during the reporting period. Actual results could differfrom those estimates, and such differences could affect the results ofoperations reported in future periods and such differences could be material.

 

*Concentrationof Credit Risk*

 

Financialinstruments that potentially subject the Company to concentration of creditrisk consist primarily of cash, cash equivalents, and accounts receivable.  Cash and cash equivalents are maintained infederally-insured banks in the United States of America.  Deposits in such banks may exceed USfederally-insured limits and be subject to the current risks and uncertaintiesof dealing with such US banks. Etelos maintains the majority of cash balancesand all short-term investments with one financial institution.

 

TheCompany’s accounts receivables are derived primarily from customers.  For the three months ended March 31,2009, two customers accounted for 93% of the Company’s revenue in the period,and 51% of the Company’s accounts receivable as of March 31, 2009. Therewas no single customer accounting for more than 10% of the Company’s revenuesor accounts receivable during the quarter ended March 31, 2008.

 

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*Allowancefor Doubtful Accounts*

 

TheCompany provides, when appropriate, an allowance for doubtful accounts toensure trade receivables are not overstated due to un-collectability. Thecollectability of the Company’s receivables is evaluated based on a variety offactors, including the length of time receivables are past due, indication ofthe customer’s willingness to pay, significant one-time events, and historicalexperience. As of March 31, 2009, and December 31, 2008, the Companydetermined that an allowance for doubtful accounts was not necessary orwarranted.

 

*DeferredRevenue*

 

Deferredrevenue represents money received or promised but not recognized as revenuebecause the work has not been completed or the software subscription has beenfully delivered, and therefore is deferred until the work is completed or thesoftware subscription is fully delivered when it is then transferred to theappropriate revenue account. The Company does not have a concentration of riskin any one account as subscriptions tend to be subscribed to by many individualsubscribers as compared to a small number of large enterprises.

 

*Propertyand Equipment*

 

Property,furniture, and equipment are stated at historical cost less accumulateddepreciation and amortization. Depreciation and amortization are computed on astraight-line basis over the estimated useful lives of the assets, which theCompany currently believes are three to five years.

 

*FairValue of Financial Instruments*

 

TheCompany’s balance sheet includes the following financial instruments: cash,accounts receivable, accounts payable, and accrued liabilities. The Companyconsiders the carrying amount of working capital items to approximate the fairvalue for these financial instruments because of the relatively short period oftime between origination of the instruments and their expected realization.

 

*Researchand Development and Software Development Costs*

 

Researchand development expenses consist primarily of salaries, payroll taxes,benefits, and related expenditures for technology, software development,project management, and support personnel. Costs related to the research anddevelopment of new products, services and enhancements to existing products areexpensed as provided for by SFAS NO. 86, “Accounting for Costs of ComputerSoftware to be Sold, Leased or Otherwise Marketed” (SFAS 86).  Under SFAS86, costs incurred in the research and development of new software products areexpensed as incurred until technological feasibility is established. Researchand development costs are capitalized beginning when a product’s technologicalfeasibility has been established and ending when the product is available forgeneral release to customers. Technological feasibility is reached when theproduct reaches the working model stage. To date, products and enhancementshave generally reached technological feasibility and have been released forsale at substantially the same time and all research and development costs havebeen expensed.

 

Statementof Position 98-1, “Accounting for Costs of Computer Software Developed orObtained for Internal Use” (SOP 98-1), which applies to SaaS business model,are met for the capitalization of software development cost.  Under SOP98-1, software development costs, including costs incurred to purchase thirdparty software, are capitalized beginning when the Company has determinedcertain factors are present, including, among others, that technology exists toachieve the performance requirements, buy versus internal development decisionshave been made, and the Company’s management has authorized the funding for theproject. Capitalization of software development costs ceases when the softwareis substantially complete and is ready for its intended use.  To date, nosoftware development costs incurred have met the criteria set forth in SOP 98-1for capitalization.

 

*RevenueRecognition*

 

Etelosdistributes Web Applications and it Marketplace Platform as a subscriptionservice using the SaaS or software-on-demand business model and allow thirdparties to offer their products or services through storefronts in an EtelosMarketplace, and to advertise on its web site or in its magazine for afee.  It also license certain of its software products 

 

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underperpetual and term licenses.  Revenues are recognized on these service andlicensing transactions using the criteria in SEC Staff Accounting Bulletin 104,“Revenue Recognition in Financial Statements”, and SOP 97-2, “Software RevenueRecognition”, respectively, which both provide that revenue may be recognizedwhen all of the following are met:

 
| · | persuasive  evidence of an arrangement exists,                             |
|--------|----------------------------------------------------------------------------|
| · | the  product or service has been delivered,                                |
| · | the  fee is fixed or determinable, and                                     |
| · | collection  of the resulting receivable is reasonably assured or probable. |

 

Forthe SaaS business model, persuasive evidence is generally an acceptance by thecustomer of a binding agreement and authorization by the customer to charge acredit card; delivery generally occurs over the term of the subscriptionagreement related to the SaaS; and the fee is fixed and collection reasonablyassured when the customer’s credit card is charged.  Accordingly, revenueis recognized over the period the SaaS is provided.

 

Forsoftware licensed under term or perpetual agreements, persuasive evidence of anarrangement is evidenced by a binding agreement signed by the customer anddelivery generally occurs upon delivery of the software to a common carrier. Ifa significant portion of a fee is due after our normal payment terms of typically30 days, then we recognize revenue as the fees become due. If the Companydetermines that collection of a fee is not reasonably assured, then it defersthe fees and recognizes revenue upon cash receipt, provided that all otherrevenue recognition criteria are met.

 

Advertisingon the Company’s web site is recognized as revenue over the period theadvertisement appears on its web site and advertising presented in its magazineis recognized upon publication of the magazine provided the other criteria forrevenue recognition set forth above have been met.

 

Arrangementsfor which the fees are not deemed reasonably assured for collection arerecognized upon cash collection.

 

*StockBased Compensation*

 

TheCompany, under SFAS No. 123 (revised 2004), “Share-Based Payment” (FAS123R), is applying the “modified prospective method” and used the Black-ScholesMerton model to value all new stock based compensation awards granted starting January 1,2007, and for any modification, cancellation, or repurchase of awards grantedprior to January 1, 2007.  As a result, the Company has recordedcompensation cost in the statement of operations based on the fair value of theaward for the requisite service period. FAS 123(R) also requires theCompany to estimate forfeitures in calculating the expense relating toshare-based compensation as opposed to only recognizing these forfeitures andthe corresponding reduction in expense as they occur. This resulted in $44thousand and $0 thousand of expense for the quarters ended March 31, 2009and 2008, respectively.

 

FAS123(R) requires the cash flows resulting from the tax benefits resultingfrom tax deductions in excess of the compensation cost recognized for thoseoptions to be classified as financing cash flows. Due to its loss position,there were no such tax benefits during quarters ended March 31, 2009 and2008. Prior to the adoption of FAS 123(R), those benefits would have beenreported as operating cash flows had we received any tax benefits related tostock option exercises.

 

*IncomeTaxes*

 

TheCompany accounts for income taxes in accordance with SFAS No. 109, “Accountingfor Income Taxes” which utilizes the liability method of accounting for incometaxes. Deferred tax assets and liabilities are recognized for the future tax consequencesattributable to differences between the financial statement carrying amount ofexisting assets and liabilities and their respective tax bases. Deferred taxassets and liabilities are measured using enacted tax rates expected to applyto taxable income in the years in which those temporary differences areexpected to be recovered or settled. Valuation allowances are established whennecessary to reduce deferred tax assets to the amounts expected to be realized.

 

TheCompany adopted the provisions of Financial Accounting Standards Board (“FASB”)Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — anInterpretation of FASB Statement No. 109” (“FIN 48”) on January 1,2007. The Company did not have any unrecognized tax benefits and there was noeffect on its financial condition or results of operations as a result ofimplementing FIN 48.

 

TheCompany files income tax returns in the United States of America federaljurisdiction and various state jurisdictions in the United States of America.  The Company does not believe that there wilbe any material changes in its unrecognized tax positions over the next twelvemonths.  The Company believes that itsincome tax filing positions and deductions would be sustained on audit and doesnot anticipate any adjustments that will result in a material adverse effect onthe Company’s financial position, results of operations, or cash flow.  Therefore, no reserves for uncertain incometax positions have been 

 

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recordedpursuant to FIN 48.  In addition, theCompany did not record a cumulative effect adjustment related to the adoptionof FIN 48.

 

TheCompany’s policy is to recognize interest and penalties accrued on anyunrecognized tax benefits as a component of income tax expense.  As of the date of the adoption of FIN 48, theCompany did not have any accrued interest or penalties associated with anyunrecognized tax benefits, nor was any such interest expense recognized duringthe three months ended March 31, 2009 and 2008, or the year ended December 31,2008.  The Company’s effective tax ratediffers from the federal statutory rate primarily due to increases in itsdeferred income tax valuation allowance.

 

*NetLoss per Share*

 

Basicnet loss per share is computed by dividing the net loss available to commonstockholders for the period by the weighted average number of shares of commonstock outstanding during the period, excluding any unvested restricted stockthat is subject to repurchase. Diluted net income per share is computed usingthe weighted average number of common shares and, if dilutive, potential commonshares outstanding during the period. Potential common shares consist ofunvested restricted stock (using the treasury stock method), the incrementalcommon shares issuable upon the exercise of stock options and warrants (usingthe treasury stock method) and the conversion of the Company’s convertible notesand debentures (using the if-converted method).  As their effect isantidilutive, 4,794,830 and 4,717,235 shares of common stock exercisable underoutstanding employee stock options, 4,114,444 and 1,833,333 shares of commonstock exercisable under outstanding warrants, 6,426,074 and 3,833,481 shares ofcommon stock issuable upon conversion of the outstanding convertible notespayable and debentures, as of March 31, 2009 and 2008, respectively, havebeen excluded from this calculation.  The average exercise price ofoutstanding employee stock options and warrants to purchase the Company’scommon stock is $0.24 and $1.08, and $0.55 and $0.10, respectively, at March 31,2009 and 2008.

 

Thefollowing table, which has been adjusted to reflect the three for oneconversion ratio effected in connection with the Merger, sets forth thecomputation of basic and diluted net loss per share for the periods presented(in thousands, except per share amounts):

 
| ** **                                         | ** ** | **For the Three Months** | ** ** |
|----------------------------------------------------|------------|------------------------------------|------------|
| ** **                                         | ** ** | **Ended March 31**            | ** ** |
| ** **                                         | ** ** | **2009**                           | ** ** | **2008** | ** ** |
|                                               |       |                               |       |   |   |
| Numerator:                                         |       |                               |       |   |   |
| Net income (loss)                                  |       | $                                  | (6,435     | ) | $ | (2,232 | ) |
|                                               |       |                               |       |   |   |
| Net income (loss) available to common stockholders |       | (6,435                             | )          | (2,232 | ) |
|                                               |       |                               |       |   |   |
| Denominator:                                       |       |                               |       |   |   |
| Weighted average common stock                      |       | 23,367                             |       | 7,358 |   |
|                                               |       |                               |       |   |   |
| Net loss per share:                                |       |                               |       |   |   |
| Basic and Diluted                                  |       | $                                  | (0.28      | ) | $ | (0.30 | ) |
|                                               |       |                               |       |   |   |

*Use ofEstimates*

 

Thepreparation of the financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities, the disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting period. Actual results could differ from thoseestimates.

 

*SegmentReporting*

 

TheCompany has one operating segment because the Company is not organized intomultiple segments for the purpose of making operating decisions or forassessing performance. The chief operating decision maker evaluates performance,makes operating decisions, and allocates resources based on financial dataconsistent with the presentation in the accompanying financial statements.

 

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***4. Going Concern***

 

Thefinancial statements have been prepared with the assumption that the Companywill continue as a going concern.  The Company has experienced net lossesof $6.4 million and $2.2 million for the three months ended March 31, 2009and 2008, respectively, and has a total stockholders’ deficit of $36.2 millionand $29.8 million, as of March 31, 2009 and December 31, 2008,respectively, all of which raise substantial doubt about its ability tocontinue as a going concern. The financial statements do not include anyadjustments relating to the recoverability and classification of asset carryingamounts or the amount and classification of liabilities that might arise shouldit be unable to continue as a going concern.

 

Managementhas supported current operations by raising additional operating cash throughthe private sale of convertible debentures and notes payable and preferredstock. This has provided the cash inflows to continue the Company’s businessplan, but has not resulted in significant improvement in its financial positionor results of operations.  Managementalso has substantially reduced operating expenses by termination of employeesand other reductions in operating expenses. Alternatives being pursued to improve the Company’s cash flow used inoperations include (1) raising additional working capital throughadditional sale of preferred stock, common stock and/or debt and (2) reducingcash operating expenses to levels that are in line with current revenues. The first alternative could result in substantial dilution to existingshareholders. There can be no assurance that the Company’s current financialposition can be improved, that it can raise additional working capital, or thatit can achieve positive cash flows from operations. The Company’s long-termviability as a going concern is dependent upon its ability to (1) locatesources of debt or equity funding to meet current commitments and near-termfuture working capital requirements and (2) achieve profitability andultimately generate sufficient cash flow from operations to sustain itscontinuing operations.

 

TheCompany’s cash balance including proceeds from its recent debt financings andpreferred stock financing may not be sufficient to fund operations beyond June 2009. If cash reserves are not sufficient to sustain operations, then managementplans to further reduce operating expenses and/or raise additional capital byselling shares of capital stock or other securities that could result insubstantial dilution to existing shareholders.  However, there are nocommitments or arrangements for future financings in place at this time and theCompany can give no assurance that such capital will be available on favorableterms, or at all.  The Company may need additional financing thereafteruntil it can achieve profitability.  If it cannot, then it will be forcedto further curtail operations or possibly be forced to evaluate a sale orliquidation of assets.  Even if it is successful in raising additionalfunds, there is no assurance regarding the terms of any additional investment.

 

Inthe quarter ended March 31, 2009, the Company entered into a series ofbridge loans with certain purchasers of its New Series A Preferred stockand with the holders of its January 2008 and April 2008Debentures.  In the aggregate thesebridge loans were for the principal amount of $270 thousand which, togetherwith a subsequent bridge loan from the holder of its January 2008 and April 2008Debentures in the amount of $385 thousand after the end of the quarter, isestimated to cover its operating expenses through June 2009.  These notes bear interest at ten percent perannum, and have maturities ranging from May 31, 2009, through October 31,2009.  The notes payable to the holdersof its New Series A Preferred stock were accompanied by 160,000 warrantsto purchase shares of its Common Stock at $0.75 per share, with a term of threeyears.  The notes payable to the holderof its January 2008 and April 2008 Debentures are subject to thesecurity interest granted to those holders in connection with those debentures.

 

***5. Recently Issued Accounting Standards***

 

In May 2008, the FASB issued SFAS No. 162 (“SFAS 162”), TheHierarchy of Generally Accepted Accounting Principles.  SFAS 162identifies the sources of accounting principles and the framework for selectingprinciples to be used in the preparation of financial statements ofnongovernmental entities that are presented in conformity with generallyaccepted accounting principles in the United States.  SFAS 162 waseffective on November 15, 2008 and upon adoption of SFAS 162 there was nomaterial impact on the Company’s financial statements.

 

InMarch 2008, the FASB issued SFAS No. 161 (“SFAS 161”), Disclosuresabout Derivative Instruments and Hedging Activities-an amendment of SFAS No. 133.This new standard requires enhanced disclosures for derivative instruments,including those used in hedging activities. SFAS 161 is effective for fiscalyears and interim periods beginning after November 15, 2008. The Companyhas determined the impact, if any, that the adoption of SFAS 161 will have nomaterial impact on its financial statements and related disclosures.

 

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InJune 2008, the FASB issued FSP No. EITF 03-6-1, DeterminingWhether Instruments Granted in Share-Based Payment Transactions AreParticipating Securities (“FSP EITF 03-6-1”), which requires entities toapply the two-class method of computing basic and diluted earnings per sharefor participating securities that include awards that accrue cash dividends(whether paid or unpaid) any time common shareholders receive dividends andthose dividends do not need to be returned to the entity if the employeeforfeits the award. FSP EITF 03-6-1 will be effective for the Company on January 1,2009, and will require retroactive disclosure. The Company has determined thatthe impact of adopting FSP EITF 03-6-1 is not material to its financialposition, cash flows, and results of operations.

 

Effective January 1,2009, the Company adopted Emerging Issues Task Force (“EITF”) Issue 07-05 *Determining Whether an Instrument (or Embedded Feature)is Indexed to an Entity’s Own Stock*(“EITF 07-05”), which provide guidance for determining whetheran equity linkedfinancial instrument (or embedded feature) isindexed to an entity’s own stock. The adoption of EITF 07-05 did not havematerial impact on the Company’s financial position, results of operations, orcash flows.

 

***6. Convertible Notes and Debentures and Embedded Derivative and WarrantLiability***

 

Convertiblenotes and debentures comprise (in thousands):

 

| ** **                       | ** ** | **March 31,  2009** | ** ** | **December 31,  2008** | ** ** |
|----------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| 6% convertible notes             |       | 1,764                    |       | 1,764                       |       |
| January 2008 Debentures     |       | 2,000                    |       | 2,000                       |       |
| April 2008 Debentures       |       | 3,500                    |       | 3,500                       |       |
|                             |       | 7,264                    |       | 7,264                       |       |
| Less discount on notes payable   |       | (—                  | )          | (—                     | )          |
|                             |       |                     |       |                        |       |
| Current portion of notes payable |       | $                        | 7,264      |                        | $          | 7,264 |   |
|                                  |            |                          |            |                             |            |  |  |

 

*6%Convertible Notes*

 

Duringthe period August 2007 to October 2007, the Company issued 6 percentconvertible notes with a face value of $3,326 thousand at an original issuediscount of 10 percent with detachable warrants to purchase shares of itscommon stock in exchange for $3,024 thousand.  These notes mature on March 31,2009, with interest due and payable on February 1, 2008, and on the lastday of each calendar quarter thereafter. The Company is required to makepayments on the outstanding principal balance beginning September 1, 2008,and on the 1st day of each calendar quarter thereafter. The 

 

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defaultinterest rate is 8 percent. The notes and unpaid interest are convertible intoshares of the Company’s common stock at the option of the holder orinvoluntarily upon the occurrence of certain financing events. As of March 31,2009, and December 31, 2008, $1,562 thousand of the face value of the 6%convertible notes have been converted to 2,352 thousand shares of the Company’scommon stock and $1,764 thousand remain outstanding. The Company failed to makethe required interest and principal payments on the 6 percent convertible notesduring the quarter ended March 31, 2009. Accordingly, the Company is indefault under the terms of the 6 percent convertible notes, which results inall principal and interest related to the 6 percent convertible notes becomingdue and payable to the holders. As a result, the Company has classified allamounts due related to the 6 percent convertible notes as current liabilities.

 

Inaddition, the purchasers of the 6 percent convertible notes received warrantsto purchase 1,080,000 shares of the Company’s common stock at an exercise priceof $0.12. At December 31, 2008, all of these warrants had been exercisedor expired and none are outstanding.

