Table ofContents

 

 

 

**UNITED STATES**

**SECURITIES 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 the quarterly period ended September 30,2009**

 

**or**

 

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

 

**For the transition period from            to           **

 

**Commission file number 000-51995**

 

----

 

**ETELOS,INC.**

(Exact name of registrant asspecified in its charter)

 

| **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 areacode)

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes x  No o

 

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

 

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

 

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

 

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

 

As of September 30, 2009, 24,826,360 shares ofthe issuer’s common stock, par value $0.01 per share, were outstanding.

 

 

 

----

Table of Contents

 

**EXPLANATORY NOTE**

** **

On February 8, 2007,Tripath Technology Inc., a Delaware corporation (“Tripath”) filed a voluntarypetition for relief under Chapter 11 of the Bankruptcy Code. On February 1,2008, the bankruptcy court issued an order confirming approval of the Plan ofReorganization, including the merger and the transfer of all of Tripath’sexisting assets into a separate bankruptcy estate and the discharge of all ofTripath’s liabilities.  The Plan ofReorganization also contemplated the merger of Etelos, Incorporated, aWashington corporation (“Etelos-WA”) with Tripath.   The overall impact of the confirmed Plan ofReorganization was for Tripath to emerge from the bankruptcy proceeding with noassets 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 to employees),warrants, and other shares of common stock to be canceled and extinguished.

 

On April 23, 2008,Tripath filed a Current Report on Form 8-K announcing, among other things,that Etelos-WA merged with and into Tripath, and that the surviving corporationchanged 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 thebusiness and operations previously conducted by Etelos-WA.  In connection with the merger, all outstandingshares of Etelos-WA common stock were converted into shares of Etelos, Inc.common stock on a three for one ratio: one share of Etelos, Inc. commonstock for every three shares of common stock of Etelos-WA.  Also in connection with the merger, (i) alloutstanding shares of preferred stock of Etelos-WA were converted into sharesof common stock of Etelos, Inc., (ii) Etelos, Inc. issued anaggregate of 5,010,000 shares of its common stock to the secured and unsecuredcreditors 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 ofEtelos-WA with 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 quarterly and twelve month periods ended December 31,2008 and 2007.

 

Also, on April 23,2008, Etelos, Inc., formerly Tripath, amended its certificate ofincorporation with the state of Delaware to change its total authorized sharesof 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 aredesignated “preferred stock” with a par 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.

 

Information concerningnumber of shares outstanding for Etelos, Inc. including the conversionprices and number of shares issuable upon conversion of convertible securitiesand exercise prices of warrants and stock options and the number of sharesissuable upon exercise of such options and warrants, has been adjusted toreflect the three for one conversion ratio effected in connection with themerger as if it had occurred for all periods presented.

 

i

----

Table ofContents

 

**Etelos, Inc.**

 

**Quarterly Report on Form 10-Q**

 

**For the Quarterly Period Ended September 30, 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 |     | 25 |
|                                         |                                                                                        |     |   |
| Item 3.                                      | QUANTITATIVE AND QUALITATIVE DISCLOSURES  ABOUT MARKET RISK                                 |     | 34 |
|                                         |                                                                                        |     |   |
| Item 4.                                      | CONTROLS AND PROCEDURES                                                                     |     | 34 |
|                                         |                                                                                        |     |
| **PART II  —OTHER INFORMATION**    |                                                                                        | 34       |
| ** **                                   |                                                                                        |     |
| Item 1.                                      | LEGAL PROCEEDINGS                                                                           |     | 34 |
|                                         |                                                                                        |     |   |
| Item 1A.                                     | RISK FACTORS                                                                                |     | 36 |
|                                         |                                                                                        |     |   |
| Item 6.                                      | EXHIBITS                                                                                    |     | 48 |
|                                         |                                                                                        |     |
| SIGNATURES                                   |                                                                                        | 49       |
|                                         |                                                                                        |     |
| EXHIBIT  INDEX                               |                                                                                        | 50       |

 

ii

----

Table of Contents

 

**FORWARDLOOKING STATEMENTS**

 

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

 

This Quarterly Report on Form 10-Qcontains forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1933, or the “Securities Act,” and Section 21E ofthe Securities 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 canidentify forward looking statements by terms such as “may,” “intend,” “might,”“will,” “should,” “could,” “would,” “expect,” “believe,” “anticipate,”“estimate,” “predict,” “potential,” or the negative of these terms.  These terms and similar expressions areintended to identify forward-looking statements.  Such statements are subject to certain risksand uncertainties, which could cause actual results to differ materially fromthose projected.  The forward-lookingstatements in this report are based upon management’s current expectations andbelief, 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 thatour actual results could differ materially from those contained in theforward-looking statements due to a number of factors, including:

 

·                                          our ability to obtain future financing orfunds when needed;

·                                          new competitors are likely to emerge andnew technologies may further increase competition;

·                                          our operating costs may increase beyondour current expectations and we may be unable to fully implement our currentbusiness plan;

·                                          our ability to successfully obtain adiverse customer base;

·                                          our ability to protect our intellectualproperty through patents, trademarks, copyrights and confidentialityagreements;

·                                          our ability to attract and retain aqualified employee base;

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

·                                          acquisitions, business combinations,strategic partnerships, divestures, and other significant transactions mayinvolve additional uncertainties;

·                                          our ability to maintain and execute asuccessful business strategy; and

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

 

Other risks anduncertainties include such factors as market acceptance and market demand forour products and services, pricing, the changing regulatory environment, theeffect of our accounting policies, potential seasonality, industry trends,adequacy of our financial resources to execute our business plan, our abilityto attract, retain and motivate key technical, marketing and managementpersonnel, possible disruption in commercial activities occasioned by terroristactivity and armed conflict, and other risk factors detailed in this report andour other SEC filings.  You shouldconsider carefully the statements under “Item 1A. Risk Factors” in Part IIand other sections of this report, which address additional factors that couldcause our actual results to differ from those set forth in the forward-lookingstatements and could materially and adversely affect our business, operatingresults and financial condition.  Allsubsequent written and oral forward-looking statements attributable to us orpersons acting on our behalf are expressly qualified in their entirety by theapplicable cautionary statements.

 

1

----

Table of Contents

 

**PART I—FINANCIAL INFORMATION**

 

**ITEM 1. - FINANCIAL STATEMENTS (UNAUDITED)**

 

**ETELOS, INC.**

**CONDENSED BALANCE SHEETS**

(in thousands, except share data)

(Unaudited)

 
| ** **                                                                                                                                                                             | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                                                                                                                                                                                   |       |                         |       |                        |       |
| ASSETS                                                                                                                                                                                 |       |                         |       |                        |       |
| Current assets:                                                                                                                                                                        |       |                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                             |       | $                            | 287        |                        | $          | 7 |   |
| Accounts receivable,  net                                                                                                                                                              |       | 4                            |       | 60                          |       |
| Other receivable                                                                                                                                                                       |       | 500                          |       | —                      |       |
| Prepaid expenses and  other current assets                                                                                                                                             |       | 9                            |       | 46                          |       |
| Accreting interest on convertible  notes payable                                                                                                                                       |       | 332                          |       | —                      |       |
| Total current assets                                                                                                                                                                   |       | 1,132                        |       | 113                         |       |
|                                                                                                                                                                                   |       |                         |       |                        |       |
| Property and equipment,  net                                                                                                                                                           |       | 54                           |       | 82                          |       |
| Debt issuance costs                                                                                                                                                                    |       | 33                           |       | —                      |       |
| Other assets                                                                                                                                                                           |       | 2                            |       | 10                          |       |
|                                                                                                                                                                                   |       |                         |       |                        |       |
| **Total  assets**                                                                                                                                                                      | ** ** | **$**                        | **1,221**  | ** **                  | **$**      | **205** | ** ** |
|                                                                                                                                                                                   |       |                         |       |                        |       |
| LIABILITIES AND  STOCKHOLDERS’ DEFICIT                                                                                                                                            |       |                         |       |                        |       |
| Current liabilities:                                                                                                                                                                   |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                       |       | $                            | 1,125      |                        | $          | 983 |   |
| Accounts payable  related parties                                                                                                                                                      |       | 25                           |       | 42                          |       |
| Accrued payroll and  related expenses                                                                                                                                                  |       | 987                          |       | 399                         |       |
| Other accrued expenses                                                                                                                                                                 |       | 1,312                        |       | 1,381                       |       |
| Deferred revenue                                                                                                                                                                       |       | 4                            |       | 64                          |       |
| Current portion  convertible notes payable, net of discounts                                                                                                                           |       | 1,764                        |       | 7,264                       |       |
| Current portion other  notes payable                                                                                                                                                   |       | 152                          |       | 89                          |       |
| Current portion notes  payable to related parties, net of discounts                                                                                                                    |       | 220                          |       | 132                         |       |
| Current portion capital  leases                                                                                                                                                        |       | 9                            |       | 9                           |       |
| Warrant and derivative  liability                                                                                                                                                      |       | 293                          |       | 108                         |       |
| Total current  liabilities                                                                                                                                                             |       | 5,891                        |       | 10,471                      |       |
|                                                                                                                                                                                   |       |                         |       |                        |       |
| Long-term convertible  notes payable, net of premiums and discounts, less current portion                                                                                              |       | 6,711                        |       | —                      |       |
| Long-term notes payable  to related parties, less current portion                                                                                                                      |       | 552                          |       | 552                         |       |
| Long-term capital  leases, less current portion                                                                                                                                        |       | 13                           |       | 24                          |       |
|                                                                                                                                                                                   |       |                         |       |                        |       |
| Total liabilities                                                                                                                                                                      |       | 13,167                       |       | 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  September 30, 2009 and 833,333 shares at December 31, 2008                       |       | 8                            |       | 8                           |       |
| Common stock, $0.01 par  value: 250,000,000 shares authorized; issued and outstanding - 24,826,360  shares at September 30, 2009 and 23,027,624 shares at December 31,  2008 |       | 249                          |       | 231                         |       |
| Additional paid-in  capital                                                                                                                                                            |       | 22,325                       |       | 18,722                      |       |
| Accumulated deficit                                                                                                                                                                    |       | (34,528                      | )          | (29,803                     | )          |
| Total stockholders’  deficit                                                                                                                                                      |       | (11,946                      | )          | (10,842                     | )          |
|                                                                                                                                                                                   |       |                         |       |                        |       |
| **Total  liabilities and stockholders’ deficit**                                                                                                                                  | ** ** | **$**                        | **1,221**  | ** **                  | **$**      | **205** | ** ** |

 

The accompanying notesare an integral part of these condensed interim financial statements.

 

2

----

Table of Contents

 

**ETELOS, INC.**

**CONDENSED STATEMENTS OF OPERATIONS**

(in thousands, except per share data)

(Unaudited)

 
| ** **                                                                                                 | ** ** | **Three  Months  Ended  September 30,  2009** | ** ** | **Three  Months  Ended  September 30,  2008** | ** ** | **Nine  Months  Ended  September 30,  2009** | ** ** | **Nine  Months  Ended  September 30,  2008** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | ** **                                         | ** ** | ** **                                         | ** ** | ** **                                        | ** ** | ** **                                        | ** ** |
| Revenue                                                                                                    |       | $                                                  | 5          |                                               | $          | 10                                                |       | $                                                 | 131        |   | $ | 55 |   |
| Cost of revenue                                                                                            |       | 74                                                 |       | 211                                                |       | 246                                               |       | 459                                               |       |
| Gross loss                                                                                                 |       | (69                                                | )          | (201                                               | )          | (115                                              | )          | (404                                              | )          |
|                                                                                                       |       |                                               |       |                                               |       |                                              |       |                                              |       |
| Operating expenses:                                                                                        |       |                                               |       |                                               |       |                                              |       |                                              |       |
| Research and  development                                                                                  |       | 209                                                |       | 844                                                |       | 1,397                                             |       | 3,320                                             |       |
| Sales and marketing                                                                                        |       | 132                                                |       | 514                                                |       | 877                                               |       | 1,315                                             |       |
| General and  administrative                                                                                |       | 312                                                |       | 529                                                |       | 1,377                                             |       | 1,629                                             |       |
| Change in valuation of  liability related to warrants from settlement, financing, and consulting  services |       | —                                             |       | —                                             |       | (299                                              | )          | —                                            |       |
| Total operating  expenses                                                                                  |       | 653                                                |       | 1,887                                              |       | 3,352                                             |       | 6,264                                             |       |
|                                                                                                       |       |                                               |       |                                               |       |                                              |       |                                              |       |
| Loss from Operations                                                                                       |       | (722                                               | )          | (2,088                                             | )          | (3,467                                            | )          | (6,668                                            | )          |
|                                                                                                       |       |                                               |       |                                               |       |                                              |       |                                              |       |
| Other income (expense)                                                                                     |       |                                               |       |                                               |       |                                              |       |                                              |       |
| Merger costs                                                                                               |       | —                                             |       | —                                             |       | —                                            |       | (13,444                                           | )          |
| Other income (expense)                                                                                     |       | 15                                                 |       | —                                             |       | 15                                                |       | (15                                               | )          |
| Loss on extinguishment  of debt                                                                            |       | (288                                               | )          | —                                             |       | (587                                              | )          | —                                            |       |
| Total other expense                                                                                        |       | (273                                               | )          | —                                             |       | (572                                              | )          | (13,459                                           | )          |
|                                                                                                       |       |                                               |       |                                               |       |                                              |       |                                              |       |
| Interest expense, net                                                                                      |       | (154                                               | )          | (103                                               | )          | (427                                              | )          | (420                                              | )          |
| Amortization of notes  discount premiums and debt issuance costs                                           |       | (67                                                | )          | (358                                               | )          | (139                                              | )          | (783                                              | )          |
| Change in valuation of  liability relating to embedded derivatives and warrants                            |       | 16                                                 |       | 4,200                                              |       | (120                                              | )          | 168                                               |       |
| Beneficial conversion  of interest conversion                                                              |       | —                                             |       | —                                             |       | —                                            |       | (991                                              | )          |
| Total interest income  (expense)                                                                           |       | (205                                               | )          | 3,739                                              |       | (686                                              | )          | (2,026                                            | )          |
|                                                                                                       |       |                                               |       |                                               |       |                                              |       |                                              |       |
| Income (Loss) before  taxes                                                                                |       | (1,200                                             | )          | 1,651                                              |       | (4,725                                            | )          | (22,153                                           | )          |
|                                                                                                       |       |                                               |       |                                               |       |                                              |       |                                              |       |
| Provision for income  taxes                                                                                |       | —                                             |       | —                                             |       | —                                            |       | —                                            |       |
|                                                                                                       |       |                                               |       |                                               |       |                                              |       |                                              |       |
| **Net  income (loss)**                                                                                     | ** ** | **$**                                              | **(1,200** | **)**                                              | **$**      | **1,651**                                         | ** ** | **$**                                             | **(4,725** | **)** | **$** | **(22,153** | **)** |
|                                                                                                       |       |                                               |       |                                               |       |                                              |       |                                              |       |
| Basic net income (loss)  per share                                                                         |       | $                                                  | (0.05      | )                                                  | $          | 0.07                                              |       | $                                                 | (0.20      | ) | $ | (1.34 | ) |
| Diluted net income  (loss) per share                                                                       |       | $                                                  | (0.05      | )                                                  | $          | 0.06                                              |       | $                                                 | (0.20      | ) | $ | (1.34 | ) |
|                                                                                                       |       |                                               |       |                                               |       |                                              |       |                                              |       |
| Weighted average number  of common shares used in computing basic net income (loss) per share              |       | 24,074                                             |       | 23,036                                             |       | 23,839                                            |       | 16,522                                            |       |
| Weighted average number  of common shares used in computing diluted net income (loss) per share            |       | 24,074                                             |       | 26,418                                             |       | 23,839                                            |       | 16,522                                            |       |

 

The accompanying notesare an integral part of these condensed interim financial statements.

 

3

----

Table of Contents

 

**ETELOS,INC.**

**CONDENSEDSTATEMENTS OF STOCKHOLDERS’ DEFICIT**

(in thousands, exceptshare data)

(Unaudited)

 
| ** **                                                          | ** ** | **Preferred Stock**   | ** ** | ** **       | ** ** | ** **               | ** **     | ** **      | ** ** | ** **             | ** ** | **Total**   | ** ** |
|---------------------------------------------------------------------|------------|-----------------------|------------|------------------|------------|--------------------------|----------------|-----------------|------------|------------------------|------------|-------------|------------|
| ** **                                                          | ** ** | **New Series A** | ** ** | **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                |       | —           |       | —                   |           | —          |       | 6                      |       | —      |       | 6 |   |
| Issuance  of common stock upon exercise of options                  |       | —                |       | —           |       | 48,736                   |           | —          |       | 2                      |       | —      |       | 2 |   |
| Issuance  of common stock to consultant                             |       | —                |       | —           |       | 1,000,000                |           | 10              |       | 500                    |       | —      |       | 510 |   |
| Issuance  of common stock warrants with promissory notes            |       | —                |       | —           |       | —                   |           | —          |       | 110                    |       | —      |       | 110 |   |
| Issuance  of common stock with senior secured debentures.           |       | —                |       | —           |       | 750,000                  |           | 8               |       | 183                    |       | —      |       | 191 |   |
| Issuance  of Series I Warrants with senior secured debentures  |       | —                |       | —           |       | —                   |           | —          |       | 424                    |       | —      |       | 424 |   |
| Issuance  of Series II Warrants with senior secured debentures |       | —                |       | —           |       | —                   |           | —          |       | 565                    |       | —      |       | 565 |   |
| Beneficial  conversion on issuance of senior secured debentures     |       | —                |       | —           |       | —                   |           | —          |       | 776                    |       | —      |       | 776 |   |
| Stock  based compensation                                           |       | —                |       | —           |       | —                   |           | —          |       | 106                    |       | —      |       | 106 |   |
| Reclass  warrant and derivative liability                           |       | —                |       | —           |       | —                   |           | —          |       | 931                    |       | —      |       | 931 |   |
| Net  loss                                                           |       | —                |       | —           |       | —                   |           | —          |       | —                 |       | (4,725      | )          | (4,725 | ) |
| **Balance at September 30, 2009**                              | ** ** | **843,333**           | ** ** | **$**            | **8**      | ** **               | **24,826,360** | ** **      | **$**      | **249**                | ** ** | **$**       | **22,325** | ** ** | **$** | **(34,528** | **)** | **$** | **(11,946** | **)** |

 

The accompanying notesare an integral part of these condensed interim financial statements.

 

4

----

Table of Contents

 

**ETELOS, INCORPORATED**

**CONDENSED STATEMENTS OF CASH FLOWS**

(in thousands)

(Unaudited)

 
| ** **                                                                   | ** ** | **Nine Months  Ended  September 30,  2009** | ** ** | **Nine Months  Ended  September 30,  2008** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| **Cash flows from operating activities:**                                    | ** ** | ** **                                       | ** ** | ** **                                       | ** ** |
| Net  loss                                                                    |       | $                                                | (4,725     | )                                                | $          | (22,153 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                                             |       |                                             |       |
| Depreciation  and amortization                                               |       | 28                                               |       | 13                                               |       |
| Amortization  (accretion) of notes discount (premium)                        |       | 138                                              |       | 201                                              |       |
| Amortization  of financing fees and debt issuance costs                      |       | 1                                                |       | 63                                               |       |
| Accretion  of interest                                                       |       | 81                                               |       | —                                           |       |
| Stock  based compensation                                                    |       | 106                                              |       | 73                                               |       |
| Interest  expense paid in common stock                                       |       | —                                           |       | 77                                               |       |
| Consulting  expenses paid through issuance of common stock and warrants      |       | 1,511                                            |       | —                                           |       |
| Beneficial  conversion of interest conversion                                |       | —                                           |       | 991                                              |       |
| Change  in valuation of embedded derivatives and warrant liabilities         |       | (180                                             | )          | 636                                              |       |
| Loss  on extinguishment of restructured debentures and promissory notes      |       | 587                                              |       | —                                           |       |
| Merger  costs paid in common stock                                           |       | —                                           |       | 13,177                                           |       |
| Changes  in operating assets and liabilities:                                |       |                                             |       |                                             |       |
| Accounts  receivable, net                                                    |       | 56                                               |       | (6                                               | )          |
| Prepaid  expenses and other current assets                                   |       | 37                                               |       | (2                                               | )          |
| Other  assets                                                                |       | (26                                              | )          | —                                           |       |
| Accounts  payable                                                            |       | 229                                              |       | 651                                              |       |
| Accounts  payables related parties                                           |       | (17                                              | )          | (50                                              | )          |
| Accrued  payroll and related expenses                                        |       | 588                                              |       | (366                                             | )          |
| Other  accrued expenses                                                      |       | 388                                              |       | 92                                               |       |
| Other  current liabilities                                                   |       | —                                           |       | 200                                              |       |
| Deferred  revenues                                                           |       | (60                                              | )          | 5                                                |       |
| Deferred  rent                                                               |       | —                                           |       | 9                                                |       |
| **Net cash used in operating activities**                                    |       | (1,258                                           | )          | (6,389                                           | )          |
| **Cash flows from investing activities:**                                    |       |                                             |       |                                             |       |
| Purchases  of property and equipment                                         |       | —                                           |       | (55                                              | )          |
| **Net cash used in investing activities**                                    |       | —                                           |       | (55                                              | )          |
| **Cash flows from financing activities:**                                    |       |                                             |       |                                             |       |
| Proceeds  from notes payable                                                 |       | 1,485                                            |       | 5,489                                            |       |
| Proceeds  from notes payable to related parties                              |       | 100                                              |       | —                                           |       |
| Payments  of notes payable                                                   |       | (44                                              | )          | —                                           |       |
| Payment  on capital lease                                                    |       | (11                                              | )          | (10                                              | )          |
| Proceeds  from issuance of preferred stock                                   |       | 6                                                |       | —                                           |       |
| Proceeds  from issuance of common stock                                      |       | 2                                                |       | 459                                              |       |
| Payment  of fees for financing transactions                                  |       | —                                           |       | (284                                             | )          |
| Payments  of notes payable to related parties                                |       | —                                           |       | (132                                             | )          |
| **Net cash provided by financing activities**                                |       | 1,538                                            |       | 5,522                                            |       |
| ** **                                                                   |       |                                             |       |                                             |       |
| **Net increase (decrease) in cash and cash equivalents**                     |       | 280                                              |       | (922                                             | )          |
| ** **                                                                   |       |                                             |       |                                             |       |
| **Cash and cash equivalents at beginning of year**                           |       | 7                                                |       | 928                                              |       |
| ** **                                                                   | ** ** | ** **                                       | ** ** | ** **                                       | ** ** |
| **Cash and cash equivalents at end of period**                               | ** ** | **$**                                            | **287**    | ** **                                       | **$**      | **6** | ** ** |
| ** **                                                                   | ** ** | ** **                                       | ** ** | ** **                                       | ** ** |
| **Supplemental disclosures of cash flow information:**                       | ** ** | ** **                                       | ** ** | ** **                                       | ** ** |
| Cash  paid for income taxes                                                  |       | —                                           |       | —                                           |       |
| Cash  paid for interest                                                      |       | —                                           |       | 126                                              |       |
| ** **                                                                   |       |                                             |       |                                             |       |
| **Supplemental disclosures of non-cash financing activities:**               |       |                                             |       |                                             |       |
| Reclass  of warrants from liability to equity                                |       | 799                                              |       | —                                           |       |
| Issuance  of detachable warrants                                             |       | 989                                              |       | 73                                               |       |
| Increase  in convertible notes principal                                     |       | 413                                              |       | —                                           |       |
| Issuance  of common stock for convertible debt                               |       | 191                                              |       | 2,463                                            |       |
| Reclass  of derivatives from liability to equity                             |       | 132                                              |       | —                                           |       |
| Record  warrants and embedded derivatives as liabilities                     |       | 45                                               |       | 6,489                                            |       |
| Issuance  of common stock for interest conversion                            |       | —                                           |       | 199                                              |       |
| Discount  on convertible notes                                               |       | —                                           |       | 68                                               |       |
| Issuance  of common stock for anti-dilution                                  |       | —                                           |       | 55                                               |       |
| Repurchase  of common stock                                                  |       |                                             |       | 36                                               |       |
| Conversion  of preferred stock to common stock                               |       | —                                           |       | 15                                               |       |

 

The accompanying notesare an integral part of these condensed interim financial statements.

 

5

----

Table ofContents

 

NOTES TO FINANCIAL STATEMENTS

 

***1. Organization***

 

OnFebruary 8, 2007, Tripath Technology Inc., a Delaware corporation(“Tripath”) filed a voluntary petition for relief under Chapter 11 of theBankruptcy Code. On February 1, 2008, the bankruptcy court issued an orderconfirming approval of the Plan of Reorganization, including the merger and thetransfer of all of Tripath’s existing assets into a separate bankruptcy estateand the discharge of all of Tripath’s liabilities.  The Plan ofReorganization also contemplated the merger of Etelos, Incorporated, aWashington corporation (“Etelos-WA”) with Tripath.  The overallimpact of the confirmed Plan of Reorganization was for Tripath to emerge fromthe bankruptcy proceeding with no assets and no liabilities as a shellcorporation and for all issued and outstanding securities of and interests inTripath, including debentures, stock options (including, but not limited to, allstock options granted to employees), warrants, and other shares of common stockto be canceled and extinguished.

 

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.

 

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, thestockholders’ deficit section of the accompanying balance sheet has beenadjusted to reflect the legal capital structure of Tripath adjusted for thechange in authorized shares of common and preferred stock.

 

***2.  The Company***

 

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

 

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.

 

Eteloshas developed products for Web Applications, which include open standards-basedtools for Web developers, businesses and individual users such as the EtelosApplication ServerTM (EASTM) and the Etelos Development EnvironmentTM (EDETM).  EAS andEDE support many common programming languages and also support the EnglishApplication Scripting Engine (EASETM), a simple-to-use open standards-based scriptinglanguage developed by the Company.  Inorder to support broader adoption of its products, 

 

6

----

Table ofContents

 

EASEand other components of the EDE are made available to developers at marketappropriate pricing.  This is done tosupport the development of new Web Applications and the migration of existingWeb Applications into the Etelos ecosystem where there are tools and othersupport mechanisms for the marketing, distribution, and support of theseapplications.  Etelos generally receivesa transaction fee or subscription fee for transactions that occur within theEtelos ecosystem either via the Etelos MarketplaceTM pursuant to StorefrontOperating Agreements, or in third-party branded Marketplaces operated by Etelospursuant to Marketplace Partner Agreements (sometimes referred to as “an EtelosMarketplace” or, collectively, as “the Etelos Marketplaces”).  Most customers in Etelos Marketplaces pay asubscription fee, which revenue Etelos shares with Syndication Partners andMarketplace Partners; this revenue share is calculated as a percentage of grossrevenues from the sale of subscriptions to customers of Syndication Partnerproducts and service in the Etelos Marketplaces.

 

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

 

*Basis of Presentation*

 

The accompanyingcondensed financial statements include our accounts as of September 30,2009, and December 31, 2008, and for the nine months ended September 30,2009 and 2008. The accompanying condensed balance sheet as of December 31,2008, has been derived from the audited balance sheet in the Company’s annualreport on Form 10-K for the fiscal year ended December 31, 2008.These condensed financial statements have been prepared by management, withoutaudit, pursuant to the rules and regulations of the Securities andExchange Commission, or SEC. Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to such rules and regulations. TheCompany has performed an evaluation of subsequent events through the date offiling of the financial statements.

 

In the opinion ofmanagement, all adjustments (which consist of normal recurring adjustments,except as disclosed herein) necessary to fairly present the financial position,results of operations and cash flows for the interim periods presented havebeen included. The results of operations for the quarter ended September 30,2009, and the nine months ended September 30, 2009, are not necessarilyindicative of the results to be expected for the full year or for any futureperiods.

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and reported amounts of revenues and expenses during the reportingperiod. Actual results could differ from those estimates, and such differencescould affect the results of operations reported in future periods and suchdifferences could be material.  Thesefinancial statements should be read in conjunction with the audited financialstatements and accompanying notes included in the Company’s annual report on Form 10-Kfor the fiscal year ended December 31, 2008.  Certain prior period amounts have beenreclassified to conform to the present period presentation.

 

During the third quarter of2009, the Company adopted the new Accounting Standards Codification (“ASC”) asissued by FASB.  The ASC has become the authoritative source of US GAAPrecognized by FASB to be applied by non-governmental entities.  The ASC isnot intended to amend or change US GAAP.  The adoption of the ASC did nothave a material impact on the Company’s financial statements.

 

*Concentration of 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 nine months ended September 30,2009, three customers accounted for 88% of the Company’s revenue in the period.One customer accounted for 100% of the Company’s accounts receivable as of September 30,2009.

 

*Allowance for 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 September 30, 2009, and December 31, 2008, theCompany determined that an allowance for doubtful accounts was not necessary orwarranted.

 

7

----

Table of Contents

 

*Deferred Revenue*

 

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.

 

*Property and 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.