 

*January 2008Debentures*

 

OnJanuary 31, 2008, the Company issued convertible debentures (“the January 2008Debentures”) with a principal amount of $2 million and detachable warrants topurchase 222,222 shares of its common stock in exchange for $1.9 million. The January 2008 Debentures are due on January 31, 2010, and bearinterest at 6 percent per annum, which is payable semiannually on January 1and July 1, commencing on July 1, 2008.  Monthly principalpayments equal to 1/18th of the principal amount were to begin on September 1,2008.  The Company has the right to pay interest and monthly principalpayments in cash, or upon notice to the holders and compliance with certainequity conditions, it can pay all or a portion of any such payment in commonstock valued at a price equal to the lesser of the then effective conversionprice (currently $1.35) or 85 percent of the average of the volume weightedaverage price per share for its common stock for the 10 consecutive tradingdays immediately prior to the applicable payment date.  The equityconditions that it must meet include having a currently effective registrationstatement covering the shares of common stock issuable upon conversion of thedebenture, and having the daily dollar trading volume for its common stockexceed $250,000 for each of the 20 consecutive trading days before the date inquestion.  The January 2008 Debentures and any accrued interest areconvertible at anytime at the discretion of the holder at a conversion priceper share of $1.35, subject to a cap on the beneficial ownership of its sharesof common stock by the holder and its affiliates following such conversion. Theconversion price is adjusted upon a stock split, reverse stock split, or uponissuance of stock dividends, whereby the conversion price would be adjusted toensure that the holder would be receiving the same number of shares, as thoughthe conversion right had been exercised prior to the triggering event. Further, the conversion price is adjusted if common stock or equivalents aresubsequently sold or re-priced at a price below the conversion price or rights,options or warrants are issued to holders of its common stock entitling them topurchase common stock at prices lower than the volume weighted average price onthe date issued.

 

TheCompany has the option to redeem the January 2008 Debentures before theirmaturity by payment in cash of an amount equal to 120 percent of thethen-outstanding principal amount, plus accrued interest and other charges, andthe right to force conversion of the debentures if the average of the volumeweighted average price of its common stock exceeds $3.39 for 20 trading daysout of a consecutive 30 trading day period.  This redemption option andforced conversion right are subject to the Company meeting certain equityconditions, including having the daily dollar trading volume for its commonstock exceed $250 thousand for each of the 20 consecutive trading days beforethe date in question and having a currently effective registration statementcovering the shares of common stock issuable upon conversion of the debenturesand the forced conversion option, subject to the applicable cap on thebeneficial ownership of its shares of common stock by the holder and itsaffiliates following such conversion.  The January 2008 Debenturesare collateralized by substantially all the assets of the Company.

 

TheJanuary 2008 Debentures impose certain covenants on the Company, includingrestrictions against incurring additional indebtedness, creating any liens onits property, amending its certificate of incorporation or bylaws, redeeming orpaying dividends on shares of our outstanding common stock, and entering intocertain related party transactions.  The January 2008 Debentures alsodefine certain events of default, including, without limitation, failure tomake a payment obligation, failure to observe other covenants of the debentureor related agreements (subject to applicable cure periods), breach ofrepresentation or warranty, bankruptcy, default under another significantcontract or credit obligation, delisting of its common stock, a change incontrol, failure to secure and maintain an effective registration statementcovering the resale of the common stock underlying the debentures and thewarrants, or failure to deliver share certificates in a timely manner.  Inthe event of default, the holders of the January 2008 Debentures have theright to accelerate all amounts outstanding under the debentures and demandpayment of a mandatory default amount equal to 130 percent of the amountoutstanding plus accrued interest and expenses. The Company has failed to makethe required interest and principal payments on the 

 

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January 2008Debentures due on September 30 and December 31, 2008, and March 31,2009, through the filing date of this report. Accordingly, the Company is indefault under the terms of the January 2008 Debentures, and the holdershave the right to demand that the default amount equal to 130% of the amountoutstanding plus accrued interest be paid to the holders. As of the date ofthese financial statements, the Company has classified all amounts due relatedto the January 2008 Debentures as current liabilities, and the holdershave not elected to exercise their rights arising from the Company’s default.

 

Debtissuance costs of $85.2 thousand were incurred in conjunction with the issuanceof the January 2008 Debentures, which have been capitalized as OtherAssets and are amortized using the effective interest method.  As the January 2008 Debentures were indefault and are deemed currently payable, the debt issuance costs have beenfully amortized for the year ended December 31, 2008.

 

Thedetachable warrants, which are fully exercisable, to purchase 222,222 shares ofour common stock, expire in January 2011 and are exercisable at a price of$1.80 per share, subject to adjustment.  As of March 31, 2009, noneof these warrants had been exercised.

 

*April 2008Debentures*

 

OnApril 22, 2008, the Company issued convertible debentures (“the April 2008Debentures”) with a principal amount of $3.5 million and detachable warrants topurchase 388,889 shares of our common stock in exchange for $3.4 million. The April 2008 Debentures are due on April 30, 2010, and havethe identical terms and conditions to the January 2008 Debenturesdescribed above. The Company has failed to make the required interest andprincipal payments on the April 2008 Debentures due on September 30, December 31,2008, and March 31, 2009. Accordingly, the Company is in default under theterms of the April 2008 Debentures, and the holders have the right todemand that the default amount equal to 130% of the amount outstanding plusaccrued interest be paid to the holders. As of the date of this report, the holdershave not elected to exercise their rights arising from the Company’s default.

 

Debtissuance costs of $149 thousand were incurred in conjunction with the issuanceof the April 2008 Debentures, which have been capitalized as Other Assetsand are amortized using the effective interest method.  As the April 2008 Debentures were indefault and are deemed currently payable, the debt issuance costs have beenfully amortized for the year ended December 31, 2008.

 

Thedetachable warrants, which are fully exercisable, to purchase 388,889 shares ofour common stock, expire in April 2011 and are exercisable at a price of$1.80 per share, subject to adjustment, for the events described above, whichadjust the conversion price of the January 2008 Debentures.  As of March 31,2009, none of these warrants had been exercised.

 

Inconnection with the January 2008 Debentures and the April 2008Debentures, the Company also entered into a registration rights agreement withthe investors, pursuant to which it agreed to file a registration statementcovering the resale of the shares of common stock that may be issued to suchinvestors upon the conversion of the debentures, payment in kind, and theexercise of the related warrants.  The Company agreed to maintain the effectivenessof the registration statement (subject to certain limitations) for a period oftime until the holders can sell the underlying common stock without volumerestrictions under Rule 144 of the Securities Act of 1933, or theSecurities Act. If the registration statement is not declared effective by anagreed to date, or if the Company fail to maintain the effectiveness of theregistration statement, then the Company is required to pay to each investor,as partial liquidated damages, cash equal to 1.0 percent of the aggregatepurchase price paid by such investor for the securities purchased in thefinancing and then held by such investor, and must pay to such investor 1percent for each subsequent 30-day period that the default remains uncured, upto a maximum aggregate liquidated damages amount of 10 percent of the aggregatepurchase price paid by the holders of the debentures.

 

*Accountingfor Convertible Notes and Debentures, Embedded Derivatives and Warrants*

 

TheCompany has evaluated the embedded derivatives included in the 6% ConvertibleNotes (the “Convertible Notes”) and the January 2008 and April 2008 Debentures,consisting of the conversion features and certain put and call featuresdescribed above, under the guidance in Statement of Financial AccountingStandard No. 133 Accounting for Derivative 

 

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Instrumentsand Hedging Activities and its related guidance and interpretations (“SFAS 133”)on the issuance date of the Convertible Notes and January 2008 and April 2008Debentures and on each subsequent reporting date.  The purpose of theevaluation is to determine whether the embedded derivatives need to be bifurcatedfrom the debt host and accounted for as a derivative at their estimated fairvalue as a liability at the date of issuance and thereafter, adjusted toestimated fair value with a charge or credit to the Company’s statement ofoperations.  SFAS 133 generally indicates that if the conversion featuresare (i) indexed to the Company’s capital stock and (ii) would beclassified as equity if a freestanding derivative under the guidance in EITF00-19, Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock (“EITF 00-19”), the embeddedderivatives need not be bifurcated from the debt host.  EITF 00-19generally requires, among other factors, that (i) the Company can settlethe derivative in cash or its own stock, at its option, (ii) settlementcan be made in unregistered shares, and (iii) the Company has sufficientauthorized shares to issue shares of its common stock for all equityinstruments convertible to or which can be exercised for its capitalstock.  SFAS 133 also provides guidance on when put and call featuresincluded in a debt host agreement are not clearly and closely related to thedebt host must be bifurcated and recorded as a liability.  Only the January 2008and April 2008 Debentures include put and call features.

 

TheCompany concluded that the conversion features embedded in the 6% ConvertibleNotes met the criteria in SFAS 133 at issuance and through April 23, 2008,the day prior to the merger with Tripath, because the conversion to the Company’scommon stock could only be settled in its capital stock, the capital stockcould be unregistered and the sufficiency of the authorized shares was underthe Company’s control as it could control the outcome of a shareholder vote toincrease the authorized shares.  However, on the date of the merger withTripath, April 22, 2008, the Company concluded it no longer had control toensure the sufficiency of its authorized shares of common stock and recordedthe embedded conversion feature in the 6% Convertible Notes with an estimatedfair value of $3,674 thousand and recorded the amount in the line entitled “Warrantand derivative liability” in the accompanying balance sheets.  At March 31, 2009, the estimated fair valueof the conversion feature was subsequently revalued to $967 thousand with therelated debit of $965 thousand included in the Company’s statement ofoperations in interest expense for the quarter ended March 31, 2009. TheCompany determined the estimated fair value of the conversion feature on April 22,2008, and March 31, 2009, by using the Black-Scholes Merton valuation model andthe following assumptions: fair value of the Company’s common stock of $2.91and $1.20, respectively, per share; terms of 0.95 years and 0.00 years,respectively; risk free interest rates of 1.82% and 0.00%, respectively; andvolatility of 47.16% and 0.00%, respectively. Probabilities were then appliedto the outputs using the Matlab Monte Carlo Simulation of the Company’s stockprices to arrive at a value for the conversion options.

 

TheCompany concluded that the conversion features embedded in the January 2008Debentures met the criteria in SFAS 133 at issuance and through March 31,2008, and therefore, were not bifurcated from the debt host because theconversion to the Company’s common stock could only be settled in its commonstock, the common stock could be unregistered and the sufficiency of theauthorized shares was under the Company’s control as it could control theoutcome of a shareholder vote to increase the authorized shares.  Whilethe Company concluded that the put and call embedded in the January 2008Debentures was not clearly and closely related to the debt host, the estimatedfair value of the put and call was determined to be de minimus and therefore wasnot bifurcated from the debt host.  However, on the date of the mergerwith Tripath, April 22, 2008, the Company concluded it no longer hadcontrol to ensure the sufficiency of its authorized shares of common stock norcould it settle the conversion feature in unregistered shares. Therefore, theCompany recorded the embedded conversion feature and put and call in the January 2008Debentures with an estimated fair value of $896 thousand and recorded theamount in the line entitled “Warrant and derivative liability” in theaccompanying balance sheet.  At March 31, 2009, the estimated fairvalue of the conversion feature was subsequently revalued to $302 thousand,with the related debit of $297 thousand included in the Company’s statement ofoperations in interest expense for the quarter ended March 31, 2009. TheCompany determined the estimated fair value of the conversion options on April 22,2008, and March 31, 2009, using the Black-Scholes Merton valuation modeland the following assumptions: fair value of the Company’s common stock of$2.91 and $1.20, and 2.14% respectively, per share; terms of 1 year and 1.75years, and 0.83 years, respectively; risk free interest rates of 1.84% and0.52%, and 2.14% respectively; and volatility of 47.16% and 48.48%, and 58.36%,respectively.  Probabilities were then applied to the outputs using theMatlab Monte Carlo Simulation of the Company’s stock prices to arrive at avalue for the conversion options.

 

TheCompany concluded that the embedded conversion features in the April 2008Debentures should be bifurcated from the debt host and recorded as liabilitiesbecause the conversion features must be settled in registered shares and thatdue to the Merger with Tripath the Company no longer had control over ashareholder vote to ensure the sufficiency of our authorized shares of commonstock. The Company also concluded that the put and call in the April 2008Debentures were embedded derivatives and were not clearly and closely relatedto the debt host and therefore should be bifurcated from the debt host 

 

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alongwith the conversion features and recorded as a liability at their estimatedfair value at issuance.  The estimated fair value of the embeddedconversion features and put and call was $1,507 thousand at April 22,2008, and recorded in the line entitled “Warrant and derivative liability” inthe accompanying Balance Sheet. At March 31, 2009, the estimated fairvalue of the conversion feature was subsequently revalued to $573 thousand,with the related debit of $563 thousand included in the Company’s statement ofoperations in interest expense for the quarter ended March 31, 2009. TheCompany determined the estimated fair value of the conversion options on April 22and December 31, 2008, and March 31, 2009, using the Black-ScholesMerton valuation model and the following assumptions: fair value of the Company’scommon stock of $2.91 and $1.20, respectively, per share; terms of 1 year and 2years, and 1.08 years respectively; risk free interest rates of 1.87% and2.24%, and 0.59%, respectively; and volatility of 45.76% and 49.00%, and56.80%, respectively.  Probabilities were then applied to the outputsusing the Matlab Monte Carlo Simulation of the Company’s stock prices to arriveat a value for the conversion options.

 

TheCompany evaluated the terms and conditions of the detachable warrants issuedwith the January 2008 and April 2008 Debentures under the guidance inEITF 00-19 to determine whether the detachable warrants should be accounted foras equity or a liability and thereafter adjusted to their respective estimatedfair value at each reporting date.

 

TheCompany concluded that the detachable warrants issued with the January 2008Debentures met the criteria in SFAS 133 at issuance and through March 31,2008, and therefore, were accounted for as equity because the warrants couldonly be settled by issuance of the Company’s common stock, the common stockcould be unregistered, and the sufficiency of the authorized shares was underthe Company’s control as it could control the outcome of a shareholder vote toincrease the authorized shares.  However, on the date of the merger withTripath, April 22, 2008, the Company concluded it no longer had control toensure the sufficiency of its authorized shares of common stock nor could itsettle the warrants in unregistered shares and therefore, recorded theestimated value fair value of the warrants of $320 thousand in the lineentitled “Warrant and embedded derivative liability” in the accompanyingBalance Sheets.  At March 31, 2009, the estimated fair value of thewarrants was revalued to $56 thousand, with the related debit of $55 thousand includedin the Company’s statement of operations in interest expense for the quarterended March 31, 2009. The Company determined the estimated fair value ofthe warrants on April 22 and December 31, 2008, and March 31,2009, by using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $2.91 and $1.20,respectively, per share; terms of 2.5 and 1.83 years, respectively; risk freeinterest rates of 2.54% and 0.77%, respectively; and volatility of 47.81% and63.41%, respectively.

 

TheCompany concluded that the detachable warrants issued with the April 2008Debentures did not meet the criteria in SFAS 133 at issuance because it nolonger had control to ensure the sufficiency of its authorized shares of commonstock nor could it settle the warrants in unregistered shares and therefore,recorded the estimated value fair value of the warrants of $590 thousand in theline entitled “Warrant and embedded derivative liability” in the accompanyingBalance Sheet.  At March 31, 2009, the estimated fair value of thewarrants was revalued to $97 thousand with the related debit of $93 thousandincluded in the Company’s statement of operations in interest expense for thequarter ended March 31, 2009. The Company determined the estimated fairvalue of the warrants on April 22, 2008, and March 31, 2009, by usingthe Black-Scholes Merton valuation model and the following assumptions: fairvalue of the Company’s common stock of $2.91 and $1.20, respectively, pershare; terms of 3 and 2.08 years, respectively; risk free interest ratesof 2.43% and 0.84% respectively; and volatility of 49.17% and 58.93%respectively.

 

Debtdiscounts recorded on the issuance of the Convertible Notes, the January 2008Debentures, and the April 2008 Debentures, were recorded on theconvertible notes and debentures due to the principal discount between thenominal value and the amount of principal received, the discounts due to theembedded conversion features, and the detachable warrants, and are beingamortized using the effective interest method. As the January 2008Debentures and the April 2008 Debentures were in default and are deemedcurrently payable, the debt discounts have been fully amortized for the yearended December 31, 2008.

 

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* *

*Warrants Issued in Connection with Other NotesPayable and Notes Payable to Related Parties*

 

Effective on February 23 and March 31, 2009, the Companyissued promissory notes, pursuant to which the Company issued warrants topurchase 26,667 and 133,333 shares, respectively, of the Company’s common stockat an exercise price of $0.75 per share, which warrants have a term of threeyears.

 

The Company evaluated the terms and conditions of the warrants issuedwith the promissory notes under the guidance in EITF 00-19 and EITF 07-05 todetermine whether the warrants should be accounted for as equity or a liabilityand thereafter adjusted to their respective estimated fair value at eachreporting date.

 

The Company concluded that the warrant issued with the promissory notein February 2009, did not meet the criteria in SFAS 133 at issuance because theCompany did not have control to ensure the sufficiency of its authorized sharesof common stock and therefore, recorded the estimated value fair value of thewarrant of $36 thousand in the line entitled “Warrant and embedded derivativeliability” in the accompanying Balance Sheet.  At March 31, 2009, theestimated fair value of the warrant was revalued to $16 thousand with therelated credit of $20 thousand included in the Company’s statement ofoperations in interest expense for the quarter ended March 31, 2009. TheCompany determined the estimated fair value of the warrant on February 23 andMarch 31, 2009, by using the Black-Scholes Merton valuation model and thefollowing assumptions: fair value of the Company’s common stock of $2.01 and$1.20, respectively, per share; terms of 3 and 2.92 years, respectively; riskfree interest rates of 1.34% and 1.12%, respectively; and volatility of 53.63%and 51.93%, respectively.

 

The fair value of the warrant recorded upon issuance was treated as adiscount on other notes payable, and is being amortized over the life of thepromissory note, which is due to mature on May 31, 2009, using the interestmethod. During the quarter ended March 31, 2009, $13 thousand of the discountwas amortized to interest expense.

 

The Company concluded that the warrant issued with the promissory notein March 2009, did not meet the criteria in SFAS 133 at issuance because theCompany did not have control to ensure the sufficiency of its authorized sharesof common stock and therefore, recorded the estimated value fair value of thewarrant of $83 thousand in the line entitled “Warrant and embedded derivativeliability” in the accompanying Balance Sheet.  The Company determined theestimated fair value of the warrant on March 31, 2009, by using the Black-ScholesMerton valuation model and the following assumptions: fair value of theCompany’s common stock of $1.20 per share; term of 3 years; risk free interestrate of 1.15%; and volatility of 53.28%.

 

The fair value of thewarrant recorded upon issuance was treated as a discount on notes payable torelated parties, and will be amortized over the life of the promissory note,which is due to mature on October 31, 2009, using the interest method.

 

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*New Series APreferred Warrants—Warrant Liability*

 

InOctober 2008 and as amended in December 2008, the Board of Directorsauthorized the designation and issuance of up to 3,333,333 shares of a New Series AConvertible Preferred Stock (the “New Series A Preferred Stock”), and theoffering of a December 2008 Preferred Stock Financing of up to $2,500,000of New Series A Preferred Stock and a number of warrants with an exerciseprice of $0.75 equal to 100% of the number of shares purchased by eachpurchaser. During the quarter ended March 31, 2009, and the period ending December 31,2008, respectively, the Company closed a round of financing for the sale of10,000 and 833,333 shares, respectively, of its New Series A PreferredStock at $0.75 per share, for an aggregate purchase price of $7.5 thousand and$625 thousand, respectively, and warrants to purchase 10,000 and 833,333 sharesof common stock of the Company, respectively, at an exercise price of $0.75 pershare, with a three year term. This financing was led by Daniel J.A. Kolke, theCompany’s founder, chairman, chief executive officer, acting chief financialofficer, and chief technology officer, with participation from two of itsdirectors and other prior investors. The holders of the January 2008Debentures and the April 2008 Debentures consented to this financing, butdid not participate.