 

*Fair Value 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.

 

*Research and 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 ASC 985-20 “Costs of Software to be Sold, Leased,or Marketed” (ASC 985-20). Under ASC 985-20, costs incurred in the research anddevelopment of new software products are expensed as incurred untiltechnological feasibility is established. Research and development costs arecapitalized beginning when a product’s technological feasibility has beenestablished and ending when the product is available for general release tocustomers. Technological feasibility is reached when the product reaches theworking model stage. To date, products and enhancements have generally reachedtechnological feasibility and have been released for sale at substantially thesame time and all research and development costs have been expensed.

 

ASC350-40 “Internal-Use Software” (ASC 350-40), which applies to SaaS businessmodel, are met for the capitalization of software development cost.  UnderASC 350-40, software development costs, including costs incurred to purchasethird party 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 ASC 350-40for capitalization.

 

*Revenue Recognition*

 

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 under perpetual andterm licenses.  Revenues are recognized on these service and licensingtransactions using the criteria in ASC 605-10, “Revenue Recognition”, (ASC605-10) and ASC 985-605, “Software Revenue Recognition” (ASC 985-605),respectively, which both provide that revenue may be recognized when all of thefollowing are met:

 

·                                          persuasive evidence of anarrangement exists,

·                                          the product or service hasbeen delivered,

·                                          the fee is fixed ordeterminable, and

·                                          collection of the resultingreceivable 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.

 

8

----

Table of Contents

 

For software licensed under term or perpetualagreements, persuasive evidence of an arrangement is evidenced by a bindingagreement signed by the customer and delivery generally occurs upon delivery ofthe software to a common carrier. If a significant portion of a fee is dueafter our normal payment terms of typically 30 days, then we recognize revenueas the fees become due. If the Company determines that collection of a fee isnot reasonably assured, then it defers the fees and recognizes revenue uponcash receipt, provided that all other revenue 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.

 

*Stock Based Compensation*

 

TheCompany, under ASC 718-10, “Compensation — Stock Compensation” (ASC 718-10) isapplying the “modified prospective method” and used the Black-Scholes Mertonmodel 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. ASC 718-10 also requires the Company toestimate forfeitures in calculating the expense relating to share-basedcompensation as opposed to only recognizing these forfeitures and thecorresponding reduction in expense as they occur. This resulted in $106thousand and $73 thousand of expense for the nine months ended September 30,2009 and 2008, respectively.

 

ASC718-10 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 the nine months ended September 30,2009 and 2008. Prior to the adoption of ASC 718-10, those benefits would havebeen reported as operating cash flows had we received any tax benefits relatedto stock option exercises.

 

*Income Taxes*

 

TheCompany accounts for income taxes in accordance with ASC 740-10, “Income Taxes”(ASC 740-10) which utilizes the liability method of accounting for incometaxes. Deferred tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statementcarrying amount of existing assets and liabilities and their respective taxbases. Deferred tax assets and liabilities are measured using enacted tax ratesexpected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled. Valuation allowances areestablished when necessary to reduce deferred tax assets to the amountsexpected to be realized.

 

TheCompany has adopted the provisions of ASC 740-10-25, “Income Taxes — Overall —Recognition” (ASC 740-10-25). The Company did not have any unrecognized taxbenefits and there was no effect on its financial condition or results ofoperations as a result of implementing ASC 740-10-25.

 

TheCompany files income tax returns in the United States of America federaljurisdiction and various state jurisdictions in the United States ofAmerica.  The Company does not believethat there will be any material changes in its unrecognized tax positions overthe next twelve months.  The Companybelieves that its income tax filing positions and deductions would be sustainedon audit and does not anticipate any adjustments that will result in a materialadverse effect on the Company’s financial position, results of operations, orcash flow.  Therefore, no reserves foruncertain income tax positions have been recorded pursuant to ASC740-10-25.  In addition, the Company didnot record a cumulative effect adjustment related to the adoption of ASC740-10-25.

 

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 ASC740-10-25, the Company did not have any accrued interest or penaltiesassociated with any unrecognized tax benefits, nor was any such interestexpense recognized during the nine months ended September 30, 2009 and2008, or the year ended December 31, 2008. The Company’s effective tax rate differs from the federal statutory rateprimarily due to increases in its deferred income tax valuation allowance.

 

*Net Income (Loss) per Share*

 

Basicnet income (loss) per share is computed by dividing the net loss available tocommon stockholders for the period by the weighted average number of shares ofcommon stock outstanding during the period, excluding any unvested restrictedstock that is subject to repurchase. Diluted net income per share is computedusing the weighted average number of common shares and, if dilutive, potentialcommon shares outstanding during the period. Potential common shares consist ofunvested restricted stock (using 

 

9

----

Table ofContents

 

thetreasury stock method), the incremental common shares issuable upon theexercise of stock options and warrants (using the treasury stock method) andthe conversion of the Company’s convertible notes and debentures (using theif-converted method).  As their effect is antidilutive, 108,731 and4,480,911 shares of common stock exercisable under outstanding employee stockoptions, 9,864,444 and 611,111 shares of common stock exercisable underoutstanding warrants, 11,191,424 and 6,426,074 shares of common stock issuableupon conversion of the outstanding convertible notes payable and debentures, asof, and for the nine months ended September 30, 2009 and 2008, respectively,have been excluded from this calculation.  The average exercise price ofoutstanding employee stock options to purchase the Company’s common stock is$0.22 and $0.23, respectively, at September 30, 2009 and 2008. The averageexercise price of outstanding warrants to purchase the Company’s common stockis $0.45 and $1.80, respectively, at September 30, 2009 and 2008.

 

The following table sets forth the computation ofbasic and diluted net loss per share for the periods presented (in thousands,except per share amounts):

 
| ** **                              | ** ** | **For the Three Months********Ended September 30,** | ** ** | **For the Nine Months********Ended September 30,** | ** ** |
|-----------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                              | ** ** | **2009**                                                                     | ** ** | **2008**                                                               | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                    |       |                                                                         |       |                                                                   |       |   |   |   |   |
| Numerator:                              |       |                                                                         |       |                                                                   |       |   |   |   |   |
| Net income (loss)                       |       | $                                                                            | (1,200     | )                                                                      | $          | 1,651 |   | $ | (4,725 | ) | $ | (22,153 | ) |
|                                    |       |                                                                         |       |                                                                   |       |   |   |   |   |
| Net income (loss) - diluted             |       | $                                                                            | (1,200     | )                                                                      | $          | 1,651 |   | $ | (4,725 | ) | $ | (22,153 | ) |
|                                    |       |                                                                         |       |                                                                   |       |   |   |   |   |
| Denominator:                            |       |                                                                         |       |                                                                   |       |   |   |   |   |
| Weighted average common stock           |       | 24,074                                                                       |       | 23,036                                                                 |       | 23,839 |   | 16,522 |   |
|                                    |       |                                                                         |       |                                                                   |       |   |   |   |   |
| Convertible notes payable               |       | —                                                                       |       | 3,382                                                                  |       | — |   | — |   |
|                                    |       |                                                                         |       |                                                                   |       |   |   |   |   |
| Weighted average common stock - diluted |       | 24,074                                                                       |       | 26,418                                                                 |       | 23,839 |   | 16,522 |   |
|                                    |       |                                                                         |       |                                                                   |       |   |   |   |   |
| Net income (loss) per share:            |       |                                                                         |       |                                                                   |       |   |   |   |   |
| Basic                                   |       | $                                                                            | (0.05      | )                                                                      | $          | 0.07 |   | $ | (0.20 | ) | $ | (1.34 | ) |
| Diluted                                 |       | $                                                                            | (0.05      | )                                                                      | $          | 0.06 |   | $ | (0.20 | ) | $ | (1.34 | ) |

 

*Use of Estimates*

 

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 fromthose estimates.

 

*Segment Reporting*

 

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 evaluatesperformance, makes operating decisions, and allocates resources based onfinancial data consistent with the presentation in the accompanying financialstatements.

 

***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 $4.7 million and $22.2 million for the nine months ended September 30,2009 and 2008, respectively, and has a total stockholders’ deficit of $11.9 millionand $10.8 million, as of September 30, 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 

 

10

----

Table ofContents

 

operatingexpenses by termination of employees and other reductions in operatingexpenses.  Alternatives being pursued toimprove the Company’s cash flow used in operations include (1) raisingadditional working capital through additional sale of preferred stock, commonstock and/or debt and (2) reducing cash operating expenses to levels thatare in line with current revenues.  The first alternative could result insubstantial dilution to existing shareholders. There can be no assurance thatthe Company’s current financial position can be improved, that it can raiseadditional working capital, or that it can achieve positive cash flows fromoperations. The Company’s long-term viability as a going concern is dependentupon its ability to (1) locate sources of debt or equity funding to meetcurrent commitments and near-term future working capital requirements and (2) achieveprofitability and ultimately generate sufficient cash flow from operations tosustain its continuing operations.

 

TheCompany’s cash balance including proceeds from its recent debt financings andpreferred stock financing may not be sufficient to fund operations beyond June 2010. 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.

 

On September 30,2009, the Company issued convertible debentures (the “10% Senior SecuredDebentures”) with a principal amount of $2.0 million, warrants to purchase5,250,000 shares of the Company’s common stock, and 750,000 shares of commonstock in exchange for $0.8 million in cash and the cancellation of $1.2 millionin promissory notes and accrued interest. Seventy-five percent of the 10% Senior Secured Debentures are held byEnable Capital Management LLC or its affiliates (“Enable Capital”).  Enable Capital beneficially owns more than10% of the Company’s common stock. Under the terms of thesecurities purchase agreement pursuant to which the 10% Senior SecuredDebentures were issued, subject to the satisfaction of certain covenants andconditions, the Company has the right, at any time after December 15, 2009and before January 15, 2010, to require the purchasers of the 10% SeniorSecured Debentures to purchase an aggregate of $1.0 million in additionalprincipal amount of 10% Senior Secured Debentures.  At September 30, 2009, the purchasers of the 10%Senior Secured Debentures executed and delivered all documents in thetransaction except for funding of $500,000 which was paid in full subsequent tothe period end. The $500,000 of funding was recorded as an Other Receivable inthe accompanying condensed balance sheet as of September 30, 2009.

 

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

 

InOctober 2009, the FASB issued new accounting guidance related to therevenue recognition of multiple element arrangements. The new guidance statesthat if vendor specific objective evidence or third party evidence fordeliverables in an arrangement cannot be determined, companies will be requiredto develop a best estimate of the selling price to separate deliverables andallocate arrangement consideration using the relative selling price method. Theaccounting guidance will be applied prospectively and will become effective forthe Company during the first quarter of fiscal 2011. Early adoption is allowed.The Company is currently evaluating the impact of this accounting guidance onits financial statements.

 

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

 

Convertible notes and debentures comprise (in thousands):

 
| ** **                                                                | ** ** | **September 30,********2009** | ** ** | **December 31,  2008** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------|------------|
|                                                                      |       |                               |       |                        |       |
| 6% Convertible Notes                                                      |       | $                                  | 1,764      |                        | $          | 1,764 |   |
| January 2008  Debentures                                             |       | 2,320                              |       | 2,000                       |       |
| April 2008 Debentures                                                |       | 4,012                              |       | 3,500                       |       |
| 10% Senior Secured Debentures                                             |       | 2,000                              |       | —                      |       |
|                                                                      |       | 10,096                             |       | 7,264                       |       |
|                                                                      |       |                               |       |                        |       |
| Plus (less) premium (discount) on notes payable                           |       | (1,621                             | )          | (—                     | )          |
|                                                                      |       | 8,475                              |       | 7,264                       |       |
| Less current portion of notes payable                                     |       | (1,764                             | )          | (7,264                      | )          |
|                                                                      |       |                               |       |                        |       |
| Long term notes payable, net of premium (discount),  less current portion |       | $                                  | 6,711      |                        | $          | — |   |

 

11

----

Table ofContents

 

*6%Convertible Notes*

 

During the period August 2007to October 2007, the Company issued 6% convertible notes (the “6%Convertible 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 matured on March 31,2009, with interest due and payable on February 1, 2008, and on the lastday of each calendar quarter thereafter. The Company was required to makepayments on the outstanding principal balance beginning September 1, 2008,and on the 1st day of each calendar quarter thereafter. The default interestrate was 8 percent. The notes and unpaid interest are convertible into sharesof the Company’s common stock at the option of the holder or involuntarily uponthe occurrence of certain financing events. As of December 31, 2008, and September 30,2009, $1,562 thousand of the face value of the 6% Convertible Notes had beenconverted to 2,083 thousand shares of the Company’s common stock and $1,764thousand remain outstanding. The Company failed to make required interest andprincipal payments as of December 31, 2008, and through September 30,2009. Accordingly, the Company was and remains in default under the terms ofthe notes, which resulted in all principal and interest related to the notesbecoming due and payable to the holders. As a result, the Company classifiedall amounts due related to the 6% Convertible Notes as current liabilities asat December 31, 2008, and September 30, 2009.

 

In addition, thepurchasers of the 6% Convertible Notes received warrants to purchase 1,080,000shares of the Company’s common stock at an exercise price of $0.12. At December 31,2008, all of these warrants had been exercised or expired and none areoutstanding.

 

*January 2008Debentures — Prior to Restructuring on June 30, 2009 (see below)*

 

On January 31, 2008,the Company issued convertible debentures (the “January 2008 Debentures”)with a principal amount of $2 million and detachable warrants to purchase222,222 shares of its common stock in exchange for $1.9 million.  The January 2008Debentures are all held by Enable Capital. Enable Capital beneficially owns morethan 10% of the Company’s common stock. The January 2008 Debentures are due on January 31, 2010, andbear interest at 6 percent per annum payable semiannually on January 1 andJuly 1, commencing July 1, 2008.  Monthly principal paymentsequal to 1/18th of the principal amount were to begin on September 1,2008.  The Company had 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 or 85 percent of the average of the volume weighted average price pershare for its common stock for the 10 consecutive trading days immediately priorto the applicable payment date.  The equity conditions that it must meetinclude having a currently effective registration statement covering the sharesof common stock issuable upon conversion of the debenture, and having the dailydollar trading volume for its common stock exceed $250,000 for each of the 20consecutive trading days before the date in question.  The January 2008Debentures and any accrued interest are convertible at anytime at thediscretion of the holder at a conversion price per share of $1.35, subject to acap on the beneficial ownership of its shares of common stock by the holder andits affiliates following such conversion. The conversion price is adjusted upona stock split, reverse stock split, or upon issuance of stock dividends,whereby the conversion price would be adjusted to ensure that the holder wouldbe receiving the same number of shares, as though the conversion right had beenexercised prior to the triggering event.  Further, the conversion price isadjusted if common stock or equivalents are subsequently sold or re-priced at aprice below the conversion price or rights, options or warrants are issued toholders of its common stock entitling them to purchase common stock at priceslower than the volume weighted average price on the date issued.

 

The Company has theoption to redeem the January 2008 Debentures before their maturity bypayment in cash of an amount equal to 120 percent of the then outstandingprincipal amount, plus accrued interest and other charges, and the right toforce conversion of the debentures if the average of the volume weightedaverage price of its common stock exceeds $3.39 for 20 trading days out of aconsecutive 30 trading day period.  This redemption option and forcedconversion right are subject to the Company meeting certain equity conditions,including having the daily dollar trading volume for its common stock exceed$250 thousand for each of the 20 consecutive trading days before the date inquestion and having a currently effective registration statement covering theshares of common stock issuable upon conversion of the debentures and theforced conversion option, subject to the applicable cap on the beneficialownership of its shares of common stock by the holder and its affiliates followingsuch conversion.  The January 2008 Debentures are collateralized bysubstantially all the assets of the Company.

 

The January 2008Debentures impose certain covenants on the Company, including restrictionsagainst incurring additional indebtedness, creating any liens on its property,amending its certificate of incorporation or bylaws, redeeming or payingdividends on shares of our outstanding common stock, and entering into certainrelated party transactions.  The January 2008 Debentures also definecertain events of default, including, without limitation, failure to make apayment obligation, failure to observe other covenants of the debenture orrelated 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 the 

 

12

----

Table ofContents

 

right to accelerate allamounts outstanding under the debentures and demand payment of a mandatorydefault amount equal to 130 percent of the amount outstanding plus accruedinterest and expenses. The Company failed to make required interest andprincipal payments on the January 2008 Debentures beginning with thepayment due on September 30, 2008 and through June 30, 2009.Accordingly, the Company is in default under the terms of the January 2008Debentures, and the holders have the right to demand that the default amountequal to 130% of the amount outstanding plus accrued interest be paid to theholders. As of December 31, 2008 and June 30, 2009, the Companyclassified all amounts due related to the January 2008 Debentures ascurrent liabilities, and the holders had not elected to exercise their rightsarising from the Company’s default.

 

The detachable warrants,which are fully exercisable, to purchase 222,222 shares of our common stock,expire in January 2011 and are exercisable at a price of $1.80 per share,subject to adjustment.  As of September 30, 2009, none of thesewarrants had been exercised.

 

*Restructuringof January 2008 Debentures*

 

On June 30, 2009,the Company executed an agreement to restructure the January 2008Debentures. Under the terms of the agreement, the maturity of the debentureswas extended to December 31, 2012; the outstanding interest as of June 30,2009, and interest that would have been earned under the original terms of theDebentures was added to principal as of June 30, 2009; the interest ratewas reduced to 0% until September 30, 2010; the monthly amortizingredemption payment schedule was eliminated and replaced with a requirement topay interest only on a semi-annual basis beginning January 1, 2011, and topay principal at maturity; the option to make principal and interest paymentsin shares of common stock instead of cash was removed; the anti-dilutionprovisions were modified so that the conversion price cannot be reduced below$0.10 as a result of subsequent equity sales; the registration rights agreemententered into in conjunction with the debentures was terminated; the optionalredemption amount was reduced to 100% of the then outstanding principal amountplus accrued but unpaid interest and plus all liquidated damages and otheramounts due; and all past defaults were waived. Additionally, the warrantsissued in conjunction with the debentures were modified so that the warrant maybe exchanged for a share of common stock on a 1:1 basis, and were modified toeliminate the anti-dilution provisions afforded for subsequent equity sales ata price lower than the original conversion price. No direct fees were eithercharged by or received from the debenture holders for the restructuring.

 

The Company evaluated therestructuring of the January 2008 Debentures, under the guidance inASC 470-50 “Debt — Modifications and Extinguishments” (ASC 470-50) as of June 30,2009. The Company concluded that the restructuring of the January 2008Debentures met the definition of an extinguishment of debt as the terms of themodified debentures were substantially different from the original terms.Accordingly, the Company recorded the difference between the fair value andcarrying value of the January 2008 Debentures as a loss on extinguishmentof debt of $300 thousand in earnings for the six months ended June 30,2009.

 

Additionally, as part ofthe restructuring of the January 2008 Debentures, the outstanding accruedinterest of $170 thousand as of June 30, 2009, was reclassified tooutstanding principal, and the interest that was to have been earned under theoriginal terms of the debentures from July 1, 2009, through September 30,2010, of $150 thousand was recorded as an increase to outstanding principal withthe corresponding debit amount being recorded as Accreting Interest onConvertible Notes Payable. This interest amount will be accreted to earningsover the revised maturity date of the January 2008 Debentures using theeffective interest method.

 

The Company recorded adebt premium of $300 thousand related to the difference between the fair valueand the revised principal amount of the January 2008 Debentures, alongwith the increase in the fair value of the embedded conversion option of $50thousand as a debt discount, and debt issuance costs related to fees incurredby the Company from service providers related to the restructuring of the January 2008Debentures of $9 thousand were capitalized as Debt Issuance Costs. These itemswill be accreted or amortized to earnings over the revised maturity date of theJanuary 2008 Debentures using the effective interest method.

 

*April 2008Debentures — Prior to Restructuring on June 30, 2009 (see below)*

 

On April 22, 2008,the Company issued convertible debentures (the “April 2008 Debentures”)with a principal amount of $3.5 million and detachable warrants to purchase388,889 shares of our common stock in exchange for $3.4 million.  The April 2008Debentures are all held by Enable Capital. Enable Capital beneficially owns more than 10% of the Company’s commonstock.  The April 2008 Debenturesare due on April 30, 2010, and have identical terms and conditions to the January 2008Debentures described above. The Company failed to make required interest andprincipal payments on the April 2008 Debentures beginning with the paymentdue on September 30, 2008, and through June 30, 2009. Accordingly,the Company is in default under the terms of the April 2008 Debentures,and the holders have the right to demand that the default amount equal to 130%of the amount outstanding plus accrued interest be paid to the holders. As of December 31,2008 and June 30, 2009, the Company classified all amounts due related tothe April 2008 Debentures as current liabilities, and the holders had notelected to exercise their rights arising from the Company’s default.

 

13

----

Table ofContents

 

The detachable warrants,which are fully exercisable, to purchase 388,889 shares of our common stock,expire in April 2011 and are exercisable at a price of $1.80 per share,subject to adjustment.  As of September 30, 2009, none of thesewarrants had been exercised.

 

In connection with the January 2008Debentures and the April 2008 Debentures, the Company also entered into aregistration rights agreement with the investors, pursuant to which it agreedto file a registration statement covering the resale of the shares of commonstock that may be issued to such investors upon the conversion of thedebentures, payment in kind, and the exercise of the related warrants. The Company agreed to maintain the effectiveness of the registration statement(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 of 1933, or the Securities Act. If the registrationstatement is not declared effective by an agreed to date, or if the Companyfail to maintain the effectiveness of the registration statement, then theCompany is required to pay to each investor, as partial liquidated damages,cash equal to 1.0 percent of the aggregate purchase price paid by such investorfor the securities purchased in the financing and then held by such investor,and must pay to such investor 1 percent for each subsequent 30-day period thatthe default remains uncured, up to a maximum aggregate liquidated damagesamount of 10 percent of the aggregate purchase price paid by the holders of thedebentures.

 

The Company’sregistration statement was effective July 31, 2008, which was eight daysafter the deadline in the registration rights agreements. However, thepenalties for this delay were waived in the agreement to restructure the January 2008and April 2008 Debentures on June 30, 2009.

 

*Restructuringof January 2008 and April 2008 Debentures*

 

On June 30, 2009,the Company executed an agreement to restructure the January 2008 and April 2008Debentures. Under the terms of the agreement, the maturity of these debentureswas extended to December 31, 2012; the outstanding interest as of June 30,2009, and interest that would have been earned under the original terms of thedebentures was added to principal as of June 30, 2009; the interest ratewas reduced to 0% until September 30, 2010; the monthly amortizingredemption payment schedule was eliminated and replaced with a requirement topay interest only on a semi-annual basis beginning January 1, 2011, and topay principal at maturity; the option to make principal and interest paymentsin shares of common stock instead of cash was removed; the anti-dilutionprovisions were modified so that the conversion price cannot be reduced below$0.10 as a result of subsequent equity sales; the registration rights agreemententered into in conjunction with these debentures was terminated; the optionalredemption amount was reduced to 100% of the then outstanding principal amountplus accrued but unpaid interest and plus all liquidated damages and otheramounts due; and all past defaults were waived. Additionally, the warrantsissued in conjunction with these debentures were modified so that the warrantmay be exchanged for a share of common stock on a 1:1 basis, and were modified toeliminate the anti-dilution provisions afforded for subsequent equity sales ata price lower than the original exercise price. No direct fees were eithercharged by or received from the debenture holders for the restructuring.

 

The Company evaluated therestructuring of these debentures under the guidance of ASC 470-50 “Debt —Modifications and Extinguishments” (ASC 470-50) as of June 30, 2009.  The Company concluded that the restructuringof the January 2008 Debentures met the definition of an extinguishment ofdebt, as the terms of the modified debentures were substantially different fromthe original terms.  Accordingly, theCompany recorded the difference between the fair value and carrying value ofthe January 2008 Debentures as a loss on extinguishment of debt of $300thousand in earnings for the six months ended June 30, 2009.

 

The Company concludedthat the restructuring of the April 2008 Debentures did not meet thedefinition of an extinguishment of debt as the terms of the modified debentureswere not substantially different from the original terms. However, as the April 2008Debentures included an embedded conversion feature, the Company is required toaccount for any increase in the fair value of the embedded conversion optionimmediately prior to and immediately after the transaction as a debt discountwith the credit being recorded as additional paid in capital. Accordingly, theCompany recorded the increase in the fair value of the embedded conversionoption of $80 thousand as a debt discount that will be amortized over therevised maturity date of the April 2008 Debentures using the effectiveinterest method.

 

The Company recorded adebt premium of $300 thousand related to the difference between the fair valueand the revised principal amount of the January 2008 Debentures, alongwith the increase in the fair value of the embedded conversion option of $50thousand as a debt discount, and debt issuance costs related to fees incurredby the Company from service providers related to the restructuring of the January 2008Debentures of $9 thousand were capitalized as Debt Issuance Costs. These itemswill be accreted or amortized to earnings over the revised maturity date of theJanuary 2008 Debentures using the effective interest method.

 

Additionally, as part ofthe restructuring of the April 2008 Debentures, the outstanding accruedinterest of $420 thousand as of June 30, 2009, was reclassified tooutstanding principal, and the aggregate interest that would have accrued underthe original terms of the debentures from July 1, 2009, through September 30,2010, of $413 thousand was recorded as an increase to outstanding principalwith the corresponding debit amount being recorded as Accreting Interest onConvertible Notes Payable. This interest amount will be accreted to earningsover the revised maturity date of these Debentures using the effective interestmethod.

 

14

----

Table ofContents

 

*10% Senior Secured Debentures*

 

On September 30,2009, the Company issued 10% Senior Secured Debentures with a principal amountof $2.0 million, warrants to purchase 5,250,000 shares of our common stock, and750,000 shares of our common stock in exchange for $0.8 million in cash and thecancellation of $1.2 million in promissory notes and accrued interest. Seventy-five percent of the 10% Senior Secured Debentures are held byEnable Capital.  Enable Capital beneficiallyowns more than 10% of the Company’s common stock.  The 10% Senior Secured Debentures are due on September 30,2011, and bear interest at 10 percent per annum payable quarterly on January 1,April 1, July 1, and October 1, commencing January 1,2010.  The principal amount is due on maturity.  The 10% Senior Secured Debentures areconvertible at anytime at the discretion of the holder at a conversion priceper share of $0.50, subject to a cap on the beneficial ownership of its sharesof common stock by the holders and their affiliates following such conversion.The conversion price is adjusted upon a stock split, reverse stock split, orupon issuance of stock dividends, whereby the conversion price would beadjusted to ensure that the holder would be receiving the same number ofshares, as though the conversion right had been exercised prior to thetriggering event.  Further, the conversion price is adjusted if commonstock or equivalents are subsequently sold or re-priced at a price below theconversion price, or rights, options or warrants are issued to holders of itscommon stock entitling them to purchase common stock at prices lower than thevolume weighted average price on the date issued, with a floor for theconversion price of $0.10 per share.

 

The Company has theoption to redeem the 10% Senior Secured Debentures before their maturity bypayment in cash of an amount equal to 100 percent of the then outstandingprincipal amount, plus outstanding accrued interest and other charges, and allinterest that would have accrued if the outstanding principal amount hadremained outstanding through maturity.  This redemption option is subjectto the Company meeting certain equity conditions, including having the dailydollar trading volume for its common stock exceed $250 thousand for each of the20 consecutive trading days before the date in question and having a currentlyeffective registration statement covering the shares of common stock issuableupon conversion of the debentures, subject to the applicable cap on thebeneficial ownership of its shares of common stock by the holders and theiraffiliates following such conversion.  The 10% Senior Secured Debenturesare collateralized by substantially all the assets of the Company.

 

The 10% Senior SecuredDebentures impose certain covenants on the Company, including restrictionsagainst incurring additional indebtedness, creating any liens on its property,amending its certificate of incorporation or bylaws, redeeming or payingdividends on shares of our outstanding common stock, and entering into certainrelated party transactions.  The 10% Senior Secured Debentures also definecertain events of default, including, without limitation, failure to make apayment obligation, failure to observe other covenants of the debenture orrelated 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 10% Senior Secured Debentures have theright to accelerate all amounts outstanding under the debentures and demandpayment of a mandatory default amount equal to the greater of (i) theoutstanding principal amount plus all accrued and unpaid interest divided bythe conversion price multiplied by the volume weighted average price or (ii) 120percent of the amount outstanding, plus accrued interest and expenses, and allinterest that would have accrued if the then outstanding principal amount hadremained outstanding through maturity. Additionally the mandatory defaultamount would also include all other amounts, costs, expenses and liquidateddamages due in respect of the debentures.

 

The detachable warrants,which are fully exercisable, to purchase 3,000,000 and 2,250,000 shares of ourcommon stock, expire in September 2014 and September 2016,respectively, and are exercisable at a price of $0.60 and $0.01 per share,respectively, subject to adjustment.  The warrants may be exchanged for ashare of common stock on a 1:1 basis, and the warrants that expire in September 2014include a floor on the exercise price of $0.10 per share.  As of September 30, 2009, none of thesewarrants had been exercised.