 

TheCompany concluded at the date of issuance and the reporting date that theembedded conversion features in the New Series A Preferred Stock shouldnot be bifurcated from the equity host as they were clearly and closely relatedto the equity host. Also during the year ended December 31, 2008, theCompany recorded a beneficial conversion feature related to the New Series APreferred Stock, which could have been converted to the Company’s common stock,through the date the conversion feature was recorded, as a dividend expense of$22 thousand.

 

TheCompany evaluated the terms and conditions of the detachable warrants issuedwith the New Series A Preferred Stock under the guidance in EITF 00-19 and EITF 07-05 to determinewhether the detachable warrants should be accounted for as equity or aliability and thereafter adjusted to their respective estimated fair value ateach reporting date.

 

TheCompany concluded that the detachable warrants issued with the New Series APreferred Stock did not meet the criteria in SFAS 133 at issuance because theCompany did not have control to ensure the sufficiency of its authorized sharesof common stock. Therefore, the Company recorded the estimated value fair valueof the warrants of $148 thousand in the line entitled “Warrant and embeddedderivative liability” in the accompanying Balance Sheet.  At March 31,2009, the estimated fair value of the warrants was revalued to $510 thousand,with the related debit of $469 thousand included in the Company’s statement ofoperations in financing expense for the quarter ended March 31, 2009. TheCompany determined the estimated fair value of the warrants on December 3,2008, and February 27 and March 31, 2009, by using the Black-ScholesMerton valuation model and the following assumptions: fair value of the Company’scommon stock of $0.60, $0.51, and $1.20, respectively, per share; terms of 3.0,3.0, and 2.67 years, respectively; risk free interest rates of 1.07%, 1.4%, and1.04%, respectively; and volatility of 53.07%, 53.63%, and 52.75%,respectively.

 

*WarrantsIssued in Connection with Litigation Settlement*

 

Effectiveon December 5, 2008, the Company entered into a settlement agreement withKaufman Bros., pursuant to which the Company issued to Kaufman Bros. warrantsto purchase 500,000 shares of the Company’s common stock at an exercise priceof $0.75 per share, which warrants have a term of five years. See discussion *infra* Note 11.

 

TheCompany evaluated the terms and conditions of the warrants issued in thesettlement under the guidance in EITF 00-19 to determine whether the warrantsshould be accounted for as equity or a liability and thereafter adjusted totheir respective estimated fair value at each reporting date.

 

TheCompany concluded that the warrants issued in the settlement did not meet thecriteria in SFAS 133 at issuance because the Company did not have control toensure the sufficiency of its authorized shares of common stock and therefore,recorded the estimated value fair value of the warrants of $130 thousand in theline entitled “Warrant and embedded derivative liability” in the accompanyingBalance Sheet.  At March 31, 2009, the estimated fair value of thewarrants was revalued to $353 thousand with the related debit of $307 thousandincluded in the Company’s statement of operations in settlement expense for thequarter ended March 31, 2009. The Company determined the estimated fairvalue of the warrants on December 5, 2008, and March 31, 2009, byusing the Black-Scholes Merton valuation model and the following assumptions:fair value of the Company’s common stock of $0.60 and $1.20, respectively, pershare; terms of 5 and 4.67 years, respectively; risk free interest rates of1.67% and 1.46% respectively; and volatility of 56.16% and 54.02% respectively.

 

*WarrantsIssued in Connection with Consulting Agreement*

 

Effectiveon March 2, 2009, the Company entered into a consulting agreement withSalzwedel Financial Communications, Inc., pursuant to which the Companyissued a warrant to purchase 2,000,000 shares of the Company’s common stock atan exercise price of $0.01 per share, which warrants have a term of five years.

 

TheCompany evaluated the terms and conditions of the warrants issued in relationto the consulting agreement under the guidance in EITF 00-19 and EITF 07-05 todetermine whether the warrants should be accounted for as equity or a liabilityand thereafter adjusted to their respective estimated fair value at eachreporting date.

 

TheCompany concluded that the warrants issued in relation to the consultingagreement did not meet the criteria in SFAS 133 at issuance because the Companydid not have control to ensure the sufficiency of its authorized shares ofcommon stock and therefore, recorded the estimated value fair value of thewarrants of $1,001 thousand in the line entitled “Warrant and embeddedderivative liability” in the accompanying Balance Sheet.  At March 31,2009, the estimated fair value of the warrants was revalued to $2,381 thousandwith the related debit of $1,380 thousand included in the Company’s statementof operations in investor relations expense for the quarter ended March 31,2009. The Company determined the estimated fair value of the warrants on March 2and March 31, 2009, by using the Black-Scholes Merton valuation model andthe following assumptions: fair value of the Company’s common stock of $0.51and $1.20, respectively, per share; terms of 5 years and 4.92 years,respectively; risk free interest rates of 1.86% and 1.63%, respectively; andvolatility of 56.68% and 54.11%, respectively.

 

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* *

***7.Notes Payable to Related Parties***

 

TheCompany previously entered into a series of unsecured loan transactions withrelatives of Daniel J.A. Kolke, its executive chairman, chief executiveofficer, acting chief financial officer, and chief technology officer.  OnDecember 30, 2007, in connection with settlement of these loans, theCompany entered into three unsecured promissory notes with an aggregateoriginal principal amount of $816 thousand, each of which will becomecollateralized by certain presently unidentified assets of the Company if andwhen Daniel J.A. Kolke is no longer an employee nor a member of its board ofdirectors.  Such security interest, if granted, would be subordinated toany and all bank debt or convertible corporate debt.  These three notesare outstanding and in default in an aggregate balance of $685 thousand as of December 31,2008.  No demands for payment have beenmade as of the date of this report and the default has been waived through thequarter ended March 31, 2009.

 

During the quarter ended March 31, 2009, theCompany entered into an unsecured promissory note with a director, in theprincipal amount of $100,000, with a maturity date of October 31, 2009,and an interest rate of ten percent per annum. In connection with this promissory note, the Company also issued to thedirector 133,333 detachable warrants to purchase common stock of the Companywith an exercise price of $0.75 per share and a term of three years.  See discussion re: warrants at, *supra*, note 6.

 

***8.Equity***

*** ***

*PreferredStock*

* *

Duringthe quarter ended March 31, 2009, the Company closed the sale of 10,000shares of its New Series A Preferred Stock at $0.75 per share, for anaggregate purchase price of $7.5 thousand, and warrants to purchase 10,000shares of common stock of the Company, at an exercise price of $0.75 per share,and a three year term.  See discussionre: warrants at, *supra*, note 6.

 

*CommonStock*

* *

TheCompany has issued 24,069,291 shares of common stock from a total of250,000,000 authorized shares with a par value of $0.01 per share.

 

OnMarch 2, 2009, the Company entered into a consulting agreement withSalzwedel Financial Communications, Inc. to provide services to theCompany for a period of one year. Compensation payable under that agreement included 1,000,000 shares ofthe Company’s common stock and, as a signing bonus, a warrant to purchase2,000,000 shares of the Company’s common stock at a price of $0.01 per share,until March 14, 2014.  See discussion re: warrants at, *supra*, note 6.

 

***9. Accounting for Share-Based Compensation***

*** ***

Thefollowing table summarizes stock option activity under the Company’s stockoption plans (in thousands, except share and per share data):

 
| **Options**                           | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price Per  Share** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|---------------------------------------|------------|------------|------------|----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding at December 31, 2008 |       | 4,086,497  |       | $                                                              |  0.26 |                                                        | 8.6        |                                | $          | 1,053 |   |
| Granted                               |       | 750,000    |       | $                                                              |  0.10 |                                                        |       |                                |       |   |
| Exercised                             |       | (41,667    | )          | $                                                              |  0.05 |                                                        |       |                                |       |   |
| Canceled                              |       | —     |       | —                                                         |       |                                                        |       |                                |       |
| Outstanding at March 31, 2009    |       | 4,794,830  |       | $                                                              |  0.24 |                                                        | 8.6        |                                | $          |  5,116 |   |
| Exercisable at March 31, 2009    |       | 1,052,427  |       | $                                                              |  0.18 |                                                        | 8.3        |                                | $          |  1,138 |   |
| Unvested at March 31, 2009       |       | 3,742,403  |       | $                                                              |  0.26 |                                                        | 8.7        |                                | $          |  3,978 |   |

 

AggregateIntrinsic Value was determined based upon the closing price of the Company’spublicly listed common stock price on March 31, 2009.

 

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Totalcash received as a result of options exercised during the three months ended March 31,2009, was $2 thousand. There were no equity instruments granted undershare-based payment arrangements and therefore there was no cash used to settleany equity instrument. The Company does not plan to repurchase any sharesduring the upcoming annual period.

 

***10. Restructuring***

*** ***

Aspart of its reduction of monthly cash operating expenses during the quarterended September 30, 2008, and continuing during the quarter and year endedDecember 31, 2008, as of the date of these financial statements, theCompany placed all employees on partial deferrals of salary, ranging from 10%to 100% of base salary and accrued these deferrals.  At the end of the period, and as of the dateof these financial statements, this deferral amount remains unpaid, includingamounts due to employees in its California office who were terminated duringthe period.  As of March 31, 2009, $876thousand has been accrued for deferred salary, of which $386 thousand wasincurred during the quarter ended March 31, 2009.

 

***11. Litigation and Claims***

*** ***

InJune 2008, Kaufman Bros. L.P. filed suit against the Company in the UnitedStates District Court for the Southern District of New York (Case No. 80CV 5716) and sought a temporary restraining order and other extraordinaryrelief.  The complaint arises out of an advisory services agreement,pursuant to which Kaufman Bros. was to provide to the Company advisory servicesin connection with financings and strategic transactions. The Company notifiedKaufman Bros. that it believed Kaufman Bros. had failed to provide the requiredservices under the agreement, and that it were therefore entitled to terminatethe agreement for cause. In the suit, Kaufman Bros. was seeking (i) monetarydamages of $400,000 for anticipatory breach of the agreement; (ii) $73,800in fees allegedly owed in connection with a previously closed financingtransaction; (iii) and injunction prohibiting us from cancelling anyshares issued to Kaufman Bros. as compensation, (iv) a declaration fromthe court that the Company are not entitled to a refund of any fees previouslypaid to Kaufman Bros., and (v) a declaration that the Company areobligated to pay Kaufman Bros. a commission on any financing or transactionthat we enter into within 18 months following the termination of theagreement.  On July 15, 2008, Kaufman Bros. voluntarily filed anotice of dismissal without prejudice.  Settlement discussions wereunsuccessful and, on July 31, 2008, Kaufman Bros. re-filed substantiallythe same claims in the Supreme Court of New York - County of New York (Index No. 08-602239).Effective on December 5, 2008, the Company entered into a settlementagreement with Kaufman Bros., pursuant to which (i) the Company agreed topay to Kaufman Bros. $210,000, in twelve monthly installments of $17,500; (ii) theCompany issued to Kaufman Bros. warrants to purchase 500,000 shares of theCompany’s common stock at an exercise price of $0.75 per share, which warrantshave a term of five years; (iii) the Company and Kaufman Bros. agreedimmediately to terminate all provisions, terms and conditions of the advisoryservices agreement and exchanged mutual releases; and (iv) Kaufman Bros.agreed to dismiss the pending lawsuit in the Supreme Court of New York, withoutprejudice. Subsequent to entering into the settlement agreement, the Companyhas not fully complied with its payment obligations under the settlementagreement but, through the date of filing of these financial statements,Kaufman Bros. has not exercised any of its remedies for default under thesettlement agreement.

 

OnOctober 31, 2008, the Company closed its offices in San Mateo, Californiaand abandoned the leased premises of its former offices there.  The landlord for these premises has asserteda claim for $659 thousand and other amounts and filed a proceeding in theSuperior Court of San Mateo County, California (Case No. CIV 479535).  This matter is pending and the Companyintends to defend its position.

 

OnSeptember 18, 2008, the employment of Jeffrey L. Garon as president andchief executive officer of the Company was terminated.  On October 19, 2008, Mr. Garonresigned from the Board of Directors.  Mr. Garonand the Company entered into an Employment Agreement dated August 11,2007, which provided certain benefits to Mr. Garon in the event oftermination of his employment, and granted to the Company certain rights torepurchase shares issued on behalf of Mr. Garon pursuant to his employmentagreement.  The Company and Mr. Garonhave been engaged in discussions about these benefits and rights, and no finalagreement has been reached as of the date of these financial statements.

 

***12. Subsequent Events***

 

In April 2009, we entered into an additional secured bridge loan with EnableGrowth Partners, LP, in the principal amount of $385 thousand, with interest at10% per annum, due October 17, 2009.

 

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**Item 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**.

 

**Overview**

** **

The following discussion of our financial conditionand results of operations should be read in conjunction with our condensedconsolidated financial statements and the related notes and other financialinformation appearing elsewhere in this report. Readers are also urged tocarefully review and consider the various disclosures made by us which attemptto advise interested parties of the factors which affect our business,including without limitation, the disclosures made under “Item 1A. Risk Factors”included in Part II of this report.

 

***Business***

 

We have a Web Application distribution platformdelivering Web Applications for businesses. We provide a Software-as-a-Service (SaaS) ecosystem for building,distributing, and using Web Applications, including a marketplace to deploy andsupport them.  Unlike other cloudcomputing and Platform-as-a-Service (PaaS) solutions, we enable softwaremanufacturers to migrate existing applications or create new applications, thenpackage, distribute, host, bill, market and support their SaaS enabledapplications through multiple private label applications marketplaces.

 

We have developed products for Web Applications, whichinclude open standards-based tools for Web developers, businesses andindividual users such as the Etelos Application ServerTM (EASTM)and the Etelos Development EnvironmentTM (EDETM).  EAS and EDE support many common programminglanguages and also support the English Application Scripting Engine (EASETM), a simple-to-use open standards-based scriptinglanguage developed by us.  In order tosupport broader adoption of our products, EASE and other components of the EDEare made available to developers at market appropriate pricing.  This is done to support the development ofnew Web Applications and the migration of existing Web Applications into theEtelos ecosystem where there are tools and other support mechanisms for themarketing, distribution, and support of these applications.

 

We generally receive a transaction fee or subscriptionfee for transactions that occur within the Etelos ecosystem either via theEtelos MarketplaceTM pursuant to Storefront Operating Agreements, or inthird-party branded Marketplaces operated by us pursuant to Marketplace PartnerAgreements (sometimes referred to as “an Etelos Marketplace” or, collectively,as “the Etelos Marketplaces”).  Mostcustomers in Etelos Marketplaces pay a subscription fee, which we share withSyndication Partners and Marketplace Partners; this revenue share is calculatedas a percentage of gross revenues from the sale of subscriptions to SyndicationPartner offerings in the Etelos Marketplaces.

 

Etelos Marketplaces support and encourage communitiesof developers, distributors, and consumers to expand their offerings,collaborate on new ideas and improvements, and provide scalable solutions usingWeb Applications available to others.

 

***History***

 

We were originally organized as Etelos, Incorporated,a Washington corporation on May 5, 1999. We have been engaged in thebusiness of web application development and services since our inception.

 

On February 8, 2007, Tripath Technology Inc., aDelaware corporation (“Tripath”) filed a voluntary petition for relief underChapter 11 of the Bankruptcy Code. On February 1, 2008, the bankruptcycourt issued an order confirming approval of the Plan of Reorganization,including the merger and the transfer of all of Tripath’s existing assets intoa separate bankruptcy estate and the discharge of all of Tripath’sliabilities.  The Plan of Reorganizationalso contemplated the merger of Etelos, Incorporated with and into Tripath.

 

On April 22, 2008, we completed the merger withand into Tripath, changed the name of the surviving entity to Etelos, Inc.and changed its fiscal year end to December 31.

 

***Recent Developments***

 

On November 6, 2008, we announced changes to ourbusiness model to focus on the sales and operation of private label Webapplication marketplaces, including provision of the professional servicesrequired to develop, deploy and operate such marketplaces, and the launch ofofferings of the Etelos Platform SuiteTM.  The Etelos Platform Suite focuses onenabling Independent Software Vendors (ISVs) to implement SaaS delivery oftheir existing applications, whether or not those applications are already WebApplications, and syndicating the offering of those applications throughmultiple private label marketplaces. In these difficult economic times, webelieve that a variety of ISVs will have applications that they need to move tothe Web for lower cost implementation, easier, simpler scalability, and broaderdistribution.  The Etelos Platform Suite also enables Marketplace Partners,including non-technology businesses, to have their own private labelmarketplaces and tools to offer SaaS Web Applications to better serve theircustomers in multiple distribution channels.

 

Although we have long enabled applications to bedistributed via the Web, we believe this shift away from a core directmarketing focus of offering multiple products through a single portal in theEtelos Marketplace will have four major 

 

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benefits for our business.  First, this offering will expose the coreplatform to more ISVs for greater benefit to their end users and the creationof a larger pool of applications for syndication. Second, the development andoperation of third party-branded marketplaces shifts the financial expense andoperational burdens of sales and marketing to end users to Marketplace Partnersthat better know their customers and are better capitalized to supportnecessary sales and marketing activities.  Third, because this two-prongedgo-to-market strategy is offered on a revenue-sharing basis, it fundamentallyreduces barriers to acceptance by eliminating up front costs for Syndication Partnersto offer their products through multiple Marketplace Partners, and by chargingMarketplace Partners only for sales success. Finally, this shift allows us to focus on our core competency indevelopment and operation of online marketplaces, while better managing limitedfinancial and other resources.

 

During the quarter ended December 31, 2008, webegan to implement this shift and, during the period up to the date of thisreport, we entered into new Syndication Partner agreements with ISVs to deliverSaaS-enabled versions of their products and to syndicate those apps fordistribution through a number of third party-branded SaaS marketplaces, and wehave announced agreements to launch third party private label marketplaces,including third parties not traditionally regarded as technology providers. We expect to make further such announcements reflecting this shift duringthe coming months but we do not have an estimate or projection of how, or when,or if, the benefits, if any, of this shift will be reflected in our operatingresults.

 

In the quarter ended March 31, 2009, and in April2009, we entered into a series of bridge loans with certain purchasers of ourNew Series A Preferred stock and with the holders of our January 2008and April 2008 Debentures.  In theaggregate these bridge loans were for the principal amount of $655 thousand,which is estimated to cover our operating expenses through June 2009.  These notes bear interest at ten percent perannum, and have maturities ranging from May 31, 2009, through October 31,2009.  The notes payable to the holdersof our New Series A Preferred stock were accompanied by 160,000 warrantsto purchase shares of our Common Stock at $0.75 per share, with a term of threeyears.  The notes payable to the holderof our January 2008 and April 2008 Debentures are subject to thesecurity interest granted to those holders in connection with those debentures.

 

***Critical Accounting Policies Involving Management Estimates andAssumptions***

*** ***

Ourdiscussion and analysis of our financial condition and results of operations isbased on our financial statements.  Inpreparing our financial statements in conformity with accounting principlesgenerally accepted in the United States, we must make a variety of estimatesand assumptions that affect the reported amounts of assets and liabilities, thedisclosure of contingent assets and liabilities, and the reported amounts ofrevenues and expenses.  We haveidentified the following accounting policies that we believe requireapplication of management’s most subjective judgments, often requiring the needto make estimates about the effect of matters that are inherently uncertain andmay change in subsequent periods.

 

***Allowance for Doubtful Accounts***

*** ***

Weprovide, when appropriate, an allowance for doubtful accounts to ensure thatour trade receivables are not overstated due to un-collectability. Thecollectability of our accounts receivables is evaluated based on a variety offactors, including the length of time receivables are past due, indication ofthe customer’s willingness to pay, significant one-time events and historicalexperience.  We have not recorded anallowance for doubtful accounts at this time as we believe all our accountsreceivable will be collected.

 

***Revenue Recognition***

*** ***

Weprovide Web Applications as a subscription service using theSoftware-as-a-Service (SaaS) or software-on-demand business model and allowthird parties to offer their products and service through Storefronts in anEtelos Marketplace, and to advertise on our web site or in our annual magazinefor a fee.  We also license our softwareunder perpetual and term licenses. Revenues are recognized on these service and licensing transactions usingthe criteria in Securities and Exchange Commission Staff Accounting Bulletin104, “Revenue Recognition in Financial Statements” (SAB 104) and SOP 97-2, “SoftwareRevenue Recognition”, (SOP 97-2) respectively, which both provide that revenuemay be recognized when all of the following criteria are met:

 

·                  Persuasive evidence of an arrangement exists,

·                  The product or service has been delivered,

·                  The fee is fixed or determinable, and

·                  Collection of the resulting receivable isreasonably assured or probable.

 

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Wemust first determine whether SAB 104 or SOP 97-2 applies to our revenuetransactions.  We than determine if thecriteria above have been met by assessing the SAB 104 and SOP 97-2 and theirvarious interpretations in view of the agreements and other documentationrelated to the revenue transactions.  Theinterpretation of the agreements often requires considerable judgment as wellas determining what accounting literature is appropriate and how thatliterature should be applied.  If ourstandard agreements are used to establish evidence of the arrangement, then ourrevenue is generally recognized as follows:

 

ForSaaS revenue transactions, persuasive evidence of an arrangement exists uponacceptance by the customer of a binding agreement and authorization by thecustomer to charge a credit card; delivery generally occurs over the term ofthe subscription agreement related to the SaaS; and the fee is fixed andcollection reasonably assured when the customer’s credit card is charged.  Accordingly, revenue is recognized over theperiod the SaaS is provided.

 

Forsoftware licensed under term or perpetual agreements, persuasive evidence ofthe arrangement is evidenced by a binding agreement signed by the customer anddelivery generally occurs upon delivery of the software to a common carrier. Ifa significant portion of a fee is due after our normal payment terms oftypically 30 days, we recognize revenue as the fees become due. If we determinethat collection of a fee is not reasonably assured, we defer the fees andrecognize revenue upon cash receipt, provided that all other revenuerecognition criteria are met.

 

However,if the terms and conditions of an agreement are nonstandard, then significantcontract interpretation is sometimes required to determine the appropriateaccounting for these transactions including: (1) whether an arrangementexists; (2) how the arrangement consideration should be allocated amongpotential multiple elements; (3) when to recognize revenue on thedeliverables; (4) whether all elements of the arrangement have beendelivered; (5) whether the arrangement should be reported gross as aprincipal versus net as an agent; (6) whether we receive a separatelyidentifiable benefit from the purchase arrangements with our customer for whichwe can reasonably estimate fair value; and (7) whether the arrangementshould be characterized as revenue or a reimbursement of costs incurred. Inaddition, our revenue recognition policy requires an assessment as to whethercollection is reasonably assured, which inherently requires us to evaluate thecreditworthiness of our customers. Changes in judgments on these assumptionsand estimates could materially impact the timing or amount of revenuerecognition.

 

***Internal Use Software***

*** ***

UnderSFAS NO. 86, “Accounting for Costs of Computer Software to be Sold, Leased orOtherwise Marketed” (SFAS 86), costs incurred in the research and developmentof new software products are expensed as incurred until technologicalfeasibility is established. Alternatively, Statement of Position 98-1, “Accounting for Costs ofComputer Software Developed or Obtained for Internal Use” (SOP 98-1), appliesto software development costs that are not related to software to be sold,licensed, leased or otherwise marketed as a separate product or as part of aproduct or process and are within the scope of SFAS 86.  Under SOP 98-1, software development costsincurred for software that is only used internally, including costs incurred topurchase third party software, are capitalized beginning when the Company hasdetermined certain factors are present, including among others, that technologyexists to achieve the performance requirements, buy versus internal developmentdecisions have been made, and the Company’s management has authorized thefunding for the project.  We mustdetermine whether SFAS 86 or SOP 98-1 is applicable to our software developmentcosts.  We then must determine whensoftware capitalization should begin and cease and what costs under theapplicable standard can be capitalized. Both of these tasks involves considerable judgment and can result inmaterial different amounts of software being capitalized and have a significantimpact on our reported results of operations. To date, because we plan to license all our software products, we havedetermined that the provisions of SFAS 86 should be applied to the cost of ourproduct development.  As products andenhancements have generally reached technological feasibility and have beenreleased for sale at substantially the same time, all research and developmentcosts have been expensed.

 

***Stock-Based Compensation Expense***

*** ***

EffectiveJanuary 1, 2006, we adopted SFAS 123R using the modified prospectivemethod and therefore have not restated prior periods’ results. Under the fairvalue recognition provisions of SFAS 123R, we recognize stock-basedcompensation expense net of an estimated forfeiture rate and therefore onlyrecognize compensation cost for those shares expected to vest over the serviceperiod of the award.  Calculatingstock-based compensation expense requires the input of highly subjectiveassumptions, including the expected term of the stock-based awards, stock pricevolatility, and the pre-vesting option forfeiture rate. We estimate theexpected life of options granted based on historical exercise patterns, whichwe believe are representative of future behavior. We estimate the volatility ofour common stock on the date of grant based on the 

 

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historicalvolatility of other publicly traded companies in our industry. The assumptionsused in calculating the fair value of stock-based awards represent our bestestimates, but these estimates involve inherent uncertainties and theapplication of management judgment. As a result, if factors change and we usedifferent assumptions, our stock-based compensation expense could be materiallydifferent in the future. In addition, we are required to estimate the expectedforfeiture rate, as well as the probability that performance conditions thataffect the vesting of certain awards will be achieved, and only recognizeexpense for those shares expected to vest. We estimate the forfeiture ratebased on historical experience of our stock-based awards that are granted,exercised, and cancelled. If our actual forfeiture rate is materially differentfrom our estimate, the stock-based compensation expense could be significantlydifferent from what we have recorded in the current period. Beginning in thequarter ended December 31, 2008, and contuining in the quarter ended March 31,2009, to the date of this report, the global economy has been highly volatileand, during this period, the Company found it necessary to take drasticmeasures to reduce operating expenses, but the likelihood of success of theseefforts cannot be predicted.  Thereforethe forfeiture rate in the quarter ended December 31, 2008, was veryhigh.  The forfeiture rate declinedsubstantially during the quarter ended March 31, 2009, but it is not knownwhether this forfeiture rate will be maintained in the future; management willcontinue to monitor its estimates.

 

*Accountingfor Convertible Notes and Debentures, Embedded Derivatives and Warrants*

* *

TheCompany evaluates the embedded derivatives included in the debt instruments itissues under the guidance in Statement of Financial Accounting Standard No. 133“Accounting for Derivative Instruments and Hedging Activities” and its relatedguidance and interpretations (SFAS 133) on the issuance date of the debt and oneach subsequent reporting date to determine whether such embedded derivativesare clearly and closely related to the debt host.  The purpose of the evaluation is to determinewhether the embedded derivatives, which are not clearly and closely related tothe debt host, need to be bifurcated from the debt host and accounted for as aderivative at their estimated fair value as a liability or asset at the date ofissuance and thereafter, adjusted to estimated fair value with a charge orcredit to the Company’s statement of operations.  SFAS 133 generally indicates that if theconversion features are (i) indexed to the Company’s capital stock and (ii) wouldbe classified as equity if a freestanding derivative under the guidance in EITF00-19, “Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock” (EITF 00-19), then the embeddedderivatives need not be bifurcated from the debt host.  We also evaluate the warrants issued with thedebt under EITF 00-19 to determine whether the proceeds allocated to thewarrants or the fair value of the warrants should be recorded as equity or aliability, respectively, and if a liability adjusted to fair value with acharge or credit to the Company’s statement of operations.  EITF 00-19 generally requires, among otherfactors, that (i) the Company can settle the derivative in cash or its ownstock, at its option, (ii) settlement can be made in unregistered shares,and (iii) the Company has sufficient authorized shares to issue shares ofits common stock for all equity instruments convertible to or which can beexercised for its capital stock.  SFAS133 also provides guidance on when put and call features included in a debthost agreement are not clearly and closely related to the debt host and must bebifurcated and recorded as liability. The guidance in SFAS 133 is complex and it has manyinterpretations.  Accordingly, we mustuse judgment to apply and interpret this guidance as well as ensure we haveapplied the correct guidance.

 

Ifthe embedded derivatives or warrants must be recorded as a liability, then wemust make certain assumptions to value the embedded derivative.  This includes computing the discounted netpresent value (DNPV) of the debt and making assumptions about interest rates,probabilities of outcomes, volatility, fair value of the Company’s stock priorto its merger with Tripath, and discount rates. The discount factor is the Company’s estimate of the appropriate rate ofreturn that an investor would expect from a similar debenture not taking intoconsideration the conversion feature or warrants.  All of these assumptions have a materialimpact on the value attributed to the derivative or warrant.

 

**Resultsof Operations**

** **

***Three Months Ended March 31, 2009, Compared with Three MonthsEnded March 31, 2008***

*** ***

***Revenues***

*** ***

Revenueswere $58 thousand and $24 thousand for the three months ended March 31,2009 and 2008, respectively. Revenues increased by $34 thousand, or 142percent, in the three months ended March 31, 2009, compared to the sameperiod in 2008. In the year ended December 31, 2008, and to the date ofthis report, we also experienced a significant decline in sales of our customerresource management product, which had been introduced in mid-2007.

 

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***Cost of Revenue***

* *

Costof revenue includes our costs of hardware, software and other resources used indelivery of our products and services. Cost of revenue was $93 thousand and$101 thousand for the three months ended March 31, 2009 and 2008,respectively. Cost of revenue for the three months ended March 31, 2009,decreased by $8 thousand, or by 8 percent. The decrease in cost of revenue from 2008 to 2009 was primarilyattributable to the decreased costs of hosting and Internet bandwidthassociated with the deployment of our products and services. Stated as apercentage of revenues, cost of revenue for the three months ended March 31,2009, was 160 percent and for the corresponding period of 2008 was 421 percent.

 

***Operating Expenses***

*** ***

*Researchand Development*.  Researchand development expenses include primarily employee and employee relatedexpenses. Research and development expenses were $0.9 million and $1.2 millionfor the three months ended March 31, 2009 and 2008, respectively. Statedas a percentage of revenues, research and development expense for thecorresponding periods was 1,551 percent and 5,000 percent, respectively.  Research and development expenses decreasedby $300 thousand or by 25 percent, in the three months ended March 31,2009, compared to the same period in 2008. This decrease was primarily due to reduced headcount and related salaryand benefits expenses for engineers engaged in research and development.

 

*Salesand Marketing Expenses*. Sales and marketing expenses include payroll, employee benefits, andother headcount-related costs associated with sales and marketing personnel andtravel, advertising, promotions, trade shows, seminars, and other programs.Sales and marketing expenses were $571 thousand and $293 thousand for the threemonths ended March 31, 2009 and 2008, respectively. The $278 thousand, or 94percent, increase in sales and marketing expense was due to increasedactivities of sales and marketing following the completion of the merger in April 2008.Stated as a percentage of revenues, sales and marketing expense for thecorresponding periods was 984 percent and 1,220 percent, respectively.

 

*Generaland Administrative.*  General andadministrative expenses include payroll and related employee benefits, andother headcount-related costs associated with finance, facilities, legal andother administrative expenses. General and administrative expenses were $670thousand and $470 thousand for the three months ended March 31, 2009 and2008, respectively. The $200 thousand, or 42 percent, increase in general andadministrative expense was primarily attributable to increased hiring ofaccounting, administrative, legal, and compliance personnel and greater use ofconsultants and temporary personnel to support being a public company.  Stated as a percentage of revenues, generaland administrative expense for the corresponding periods was 1,155 percent and1,958 percent, respectively.

 

*InterestExpense*

* *

Interestexpense was $2,094 thousand for the three months ended March 31, 2009,compared to $199 thousand for the comparable period of 2008. Interest expenseprimarily consisted of $13 thousand of amortization of notes discount, $127thousand of interest expense on convertible notes and debentures, and a changein the valuation of liability relating to embedded derivatives and warrants of$1,954 thousand for the quarter ended March 31, 2009, compared to $65thousand of amortization of notes discount and $134 thousand of interestexpense on convertible notes for the three months ended March 31, 2008.  The increase in interest expense from 2008 to2009 was primarily due to the change in valuation of liability relating toembedded derivatives and warrants when our stock price increased significantlyduring the quarter ended March 31, 2009.

 

***Net Loss***

*** ***

Ournet loss was $6.4 million and $2.2 million for the three months ended March 31,2009 and 2008, respectively, an increase of $4.2 million, or 191 percent.  The increase in net loss from 2008 to 2009was primarily due to a change in valuation of liability relating to embeddedderivatives and warrants.

 

**Liquidityand Capital Resources**

** **

OnMarch 31, 2009, we had $66 thousand in cash and cash equivalents, netaccounts receivable of $10 thousand, and prepaid expenses and other currentassets of $94 thousand. Our working capital deficit at March 31, 2009, was$16.2 million, compared to a deficit of $10.3 million at December 31,2008. The increase in working capital deficit is mainly attributable to theincrease in warrant and derivative liability and further discussed in “Note 6Convertible Notes and Debentures and Embedded Derivative and Warrant Liability”in our financial statements included in this report.

 

Netcash used by operating activities during the three months ended March 31,2009, was $218 thousand, compared to $2.3 million during the three months endedMarch 31, 2008. The primary use of cash from operating activities duringthe three months ended March 31, 2009, was related to payment of expensesrelating to accounting and compliance.

 

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Netcash provided by financing activities during the three months ended March 31,2009, was $277 thousand, primarily from the issuance of bridge loan notes andthe sale of the New Series A Preferred shares, further discussed in “Note6 — Convertible Notes and Debentures and Embedded Derivative and WarrantLiability” in our financial statements included in this report.

 

Inthe three months ended March 31, 2009, and subsequently in April 2009, weentered into a series of bridge loans with certain purchasers of our New Series APreferred stock and with the holders of our January 2008 and April 2008Debentures.  In the aggregate thesebridge loans were for the principal amount of $655 thousand, which is estimatedto cover our operating expenses through June 2009.  These notes bear interest at ten percent perannum, and have maturities ranging from May 31, 2009, through October 31,2009.  The notes payable to the holdersof our New Series A Preferred stock were accompanied by 160,000 warrantsto purchase shares of our Common Stock at $0.75 per share, with a term of threeyears.  The notes payable to the holderof our January 2008 and April 2008 Debentures are subject to thesecurity interest granted to those holders in connection with those debentures.

 

Weare currently in default of our September 2007 notes, January 2008Debentures, and April 2008 Debentures for failure to make payments whendue.  The aggregate principal and accruedinterest currently due under these debt securities as of March 31, 2009,is $7.8 million.  Our January 2008Debentures and April 2008 Debentures are secured by substantially all ofour assets.  If the holders of ouroutstanding debt securities determine to demand payment and we haveinsufficient cash to make the required payments, as is currently the case, theholders could force a sale of our assets for their benefit. Under such circumstances,we may need to cease operations or file for protection from claims of ourcreditors under the federal bankruptcy laws.

 

Weneed immediate and substantial cash to continue our operations. Management hasprojected that the combination of cash on hand will be sufficient to allow usto continue our operations only through June 2009, and only if the holdersof our outstanding debt securities do not demand payment of such securities orexercise other remedies. If cash reserves are not sufficient to sustainoperations, then we plan to raise additional capital by selling shares of ourcapital stock or other securities. However, there are no commitments or arrangements for future financingsin place at this time and we can give no assurance that such capital will beavailable on favorable terms, or at all. We may need additional financing thereafter until we can achieveprofitability.  If we cannot obtainadditional financing, then we may be forced to curtail our operations, ceasevoluntarily filing reports with the SEC, or possibly be forced to evaluate asale or liquidation of our assets or consider other strategic alternatives suchas bankruptcy.  Even if we are successfulin raising additional funds, there is no assurance regarding the terms of any additionalinvestment and any such investment or other strategic alternative would likelysubstantially dilute or eliminate the interests of our stockholders.

 

***September 2007 Notes***

*** ***

OurSeptember 2007 notes were issued as part of a private placement that wascompleted during August and September 2007.  In that private placement we issued a totalof approximately $3.3 million of 6% convertible notes at an original issuediscount of 10% with warrants to purchase 1,080,000 shares of common stock withan exercise price of $1.20 per share. In connection with the Merger that closedon April 22, 2008, $1.5 million of these notes were converted at $0.75 pershare. At the time of the Merger, 974,667 of the warrants had been exercisedand the remaining 33,333 warrants expired by their terms upon closing theMerger.

 

Underthe terms of the remaining $1.8 million of the notes that were not converted,principal payments began being payable on September 1, 2008, and willcontinue to be payable on the last day of each calendar quarter, and interestpayments began being payable beginning February 1, 2008. On June 15,2008, the holders of these notes agreed to either convert the then-accruedinterest to shares of common stock at a rate of one share for each $1.35 ofinterest owed or to add the then-accrued interest to the principal, and towaive any default arising out of our failure to pay the accrued and unpaidinterest through June 15, 2008.

 

Theprincipal payment amounts remaining on our September 2007 notes werescheduled to be paid as follows (in thousands):

 

| **Date**   | ** ** | **September 2007 Notes** | ** **  |
|------------|------------|------------------------------------|-------------|
| 9/1/2008   |       | $                                  | 441         |   |
| 9/30/2008  |       | $                                  | 441         |   |
| 12/31/2008 |       | $                                  | 441         |   |
| 3/31/2009  |       | $                                  | 441         |   |
|       |       | $                                  |  1,764 |   |

 

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Assumingprincipal payments are made in accordance with the schedule set forth above,the amount of interest to be paid through the March 31, 2009, maturitydate is $55.9 thousand with respect to our September 2007 notes, or onaverage, $3.1 thousand per month.

 

Asof the filing date of this report, the September 2008, December 2008,and March 2009 principal payments have not been made and the Company doesnot have, or expect to have, cash on hand to make the payments in the nearfuture; no interest payments have been made for interest accrued since June 15,2008.  We are in regular communicationwith the holders of the September 2007 notes and none of the holders havedemanded payment or exercised other remedies due to our non-payments, but noassurances can be given that the holders will not exercise their remedies inthe future.