 

As part of the issuanceof the 10% Senior Secured Debentures, the Company exchanged existing promissorynotes with an aggregate principal amount of $1,150 thousand, including the $250thousand promissory note issued in July 2009, for a like portion of 10% SeniorSecured Debentures. The Company evaluated the restructuring of these promissorynotes under the guidance in ASC 470-50 “Debt — Modifications andExtinguishments” (ASC 470-50) as of September 30, 2009. The Companyconcluded that the restructuring of the various promissory notes met thedefinition of an extinguishment of debt as the terms of the 10% Senior Secured Debentureswere substantially different from the original terms of the promissory notesdue to the insertion of a conversion feature. Accordingly, the Company recordedthe difference between the fair value of the 10% Senior Secured Debentures andcarrying value of the promissory notes as a loss on extinguishment of debt of$288 thousand in earnings for the nine months ended September 30, 2009,including the remaining unamortized debt discount recorded on the July 2009promissory note of $68 thousand.

 

15

----

Table ofContents

 

The Company recorded adebt premium of $220 thousand related to the difference between the fair valueand the principal amount of the 10% Senior Secured Debentures, and debtissuance costs related to fees incurred by the Company of $25 thousand werecapitalized as Debt Issuance Costs. Additionally, the Company recognized afurther debt discount due to a beneficial conversion feature on the issuance ofthe 10% Senior Secured Debentures of $776 thousand.  These items will be accreted or amortized toearnings over the maturity date of the 10% Senior Secured Debentures using theinterest method.

 

At September 30,2009, the purchasers of the 10% Senior Secured Debentures executed anddelivered all documents in the transaction except for funding of $500,000 whichwas paid subsequent to the end of the period. The $500,000 of funding wasrecorded as an Other Receivable in the accompanying condensed balance sheet asof September 30, 2009.

 

*EmbeddedDerivatives*

 

The Company has evaluatedthe embedded derivatives included in the 6% Convertible Notes, the January 2008and April 2008 Debentures, and the 10% Senior Secured Debentures,consisting of the conversion features and certain put and call featuresdescribed above, under the guidance in ASC 815-10 “Derivatives and Hedging”(ASC 815-10) on the issuance date of the Convertible Notes, the January 2008and April 2008 Debentures, and the 10% Senior Secured Debentures, and oneach subsequent reporting date.  The purpose of the evaluation is todetermine whether the embedded derivatives need to be bifurcated from the debthost and accounted for as a derivative at their estimated fair value as aliability at the date of issuance and thereafter, adjusted to estimated fairvalue with a charge or credit to the Company’s statement of operations. ASC 815-10 generally indicates that if the conversion features are (i) indexedto the Company’s capital stock under the guidance in ASC 815-40-15,“Derivatives and Hedging — Contracts in Entity’s Own Equity — Scope and ScopeExceptions” (ASC 815-40-15), and (ii) would be classified as equity if a freestandingderivative under the guidance in ASC 815-40-25 “Derivatives and Hedging —Contracts in Entity’s Own Equity — Recognition” (ASC 815-40-25) then theembedded derivatives need not be bifurcated from the debt host.  ASC815-40-25 generally requires, among other factors, that (i) the Companycan settle the 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.  ASC 815-10 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.  The January 2008and April 2008 Debentures, and the 10% Senior Secured Debentures includeput and call features.

 

*EmbeddedDerivatives — 6% Convertible Notes*

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the conversion features embedded in the 6%Convertible Notes met the criteria in ASC 815-10 at issuance and through April 21,2008, the day prior to the merger with Tripath, because the conversion to theCompany’s common stock could only be settled in its capital stock, the capitalstock could be unregistered and the sufficiency of the authorized shares wasunder the Company’s control as it could control the outcome of a shareholdervote to increase the authorized shares.  However, on the date of themerger with Tripath, April 22, 2008, the Company concluded it no longerhad control to ensure the sufficiency of its authorized shares of common stockand recorded the conversion features embedded in the 6% Convertible Notes withan estimated fair value of $3,674 thousand and recorded the amount as Warrant andDerivative Liability. At December 31, 2008, and June 30, 2009, theestimated fair value of the conversion features was subsequently revalued to $2thousand and $0 thousand, with the related credit of $3,672 and $2 thousandincluded in the Company’s statement of operations in interest expense for theyear ended December 31, 2008, and the six months ended June 30, 2009,respectively. The Company determined the estimated fair value of the conversionfeatures on April 22 and December 31, 2008, and June 30, 2009,by using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $2.91, $0.33, and$0.36, respectively, per share; terms of 0.95, 0.25, and 0 years, respectively;risk free interest rates of 1.82%, 0.11% and 0.0%, respectively; and volatilityof 47.16%, 73.59%, and 0.0%, respectively. Probabilities were then applied tothe outputs using the Matlab Monte Carlo Simulation of the Company’s stockprices to arrive at a value for the conversion options.

 

Upon the restructuring ofthe Company’s January and April Debentures on June 30, 2009, theCompany concluded that the conversion features embedded in the 6% ConvertibleNotes met the criteria in ASC 815-10 to be accounted for as an equityinstrument because the Company had control to ensure the sufficiency of itsauthorized shares of common stock, as the modified anti-dilution provisionsrelating to the January 2008 and April 2008 Debentures include afloor on the conversion price adjustment as a result of any subsequent equitysales. Due to the change in classification from liability to equity, theCompany recorded a reclassification of the fair value as of June 30, 2009to additional paid in capital of $0 thousand. As of September 30, 2009,the Company continues to conclude that the conversion features embedded in the6% Convertible Notes meet the criteria in ASC 815-10 to be accounted for as anequity instrument.

 

16

----

Table of Contents

 

*EmbeddedDerivatives — January 2008 and April 2008 Debentures*

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the conversion features embedded in the January 2008Debentures met the criteria in ASC 815-10 at issuance and through April 21,2008, the day prior to the merger with Tripath, and therefore, were notbifurcated from the debt host because the conversion to the Company’s commonstock could only be settled in its common stock, the common stock could beunregistered and the sufficiency of the authorized shares was under theCompany’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 conversion feature in unregistered shares. Therefore, the Companyrecorded the conversion features embedded in the January 2008 Debentureswith an estimated fair value of $896 thousand and recorded the amount asWarrant and Derivative Liability.  At December 31, 2008, and June 30,2009, the estimated fair value of the conversion feature was subsequentlyrevalued to $5 thousand and $2 thousand, respectively, with the related creditof $891 thousand and $3 thousand included in the Company’s statement ofoperations in interest expense for the year ended December 31, 2008, andthe six months ended June 30, 2009. The Company determined the estimatedfair value of the conversion options on April 22 and December 31,2008, and June 30, 2009, using the Black-Scholes Merton valuation modeland the following assumptions: fair value of the Company’s common stock of$2.91, $0.33, and $0.36, respectively, per share; terms of 1.75 years, 1.08years, and 0.58 years, respectively; risk free interest rates of 1.84%, 0.40%,and 0.39%, respectively; and volatility of 47.16% 65.48%, and 48.84%,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.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the conversion features embedded 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 its authorized shares of commonstock. The estimated fair value of the embedded conversion features was $1,507thousand at April 22, 2008, and recorded in the line entitled “Warrant andderivative liability” in the accompanying Balance Sheet. At December 31,2008, and June 30, 2009, the estimated fair value of the embeddedconversion features was subsequently revalued to $10 thousand and $2 thousand,respectively, with the related credit of $1,497 thousand and $8 thousandincluded in the Company’s statement of operations in interest expense for theyear ended December 31, 2008, and the six months ended June 30, 2009,respectively. The Company determined the estimated fair value of the conversionoptions on April 22 and December 31, 2008, and June 30, 2009,using the Black-Scholes Merton valuation model and the following assumptions:fair value of the Company’s common stock of $2.91, $0.33, and $0.36,respectively, per share; terms of 2, 1.33, and 0.83 years, respectively; riskfree interest rates of 1.87%, 2.24%, and 0.49%, respectively; and volatility of49.00%, 61.48%, and 58.72%, 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.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the conversion features embedded in the January 2008and April 2008 Debentures met the criteria in ASC 815-10 to be accountedfor as an equity instrument because the Company had control to ensure thesufficiency of its authorized shares of common stock, as the modifiedanti-dilution provisions relating to the January 2008 and April 2008Debentures include a floor on the conversion price adjustment as a result ofany subsequent equity sales, and because the conversion features no longer arerequired to be settled in registered shares. Due to the change inclassification from liability to equity, the Company recorded areclassification of the fair value of the conversion features embedded in the January 2008and April 2008 Debentures as of June 30, 2009, to additional paid incapital of $0 thousand and $2 thousand, respectively. As of September 30,2009, the Company continues to conclude that the conversion features embeddedin the 6% Convertible Notes meet the criteria in ASC 815-10 to be accounted foras an equity instrument.

 

The Company alsoconcluded that the put and call in the January 2008 and April 2008Debentures were embedded derivatives that were not clearly and closely relatedto the debt host and therefore should be bifurcated from the debt host along withthe conversion features and recorded as a liability at their estimated fairvalue at issuance.  The Company determined the net fair value of the putand call embedded in the January 2008 and April 2008 Debentures on April 22and December 31, 2008 to be de minimus.

 

As of September 30,2009, the Company concluded that the put and call features embedded in the January 2008and April 2008 Debentures continue to be not clearly and closely relatedto the debt host and therefore should be bifurcated from the debt host andrecorded as a liability at their estimated fair value. The Company determinedthe net fair value of the put and call to be $91 thousand and $157 thousand forthe January 2008 and April 2008 Debentures, respectively, with therelated debit of $91 thousand and $157 thousand, respectively, included in theCompany’s statement of operations in interest expense for the nine months endedSeptember 30, 2009. The Company determined the estimated fair value of theput on September 30, 2009, using the Black-Scholes Merton valuation modeland the following assumptions: fair value and exercise price of the putembedded in the January 2008 and April 2008 Debentures equivalent to130% of the outstanding principal and accrued interest of $3,015,858 and$5,216,312, respectively; term of 3.25 years to the maturity date of December 31,2012; risk free interest rate of 1.56%; and volatility of 14.91% which wasdetermined using the volatility of the Bank Prime Lending Rate. The Companydetermined the estimated fair value of the call on September 30, 2009,using the Black-Scholes Merton valuation model and the following assumptions:fair value and exercise 

 

17

----

Table ofContents

 

price of the callembedded in the January 2008 and April 2008 Debentures equivalent to100% of the outstanding principal and accrued interest of $2,319,890 and$4,012,548, respectively; term of 3.25 years to the maturity date of December 31,2012; risk free interest rate of 1.56%; and volatility of 14.91% which wasdetermined using the volatility of the Bank Prime Lending Rate.

 

*EmbeddedDerivatives — 10% Senior Secured Debentures*

 

Upon the issuance of the10% Senior Secured Debentures on September 30, 2009, the Company concludedthat the conversion features embedded in the 10% Senior Secured Debentures metthe criteria in ASC 815-10 to be accounted for as an equity instrument eventhough the 10% Senior Secured Debentures include a reset provision on theconversion price and is considered non-conventional debt, because the Companyhas control to ensure the sufficiency of its authorized shares of common stock,as the debentures include a floor on the conversion price adjustment, andbecause the conversion features are not required to be settled in registeredshares.

 

The Company alsoconcluded that the put and call in the 10% Senior Secured Debentures wereembedded derivatives that were not clearly and closely related to the debt hostand therefore should be bifurcated from the debt host and recorded as aliability at their estimated fair value at issuance.  The Companydetermined the net fair value of the put and call embedded in the 10% SeniorSecured Debentures on September 31, 2009 to be $45 thousand, and recordeda discount on the debentures that will be amortized as interest expense overthe life of the debentures using the interest method.

 

The Company determinedthe estimated fair value of the put on September 30, 2009, using theBlack-Scholes Merton valuation model and the following assumptions: fair valueand exercise price of the put embedded in the 10% Senior Secured Debenturesequivalent to 120% of the outstanding principal and accrued interest expectedto be earned to maturity of $2,800,000; term of 2.0 years to the maturity dateof September 30, 2011; risk free interest rate of 0.95%; and volatility of18.31% which was determined using the volatility of the Bank Prime LendingRate. The Company determined the estimated fair value of the call on September 30,2009, using the Black-Scholes Merton valuation model and the followingassumptions: fair value and exercise price of the call embedded in the 10%Senior Secured Debentures equivalent to 100% of the outstanding principal andaccrued interest expected to be earned to maturity of $2,400,000; term of 2.0years to the maturity date of September 30, 2011; risk free interest rateof 0.95%; and volatility of 18.31% which was determined using the volatility ofthe Bank Prime Lending Rate.

 

*WarrantsIssued in Connection with January 2008 and April 2008 Debentures*

 

Effective with theissuance of the January 2008 and April 2008 Debentures, the Companyissued warrants to purchase 222,222 and 388,889 shares, respectively, of the Company’scommon stock at an exercise price of $1.80 per share, subject to adjustment,which warrants have a term of three years.