 

***January 2008 Debentures***

*** ***

InJanuary 2008, we issued our January 2008 Debentures with an aggregateprincipal amount of $2.0 million. Under the terms of these debentures, we wereto begin making monthly redemption payments on September 1, 2008.  The maturity date of these debentures is January 31,2010.  The total monthly principalpayment amounts on our January 2008 Debentures are scheduled to be paid asfollows:

 

MonthlyPrincipal Payment Amount (in thousands)

 

| **Date**  | ** ** | **January 2008  Debentures** | ** **  |
|-----------|------------|-----------------------------------|-------------|
| 9/1/2008  |       | $                                 | 111         |   |
| 10/1/2008 |       | $                                 | 111         |   |
| 11/1/2008 |       | $                                 | 111         |   |
| 12/1/2008 |       | $                                 | 111         |   |
| 1/1/2009  |       | $                                 | 111         |   |
| 2/1/2009  |       | $                                 | 111         |   |
| 3/1/2009  |       | $                                 | 111         |   |
| 4/1/2009  |       | $                                 | 111         |   |
| 5/1/2009  |       | $                                 | 111         |   |
| 6/1/2009  |       | $                                 | 111         |   |
| 7/1/2009  |       | $                                 | 111         |   |
| 8/1/2009  |       | $                                 | 111         |   |
| 9/1/2009  |       | $                                 | 111         |   |
| 10/1/2009 |       | $                                 | 111         |   |
| 11/1/2009 |       | $                                 | 111         |   |
| 12/1/09   |       | $                                 | 111         |   |
| 1/1/2010  |       | $                                 | 111         |   |
| 1/31/2010 |       | $                                 | 113         |   |
|      |       | $                                 |  2,000 |   |

 

Assumingmonthly principal payments are made in accordance with the schedule set forthabove, the amount of interest to be paid through the January 31, 2010,maturity date is $240 thousand with respect to our January 2008Debentures, or on average, $13.3 thousand per month.

 

On March 2, 2009, Enable Growth Partners LP, theholder — with its affiliates - of the substantial majority of the January 2008and April 2008 Debentures, purchased the remainder of the January 2008Debentures from Hudson Bay Fund LTD and its affiliate; price terms were notdisclosed.  As a result of thistransaction, Enable Growth Partners LP and its affiliates own 100% of the January 2008Debentures.

 

Asof the filing date of this report, we have not made any of the payments due andwe do not have, or expect to have, cash on hand to make the past payments dueor any payments due in the near future. We are in regular communication with the holders of the January 2008Debentures and none of the holders have demanded payment or exercised otherremedies due to our non-payment, but no assurances can be given that theholders will not exercise their remedies in the future.

 

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***April 2008 Debentures***

 

InApril 2008, we issued our April 2008 Debentures with an aggregateprincipal amount of $3.5 million. Under the terms of these debentures, we areto begin making monthly redemption payments on November 1, 2008.  The maturity date of these debentures is April 30,2010. The total monthly principal payment amounts on our April 2008Debentures are scheduled to be paid as follows:

 

MonthlyPrincipal Payment Amount (in thousands)

 

| **Date**  | ** ** | **April 2008  Debentures** | ** **  |
|-----------|------------|---------------------------------|-------------|
| 11/1/2008 |       | $                               | 194         |   |
| 12/1/2008 |       | $                               | 194         |   |
| 1/1/2009  |       | $                               | 194         |   |
| 2/1/2009  |       | $                               | 195         |   |
| 3/1/2009  |       | $                               | 194         |   |
| 4/1/2009  |       | $                               | 195         |   |
| 5/1/2009  |       | $                               | 194         |   |
| 6/1/2009  |       | $                               | 195         |   |
| 7/1/2009  |       | $                               | 194         |   |
| 8/1/2009  |       | $                               | 195         |   |
| 9/1/2009  |       | $                               | 194         |   |
| 10/1/2009 |       | $                               | 195         |   |
| 11/1/2009 |       | $                               | 194         |   |
| 12/1/09   |       | $                               | 195         |   |
| 1/1/2010  |       | $                               | 194         |   |
| 2/1/2010  |       | $                               | 195         |   |
| 3/1/2010  |       | $                               | 194         |   |
| 4/1/2010  |       | $                               | 195         |   |
|      |       | $                               |  3,500 |   |

 

Assuming monthly principal payments are made in accordance with theschedule set forth above, the amount of interest to be paid through the April 30,2010, maturity date is $420 thousand with respect to our April 2008Debentures, or on average, $23.3 thousand per month.

 

On March 2, 2009, Enable Growth Partners LP, theholder — with its affiliates - of the substantial majority of the April 2008Debentures, purchased the remainder of the April 2008 Debentures fromHudson Bay Overseas Fund LTD; price terms were not disclosed.  As a result of this transaction, EnableGrowth Partners LP owns 100% of the April 2008 Debentures.

 

Asof the filing date of this report, we have not made any of the payments due andwe do not have, or expect to have, cash on hand to make the past due paymentsor any payments due in the near future. We are in regular communication withthe holders of the April 2008 Debentures and none of the holders havedemanded payment or exercised other remedies due to our non-payment, but noassurance can be given that the holders will not exercise their remedies in thefuture.

 

Becausewe do not meet the equity conditions that would permit us to pay interest andmonthly principal payments due in respect of our January 2008 and April 2008Debentures in stock, our only option at this time is to make these payments incash, which we currently do not have the financial resources to do.  We are evaluating other equity financingopportunities, the proceeds of which could be used to repay the debentures, butwe have no commitments or arrangements in place for future financing at thistime and we can give no assurance that such financing will be available onfavorable terms, or at all.

 

Becausewe have failed to make payments when due on our September 2007 notes andour January 2008 Debentures and April 2008 Debentures, we arecurrently in default under such securities. The holders of such securities may demand that all amounts duethereunder be immediately paid in cash, and with respect to our January Debenturesand April Debentures, the holders may demand that we pay 130 percent ofthe outstanding principal amount and the interest rate accrues at a rate equalto the lesser of 18% per annum or the maximum rate permitted under applicablelaw.  If such demand was made, then wewould not currently have the financial resources to make the paymentsowed.  In addition, the holders of our January Debenturesand April Debentures may have the right to foreclose on substantially allof our assets pursuant to the terms of the security agreement we entered intowith such holders and they would have the right to take possession of ourassets and operate our business. Although we are in regular communication with the holders of ouroutstanding debt 

 

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securitiesand none of them have demanded payment or exercised other remedies due to ourcurrent default under such securities, we can give no assurance that theholders will not make such demands or exercise their remedies in the future.

 

*Bridge Loans*

 

In the quarter ended March 31, 2009, andsubsequently in April 2009, we entered into a series of bridge loans withcertain purchasers of our New Series A Preferred stock, including $100,000with a related party, and with the holders of our January 2008 and April 2008Debentures.  In the aggregate thesebridge loans were for the principal amount of $655 thousand, which is estimatedto cover our operating expenses through June 2009.  These notes bear interest at ten percent perannum, and have maturities ranging from May 31, 2009, through October 31,2009.  The notes payable to the holdersof our New Series A Preferred stock were accompanied by 160,000 warrantsto purchase shares of our Common Stock at $0.75 per share, with a term of threeyears.  The notes payable to the holderof our January 2008 and April 2008 Debentures are subject to thesecurity interest granted to those holders in connection with those debentures.

 

*Series A Financing*

 

Beginning on December 3, 2008, and continuing inthe three months ended March 31, 2009, the Company closed a round offinancing for the sale of 843,333 shares of Series A Preferred Stock, foran aggregate purchase price of $632,500, at $0.75 per share, and 843,333warrants to purchase shares of common stock of the Company, at a price of $0.75per share, for a period of three years. This financing was lead by Daniel J.A. Kolke, founder, Chairman, and CEOof the Company, with participation from two of the Company’s directors andother prior and new investors. The holders of the January 2008 Debenturesand the April 2008 Debentures consented to this financing, but did notparticipate.

 

***Operating and Capital Leases***

 

Wehave non-cancelable leases for corporate facilities and equipment.  Rent expense under the leases totaled $5.7thousand and $66.1thousand for the quarters ended March 31, 2009 and 2008,respectively.  Future minimum rentalpayments required under non-cancelable leases are as follows for the twelvemonths ended December 31:

 
| ** **                                         | ** ** | **Operating  Leases** | ** ** | **Capital  Leases** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|---------------------|------------|
|                                               |       |                  |       |                |       |
| 2010                                               |       | —                |       | 13                  |       |
| 2011                                               |       | —                |       | 13                  |       |
| 2012                                               |       | —                |       | 11                  |       |
| 2013                                               |       | —                |       | —              |       |
| Total minimum lease payments                       |       | $                     | —     |                | $          | 37 |   |
| Less: amount representing interest                 |       |                  |       | (5                  | )          |
| Present value of minimum lease payments            |       |                  |       | 32                  |       |
| Less: current portion of capital lease obligations |       |                  |       | (11                 | )          |
| Long-term capital lease obligations                |       |                  |       | $                   | 21         |   |
|                                                    |            |                       |            |                     |            |  |  |

 

OnOctober 31, 2008, we closed our offices in San Mateo, California andabandoned the leased premises of our offices there. Also on October 31,2008, we relocated our Washington offices and abandoned the leased premises ofour former offices in Renton, Washington. The landlord for the San Mateo, California leased premises has asserteda claim against us for $659 thousand and other amounts and filed suit againstus in the Superior Court of San Mateo County, California (Case No. CIV479535).  We intend to defend thisclaim.  The landlord for the Renton,Washington location has not yet asserted any claim, but the assertion of suchclaims, and the need for us to defend such claims, is foreseeable.

 

**Off BalanceSheet Arrangements**

 

Wedid not have any off-balance sheet arrangements as of the period ended March 31,2009.

 

**GoingConcern Issue**

 

Weremain dependent on outside sources of funding until our results of operationsprovide positive cash flows.  Our independentauditors issued a going concern explanatory paragraph in their report dated April 24,2009. With our current level of funding, substantial doubt exists about ourability to continue as a going concern.

 

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Duringthe quarter ended March 31, 2009, we have been unable to generate cashflows sufficient to support our operations and have been dependent on debt andequity raised from qualified individual investors.

 

Thesefactors raise substantial doubt about our ability to continue as a goingconcern.  The financial statementscontained herein do not include any adjustments relating to the recoverabilityand classification of recorded asset amounts or amounts and classification ofliabilities that might be necessary should we be unable to continue inexistence.  Our ability to continue as agoing concern is dependent upon our ability to generate sufficient cash flowsto meet our obligations on a timely basis, to obtain additional financing asmay be required, and ultimately to attain profitable operations.  However, there is no assurance thatprofitable operations or sufficient cash flows will occur in the future.

 

Wehave supported current operations by raising additional operating cash throughthe private sale of our convertible debentures and preferred stock.  This has provided us with the cash inflows tocontinue our business plan, but has not resulted in significant improvement inour financial position. We are considering alternatives to address our cashflow situation that include: (1) raising capital through additional saleof our common stock and/or debentures and (2) reducing cash operatingexpenses to levels that are in line with current revenues.

 

Thefirst alternative could result in substantial dilution of existingstockholders. There can be no assurance that our current financial position canbe improved, that we can raise additional working capital, or that we canachieve positive cash flows from operations. Our long-term viability as a goingconcern is dependent upon our ability to (i) locate sources of debt orequity funding to meet current commitments and near-term future requirementsand (ii) achieve profitability and ultimately generate sufficient cashflow from operations to sustain our continuing operations.

 

**Recent Accounting Pronouncements**

 

InMay 2008, the FASB issued SFAS No. 162 (“SFAS 162”), *The Hierarchy of Generally Accepted Accounting Principles*. SFAS 162 identifies the sources of accounting principles and the framework forselecting principles to be used in the preparation of financial statements ofnongovernmental entities that are presented in conformity with generallyaccepted accounting principles in the United States.  SFAS 162 waseffective on November 15, 2008 and upon adoption of SFAS 162 there was nomaterial impact on our financial statements.

 

InMarch 2008, the FASB issued SFAS No. 161 (“SFAS 161”)*,Disclosures about Derivative Instruments and Hedging Activities-an amendment ofSFAS No. 133*. This new standard requires enhanceddisclosures for derivative instruments, including those used in hedgingactivities. SFAS 161 is effective for fiscal years and interim periods beginningafter November 15, 2008. We have determined the impact, if any, that theadoption of SFAS 161 will have no material impact on our financial statementsand related disclosures.

 

EffectiveJanuary 1, 2008, the Company adopted Statements of Financial AccountingStandards (“SFAS”) No.157, *Fair Value Measurements*,which defines fair value as the price that would be received from selling anasset or paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. SFAS 157 establishes guidelines formeasuring fair value and expands disclosures regarding fair value measurements.The adoption of SFAS 157 did not have an impact on the Company’s financialposition, results of operations, or cash flows.

 

TheCompany also adopted SFAS 159, *The FairValue Option for Financial Assets and Financial Liabilities—including anamendment of FASB Statement No. 115,*during the first quarterof fiscal 2009, but we did not elect the fair value measurement option for anyeligible financial instruments as of December 31, 2008. SFAS 159 allows anentity the irrevocable option to elect fair value for the initial andsubsequent measurement for certain financial assets and liabilities under aninstrument-by-instrument election. Subsequent measurements for the financialassets and liabilities an entity elects to fair value will be recognized inearnings. SFAS 159 also establishes additional disclosure requirements. Theadoption of SFAS 159 did not have any impact on the Company’s results ofoperations or the fair values of its financial assets and liabilities. We couldelect this option for new or substantially modified assets and liabilities inthe future.

 

In December 2007, the FASB issued SFAS No. 141(R), “*Business Combinations”* (FAS 141R), whichrequires an acquirer to measure the identifiable assets acquired, theliabilities assumed, and any noncontrolling interest in the acquiree at theirfair values on the acquisition date, with goodwill being the excess value overthe net identifiable assets acquired. FAS 141R is effective for financialstatements issued for fiscal years beginning after December 15, 2008.Also, in December 2007, the FASB issued SFAS No. 160, “*Noncontrolling Interests in Consolidated FinancialStatements,**an**amendment**ofARB No. 51”*  (FAS 160),which clarifies that a noncontrolling interest in a subsidiary should bereported as equity in the consolidated financial statements. The calculation ofearnings per share will continue to be based on income amounts 

 

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attributable to the parent. FAS 160 is effective for financialstatements issued for fiscal years beginning after December 15, 2008. Wehave determined that the adoption of SFAS 141R and SFAS 160 will haveno material impact on our financial position, cash flows, and results ofoperations.

 

In June 2008, the FASB issued FSP No. EITF 03-6-1, “*Determining Whether Instruments Granted in Share-BasedPayment Transactions Are Participating Securities*” (FSP EITF03-6-1), which requires entities to apply the two-class method of computingbasic and diluted earnings per share for participating securities that includeawards that accrue cash dividends (whether paid or unpaid) any time commonshareholders receive dividends and those dividends do not need to be returnedto the entity if the employee forfeits the award. FSP EITF 03-6-1 will beeffective for the Company on January 1, 2009, and will require retroactivedisclosure.  We have determined that theimpact of adopting FSP EITF 03-6-1 is not material to our financialposition, cash flows, and results of operations.

 

Effective January 1, 2009, the Companyadopted Emerging Issues Task Force (“EITF”) Issue 07-05 *Determining Whether an Instrument (or EmbeddedFeature) is Indexed to an Entity’s Own Stock*(“EITF 07-05”), which provide guidance for determining whetheran equity linked financial instrument (or embedded feature) isindexed to an entity’s own stock. The adoption of EITF 07-05 did not havematerial impact on the Company’s financial position, results of operations, orcash flows.

 

**Item3.    QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

** **

Intentionally omitted pursuant to Item 305(e) ofRegulation S-K.

 

**Item4.**    CONTROLS ANDPROCEDURES

** **

Disclosure controls and procedures are controls and other proceduresthat are designed to ensure that the information required to be disclosed by acompany in the reports that it files or submits under the Securities andExchange Act of 1934, or the “Exchange Act,” is recorded, processed, summarizedand reported, within the time periods specified in the rules and forms ofthe SEC. Disclosure controls and procedures include, without limitation,controls and procedures designed to ensure that information required to bedisclosed in the reports that a company files or submits under the Exchange Actis accumulated and communicated to the company’s management, including itsprincipal executive officer and principal accounting officer, as appropriate toallow timely decisions regarding required disclosure.

 

As required by Exchange Act Rule 13a-15(b), we carried out anevaluation, under the supervision and with the participation of our management,including our chief executive officer and chief financial officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures as of March 31, 2009, the end of the period covered by thisreport. Based on that evaluation, our chief executive officer and chieffinancial officer concluded that our disclosure controls and procedures werenot effective at the reasonable assurance level as of March 31, 2009,because of certain material weaknesses in our internal controls over financialreporting.

 

Because of these weaknesses, we cannot provide reasonable assurancesthat all information required to be disclosed in our reports filed with the SECwill be accumulated and communicated to our management to allow for timelydecisions regarding required disclosure.  Please see the internal controlsdiscussion in our Form 10-K that we filed with the SEC on April 29,2009 for more information regarding the weaknesses of our internal controlsover financial reporting.

 

Furthermore, due to the resignation of our vice president &chief financial officer, and the lack of a replacement at this time, we areunable to assure that we have adequate and appropriate controls in place, orthat the controls that we do have in place are being managedappropriately.  We will attempt to engage additional appropriateprofessionals to evaluate and manage our controls as soon as financialresources permit, but there is no assurance when, or if, that will be possiblein the foreseeable future.

 

**Changes In Internal Controls Over FinancialReporting.**

 

No changes were made in our internal control over financial reporting(as defined in Rules 13a-15(f) and 15d-15(f) of the ExchangeAct) during our most recent fiscal quarter that has materially affected, or islikely to materially affect, our internal control over financial reporting.

 

**Limitations On Disclosure Controls And Procedures.**

 

Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, within our company have been detected. Thedesign of any system of controls is based in part upon a cost-benefit analysisand certain assumptions about the likelihood of future events and any designmay not succeed in achieving its stated goals under all potential futureconditions. While our management does not believe that our controls willprevent all errors or all instances of fraud, our disclosure controls andprocedures are designed to provide a reasonable assurance of achieving theirobjectives.

 

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**PART II**—**OTHER INFORMATION**

 

**Item 1.    LEGAL PROCEEDINGS**.

 

From time to time, we become subject to various legalproceedings and claims, both asserted and unasserted, that arise in theordinary course of business. Litigation in general, and securities litigationin particular, can be expensive and disruptive to normal business operations.Moreover, the results of legal proceedings are difficult to predict. Anunfavorable resolution of one or more of these lawsuits would materiallyadversely affect our business, results of operations, or financial condition.We accrue legal costs when incurred.  Theneed to defend any such claims could require payments of legal fees and ourlimited financial resources could severely impact our ability to defend anysuch claims.

 

In June 2008, Kaufman Bros. L.P. filed suitagainst us in the United States District Court for the Southern District of NewYork (Case No. 80 CV 5716) and sought a temporary restraining order andother extraordinary relief.  The complaint arises out of an advisoryservices agreement, pursuant to which Kaufman Bros. was to provide us withadvisory services in connection with financings and strategic transactions. Wenotified Kaufman Bros. that we believed it had failed to provide the requiredservices under the agreement, and that we were therefore entitled to terminatethe agreement for cause. In the suit, Kaufman Bros. was seeking (i) monetarydamages of $400,000 for anticipatory breach of the agreement; (ii) $73,800in fees allegedly owed in connection with a previously closed financingtransaction; (iii) and injunction prohibiting us from cancelling anyshares issued to Kaufman Bros. as compensation, (iv) a declaration fromthe court that we are not entitled to a refund of any fees previously paid toKaufman Bros., and (v) a declaration that we are obligated to pay KaufmanBros. a commission on any financing or transaction that we enter into within 18months following the termination of the agreement.  On July 15, 2008,Kaufman Bros. voluntarily filed a notice of dismissal without prejudice. Settlement discussions were unsuccessful and, on July 31, 2008, KaufmanBros. re-filed substantially the same claims in the Supreme Court of New York -County of New York (Index No. 08-602239). Effective on December 5,2008, the Company entered into a settlement agreement with Kaufman Bros.,pursuant to which (i) the Company agreed to pay to Kaufman Bros. $210,000,in twelve monthly installments of $17,500; (ii) the Company issued toKaufman Bros. warrants to purchase 500,000 shares of the Company’s common stockat an exercise price of $0.75 per share, which warrants have a term of fiveyears; (iii) the Company and Kaufman Bros. agreed immediately to terminateall provisions, terms and conditions of the advisory services agreement andexchanged mutual releases; and (iv) Kaufman Bros. agreed to dismiss thepending lawsuit in the Supreme Court of New York, without prejudice. Subsequentto entering into the settlement agreement, we have not fully complied with ourpayment obligations under the settlement agreement but, through the date offiling of this report, Kaufman Bros. has not exercised any of its remedies fordefault under the settlement agreement.

 

On October 31, 2008, the Company closed itsoffices in San Mateo, California and abandoned the leased premises of itsformer offices there.  The landlord forthese premises has asserted a claim for $659 thousand for alleged unpaid rentand other amounts, and filed a proceeding in the Superior Court of San MateoCounty, California (Case No. CIV 479535) on December 19, 2008.  This matter is pending and the Company intendsto defend its position.

 

As part of our reduction of monthly cash operatingexpenses during the quarter ending September 30, 2008, and continuingafter the end of the quarter, we placed all employees on partial deferrals ofsalary, ranging from 10% to 100% of base salary.  At the end of the quarter, until the date ofthis filing, a substantial part of this deferral amount remains unpaid,including amounts due to employees who subsequently were terminated.  No employee has asserted a claim or demandfor immediate payment of these unpaid amounts but the assertion of such claimsor demands by such employees, or by governmental authorities, is foreseeable.

 

In connection with our reverse merger, multiplefinancings, and protection of our intellectual property, we have incurredsubstantial accounts payable to law firms that remain unpaid and overdue.  We have been in communication with thesevendors and expect to enter into negotiated payment plans with these vendors,and others, but there is no assurance that we will be successful in thesenegotiations, or that we will be able to make payments under such plans if andwhen negotiated.  Therefore the assertionof claims by these vendors for these amounts due and owing could become thesubject of claims in litigation.

 

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**Item1A            RISKFACTORS**.

 

Investment in our common stock involves a high degree of risk. You shouldcarefully consider the risks described below together with all of the otherinformation included in this report before making an investment decision. Ifany of the following risks actually occur, our business, financial condition orresults of operations could suffer. In that case, the market price of ourcommon stock could decline, and you may lose all or part of your investment.

 

***Our current cash will fund our business as currently planned onlythrough June 2009. We need additional funding or we will be forced tocurtail or cease operations.***

 

We need immediate and substantial cash to continue our operations. Wecurrently have no funding commitments. Management has projected that cash onhand will be sufficient to allow us to continue our operations only through June 2009.  We have not made required payments under ouroutstanding debt securities and the holders of our outstanding debt securitieshave the right to demand payment of the amounts currently due under suchsecurities or exercise their other remedies, such as foreclosing on ourassets.  We also need to negotiatepayment plans for certain payables and there is a risk that trade creditorswill not accept deferred payment and exercise other remedies to collectbalances due and owing. We therefore will need additional funding, eitherthrough equity or debt financings, or we will be forced to curtail or ceaseoperations or consider other strategic alternatives such as bankruptcy.

 

***We have a limited operating history, have experienced significant expendituresrelated to funding our initial product development, and are currently carryinga net loss.  If our business model is notsuccessful, or if we are unable to generate sufficient revenue to offset ourstart-up expenditures, then we may not become profitable and you may lose yourentire investment in our company.***

 

We began our operations in 1999 but we did not adopt the SaaS on-demandWeb Applications delivery model until 2005, and further changed our businessmodel beginning in the quarter ended December 31, 2008. As such, we have alimited operating history in the SaaS industry in general, and even morelimited experience with our new business model, from which to evaluate ourbusiness and prospects.  We incurred a netloss of $35 thousand for the quarter ended March 31, 2009, and $77thousand for the quarter ended March 31, 2008, and have an accumulateddeficit of $36.2 million at Marc h 31, 2009. We cannot assure you that our future planned operations will beimplemented successfully or that we will ever have profits.  Furthermore, we are experiencing the initialcosts and uncertainties of a young operating company, including start-upexpenditures, unforeseen costs and difficulties, complications, and delays, allof which must be resolved and/or paid without the benefit of a predictablerevenue stream.  We cannot be sure thatwe will be successful in meeting these challenges and addressing these risksand uncertainties.  If we are unable todo so, then we may be required to scale back our business, sell or license someor all of our technology or assets, or curtail or cease operations.

 

***We do not have sufficient current cash to pay the principal and accruedinterest amounts due under our outstanding debt securities.***

 

The debentures we issued require monthly principal payments equal to1/18th of the principal amount due under each debenture.  The debentures accrue interest at the rate ofsix percent per annum, payable quarterly and on each monthly principal payment.  We have not made certain payments as requiredby the terms of the debentures, and do not expect to have the ability to do soin the near future.

 

We are currently in default of our debentures because of our failure tomake certain payments when due.  As aresult the holders of the debentures have the right to accelerate all amountsoutstanding under the debentures and demand payment of a mandatory defaultamount equal to 130 percent of the amount outstanding under the debenture, plusaccrued interest and expenses.  If suchdemand was made, we would be unable to repay the mandatory default amount, andthe holders could commence legal action against us.  Any such action could impose significantcosts on us and require us to curtail or cease operations.

 

In addition, as a result of being in default under our January Debenturesand April Debentures, the holders may have the right to foreclose onsubstantially all of our assets pursuant to the terms of the security agreementwe entered into with such holders and they would have the right to take possessionof our assets and operate our business. Though we are in regular communication with the holders of ouroutstanding debt securities, and none of them have demanded payment orexercised other remedies due to our current default under such securities, wecan give no assurances that the holders will not exercise their remedies in thefuture.

 

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***Our limited operating history may not serve as an adequate basis tojudge our future prospects and results of operations.***

 

We began our operations in 1999 but we did not adopt the SaaS on-demandWeb Application delivery model until 2005, and we have recently changed ourbasic business model. Our limited operating history in the SaaS industry maynot provide a meaningful basis on which to evaluate our business. Since ourinception our revenues have not always grown from year to year.  We cannot assure you that we will achieve ourgrowth targets, or that we will achieve positive cash-flow or profitability, orthat we will not incur negative cash flow or net losses in the future. Weexpect that our operating expenses will increase as we expand. Any significantfailure to realize anticipated revenue growth could result in significantoperating losses beyond our forecasts. We will continue to encounter risks anddifficulties frequently experienced by companies at a similar stage ofdevelopment, including our potential failure to:

 

·                  maintainand improve our technology;

 

·                  expandour product and service offerings and maintain the high quality of products andservices offered;

 

·                  sellsubscriptions to our products and offerings by our Syndication Partners tosufficient, quality customers to produce revenues adequate to meet ouroperating needs;

 

·                  manageour expanding operations, including the integration of any future acquisitions;

 

·                  obtainsufficient working capital to support our expansion and to fill customers’orders in time;

 

·                  maintainadequate control of our expenses;

 

·                  implementour product development, marketing, sales, and acquisition strategies and adaptand modify them as needed; and/or

 

·                  anticipateand adapt to changing conditions in the markets in which we operate as well asthe impact of any changes in government regulation, mergers and acquisitionsinvolving our competitors, technological developments, and other significantcompetitive and market dynamics.

 

If we are not successful in addressing any or all of these risks, thenour business may be materially and adversely affected.

 

***We may encounter substantial competition in our business and ourfailure to compete effectively may adversely affect our ability to generaterevenue.***

 

We believe that existing and new competitors will continue to improvethe design and performance of their products and to introduce new products withcompetitive price and performance characteristics. We expect that we will berequired to continue to invest in product development and productivityimprovements to compete effectively in our markets. Our competitors coulddevelop better technology or more efficient products or undertake moreaggressive and costly marketing campaigns than ours, which may adversely affectour marketing strategies and could have a material adverse effect on ourbusiness, results of operations, and financial condition.

 

Our major competitors may be better able than us to successfully enduredownturns in our markets. In periods of reduced demand for our products, we caneither choose to maintain market share by reducing our subscription prices tomeet competition or maintain subscription prices, which likely would result insacrifice of our market share. Sales and overall profitability would be reducedand sustained losses may continue in either case. In addition, we cannot beassured that additional competitors will not enter our existing markets, orthat we will be able to compete successfully against existing or newcompetition.

 

***We have a history of losses and we may not achieve profitability in thefuture.***

 

We have not been profitable on a quarterly or annual basis since ourformation. Our operations resulted in a net loss of $6.4 million for thequarter ended March 31, 2009 and $2.2 million for the quarter ending March 31,2008. As of March 31, 2009, our accumulated deficit was $36.2million.  We expect to make significantfuture expenditures related to the development and expansion of our business.In addition, as a public company, we will incur significant legal, accounting,and other expenses that we did not incur as a private company. As a result ofthese increased expenditures, we will have to 

 

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generate and sustain increased revenue to achieve and maintain futureprofitability. While our revenue has grown somewhat in recent periods, thatgrowth has not been significant and future revenue growth may not besustainable and we may not achieve sufficient revenue to achieve or maintainprofitability. We have incurred and may continue to incur significant losses inthe future for a number of reasons, including due to the other risks describedin this report, and we may encounter unforeseen expenses, difficulties,complications, delays, and other unknown factors. Accordingly, we may not beable to achieve or maintain profitability and we may continue to incursignificant losses for the foreseeable future.

 

***The market for on-demand Web Applications may develop more slowly thanwe expect.***

 

Our success will depend, to a large extent, on the willingness ofindividuals and SMBs to accept on-demand services for Web Applications thatthey view as critical to the success of their business. Many businesses haveinvested substantial effort and financial resources to integrate traditionalenterprise software into their businesses and may be reluctant or unwilling toswitch to a different application or to migrate these applications to on-demandWeb Applications.

 

Other factors that may affect market acceptance of our Web Applicationsinclude our ability to:

 

·                  minimizethe time and resources required to implement products distributed through anEtelos Marketplace;

 

·                  maintainhigh levels of customer satisfaction;

 

·                  implementupgrades and other changes to our products without disrupting our service;and/or

 

·                  providerapid response time during periods of intense activity on customer websites.

 

In addition, market acceptance of our Web Applications may be affectedby:

 

·                  thesecurity capabilities, reliability, and availability of on-demand services;

 

·                  customerconcerns with entrusting a third party to store and manage their data,especially confidential or sensitive data;

 

·                  thelevel of customization or configuration we offer; and/or

 

·                  theprice, performance, and availability of competing products and services.

 

***The market for our products may not develop further, or it may developmore slowly than we expect, either of which would harm our business.***

 

The market in which we participate is intensely competitive, and if wedo not compete effectively, then our operating results may be harmed.  The market for SaaS on-demand WebApplications for business is highly competitive and rapidly changing withrelatively low barriers to entry. With the introduction of new technologies andnew market entrants, we expect competition to intensify in the future. Inaddition, pricing pressures and increased competition generally could result inreduced sales, reduced margins, or the failure of our products to achieve ormaintain more widespread market acceptance. Often we offer products in anEtelos Marketplace that compete against existing systems that our potentialcustomers have already made significant expenditures to install. Competition inour market is based principally upon service breadth and functionality; serviceperformance, security and reliability; ability to tailor and customize servicesfor a specific company, vertical or industry; ease of use of the service, speedand ease of deployment, integration and configuration; total cost of ownership,including price and implementation and support costs; professional servicesimplementation; and financial resources of the vendor.

 

We face competition from both traditional software vendors and otherSaaS providers. Many of our actual and potential competitors enjoy substantialcompetitive advantages over us, such as greater name recognition, longeroperating histories, more varied products and services, and larger marketingbudgets, as well as substantially greater financial, technical, and otherresources. In addition, many of our competitors have established marketingrelationships and access to larger customer bases, and have major distributionagreements with consultants, system integrators, and resellers. If we are notable to compete effectively, then our operating results will be harmed.

 

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***Our inability to fund our capital to meet our expenditure requirementsmay adversely affect our growth and profitability.***

 

Our continued growth is dependent upon our ability to raise capitalfrom outside sources. Our ability to obtain financing will depend upon a numberof factors, including our financial condition and results of operations, thecondition of the economy, and conditions in relevant financial markets.  If we are unable to obtain financing, asneeded, on a timely basis and on acceptable terms, our financial position,competitive position, growth, and profitability may be adversely affected.  The current state of the US and globaleconomy raises substantial doubts, especially about our ability to raise theadditional capital that we will need to sustain our business operations.

 

***We have reduced our employment force and have challenges meeting ouroperating demands.***

 

We have decreased our number of full-time employees from 46 at June 30,2008, to 13 as of March 31, 2009. All of these remaining employees are on deferred salary, ranging from10% to 100% of base salary, and there is no assurance that any of thesepersonnel will be able to continue to work on this payment arrangement. Ouroperating plan has placed, and our anticipated growth plan is expected tocontinue to place, a significant strain on our very limited managerial,administrative, operational, financial, and other resources, compounded bythese recent reductions in headcount. Although we will be required to continueto improve our operational, financial, and management controls and ourreporting procedures it is clear that we may not be able to do so effectivelyand may not be able to recruit or retain adequate, qualified personnel to meetour operating demands. As such, we may be unable to manage our expenseseffectively in the future, which may negatively impact our gross margins oroperating expenses in any particular quarter.

 

***Our customers are individuals, small and medium-sized businesses, anddivisions of large companies, which may increase our costs to reach, acquireand retain customers.***

 

We market and distribute our products and services and other offeringsin Etelos Marketplaces to individuals, SMBs, and divisions of large companies.To grow our revenue quickly, we must add new customers, sell additionalservices to existing customers, and encourage existing customers to renew theirsubscriptions. However, selling to and retaining individuals and SMBs can bemore difficult than selling to and retaining large enterprises because SMBcustomers tend to be more price sensitive and more difficult to reach withbroad marketing campaigns.  In addition,individuals and SMBs have high churn rates in part because of the nature oftheir businesses and often lack the staffing to benefit fully from ourproducts.  Further, individuals and SMBsoften require higher sales, marketing, and support expenditures by vendors thatsell to them per revenue dollar generated for those vendors.

 

***Many of our customers are price sensitive, and if the prices that we orour Syndication Partners charge for subscriptions to products or servicesoffered in an Etelos Marketplace are unacceptable to our customers, then ouroperating results will be harmed.***

 

Many of our customers are price sensitive, and we have limitedexperience with respect to determining the appropriate prices for our productsor services. In addition, we have no control over prices charged by ourSyndication Partners for their products or services offered in an EtelosMarketplace. As the market for our products or services matures, or as newcompetitors introduce new products or services that compete with ours, we maybe unable to renew agreements with existing customers or attract new customersat the same price or based on the same pricing model as previously used. As aresult, it is possible that competitive dynamics in our market may require usto change pricing models or reduce prices, which could harm our revenue, grossmargin, and operating results.

 

***We may not be able to prevent others from unauthorized use of ourpatents and other intellectual property, which could harm our business andcompetitive position.***

 

Our success depends, in part, on our ability to protect our proprietarytechnologies. We own multiple filed United States and foreign patentapplications covering our technology and we expect to file more U.S. andforeign patent applications in the future. We have filed to protect most ofthose patents in many foreign countries. But the process of seeking patent protectioncan be lengthy and expensive and we cannot assure that our patent applicationswill result in patents being issued, or that our existing or future issuedpatents will be sufficient to provide us with meaningful protection orcommercial advantages.  We also cannotassure that our current or potential competitors do not have, and will notobtain, patents that will prevent, limit or interfere with our ability to make,use or sell our technology or operate an Etelos Marketplace.

 

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***Our success depends in largepart on our ability to protect and enforce our intellectual property rights.***

 

We rely on a combination of patent, copyright, service mark, trademark,and trade secret laws, as well as confidentiality procedures and contractualrestrictions, to establish and protect our proprietary rights on a globalbasis, all of which provide only limited protection. We cannot assure you thatany patent will issue from our currently pending patent applications in amanner that gives us the protection that we seek, if at all, or that any futurepatents issued to us will not be challenged, invalidated, or circumvented.Since the filing of some of these patent applications may have been, or willbe, made after the date of first sale or disclosure of the subject inventions,patent protection may not be available for these inventions outside the UnitedStates.  Any patents that may issue inthe future may not provide sufficiently broad protection or they may not proveto be enforceable in actions against alleged infringers. Also, we cannot assureyou that any future service mark or trademark registrations will be issued forpending or future applications or that any registered service marks ortrademarks will be enforceable or provide adequate protection of our domesticand foreign proprietary rights.

 

We have not maintained operating controls or logs, or initiated orconducted any forensic, code history, ‘genealogy’ or other forms of audit,analysis, processes, training, or code review of software code incorporatedinto any Etelos product or in other products offered by Syndication Partners inan Etelos Marketplace. We do not review the intellectual property rightsrelated to products or services offered by Syndication Partners in an EtelosMarketplace. These products may include code subject to various forms of ‘opensource’, ‘copyleft’, or similar licenses that require as a condition ofmodification or distribution of software subject to such license(s) that (i) suchsoftware or other software combined or distributed with such software bedisclosed or distributed in source code form, or (ii) such software orother software combined or distributed with such software, and any relatedintellectual property, be licensed on a royalty-free basis, including for thepurposes of making additional copies or derivative works of such software.  This may adversely affect our ability topatent certain inventions or to license or distribute certain products -whether by open source license or other form of license or right - and mayresult in liability to unknown parties for infringement of their patents orother intellectual property rights.

 

***We require our Syndication Partners to indemnify us for intellectualproperty claims but we cannot assure that these agreements will be enforceable.***

 

We endeavor to enter into agreements with our employees and contractorsand agreements with parties with whom we do business to limit access to anddisclosure of our proprietary information. The steps we have taken, however,may not prevent unauthorized use or the reverse engineering of our technology.Moreover, others may independently develop technologies that are competitive toours or infringe our intellectual property. Enforcement of our intellectualproperty rights also depends on our successful legal actions against theseinfringers, but these actions may not be successful, even when our rights havebeen infringed.  In addition, the legalstandards relating to the validity, enforceability, and scope of protection ofintellectual property rights in Internet-related industries are uncertain andstill evolving.

 

***Assertions by third parties that we infringe their intellectualproperty, whether successful or not, could subject us to costly andtime-consuming litigation or expensive licenses.***

 

The software and technology industries are characterized by theexistence of a large number of patents, copyrights, trademarks, and tradesecrets and by frequent litigation based on allegations of infringement orother violations of intellectual property rights. As we face increasingcompetition, the possibility of intellectual property rights claims against usmay grow; the costs of defending against such claims can be very large. Ourtechnologies may not be able to withstand any third-party claims or rightsagainst their use. Additionally, many of our partner and product agreementsrequire us to indemnify our customers for certain third-party intellectual propertyinfringement claims, which could increase our costs as a result of defendingsuch claims and may require that we pay damages or purchase expensive licenses,if there were an adverse ruling related to any such claims. These types ofclaims could harm our relationships with our customers, may deter futurecustomers from subscribing to our services, or could expose us to litigationfor these claims. Even if we are not a party to any litigation between acustomer and a third party, an adverse outcome in any such litigation couldmake it more difficult for us to defend our intellectual property in anysubsequent litigation in which we are a named party.