 

The Company evaluated theterms and conditions of the warrants issued with the January 2008 and April 2008Debentures under the guidance in ASC 815-40-25 and ASC 815-40-15 to determinewhether the warrants should be accounted for as equity or a liability andthereafter adjusted to their respective estimated fair value at each reportingdate.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrants issued with the January 2008Debentures met the criteria in ASC 815-40-25 and ASC 815-40-15 at issuance andthrough April 22, 2008, and therefore, were accounted for as equitybecause the warrants could only be settled by issuance of the Company’s 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.  However,on the date of the merger with Tripath, April 22, 2008, the Companyconcluded it no longer had control to ensure the sufficiency of its authorizedshares of common stock nor could it settle the warrants in unregistered sharesand therefore, recorded the estimated value fair value of the warrants of $320thousand asWarrant and Derivative Liability.  At December 31, 2008,and June 30, 2009, the estimated fair value of the warrants was revaluedto $1 thousand and $1 thousand, respectively, with the related credit of $319thousand and $0 thousand included in the Company’s statement of operations ininterest expense for the year ended December 31, 2008, and the six monthsended June 30, 2009, respectively. The Company determined the estimatedfair value of the warrants on April 22 and December 31, 2008, and June 30,2009, by using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $2.91, $0.33, and$0.36, respectively, per share; terms of 2.5, 2.08 and 1.58 years,respectively; risk free interest rates of 2.54%, 0.78%, and 0.88%,respectively; and volatility of 47.81%, 56.98%, and 59.34%, respectively.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrants issued with the April 2008Debentures did not meet the criteria in ASC 815-40-25 and ASC 815-40-15 atissuance because it no longer had control to ensure the sufficiency of itsauthorized shares of common stock nor could it settle the warrants inunregistered shares and therefore, recorded the estimated value fair value ofthe warrants of $590 thousand as Warrant and Derivative Liability.  At December 31,2008, and June 30, 2009, the estimated fair value of the warrants wasrevalued to $4 thousand and $2 thousand with the related credit of $586thousand and $2 thousand included in the Company’s statement of operations ininterest expense for the year ended December 31, 2008, and the six monthsended June 30, 2009, respectively. The Company determined the estimatedfair value of 

 

18

----

Table ofContents

 

the warrants on April 22and December 31, 2008, and June 30, 2009, by using the Black-ScholesMerton valuation model and the following assumptions: fair value of theCompany’s common stock of $2.91, $0.33, and $0.36, respectively, per share;terms of 3, 2.33, and 1.83 years, respectively; risk free interest rates of2.43%, 0.84%, and 1.02%, respectively; and volatility of 49.17%, 62.44%, and57.08%, respectively.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued with the January 2008 and April 2008Debentures met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accountedfor as equity because the Company had control to ensure the sufficiency of itsauthorized shares of common stock,.  TheCompany reached this conclusion because the conversion price of the January 2008and April 2008 Debentures that was subject to adjustment due toprice-based anti-dilution provisions was modified to include a floor on theconversion price adjustment as a result of any subsequent equity sales, andtherefore the Company was able to conclude that has a sufficient authorized butunissued number of shares to settle all outstanding contracts requiringsettlement in shares. Due to the change in classification from liability toequity, the Company recorded a reclassification of the fair value as of June 30,2009, to additional paid in capital of $1 thousand and $2 thousand,respectively. As of September 30, 2009, the Company continues to concludethat the warrants issued with the January 2008 and April 2008Debentures meet the criteria in ASC 815-10 to be accounted for as an equityinstrument.

 

*WarrantsIssued in Connection with 10% Senior Secured Debentures*

 

Effective with theissuance of the 10% Senior Secured Debentures, the Company issued Series Iand Series II warrants to purchase 3,000,000 and 2,250,000 shares,respectively, of the Company’s common stock at exercise prices of $0.60 and$0.01 per share, respectively, subject to adjustment, and with terms of fiveand seven years, respectively.

 

The Company evaluated theterms and conditions of the warrants issued with the 10% Senior SecuredDebentures under the guidance in ASC 815-40-25 and ASC 815-40-15 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.

 

On September 30,2009, the Company concluded that the Series I and Series II warrantsissued with the 10% Senior Secured Debentures met the criteria in ASC 815-40-25and ASC 815-40-15 at issuance, and therefore, were accounted for as equitybecause the warrants could only be settled by issuance of the Company’s commonstock, the common stock could be unregistered, and the sufficiency of theauthorized shares was under the Company’s control. The Company determined thefair value of the Series I and Series II warrants on September 31,2009 to be $424 thousand and $565 thousand, respectively, and recorded adiscount on the debentures that will be amortized as interest expense over thelife of the debentures using the interest method.

 

The Company determinedthe estimated fair value of the Series I warrants on September 30,2009, using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $0.78; exercise priceof $0.60; term of 5.0 years; risk free interest rate of 2.31%; and volatilityof 54.11%. The Company determined the estimated fair value of the Series IIwarrants on September 30, 2009, using the Black-Scholes Merton valuationmodel and the following assumptions: fair value of the Company’s common stockof $0.78; exercise price of $0.01; term of 7.0 years; risk free interest rateof 2.93%; and volatility of 57.83%.

 

*WarrantsIssued in Connection with Other Notes Payable and Notes Payable to RelatedParties*

 

Effective with theissuance of promissory notes on February 23, March 31, and July 9,2009, the Company issued warrants to purchase 26,667, 133,333, and 500,000shares, respectively, of the Company’s common stock at an exercise price of$0.75 per share, which warrants have a term of three, three, and five years,respectively.

 

The Company evaluated theterms and conditions of these warrants under the guidance in ASC 815-40-25 andASC 815-40-15 to determine whether the warrants should be accounted for asequity or a liability and thereafter adjusted to their respective estimatedfair value at each reporting date.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrant issued with the promissory note inFebruary 2009, did not meet the criteria in ASC 815-10 at issuance becausethe Company did not have control to ensure the sufficiency of its authorizedshares of common stock and therefore, recorded the estimated value fair valueof the warrant of $36 thousand as Warrant and Derivative Liability.  At June 30,2009, the estimated fair value of the warrant was revalued to $1 thousand withthe related credit of $35 thousand included in the Company’s statement ofoperations in interest expense for the six months ended June 30, 2009. TheCompany determined the estimated fair value of the warrant on February 23and June 30, 2009, by using the Black-Scholes Merton valuation model andthe following assumptions: fair value of the Company’s common stock of $2.01and $0.36, respectively, per share; terms of 3 and 2.67 years, respectively;risk free interest rates of 1.34% and 1.46%, respectively; and volatility of53.63% and 52.58%, respectively.

 

19

----

Table ofContents

 

Thefair value of the warrant recorded upon issuance was treated as a discount onother notes payable, and was amortized over the life of the promissory note,which matured on May 31, 2009, using the interest method. During the sixmonths ended June 30, 2009, $36 thousand of the discount was amortized tointerest expense.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued with the promissory note in February 2009met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for asequity because the Company had control to ensure the sufficiency of itsauthorized shares of common stock. The Company reached this conclusion becausethe conversion price of the January 2008 and April 2008 Debenturesthat was subject to adjustment due to price-based anti-dilution provisions wasmodified to include a floor on the conversion price adjustment as a result ofany subsequent equity sales, and therefore the Company was able to concludethat it has a sufficient authorized but unissued number of shares to settle alloutstanding contracts requiring settlement in shares. Due to the change inclassification from liability to equity, the Company recorded areclassification of the fair value as of June 30, 2009 to additional paidin capital of $1 thousand. As of September 30, 2009, the Company continuesto conclude that the warrants issued with the promissory note in February 2009should be accounted for as equity. The February 2009 promissory note wascancelled on September 30, 2009 in exchange for 10% Senior SecuredDebentures.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrant issued with the promissory note inMarch 2009, did not meet the criteria in ASC 815-10 at issuance becausethe Company did not have control to ensure the sufficiency of its authorizedshares of common stock and therefore, recorded the estimated value fair valueof the warrant of $83 thousand as Warrant and Derivative Liability.  At June 30,2009, the estimated fair value of the warrant was revalued to $7 thousand withthe related credit of $76 thousand included in the Company’s statement ofoperations in interest expense for the six months ended June 30,2009.  The Company determined the estimated fair value of the warrant on March 31and June 30, 2009, by using the Black-Scholes Merton valuation model andthe following assumptions: fair value of the Company’s common stock of $1.20and $0.36 per share, respectively; term of 3 and 2.75 years, respectively; riskfree interest rate of 1.15% and 1.51%, respectively; and volatility of 53.28%and 51.87%, respectively.

 

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.During the six months ended June 30, 2009, $35 thousand of the discountwas amortized to interest expense.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued with the promissory note in March 2009met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accounted for as anequity instrument because the Company had control to ensure the sufficiency ofits authorized shares of common stock. The Company reached this conclusionbecause the conversion price of the January 2008 and April 2008Debentures that was subject to adjustment due to price-based anti-dilutionprovisions was modified to include a floor on the conversion price adjustmentas a result of any subsequent equity sales, and therefore the Company was ableto conclude that it has a sufficient authorized but unissued number of sharesto settle all outstanding contracts requiring settlement in shares.  Due to the change in classification fromliability to equity, the Company recorded a reclassification of the fair valueas of June 30, 2009 to additional paid in capital of $7 thousand. As of September 30,2009, the Company continues to conclude that the warrants issued with thepromissory note in March 2009 should be accounted for as equity. The March 2009promissory note was cancelled on September 30, 2009 in exchange for 10%Senior Secured Debentures.

 

The Company concludedthat the warrant issued with the promissory note in July 2009 met thecriteria in ASC 815-40-25 and ASC 815-40-15 at issuance, and therefore, wasaccounted for as equity because the warrants could only be settled by issuanceof the Company’s common stock, the common stock could be unregistered, and thesufficiency of the authorized shares was under the Company’s control. TheCompany determined the fair value of the warrant on issuance to be $110thousand and recorded a discount on the promissory note that will be amortizedas interest expense over the life of the promissory note using the interestmethod. During the nine months ended September 30, 2009, the Companyamortized $42 thousand in the Company’s statement of operations as interestexpense. The July 2009 promissory note was cancelled on September 30,2009 in exchange for 10% Senior Secured Debentures. As a result, the remainingunamortized debt discount of $68 thousand was written off as part of the losson extinguishment of debt,

 

The Company determinedthe estimated fair value of the warrant on issuance, using the Black-ScholesMerton valuation model and the following assumptions: fair value of theCompany’s common stock of $0.55; exercise price of $0.75; term of 5.0 years;risk free interest rate of 2.34%; and volatility of 53.68%.

 

*Warrantsissued with New Series A Preferred Stock*

 

In October 2008 andas amended in December 2008, the Board of Directors authorized thedesignation and issuance of up to 3,333,333 shares of New Series AConvertible Preferred Stock (the “New Series A Preferred Stock”), and theoffering of up to $2,500,000 of New Series A Preferred Stock and a numberof warrants with an exercise price of $0.75 equal to 100% of the number of 

 

20

----

Table ofContents

 

shares purchased by eachpurchaser. Through the nine months ended September 30, 2009, and theperiod ending December 31, 2008, respectively, the Company closed a roundof financing for the sale of 10,000 and 833,333 shares, respectively, of itsNew Series A Preferred Stock at $0.75 per share, for an aggregate purchaseprice of $7.5 thousand and $625 thousand, respectively, and warrants topurchase 10,000 and 833,333 shares of common stock of the Company,respectively, at an exercise price of $0.75 per share, and a three year term.The lead investor of this financing was Daniel J.A. Kolke, the Company’sfounder, chairman, chief executive officer, acting chief financial officer, andchief technology officer, with participation from two of the Company’sdirectors and other prior investors. The holders of the January 2008Debentures and the April 2008 Debentures consented to this financing, butdid not participate.

 

The Company concluded atthe date of issuance and through the reporting date that the embeddedconversion features in the New Series A Preferred Stock should not bebifurcated from the equity host as they were clearly and closely related to theequity host. Also during the year ended December 31, 2008, the Companyrecorded 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.

 

The Company evaluated theterms and conditions of the warrants issued with the New Series APreferred Stock under the guidance in ASC 815-40-25 and ASC 815-40-15 todetermine whether the warrants should be accounted for as equity or a liabilityand thereafter adjusted to their respective estimated fair value at eachreporting date.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrants issued with the New Series APreferred Stock did not meet the criteria in ASC 815-40-25 and ASC 815-40-15 atissuance because the Company did not have control to ensure the sufficiency ofits authorized shares of common stock. Therefore, the Company recorded theestimated value fair value of the warrants of $148 thousand as Warrant andDerivative Liability.  At December 31, 2008, and June 30, 2009,respectively, the estimated fair value of the warrants was revalued to $40thousand and $40 thousand, respectively, with the related credit of $108thousand and $0 thousand included in the Company’s statement of operations infinancing expense for the year ended December 31, 2008, and the six monthsended June 30, 2009, respectively. The Company determined the estimatedfair value of the warrants on December 3 and 31, 2008 and June 30,2009, and February 27 and June 30, 2009, by using the Black-ScholesMerton valuation model and the following assumptions: fair value of theCompany’s common stock of $0.60, $0.33 and $0.36, and $0.51 and $0.36,respectively, per share; terms of 3, 2.92 and 2.42, and 3.0 and 2.67 years,respectively; risk free interest rates of 1.07%, 0.98% and 1.33%, and 1.4% and1.46%, respectively; and volatility of 53.07%, 54.96% and 54.25%, and 53.63%and 52.58%, respectively.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued in relation to the New Series APreferred Stock met the criteria in ASC 815-40-25 and ASC 815-40-15 to beaccounted for as an equity instrument because the Company had control to ensurethe sufficiency of its authorized shares of common stock. The Company reachedthis conclusion because the conversion price of the January 2008 and April 2008Debentures that was subject to adjustment due to price-based anti-dilutionprovisions was modified to include a floor on the conversion price adjustmentas a result of any subsequent equity sales, and therefore the Company was ableto conclude that it has a sufficient authorized but unissued number of sharesto settle all outstanding contracts requiring settlement in shares.  Due to the change in classification fromliability to equity, the Company recorded a reclassification of the fair valueas of June 30, 2009 to additional paid in capital of $40 thousand. As of September 30,2009, the Company continues to conclude that the warrants issued with the New Series APreferred Stock should be accounted for as equity.

 

*WarrantsIssued in Connection with Litigation Settlement*

 

Effective December 5,2008, the Company entered into a settlement agreement with Kaufman Bros.,pursuant to which the Company issued to Kaufman Bros. a warrant to purchase500,000 shares of the Company’s common stock at an exercise price of $0.75 pershare, which warrant has a term of five years. See discussion *infra* Note 12.

 

The Company evaluated theterms and conditions of the warrants issued in the settlement under theguidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrantsshould be accounted for as equity or a liability and thereafter adjusted to itsrespective estimated fair value at each reporting date.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrants issued in the settlement did notmeet the criteria in ASC 815-40-25 and ASC 815-40-15 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 thewarrants of $130 thousand as Warrant and Derivative Liability.  At December 31,2008, and June 30, 2009, respectively, the estimated fair value of thewarrants was revalued to $46 thousand and $47 thousand with the related(credit) debit of ($84) thousand and $1 thousand included in the Company’sstatement of operations in settlement expense for the year ended December 31,2008, and the six months ended June 30, 2009, respectively. The Companydetermined the estimated fair value of the warrants on December 5 and December 31,2008, and June 30, 2009, by using the Black-Scholes Merton valuation modeland the following assumptions: fair value of the Company’s common stock of$0.60, $0.33, and $0.36, respectively, per share; terms of 5 years, 4.92, and4.42 years, respectively; risk free interest rates of 1.67%, 1.53%, and 2.28%,respectively; and volatility of 56.16%, 56.74%, and 54.68%, respectively.

 

21

----

Table ofContents

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued in relation to the litigationsettlement met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accountedfor as an equity instrument because the Company had control to ensure thesufficiency of its authorized shares of common stock. The Company reached thisconclusion because the conversion price of the January 2008 and April 2008Debentures that was subject to adjustment due to price-based anti-dilutionprovisions was modified to include a floor on the conversion price adjustmentas a result of any subsequent equity sales, and therefore the Company was ableto conclude that it has a sufficient authorized but unissued number of sharesto settle all outstanding contracts requiring settlement in shares.  Due to the change in classification fromliability to equity, the Company recorded a reclassification of the fair valueas of June 30, 2009, to additional paid in capital of $47 thousand. As of September 30,2009, the Company continues to conclude that the warrants issued with thelitigation settlement should be accounted for as equity.

 

*WarrantsIssued in Connection with Consulting Agreement*

 

Effective March 2,2009, the Company entered into a consulting agreement with Salzwedel FinancialCommunications, Inc., pursuant to which the Company issued a warrant topurchase 2,000,000 shares of the Company’s common stock at an exercise price of$0.01 per share, which warrant has a term of five years.

 

The Company evaluated theterms and conditions of the warrants issued in relation to the consultingagreement under the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrants shouldbe accounted for as equity or a liability and thereafter adjusted to itsrespective estimated fair value at each reporting date.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrant issued in relation to theconsulting agreement did not meet the criteria in ASC 815-40-25 and ASC815-40-15 at issuance because the Company did not have control to ensure thesufficiency of its authorized shares of common stock and therefore, recordedthe estimated value fair value of the warrants of $1,001 thousand as Warrantand Derivative Liability.  At June 30, 2009, the estimated fair valueof the warrants was revalued to $702 thousand with the related credit of $299thousand included in the Company’s statement of operations in investorrelations expense for the six months ended June 30, 2009. The Companydetermined the estimated fair value of the warrants on March 2 and June 30,2009, by using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $0.51 and $0.36,respectively, per share; terms of 5 years and 4.67 years, respectively; riskfree interest rates of 1.86% and 2.39%, respectively; and volatility of 56.68%and 54.64%, respectively.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued in relation to the consultingagreement met the criteria in ASC 815-40-25 and ASC 815-40-15 to be accountedfor as an equity instrument because the Company had control to ensure thesufficiency of its authorized shares of common stock. The Company reached thisconclusion because the conversion price of the January 2008 and April 2008Debentures that was subject to adjustment due to price-based anti-dilutionprovisions was modified to include a floor on the conversion price adjustmentas a result of any subsequent equity sales, and therefore the Company was ableto conclude that it has a sufficient authorized but unissued number of sharesto settle all outstanding contracts requiring settlement in shares.  Due to the change in classification fromliability to equity, the Company recorded a reclassification of the fair valueas of June 30, 2009 to additional paid in capital of $702 thousand. As of September 30,2009, the Company continues to conclude that the warrants issued with theconsulting agreement should be accounted for as equity.

 

The following is asummary of the movement related to embedded derivatives and warrant liabilitiesduring the nine months ended September 30, 2009 (in thousands):

 

22

----

Tableof Contents

 
| ** **                                                                                                   | ** ** | **Embedded  derivatives** | ** ** | **Warrant  liabilities** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|--------------------------|------------|-----------|------------|
|                                                                                                         |       |                      |       |                     |       |      |       |
| Balance as of  December 31, 2008                                                                        |       | $                         | 16         |                     | $          | 92        |       | $ | 108 |   |
|                                                                                                         |       |                      |       |                     |       |      |       |
| Fair value of  warrant liabilities issued with Other Notes Payable and Notes Payable to  Related Parties     |       |                      |       | 120                      |       | 120       |       |
| Fair value of  warrant liabilities issued with New Series A Preferred warrants                          |       |                      |       | 1                        |       | 1         |       |
| Fair value of  warrant liabilities issued with consulting agreement                                          |       |                      |       | 1,001                    |       | 1,001     |       |
| Fair value of embedded derivatives issued with 10%  Senior Secured Debentures                                |       | 45                        |       |                     |       | 45        |       |
| Change in marked-to-market value of 6% convertible  notes payable                                            |       | (2                        | )          |                     |       | (2        | )          |
| Change in marked-to-market value of  January 2008 Debentures                                            |       | 86                        |       |                     |       | 86        |       |
| Change in marked-to-market value of April 2008  Debentures                                              |       | 150                       |       |                     |       | 150       |       |
| Change in marked-to-market value of January 2008  warrants                                              |       |                      |       | (—                  | )          | (—   | )          |
| Change in marked-to-market value of April 2008  warrants                                                |       |                      |       | (3                       | )          | (3        | )          |
| Change in marked-to-market value of Other  Notes Payable and Notes Payable to Related Parties warrants       |       |                      |       | (112                     | )          | (112      | )          |
| Change in marked-to-market value of New  Series A Preferred warrants                                    |       |                      |       | (2                       | )          | (2        | )          |
| Change in marked-to-market value of litigation  settlement warrants                                          |       |                      |       | 1                        |       | 1         |       |
| Change in marked-to-market value of consulting  agreement warrants                                           |       |                      |       | (299                     | )          | (299      | )          |
| Reclassification to additional paid in capital upon  restructuring of January and April Debentures |       | (2                        | )          | (799                     | )          | (801      | )          |
|                                                                                                         |       |                      |       |                     |       |      |       |
| Balance as of September 30, 2009                                                                        |       | $                         | 293        |                     | $          | —    |       | $ | 293 |   |

 

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

 

The Company previouslyentered into a series of unsecured loan transactions with relatives of DanielJ.A. Kolke, its executive chairman, chief executive officer, acting chieffinancial officer, and chief technology officer.  On December 30,2007, in connection with settlement of these loans, the Company entered intothree unsecured promissory notes with an aggregate original principal amount of$816 thousand, each of which will become collateralized by certain presentlyunidentified assets of the Company if and when Daniel J.A. Kolke is no longeran employee of the Company nor a member of its board of directors.  Suchsecurity interest, if granted, would be subordinated to any and all bank debtor convertible corporate debt.  These three notes are outstanding and indefault in an aggregate balance of $685 thousand as of September 30, 2009.  No demands for payment have been made as ofthe date of this report and the default has been waived through the nine monthsended September 30, 2009.

 

During the quarter ended March 31,2009, the Company issued an unsecured promissory note with one of itsdirectors, in the principal 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, theCompany also issued to that director warrants to purchase 133,333 shares ofcommon stock of the Company with an exercise price of $0.75 per share and aterm of three years.

 

***8.Notes Payable***

 

On March 19, 2009,the Company issued an unsecured note of $88 thousand for an accounts payablebalance. The note bears interest of 11% and is due on April 1, 2010, withpayment terms of $15 thousand on issuance of the note, and monthly payments of$6 thousand beginning May 1, 2009 with a final payment on March 20,2010. Interest expense was $3 thousand for the nine months ended September 30,2009.

 

***9. Equity***

 

*Preferred Stock*

 

Duringthe nine months ended September 30, 2009, the Company sold 10,000 sharesof its New Series A Preferred Stock at $0.75 per share, for an aggregatepurchase price of $7.5 thousand, and warrants to purchase 10,000 shares ofcommon stock of the Company, at an exercise price of $0.75 per share, and athree year term.

 

*Common Stock*

 

TheCompany has issued 24,826,360 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 a warrant to purchase 2,000,000 shares of theCompany’s common stock at a price of $0.01 per share, exercisable through March 14,2014.

 

23

----

Table ofContents

 

In connection with theissuance of the 10% Senior Secured Debentures, the Company also issued 750,000shares of common stock.  The Company determined the fair value of theseshares of common stock on the date of issuance to be $191 thousand, andrecorded a discount on the 10% Senior Secured Debentures that will be amortizedas interest expense over the life of the debentures using the interest method.

 

***10. 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  |       | $                                                              | 0.24       |                                                        | 8.6        |                                | $          | 3,971 |   |
| Granted                                 |       | 750,000    |       | $                                                              | 0.10       |                                                        |       |                                |       |   |
| Exercised                               |       | (48,736    | )          | $                                                              | 0.05       |                                                        |       |                                |       |   |
| Canceled                                |       | (241,179   | )          | $                                                              | 0.67       |                                                        |       |                                |       |   |
| Outstanding at  September 30, 2009 |       | 4,546,582  |       | $                                                              | 0.22       |                                                        | 8.07       |                                | $          | 3,101 |   |
| Exercisable at  September 30, 2009 |       | 1,121,189  |       | $                                                              | 0.31       |                                                        | 7.84       |                                | $          | 738 |   |
| Unvested at  September 30, 2009    |       | 3,425,393  |       | $                                                              | 0.18       |                                                        | 8.15       |                                | $          | 2,363 |   |

 

Aggregateintrinsic value was determined based upon the closing price of the Company’scommon stock price on September 30, 2009, of $0.78 per share.

 

Theamount of cash received as a result of options exercised during the nine monthsended September 30, 2009, was $2 thousand. There were no equityinstruments granted under share-based payment arrangements and therefore therewas no cash used to settle any equity instrument. The Company does not plan torepurchase any shares during the upcoming annual period.

 

***11. Restructuring***

 

Aspart of its reduction of monthly cash operating expenses during the quarterended September 30, 2008, and continuing during the year ended December 31,2008, and the nine months ended September 30, 2009, the Company placed allremaining employees on partial deferrals of salary, ranging from 10% to 100% ofbase salary and accrued these deferrals. At September 30, 2009, and as of the date of filing this report,this deferral amount remains unpaid, including amounts due to employees in theCompany’s California office who were terminated during the period.

 

***12. Commitments and Contingencies***

 

In June 2008, Kaufman Bros. L.P. filedsuit against the Company in the United States District Court for the SouthernDistrict of New York (Case No. 80 CV 5716) and sought a temporaryrestraining order and other extraordinary relief.  The complaint arisesout of an advisory services agreement, pursuant to which Kaufman Bros. was toprovide to the Company advisory services in connection with financings andstrategic transactions. The Company notified Kaufman Bros. that it believedKaufman Bros. had failed to provide the required services under the agreement,and that it were therefore entitled to terminate the agreement for cause. Inthe suit, Kaufman Bros. was seeking (i) monetary damages of $400,000 foranticipatory breach of the agreement; (ii) $73,800 in fees allegedly owedin 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 the Company are notentitled to a refund of any fees previously paid to Kaufman Bros., and (v) adeclaration that the Company are obligated to pay Kaufman Bros. a commission onany financing or transaction that we enter into within 18 months following thetermination of the agreement.  On July 15, 2008, Kaufman Bros.voluntarily filed a notice of dismissal without prejudice.  Settlementdiscussions were unsuccessful and, on July 31, 2008, Kaufman Bros.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 to KaufmanBros. warrants to purchase 500,000 shares of the Company’s common stock at anexercise price of $0.75 per share, which warrants have a term of five years; (iii) theCompany and Kaufman Bros. agreed immediately to terminate all provisions, termsand conditions of the advisory services agreement and exchanged mutualreleases; and (iv) Kaufman Bros. agreed to dismiss the pending lawsuit inthe Supreme Court of New York, without prejudice. Subsequent to entering intothe settlement agreement, the Company has not fully complied with its paymentobligations under the settlement agreement but, through the date of filing ofthese financial statements, Kaufman Bros. has not exercised any of its remediesfor default under the settlement agreement.

 

OnOctober 31, 2008, the Company closed its offices in San Mateo,California.  The landlord for thesepremises filed a complaint claiming damages of $659 thousand and other amountsagainst the Company’s predecessor Etelos, Incorporated, a Washingtoncorporation (“Etelos —WA”) in the Superior Court of San Mateo County,California (Case No. CIV 479535).  Adefault judgment was entered for the landlord but the default was set asidebecause the landlord failed to properly serve either the Company or Etelos-WA.The Company is continuing to defend its position.

 

24

----

Table ofContents

 

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, in accordance with a Stock Purchase Agreement dated February 29,2008.On June 22, 2009, the Companyfiled a demand for Arbitration with the American Arbitration Association [Case No. 74166 00535 09 LMT] seeking injunctive and other relief, includingrescission of the Employment Agreement and the Stock PurchaseAgreement that it entered into with Mr. Garon.  The demand includesassertions that Mr. Garon misrepresented his employment qualificationsand, *inter alia*, seeks to recoverfrom Mr. Garon 2,383,333 shares of the Company’s common stock thatwere issued in connection with his employment.  Mr. Garon has filed acounter-demand against the Company, certain employees of the Company, andmembers of its Board of Directors seeking declaratory relief, apreliminary injunction, and damages in an amount to be proved at thearbitration.  The Hearing in this matteris scheduled to begin on November 16, 2009.

 

Aspart of the reduction of monthly cash operating expenses beginning in thequarter ending September 30, 2008, and continuing after the end of thequarter, the Company placed all employees on partial deferrals of salary,ranging from 10% to 100% of base salary. As of September 30, 2009, anduntil the filing date of this report, a substantial part of this deferralamount remains unpaid, including amounts due to employees who subsequently wereterminated. The $987 thousand of these unpaid salaries were accrued underaccrued payroll and related expenses payable as of September 30, 2009. Twoformer employees have asserted claims with the California Labor Commission forpayment of these unpaid amounts and the assertion of other such claims ordemands by such employees, or by governmental authorities, is foreseeable.

 

OnSeptember 9, 2009, the Company entered into a Master Agreement withRenovatix Solutions, LLC to market private label marketplaces directly andthrough resellers.  As part of thatAgreement, the Company agreed to issue up to 1 million shares of the Company’scommon stock to Renovatix Solutions LLC as bonus compensation for achievementof mutually agreed sales goals, which have not yet been established.

 

***13. Subsequent Events***

 

Underthe terms of the securities purchase agreement pursuant to which the 10% SeniorSecured Debentures were issued, the parties were obligated to fund theirpurchases on the Closing Date.  Howevertwo purchasers failed to make such payments before September 30, 2009, inthe aggregate amount of $500 thousand and that amount was recorded as an othercurrent asset on the accompanying condensed balance sheet.  Subsequent to September 30, 2009, bothpurchasers have made their payments, in the amounts of $250 thousand each.

 

OnSeptember 4, 2009, the Board of Directors adopted the 2009 EquityIncentive Plan (the “Plan”) and reserved 6 million shares for issuance underthe Plan.  On that date the Board alsoamended certain outstanding Stock Options to reduce the exercise price to theclosing price of the Company’s shares on October 2, 2009, and authorizedthe issuance of 4.725 million options with an exercise price to be set at theclosing price of the Company’s shares on October 2, 2009.  The closing price of the Company’s shares on October 2,2009, was $0.51.  Since the exerciseprice of the Options was not known until after September 30, 2009, theseOptions were not repriced or granted until after the end of the quarter.