 

Any intellectual property rights claim against our customers, or us,with or without merit, could be time-consuming, expensive to litigate orsettle, and could divert management attention and financial resources. Anadverse determination also could prevent us from offering our products to ourcustomers and may require that we procure or develop substitute services thatdo not infringe.

 

For any intellectual property rights claim against us or against ourMarketplace Partners or customers, we may have substantial direct and indirectcosts.  Direct costs can include arequirement to pay damages or stop using technology found to be in violation ofa third party’s rights. We may have to purchase a license for the technology,which may not be available on reasonable terms, if at all, may significantlyincrease our operating expenses, or may require us to restrict our 

 

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business activities in one or more respects. As a result, we may alsobe required to develop alternative non-infringing technology, which couldrequire significant effort and expense. Substantial indirect costs also may be expected in the form of diversionof development and management resources in strategic planning for legal,technology, and business defenses to such claims.

 

***We rely on our management team and need additional personnel to growour business, and the loss of one or more key employees or our inability toattract and retain qualified personnel could harm our business.***

 

Our success and future growth depends to a significant degree on theskills and continued services of our management team, especially Daniel J.A.Kolke, our interim Chief Executive Officer, Acting Chief Financial Officer, andChairman of the Board. The loss of the services of any member of our managementteam for any reason may have a material adverse effect on our business andprospects.  We do not maintain key maninsurance on any members of our management team, including Mr. Kolke.

 

Subsequent to the termination of our former Chief Executive Officer, wesignificantly and materially reduced our management team and have not hiredreplacements for the management team in the positions of Vice President andChief Financial Officer, Vice President — Marketing, Vice President CorporateDevelopment, and Vice President — Human Resources, as well as several otherDirector-level positions, primarily in non-technical positions throughout theCompany.  We did not fill these positionsin the period ending March 31, 2009, and we have not filled any of thesepositions to the date of this report.

 

Our future success also depends on our ability to attract, retain andmotivate highly skilled technical, managerial, sales, marketing and service andsupport personnel, including members of our management team. Competition forsales, marketing, and technology development personnel is particularly intensein the software and technology industries. As a result, we may be unable tosuccessfully attract or retain qualified personnel. Our inability to attractand retain the necessary personnel could harm our business.

 

***If we do not effectively expand and train our sales force and ourservices and support teams, then we may be unable to add new customers andretain existing customers.***

 

We plan to expand our sales force and our services and support teams toincrease our customer base and revenue. We believe that there is significantcompetition for sales, service, and support personnel with the skills andtechnical knowledge that we require. Our ability to achieve significant revenuegrowth will depend, in part, on our success in recruiting, training, andretaining sufficient numbers of personnel to support our growth. New hiresrequire significant training and, in most cases, take significant time beforethey achieve full productivity. Our recent hires and planned hires may notbecome as productive as we expect and we may be unable to hire or retainsufficient numbers of qualified individuals in the markets where we dobusiness. If these expansion efforts are not successful or do not generate acorresponding increase in revenue, then our business will be harmed.

 

***If we are unable to cost-effectively market and distribute our productsto our target customers, then our ability to grow our revenue quickly and becomeprofitable will be harmed.***

 

Our quarterly operating results may fluctuate in the future. As aresult, we may fail to meet or exceed the expectations of research analysts orinvestors, which could cause our stock price to decline. Also period-to-periodcomparisons of our operating results may not be meaningful. You should not relyon the results of one quarter as an indication of future performance.

 

Fluctuations in our quarterly operating results may be due to a numberof factors, including the risks and uncertainties discussed elsewhere in thisreport. Fluctuations in our quarterly operating results could cause our stockprice to decline rapidly, may lead analysts to change their long-term model forvaluing our common stock, could cause us to face short-term liquidity issues,may impact our ability to retain or attract key personnel, or cause otherunanticipated issues. If our quarterly operating results fall below theexpectations of research analysts or investors, then the price of our commonstock could decline substantially.

 

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***We use third-party data centers to support our services. Any disruptionof service at these facilities could interrupt or delay our ability to deliverour service to our customers.***

 

We host many of our services and serve a significant number of ourcustomers from third-party data center facilities with Network OS, located inthe greater Seattle Washington area. We do not control the operation of thesefacilities. These facilities may be vulnerable to damage or interruption fromearthquakes, hurricanes, floods, fires, terrorist attacks, power losses,telecommunications failures, and similar events. These facilities also could besubject to break-ins, computer viruses, sabotage, intentional acts of vandalismand other misconduct. The occurrence of a natural disaster or an act ofterrorism, a decision to close the facilities without adequate notice, or otherunanticipated problems could result in lengthy interruptions in our services.

 

Our data center facility providers have no obligation to renew theiragreements with us on commercially reasonable terms, or at all. If we areunable to renew our agreements with any facility provider on commerciallyreasonable terms, then we may experience increased costs or downtime inconnection with the transfer to a new data center facility.

 

Any errors, defects, disruptions, or other performance problems withour services could harm our reputation and may damage our customers’businesses. Interruptions in our services might reduce our revenue, cause us toissue credits to customers, subject us to potential liability, cause customersto terminate their subscriptions, and harm our renewal rates.

 

***Any significant fluctuation in price of servers or related support mayhave a material adverse effect on the cost of our products and services.***

 

The prices of servers and related support are subject to marketconditions and generally we do not, and do not expect to, have long-termcontracts with our suppliers for those items. While these items are generallyavailable and we have not experienced any shortage in the past, we cannotassure you that the necessary servers or support will continue to be availableto us at prices currently in effect or acceptable to us. The prices for theseitems have varied significantly in the past and may vary significantly in thefuture. Numerous factors, most of which are beyond our control, influenceprices of servers and related support. These factors include general economicconditions, industry capacity utilization, vendor backlogs and delays and otheruncertainties.

 

We may not be able to adjust our product prices, especially in the short-term,to recover cost increases in these items. Our future profitability may beadversely affected to the extent we are unable to pass on higher server andsupport related costs to our customers.

 

***We may become liable to our customers and lose customers if we havedefects or disruptions in our products and services or if we provide poorservice.***

 

Because we deliver products as a service through an Etelos Marketplace,errors or defects in the Web Applications underlying the service, or a failureof our hosting infrastructure may make the service unavailable to ourcustomers. Because our customers use the products to manage critical aspects oftheir business, any errors, defects, disruptions in service, or otherperformance problems with the products, whether in connection with theday-to-day operation of the products, upgrades or otherwise, could damage ourcustomers’ businesses. If we have any errors, defects, disruptions in service,or other performance problems with the products, then customers could elect notto renew their subscriptions or delay or withhold payment to us. As a result,we could lose future sales or customers may make warranty claims against us orour Syndication Partners, which could result in an increase in our provisionfor doubtful accounts, an increase in collection cycles for accountsreceivable, or costly litigation.

 

***If our security measures are breached and unauthorized access isobtained to a customer’s data, then we may incur significant liabilities, ourservice may be perceived as not being secure, and customers may curtail or stopusing our products.***

 

The products and services we offer in an Etelos Marketplace involve thestorage of large amounts of our customers’ sensitive and proprietary businessinformation. If our security measures are breached as a result of third-partyaction, employee error, malfeasance, or otherwise, and someone obtainsunauthorized access to our customers’ data, then we could incur significantliability to our Syndication and Marketplace Partners, our customers, and toindividuals or businesses whose information was being stored by our customers,our business may suffer and our reputation may be damaged. Because techniquesused to obtain unauthorized access to, or to sabotage, systems changefrequently and generally are not recognized until launched against a target, wemay be unable to anticipate these techniques or to implement adequatepreventive measures. If an actual or perceived breach of our security occurs,then the market perception of the effectiveness of our security measures couldbe harmed and we could lose sales and customers.

 

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***If we are unable to develop new products or services, distribute ourproducts or services into new markets, or add Syndication Partners to offertheir products or services for distribution in an Etelos Marketplace, then ourrevenue growth will be harmed and we may not be able to achieve profitability.***

 

Our ability to attract new customers and to increase revenue fromexisting customers will depend in large part on our ability to enhance andimprove our existing products and to add new Marketplace Partners and newSyndication Partners to offer their products and services and distribute intonew markets. The success of any enhancement or new Syndication Partner offeringdepends on several factors, including the timely completion, introduction, andmarket acceptance of the enhancement, product or service. Any new product orservice offered by a Syndication Partner or that we develop or acquire may notbe introduced in a timely or cost-effective manner and may not achieve thebroad market acceptance necessary to generate significant revenue. Any newmarkets into which we attempt to distribute our products or services may not bereceptive. If we are unable to successfully develop or acquire new products orservices, enhance our existing products and services to meet customerrequirements, or distribute our products and services into new markets, thenour revenue will not grow as expected and we may not be able to achieveprofitability.

 

***If we fail to maintain proper and effective internal controls or areunable to remediate the material weakness in our internal controls, then ourability to produce accurate and timely financial statements could be impairedand investors’ views of us could be harmed.***

 

Ensuring that we have adequate internal financial and accountingcontrols and procedures in place so that we can produce accurate financialstatements on a timely basis is a costly and time-consuming effort that needsto be re-evaluated frequently. Our internal control over financial reporting isa process designed to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements in accordancewith generally accepted accounting principles.

 

During our audit for the year ended December 31, 2008, weidentified material weaknesses in our internal controls. The materialweaknesses relate to the absence of specific policies and procedures for someaccounting functions and the need for accounting personnel who possess theskill sets necessary to operate and report as a public company, and specificallythe skills necessary to ensure that adequate review of critical accountreconciliations is performed and that supporting documentation is complete,accurate, and in accordance with generally accepted accounting principles. Ourfinancial position and limited resources make it difficult for us to addressthese weaknesses.  If we fail to addressthese material weaknesses or if additional material weaknesses in our internalcontrols are discovered in the future, then we may fail to meet our futurereporting obligations, our financial statements may contain materialmisstatements and the price of our common stock may decline.

 

Implementing any appropriate changes to our internal controls maydistract our officers and employees, entail substantial costs to modify ourexisting processes, and add personnel and take significant time to complete.These changes may not, however, be effective in maintaining the adequacy of ourinternal controls, and any failure to maintain that adequacy, or consequentinability to produce accurate financial statements on a timely basis, couldincrease our operating costs and harm our business. In addition, investors’perceptions that our internal controls are inadequate or that we are unable toproduce accurate financial statements on a timely basis may harm our stockprice and make it more difficult for us to effectively market and distributeour products and services to new and existing customers.

 

***Material defects or errors in the software we use to deliver ourproducts and services and the offerings by our Marketplace and SyndicationPartners could harm our reputation, result in significant costs to us, andimpair our ability to distribute our services.***

 

The Web Applications underlying the offerings in an Etelos Marketplaceare inherently complex and may contain material defects or errors, particularlywhen first introduced or when new versions or enhancements are released. Wehave, from time to time, found defects in our products and services, and newerrors in our existing software and services may be detected in the future. Wehave no actual knowledge, but we reasonably expect that the products andservices offered by our Syndication Partners may have similar errors and/ordefects. Any errors or defects that cause interruptions to the availability ofour services and the services for our Marketplace Partners could result in:

 

·                  areduction in sales or delay in market acceptance of services from us or ourMarketplace Partners;

 

·                  salescredits or refunds to our customers and customers of our Marketplace Partners;

 

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·                  lossof existing customers and difficulty in attracting new customers;

 

·                  diversionof development resources;

 

·                  harmto our reputation, or the reputation of our Marketplace Partners; and/or

 

·                  increasedwarranty and insurance costs.

 

After the release of our services, defects or errors may also beidentified from time to time by our internal team, our Marketplace andSyndication Partners, and by our customers. The costs incurred in correctingany material defects or errors in such products or services may be substantialand could harm our operating results.

 

***Government regulation of the Internet and e-commerce is evolving, andunfavorable changes or our failure to comply with regulations could harm ouroperating results.***

 

As Internet commerce continues to evolve, increasing regulation bysuper-national, federal, state or local government agencies becomes morelikely. Increased regulation in the area of data privacy, and laws andregulations applying to the solicitation, collection, processing, or use ofpersonal or consumer information could affect our customers’ ability to use andshare data, potentially reducing demand for Web-based applications andrestricting our ability to store, process, and share our customers’ data. Inaddition, taxation of services provided over the Internet or other chargesimposed by government agencies or by private organizations for accessing theInternet may also be imposed. Any regulation imposing greater fees for Internetaccess or use or restricting information exchange over the Internet couldresult in a decline in the use of the Internet and the viability of Web-basedservices, which could harm our business and operating results.

 

***Privacy concerns and laws or other regulations may reduce theeffectiveness of our products and services and harm our business.***

 

Our customers can use the products and services offered in an EtelosMarketplace to store personal or identifying information regarding theircustomers and contacts. Super-national, federal, state and other governmentbodies and agencies have adopted or are considering adoption of laws andregulations regarding the collection, use, and disclosure of personalinformation obtained from consumers and other individuals. The costs ofcompliance with, and other burdens imposed by, such laws and regulations thatare applicable to the businesses of our customers may limit the use andadoption of our products and services and reduce overall demand.

 

In addition to government activity, privacy advocacy groups and thetechnology and other industries are considering various new, additional, ordifferent self-regulatory standards that may place additional burdens on us andour Marketplace and Syndication Partners. If the gathering of personalinformation were to be curtailed, then Web-based applications would be lesseffective, which may reduce demand for the products and services offered in anEtelos Marketplace and harm our business.

 

***Our operating results may be harmed if we are required to collect taxesfor our subscription services in jurisdictions where we have not historicallydone so.***

 

We have not collected any sales or other taxes from our customers orremitted any such taxes to any taxing jurisdiction where we may be required todo so. We have begun an analysis of this issue but to date have not made anyaccrual for any potential liability.  Inaddition, additional taxing jurisdictions at various local, national andsuper-national levels may seek to impose sales or other tax collectionobligations on us.  We have not recordedsales or other tax liabilities for the quarters ended March 31, 2009 or2008, in respect of sales or other tax liabilities in any jurisdiction. Asuccessful assertion that we should be collecting sales or other taxes on ourservice could result in substantial tax liabilities for past sales, discouragecustomers from purchasing our products, or otherwise harm our business andoperating results.

 

***Changes in financial accounting standards or practices may causeadverse, unexpected financial reporting fluctuations, and harm our operatingresults.***

 

A change in accounting standards or practices could harm our operatingresults and may even affect our reporting of transactions completed before thechange is effective. New accounting pronouncements and varying interpretationsof 

 

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accounting pronouncements have occurred and may occur in the future.Changes to existing rules or the questioning of current practices may harmour operating results or the way we conduct our business.

 

***We may expand by acquiring or investing in other companies, which maydivert management’s attention, result in additional dilution to ourstockholders, and consume resources that are necessary to operate and sustainour business.***

 

Although we have no ongoing negotiations or current agreements orcommitments for any acquisitions, our business strategy may include acquiringcomplementary products, services, technologies, or businesses. We also mayenter into relationships with other businesses to expand our product or serviceofferings or our ability to provide service in foreign jurisdictions, whichcould involve preferred or exclusive licenses, additional channels ofdistribution, discount pricing, investments in other companies, or otherstrategies. Negotiating these transactions can be time-consuming, difficult,and expensive, and our ability to close these transactions may often be subjectto approvals that are beyond our control. Consequently, these transactions,even if undertaken and announced, may not close.

 

An acquisition, investment, or business relationship may result inunforeseen operating difficulties and expenditures. In particular, we mayencounter difficulties assimilating or integrating the businesses,technologies, products, services offerings, personnel, or operations of theacquired companies, particularly if the key personnel of the acquired companychoose not to work for us, the target’s software is not easily adapted to workwith ours, or we are unable to retain the customers of any acquired businessdue to changes in management or otherwise. Acquisitions may also disrupt ourbusiness, divert our resources, and require significant management attentionthat would otherwise be available for operation and development of ourbusiness. Moreover, the anticipated benefits of any acquisition, investment, orbusiness relationship may not be realized or we may be exposed to unknownliabilities. For one or more of those transactions, we may:

 

·                  issueadditional equity securities that would dilute our stockholders;

 

·                  usecash that we may need in the future to operate our business;

 

·                  incurdebt on terms unfavorable to us or that we are unable to repay;

 

·                  incurlarge charges or substantial liabilities;

 

·                  encounterdifficulties retaining key employees of the acquired company or integratingdiverse software codes or business cultures; and/or

 

·                  becomesubject to adverse tax consequences, substantial depreciation, or deferredcompensation charges.

 

Any of these risks could harm our business and operating results.

 

***We may be subject to other legal claims.***

 

In June 2008, Kaufman Bros. L.P. filed suit against us in theUnited States District Court for the Southern District of New York (Case No. 80CV 5716) and sought a temporary restraining order and other extraordinaryrelief.  The complaint arose out of an advisory services agreement,pursuant to which Kaufman Bros. was to provide us with advisory services inconnection with financings and strategic transactions. We notified KaufmanBros. that we believed it had failed to provide the required services under theagreement, and that we were therefore entitled to terminate the agreement forcause. In the suit, Kaufman Bros. was seeking (i) monetary damages of$400,000 for anticipatory breach of the agreement; (ii) $73,800 in feesallegedly owed in connection with a previously closed financing transaction; (iii) andinjunction prohibiting us from cancelling any shares issued to Kaufman Bros. ascompensation, (iv) a declaration from the court that we are not entitledto a refund of any fees previously paid to Kaufman Bros., and (v) a declarationthat we are obligated to pay Kaufman Bros. a commission on any financing ortransaction that we enter into within 18 months following the termination ofthe agreement.  On July 15, 2008, Kaufman Bros. voluntarily filed anotice of dismissal without prejudice.  Settlement discussions wereunsuccessful and, on July 31, 2008, Kaufman Bros. re-filed substantiallythe same claims in the Supreme Court of New York - County of New York (Index No. 08-602239).Effective on December 5, 2008, the Company entered into a settlementagreement with Kaufman Bros., pursuant to which (i) the Company agreed topay to Kaufman Bros. $210,000, in twelve monthly installments of $17,500; (ii) theCompany issued to Kaufman Bros. warrants to purchase 500,000 shares of the Company’scommon stock at an exercise price of $0.75 per share, which warrants have aterm of five years; (iii) the Company and Kaufman Bros. agreed immediatelyto terminate all provisions, terms and conditions of the 

 

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advisory services agreement and exchanged mutual releases; and (iv) KaufmanBros. agreed to dismiss the pending lawsuit in the Supreme Court of New York,without prejudice. Subsequent to entering into the settlement agreement, wehave not fully complied with our payment obligations under the settlementagreement but, through the date of filing of this report, Kaufman Bros. has notexercised any of its remedies for default under the settlement agreement.

 

On October 31, 2008, the Company closed its offices in San Mateo,California and abandoned the leased premises of its former offices there.  The landlord for these premises has asserteda claim for $659 thousand for alleged unpaid rent and other amounts and filed aproceeding in the Superior Court of San Mateo County, California (Case No. CIV479535) on December 19, 2008.  Thismatter is pending and the Company intends to defend its position.

 

On September 18, 2008, the employment of Jeffrey L. Garon aspresident and chief executive officer of the Company was terminated.  On October 19, 2008, Mr. Garonresigned from the Board of Directors.  Mr. Garonand the Company entered into an Employment Agreement dated August 11,2007, which provided certain benefits to Mr. Garon in the event oftermination of his employment, and granted to the Company certain rights torepurchase shares issued on behalf of Mr. Garon pursuant to his employmentagreement.  The Company and Mr. Garonhave been engaged in discussions about these benefits and rights, and no finalagreement has been reached as of the filing date of this report.

 

On October 1, 2008, we relocated our headquarters from San Mateo,California to Renton, Washington, and terminated eight employees based inCalifornia. In October 2008, we terminated eight more employees employedin both our California and Washington offices. None of these terminated employees have asserted any claims against usat this time but no assurances can be given that such employees will not assertsuch claims in the future.

 

As part of our reduction of monthly cash operating expenses during thequarter ended December 31, 2008, and continuing after the end of thequarter ended March 31, 2009, and to the filing date of this report, weplaced all employees on partial deferrals of salary, ranging from 10% to 100%of base salary.  At the end of thequarter, until the filing date of this report, this deferral amount remainsunpaid, including amounts due to employees who subsequently were terminated. Noemployee has asserted a claim or demand for immediate payment of these unpaidamounts but the assertion of such claims or demands by such employees, or byother governmental authorities, is foreseeable.

 

In connection with our reverse merger, multiple financings, andprotection of our intellectual property, we have incurred substantial accountspayable to law firms that remain unpaid and overdue.  We have been in communication with thesevendors and expect to enter into negotiated payment plans with these vendors,and others, but there is no assurance that we will be successful in thesenegotiations, or that we will be able to make payments under such plans if andwhen negotiated.  Therefore the assertionof claims by these vendors for these amounts due and owing could become thesubject of claims in litigation.

 

***Our officers, directors, and affiliates control us through theirpositions and stock ownership and their interests may differ from other stockholders.***

 

As of March 31, 2009, our officers, directors, and affiliatesbeneficially own approximately 72 percent of our common stock and 60 percent ofour preferred stock. As a result, if they act together, they are able toinfluence the outcome of stockholder votes on various matters, including theelection of directors and extraordinary corporate transactions, includingbusiness combinations. This concentration could also have the effect ofdelaying or preventing a change in control that could otherwise be beneficialto our stockholders. The interests of our officers, directors, and affiliatesmay differ from other stockholders. Furthermore, the current ratios ofownership of our common stock reduce the public float and liquidity of ourcommon stock, which can in turn affect the market price of our common stock.

 

***We are responsible for the indemnification of our officers anddirectors.***

 

Our articles of incorporation and bylaws provide for theindemnification of our directors, officers, employees, and agents, and, undercertain circumstances, against costs and expenses incurred by them in anylitigation to which they become a party arising from their association with oractivities on our behalf. Consequently, we may be required to expendsubstantial funds to satisfy these indemnity obligations.

 

***The market price of our securities could be adversely affected by salesof registered and restricted securities.***

 

Actual sales or the prospect of future sales of shares of our commonstock pursuant to a prospectus or under Rule 144 may have a depressiveeffect upon the price of, and market for, our common stock.  As of March 31, 2009, 24,069,291 sharesof 

 

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our common stock were issued and outstanding, of which 18,017,624 are “restrictedsecurities” and under some circumstances may, in the future, be under aregistration under the Securities Act or in compliance with Rule 144adopted under the Securities Act.  Ingeneral, under Rule 144, subject to the satisfaction of other conditions,a person who has beneficially owned restricted shares of common stock for atleast one year is entitled to sell, within any three month period, a number ofshares that does not exceed the greater of 1 percent of the total number ofoutstanding shares of the same class; or if the common stock is quoted onNASDAQ or a stock exchange, the average weekly trading volume during the fourcalendar weeks immediately preceding the sale. We cannot predict what effect, if any, that sales of shares of commonstock, or the availability of these shares for sale, will have on the marketprices prevailing from time to time. Nevertheless, the possibility that substantial amounts of common stockmay be sold in the public market may adversely effect prevailing prices for ourcommon stock and could impair our ability to raise capital in the futurethrough the sale of equity securities.

 

In addition to the 18,017,624 shares of “restricted securities” thatwere issued and outstanding as of March 31, 2009, we have a registrationstatement that registers for resale an aggregate of 1,906,557 shares of ourcommon stock. The additional overhang represented by these registeredsecurities could also have a depressive effect on the public trading price ofour common stock.

 

***The sale of the shares of our common stock acquired in privateplacements could cause the price of our common stock to decline.***

 

The purchasers of our January 2008 and April 2008 Debenturesand related warrants, as well as the holders of our other outstandingconvertible notes, may, subject to compliance with Rule 144, rely on theprovisions of Rule 144 to resell the shares of our common stock acquiredupon the conversion and exercise of such securities.  We have no way of knowing whether or whensuch shares may be sold.  Depending uponmarket liquidity at the time, a sale of shares by such investors at any giventime could cause the trading price of our common stock to decline.  The sale of substantial number of shares ofour common stock, or anticipation of such sales, could make it more difficultfor us to sell equity or equity-related securities in the future at a time andat a price that we might otherwise wish to effect sales.

 

In addition, in connection with our January 2008 and April 2008Debentures, in the aggregate, we issued a total of $5.5 million principalamount of convertible debentures, convertible into 4,074,074 shares of ourcommon stock, and warrants to purchase an additional 611,111 shares of ourcommon stock.  We agreed to register forresale by the investors the shares of common stock issuable upon the conversionof the debentures and the exercise of the warrants we issued in those privateplacements. The conversion or exercise into our common stock and theregistration of that common stock could result in a substantial increase in thenumber of shares in our public float. Depending upon market liquidity at the time a resale of our common stockis made by the investors in such private placements, such sale could cause thetrading price of our common stock to decline. In addition, the sale of a substantial number of shares of our commonstock, or anticipation of such sales, could make it more difficult for us tosell equity or equity-related securities in the future at a time and at a pricethat we might otherwise wish to effect sales.

 

***We have significant indebtedness and agreed to certain restrictions asa result of our recent private placements of convertible debentures.***

 

We incurred $5.5 million in principal amount of indebtedness as aresult of the issuance of our January 2008 and April 2008Debentures.  The debentures carrysubstantial covenants that impose significant restrictions on us, includingrestrictions against incurring additional indebtedness, creating any liens onour property, amending our certificate of incorporation or bylaws, redeeming orpaying dividends on shares of our outstanding common stock, and entering intocertain related party transactions.  Thedebentures also carry substantial covenants that impose significantrequirements on us, including, among others, requirements that we pay interestand other charges on the debentures;

 

Our ability to comply with these provisions may be affected by changesin our business condition or results of our operations, or other events beyondour control.  We have breached certain ofthese covenants and are in a default under the debentures, which permits theholders thereof to accelerate the maturity of the debentures and demandrepayment in full.  Such actions by suchholders could impair our ability to operate or cause us to seek bankruptcyprotection.

 

***Certain covenants we agreed to in connection with the debentures mayimpair our ability to issue additional debt or equity.***

*** ***

Our January 2008 and April 2008 Debentures impose significantcovenants on us, some of which may impair our ability to issue additional debtor equity, if necessary.  For example,the investors in our April 2008 Debentures have the right to 

 

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participate in any financing we undertake through the date that is the12 month anniversary of the effectiveness of the registration statement weagreed to file for the re-sale of our shares of common stock issuable uponconversion and exercise of our April 2008 Debentures.

 

***Our failure to secure and maintain registration of the common stockcould result in substantial liquidated damages.***

*** ***

Under the terms of the registration rights agreements we entered intowith the investors in connection with our January 2008 and April 2008Debentures, we agreed to file a registration statement covering the resale ofthe shares of common stock underlying the securities we sold in such privateplacements, and to maintain the effectiveness of the registration statements(subject to certain limitations) for a period of time until the holders cansell the underlying common stock without volume restrictions under Rule 144of the Securities Act.  If theregistration statement is not declared effective within an agreed to timeperiod, or if we fail to maintain the effectiveness of the registrationstatement, we are required to pay to the investors partial liquidated damages.Since the registration statement was effective on July 31, 2008, after thedeadline in the registration rights agreement, we may be liable for liquidateddamages, in the amount of $14.7 thousand, which we have accrued as a liability.

 

***If we need additional financing in the future and are required to issuesecurities which are priced at less than the conversion price of our debenturesor the exercise price of warrants sold in our recent private placements, itwill result in additional dilution.***

 

Our January 2008 and April 2008 Debentures and the relatedwarrants contain provisions that will require us to reduce the conversion priceand exercise price, as the case may be, if we issue additional securities whilesuch debentures or warrants are outstanding which contain purchase prices,conversion prices or exercise prices less than the conversion price of our January 2008or April 2008 Debentures or the exercise price of the warrants.  If this were to occur, current investors,other than the investors in our recent private placements, would sustainmaterial dilution in their ownership interest.

 

***Anti-takeover provisions contained in our amended and restatedcertificate of incorporation and amended and restated bylaws, as well asprovisions of Delaware law, could impair a takeover attempt.***

 

Our amended and restated certificate of incorporation, amended andrestated bylaws and Delaware law contain provisions that could have the effectof rendering more difficult or discouraging an acquisition deemed undesirableby our board of directors. Our corporate governance documents includeprovisions:

 

·                  authorizingblank check preferred stock, which could be issued with voting, liquidation,dividend, and other rights superior to our common stock;

 

·                  limitingthe liability of, and providing indemnification to, our directors and officers;

 

·                  limitingthe ability of our stockholders to call and bring business before specialmeetings;

 

·                  requiringadvance notice of stockholder proposals for business to be conducted atmeetings of our stockholders and for nominations of candidates for election toour board of directors;

 

·                  controllingthe procedures for the conduct and scheduling of board and stockholdermeetings; and

 

·                  limiting,generally, the filling of vacancies or newly created seats on the board to ourboard of directors then in office.

 

These provisions, alone or together, could delay hostile takeovers andchanges in control or changes in our management.

 

Any provision of our amended and restated certificate of incorporationor bylaws or Delaware law that has the effect of delaying or deterring a changein control could limit the opportunity for our stockholders to receive apremium for their shares of our common stock, and could also affect the pricethat some investors are willing to pay for our common stock.

 

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***We may issue additional shares of our capital stock, including throughconvertible debt securities, to finance future operations or complete abusiness combination, which would reduce the equity interest of ourstockholders and could cause a change in control of our ownership.***

 

Although we have no commitments as of the date of this report to issueany additional securities, we may issue a substantial number of additionalshares of our common stock or preferred stock, or a combination of both,including through convertible debt securities, to finance futureoperations.  We may not be able to obtainadditional debt or equity financing on favorable terms, if at all.  If we engage in debt financing, then we maybe required to accept terms that restrict our ability to incur additionalindebtedness and force us to maintain specified liquidity or other ratios.

 

Further, the issuance of additional shares of our common stock or anynumber of shares of preferred stock, including upon conversion of any debtsecurities, may:

 

·                  significantlyreduce the equity interest of our current stockholders;

 

·                  causea change in control if a substantial number of our shares of common stock orvoting preferred stock are issued, which may affect, among other things, ourability to use our net operating loss carry-forwards, if any, and could alsoresult in a change in management; and/or

 

·                  adverselyaffect prevailing market prices for our common stock.

 

If we need additionalcapital and cannot raise it on acceptable terms, we may not be able to, amongother things:

 

·                  developor enhance our products and services;

 

·                  continueto expand our development, sales and marketing organizations;

 

·                  acquirecomplementary technologies, products or businesses;

 

·                  expandoperations;

 

·                  hire,train and retain employees; and/or

 

·                  respondto competitive pressures or unanticipated working capital requirements.

 

Although we have no commitments as of the date hereof to issue anyadditional securities, we may issue a substantial number of additional sharesof our common stock or preferred stock, or a combination of both, includingthrough convertible debt securities, to finance future operations or complete abusiness combination.  The issuance ofadditional shares of our common stock or any number of shares of preferredstock, including upon conversion of any debt securities:

 

·                  maysignificantly reduce the equity interest of our current stockholders; and

 

·                  willlikely cause a change in control if a substantial number of our shares ofcommon stock or voting preferred stock are issued and could also result in achange in management; and/or may adversely affect prevailing market prices forour common stock.

 

The 2007 Stock Incentive Plan and all options issued under the 2007Stock Incentive Plan contain provisions for acceleration of all unvestedoptions in the event of a change of control, which might be a disincentive toacquisition of the Company as a liquidation strategy.

 

The 2007 Stock Incentive Plan and all options currently issuedthereunder and options granted outside such plan provides for acceleratedvesting of all unvested options in the event of a change of control, which isdefined as an acquisition by a single person of more than 50 percent of thetotal combined voting power of all of our outstanding securities. This may beregarded as a barrier to retention of key employees following achange-of-control acquisition and therefore make such an acquisition morecostly or difficult, and therefore an unattractive strategic option, for aprospective acquiror.

 

***We have never paid dividends on our capital stock and we do not anticipatepaying any cash dividends in the foreseeable future.***

 

We have paid no cash dividends on any of our classes of capital stockto date and we currently intend to retain our future earnings, if any, to fundthe development and growth of our business. In addition, the terms of the Notes prohibit us from 

 

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making any dividend payment or distribution to holders of our commonstock while any portion of the Notes remain outstanding.  As a result, capital appreciation, if any, ofour common stock will be your sole source of gain for the foreseeable future.

 

***Our securities may be thinly traded on the Over-the-Counter BulletinBoard, which may not provide liquidity for our investors.***

 

Our common stock is quoted on the Over-the-Counter Bulletin Board. TheOver-the-Counter Bulletin Board is an inter-dealer, over-the-counter marketthat provides significantly less liquidity than the NASDAQ Stock Market orother national or regional exchanges. Securities traded on the Over-the-CounterBulletin Board are usually thinly traded, highly volatile, have fewer marketmakers, and are not followed by analysts.

 

The SEC’s order handling rules, which apply to NASDAQ-listedsecurities, do not apply to securities quoted on the Over-the-Counter BulletinBoard. Quotes for stocks included on the Over-the-Counter Bulletin Board maynot be listed in newspapers. Therefore, prices for securities traded solely onthe Over-the-Counter Bulletin Board may be difficult to obtain and holders ofour securities may be unable to resell their securities at or near theiroriginal acquisition price, or at any price.

 

***Investors must contact a broker-dealer to trade Over-the-CounterBulletin Board securities. As a result, you may not be able to buy or sell ourcommon stock at the times that you may wish.***

 

Even though our common stock is quoted on the Over-the-Counter BulletinBoard, the Over-the-Counter Bulletin Board may not permit our investors to sellsecurities when and in the manner that they wish. Because there are noautomated systems for negotiating trades on the Over-the-Counter BulletinBoard, they are conducted via telephone. In times of heavy market volume, thelimitations of this process may result in a significant increase in the time ittakes to execute investor orders. Therefore, when investors place market ordersto buy or sell a specific number of shares at the current market price it is possiblefor the price of a stock to go up or down significantly during the lapse oftime between placing a market order and its execution.

 

***Our stock price may be volatile and you may not be able to sell yourshares for more than what you paid.***

 

Our stock price is likely to be subject to significant volatility andyou may not be able to sell shares of common stock at or above the price youpaid for them. The market price of the common stock could continue to fluctuatein the future in response to various factors including, but not limited to:quarterly variations in operating results; our ability to control costs andimprove cash flow; announcements of technological innovations or new productsby us or our competitors; changes in investor perceptions; and new products orproduce enhancements by us or our competitors. The stock market in general hascontinued to experience volatility, which may further affect our stock price.As such, you may not be able to resell your shares of common stock at or abovethe price you paid for them.

 

***Our common stock is likely to be subject to penny stock rules***

*** ***

Our common stock is subject to Rule 15g-1 through 15g-9 under theExchange Act, which imposes certain sales practice requirements onbroker-dealers which sell our common stock to persons other than establishedcustomers and “accredited investors” (generally, individuals with net worths inexcess of $1 million or annual incomes exceeding $200 thousand (or $300thousand together with their spouses)). For transactions covered by this rule, a broker-dealer must make aspecial suitability determination for the purchaser and have received thepurchaser’s written consent to the transaction prior to the sale.  This rule adversely affects the abilityof broker-dealers to sell our common stock and purchasers of our common stockto sell their shares of such common stock. Additionally, our common stock is likely to be subject to the SECregulations for “penny stock.”  Pennystock includes any equity security that is not listed on a national exchangeand has a market price of less than $5.00 per share, subject to certainexceptions.  The regulations require thatprior to any non-exempt buy/sell transaction in a penny stock, a disclosureschedule set forth by the SEC relating to the penny stock market must bedelivered to the purchaser of such penny stock. This disclosure must include the amount of commissions payable to boththe broker-dealer and the registered representative and current price quotationsfor the common stock.  The regulationsalso require that monthly statements be sent to holders of penny stock whichdisclose recent price information for the penny stock and information of thelimited market for penny stocks.  Theserequirements adversely affect the market liquidity of our common stock.

 

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**Item 2.             UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS**.

 

During the quarter ended March 31, 2009, the Company issued anaggregate of 1,000,000 shares of its common stock to a single accreditedinvestor.  The shares were issued ascompensation for investor relations services rendered for the Company.  The transaction was completed as a privateplacement under Section 4(2) of the Securities Act of 1933, asamended, and was therefore exempted from the registration requirements of thatact.

 

**Item 3.             DEFAULTSUPON SENIOR SECURITIES**.

 

During the quarter ended March 31, 2009, the Company continued tobe in default under its material debt obligations.

 

The Company has failed to pay interest or principal on its 6%convertible notes.  Those notes were dueand payable on March 31, 2009.  Thetotal amount due under the 6% convertible notes at March 31, 2009, is $148thousand in interest and $1,764 thousand in principal.

 

The Company has failed to make the required interest and principalpayments on the January 2008 Debentures. Because of the default, the holders have the right to accelerate all amountsdue under the debentures, and demand that the default amount equal to 130% ofthe amount outstanding plus accrued interest be paid to the holders.  The total amount due under the January 2008Debentures at March 31, 2009, is $140 thousand in interest and $2,000 thousandin principal.

 

The Company has failed to make the required interest and principalpayments on the April 2008 Debentures. Because of the default, the holders have the right to accelerate allamounts due under the debentures, and demand that the default amount equal to130% of the amount outstanding plus accrued interest be paid to theholders.  The total amount due under the April 2008Debentures at March 31, 2009, is $197 thousand in interest and $3,500 thousandin principal.

 

**Item 4.             SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**.

 

None.

 

**Item 5.             OTHERINFORMATION**.

 

None.

 

**Item 6.             EXHIBITS**.

 

See the exhibit index immediately following the signature page ofthis report.

 

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**SIGNATURES**

** **

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

 

 
|                    | **ETELOS, INC.**                                           |
|-------------------------|------------------------------------------------------------|
|                    | ** **                                                 |
|                    | ** **                                                 |
|                    | /s/  Daniel J.A. Kolke                                     |
| Date: May 15, 2009 | Daniel J.A. Kolke, Chief  Executive Officer                |
|                    | (Duly Authorized Officer  and Principal Executive Officer) |

 

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** **

**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                          |
|----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                 |       | Promissory Note  dated April 17, 2009, issued to Enable Growth Partners LP (1)                                                                                                                                      |
| 31.1*                |       | Certification of  Principal Executive Officer pursuant to Rule 13a-14(a) or  15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2*                |       | Certification of  Principal Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of  the Securities Exchange Act of 1934, as adopted pursuant to Section 302  of the Sarbanes-Oxley Act of 2002 |
| 32.1*                |       | Certification of  Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                        |
| 32.2*                |       | Certification of  Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                        |

 

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| *   | Filed with this  report                                                                                  |
|-----|----------------------------------------------------------------------------------------------------------|
| (1) | Incorporated by  reference to exhibits to Registrant’s Form 8-K filed on April 21,  2009. |

 

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