 

**Item 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Overview**

** **

The following discussionof our financial condition and results of operations should be read inconjunction with our condensed financial statements and the related notes andother financial information appearing elsewhere in this report. Readers arealso urged to carefully review and consider the various disclosures made by uswhich attempt to advise interested parties of the factors which affect ourbusiness, including without limitation, the disclosures made under “Item 1A.Risk Factors” included in Part II of this report.

 

***Business***

 

We have a Web Applicationdistribution platform delivering Web Applications for businesses.  We provide a Software-as-a-Service (SaaS)ecosystem for building, distributing, and using Web Applications, including amarketplace to deploy and support them. Unlike other cloud computing and Platform-as-a-Service (PaaS) solutions,we enable software manufacturers to migrate existing applications or create newapplications, then package, distribute, host, bill, market and support theirSaaS enabled applications through multiple private label applicationsmarketplaces.

 

25

----

Table ofContents

 

We have 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), 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 generallyreceive a transaction fee or subscription fee for transactions that occurwithin the Etelos ecosystem either via the Etelos MarketplaceTM pursuant toStorefront Operating Agreements, or in third-party branded Marketplacesoperated by us pursuant to Marketplace Partner Agreements (sometimes referredto as “an Etelos Marketplace” or, collectively, as “Etelos Marketplaces”).  Most customers in Etelos Marketplaces pay asubscription fee, which we share with Syndication Partners and MarketplacePartners; this revenue share is calculated as a percentage of gross revenuesfrom the sale of subscriptions to Syndication Partner offerings in the EtelosMarketplaces.

 

EtelosMarketplaces support and encourage communities of developers, distributors, andconsumers to expand their offerings, collaborate on new ideas and improvements,and provide scalable solutions using Web Applications available to others.

 

***History***

 

We were originallyorganized as Etelos, Incorporated, a Washington corporation on May 5,1999. We have been engaged in the business of web application development andservices since our inception.

 

On February 8,2007, Tripath Technology Inc., a Delaware corporation (“Tripath”) filed avoluntary petition for relief under Chapter 11 of the Bankruptcy Code. On February 1,2008, the bankruptcy court issued an order confirming approval of the Plan ofReorganization, including the merger and the transfer of all of Tripath’sexisting assets into a separate bankruptcy estate and the discharge of all ofTripath’s liabilities.  The Plan ofReorganization also contemplated the merger of Etelos, Incorporated with andinto Tripath.

 

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

 

***RecentDevelopments***

 

On November 6,2008, we announced changes to our business model to focus on the sales andoperation of private label Web application marketplaces, including provision ofthe professional services required to develop, deploy and operate suchmarketplaces, and the launch of offerings of the Etelos Platform SuiteTM. The Etelos Platform Suite focuses on enabling Independent SoftwareVendors (ISVs) to implement SaaS delivery of their existing applications,whether or not those applications are already Web Applications, and syndicatingthe offering of those applications through multiple private label marketplaces.In these difficult economic times, we believe that a variety of ISVs will haveapplications that they need to move to the Web for lower cost implementation,easier, simpler scalability, and broader distribution.  The EtelosPlatform Suite also enables Marketplace Partners, including non-technologybusinesses, to have their own private label marketplaces and tools to offerSaaS Web Applications to better serve their customers in multiple distributionchannels.

 

Although we havelong enabled applications to be distributed via the Web, we believe this shiftaway from a core direct marketing focus of offering multiple products through asingle portal in the Etelos Marketplace will have four major benefits for ourbusiness. First, this offering will expose the core platform to more ISVs forgreater benefit to their end users and the creation of a larger pool ofapplications for syndication. Second, the development and operation of thirdparty-branded marketplaces shifts the financial expense and operational burdensof sales and marketing to end users to Marketplace Partners that better knowtheir customers and are better capitalized to support necessary sales andmarketing activities.  Third, because this two-pronged go-to-marketstrategy is offered on a revenue-sharing basis, it fundamentally reducesbarriers 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.

 

26

----

Table ofContents

 

During the periodended December 31, 2008, we began to implement this shift and, during theperiods up to the date of this report, we have entered into new SyndicationPartner agreements with ISVs to deliver SaaS-enabled versions of their productsand to syndicate those apps for distribution through a number of thirdparty-branded SaaS marketplaces.  In theinterim periods, we have launched third party private labeled marketplaces andwe have announced agreements to market and launch additional third partyprivate label marketplaces, including to third parties not traditionallyregarded as technology providers.  We expect to make further suchannouncements reflecting this shift during the coming months but we do not havean estimate or projection of how, or when, or if, the benefits, if any, of thisshift will be reflected in our operating results.

 

On September 30,2009, we issued convertible debentures (the “10% Senior Secured Debentures”)with a principal amount of $2.0 million, warrants to purchase 5,250,000 sharesof our common stock, and 750,000 shares of common stock in exchange for $0.8million in cash and the cancellation of $1.2 million in promissory notes andaccrued interest.  Seventy-five percentof the 10% Senior Secured Debentures are held by Enable Capital Management LLCor its affiliates (“Enable Capital”). Enable Capital beneficially owns more than 10% of the Company’s commonstock. Under the terms of the securities purchase agreement pursuant to whichthe 10% Senior Secured Debentures were issued, subject to the satisfaction ofcertain covenants and conditions, we have has the right, at any time after December 15,2009 and before January 15, 2010, to require the purchasers of the 10%Senior Secured Debentures to purchase an aggregate of $1.0 million inadditional principal amount of 10% Senior Secured Debentures.  At September 30, 2009, the purchasers of the 10%Senior Secured Debentures executed and delivered all documents in thetransaction except for funding of $500,000 which was received subsequent to theperiod end.

 

***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 transactionsusing the criteria in ASC 605-10, “Revenue Recognition” (ASC 605-10) and ASC985-605, “Software Revenue Recognition”, (ASC 985-605) respectively, which bothprovide that revenue may be recognized when all of the following criteria aremet:

 

·      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 reasonablyassured or probable.

 

Wemust first determine whether ASC 605-10 or ASC 985-605 applies to our revenuetransactions.  We than determine if thecriteria above have been met by assessing the ASC 605-10 and ASC 985-605 andtheir various 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.

 

27

----

Table ofContents

 

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. In addition,our revenue recognition policy requires an assessment as to whether collectionis 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***

 

UnderASC 985-20 “Costs of Software to be Sold, Leased, or Marketed” (ASC 985-20),costs incurred in the research and development of new software products areexpensed as incurred until technological feasibility is established.  Alternatively, ASC 350-40 “Internal UseSoftware” (ASC 350-40), applies to software development costs that are notrelated to software to be sold, licensed, leased or otherwise marketed as aseparate product or as part of a product or process and are within the scope ofASC 985-20.  Under ASC 350-40, softwaredevelopment costs incurred for software that is only used internally, includingcosts incurred to purchase third party software, are capitalized beginning whenthe Company has determined certain factors are present, including among others,that technology exists to achieve the performance requirements, buy versusinternal development decisions have been made, and the Company’s management hasauthorized the funding for the project. We must determine whether ASC 985-20 or ASC 350-40 is applicable to oursoftware development costs.  We then mustdetermine when software capitalization should begin and cease and what costsunder the applicable standard can be capitalized.  Both of these tasks involves considerablejudgment and can result in material different amounts of software beingcapitalized and have a significant impact on our reported results ofoperations.  To date, because we plan tolicense all our software products, we have determined that the provisions ofASC 985-20 should be applied to the cost of our product development.  As products and enhancements have generallyreached technological feasibility and have been released for sale at substantiallythe same time, all research and development costs have been expensed.

 

***Stock-Based Compensation Expense***

 

Wehave adopted ASC 718-10 using the modified prospective method andtherefore have not restated prior periods’ results. Under the fair value recognitionprovisions of ASC 718-10, we recognize stock-based compensation expense net ofan estimated forfeiture rate and therefore only recognize compensation cost forthose shares expected to vest over the service period of the award.  Calculating stock-based compensation expenserequires the input of highly subjective assumptions, including the expectedterm of the stock-based awards, stock price volatility, and the pre-vestingoption forfeiture rate. We estimate the expected life of options granted basedon historical exercise patterns, which we believe are representative of futurebehavior. We estimate the volatility of our common stock on the date of grantbased on the historical volatility of other publicly traded companies in ourindustry. The assumptions used in calculating the fair value of stock-basedawards represent our best estimates, but these estimates involve inherentuncertainties and the application of management judgment. As a result, iffactors change and we use different assumptions, our stock-based compensationexpense could be materially different in the future. In addition, we arerequired to estimate the expected forfeiture rate, as well as the probabilitythat performance conditions that affect the vesting of certain awards will be achieved,and only recognize expense for those shares expected to vest. We estimate theforfeiture rate based on historical experience of our stock-based awards thatare granted, exercised, and cancelled. If our actual forfeiture rate ismaterially different from our estimate, the stock-based compensation expensecould be significantly different from what we have recorded in the currentperiod. Beginning in the quarter ended December 31, 2008, and continuingin the quarter ended September 30, 2009, the global economy has beenhighly volatile and, during this period, the Company found it necessary to takedrastic measures to reduce operating expenses, but the likelihood of success ofthese efforts cannot be predicted.  Thereforethe forfeiture rate in the quarter ended December 31, 2008, was veryhigh.  The forfeiture rate declinedsubstantially during the nine months ended September 30, 2009, but it isnot known whether this forfeiture rate will be maintained in the future;management will continue to monitor its estimates.

 

***Accounting for Convertible Notes and Debentures, Embedded Derivativesand Warrants***

 

Weevaluate the embedded derivatives included in the debt instruments we issueunder the guidance in ASC 815-10 “Derivatives and Hedging” (ASC 815-10) on theissuance date of the debt and on each subsequent reporting date to determinewhether such embedded derivatives are clearly and closely related to the debthost.  The purpose of the evaluation isto determine whether the 

 

28

----

Table ofContents

 

embeddedderivatives, which are not clearly and closely related to the debt host, needto be bifurcated from the debt host and accounted for as a derivative at theirestimated fair value as a liability or asset at the date of issuance andthereafter, adjusted to estimated fair value with a charge or credit to our statementof operations. ASC 815-10 generally indicates that if the conversion featuresare (i) indexed to the Company’s capital stock under the guidance in ASC815-40-15 “Derivatives and Hedging — Contracts in Entity’s Own Equity — Scopeand Scope Exceptions” (ASC 815-40-15) and (ii) would be classified asequity if a freestanding derivative under the guidance in ASC 815-40-25“Derivatives and Hedging — Contracts in Entity’s Own Equity — Recognition” (ASC815-40-25), then the embedded derivatives need not be bifurcated from the debthost.  We also evaluate the warrantsissued with the debt under ASC 815-40-25 to determine whether the proceedsallocated to the warrants or the fair value of the warrants should be recordedas equity or a liability, respectively, and if a liability adjusted to fairvalue with a charge or credit to our statement of operations. ASC 815-40-25generally 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 capital stock. ASC815-10 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 ASC 815-10 is complex and it has manyinterpretations.  Accordingly, we must usejudgment to apply and interpret this guidance as well as ensure we have appliedthe 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 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.

 

Our analysis andjudgment may vary from quarter to quarter and changes in estimates may resultin significant increases or decreases in expenses.  Moreover, because of the relative size of ouroperations and the number of stock options and derivative instruments we haveissued, income and expenses associated with changes in the value of outstandingderivative securities historically have had an overshadowing impact on ourfinancial results.  Consequently, our netincome or loss for any particular period may not be indicative of the Company’sperformance for that period as a result of the application of such accountingrules, and therefore should not be relied upon by any person as an accuratedepiction of the true financial condition of the Company.

 

**Resultsof Operations**

 

***Three Months Ended September 30, 2009, Compared withThree Months Ended September 30, 2008***

 

***Revenues***

 

Revenues were $5 thousandand $10 thousand for the quarters ended September 30, 2009 and 2008,respectively. Revenues decreased by $5 thousand, or 50 percent, in the threemonths ended September 30, 2009, compared to the same period in 2008.  This decrease was due to our focus on theimplementation of longer-term projects without immediate cash flow.  In the year ended December 31, 2008, andto the date of this report, we also experienced a significant decline in salesof our customer resource management product, which had been introduced inmid-2007.

 

***Cost of Revenue***

 

Cost of revenue includesour costs of hardware, software and other resources used in delivery of ourproducts and services. Cost of revenue was $74 thousand and $211 thousand forthe quarters ended September 30, 2009 and 2008, respectively. Cost ofrevenue for the three months ended September 30, 2009, decreased by $137thousand, or by 65 percent.  The decrease in cost of revenue from 2008 to2009 was primarily attributable to the decreased costs of hosting and Internetbandwidth associated with the deployment of our products and services. Statedas a percentage of revenues, cost of revenue for the three months ended September 30,2009, was 1480 percent and for the corresponding period of 2008 was 2110percent.

 

***Operating Expenses***

 

*Researchand Development*. Research and development expenses include primarily employee and employeerelated expenses. Research and development expenses were $209 thousand and $844thousand for the quarters ended September 30, 2009 and 2008, respectively.Stated as a percentage of revenues, research and development expenses for thecorresponding periods were 4,180 percent and 8,440 percent, respectively.Research and development expenses decreased by $635 thousand or by 75 percent,in the three months ended September 30, 2009, compared to the same periodin 2008.  This decrease was primarily due to decreased salary and benefitsexpenses for fewer engineers engaged in research and development.

 

29

----

Table ofContents

 

*Salesand Marketing Expenses*.  Sales and marketing expenses include payroll, employeebenefits, and other headcount-related costs associated with sales and marketingpersonnel and travel, advertising, promotions, trade shows, seminars, and otherprograms. Sales and marketing expenses were $132 thousand and $514 thousand forthe quarters ended September 30, 2009 and 2008, respectively. The $382thousand, or 74 percent decrease in sales and marketing expenses was due toreduced headcount and decreased activities of sales and marketing following therestructuring begun in the quarter ended December 31, 2008.  Stated as a percentage of revenues, sales andmarketing expenses for the corresponding periods was 2,640 percent and 5,140percent, respectively.

 

*Generaland Administrative.* General and administrative expenses include payroll and related employeebenefits, and other headcount-related costs associated with finance,facilities, legal and other administrative expenses. General and administrativeexpenses were $312 thousand and $529 thousand for the quarters ended September 30,2009 and 2008, respectively. The $217 thousand, or 41 percent, decrease ingeneral and administrative expense was primarily attributable to decreasedhiring of accounting, administrative, legal, and compliance personnel and muchless use of consultants and temporary personnel.  Stated as a percentageof revenues, general and administrative expense for the corresponding periodswas 6,240 percent and 5,290 percent, respectively.

 

***Interest Income(Expense)***

 

Interest expense was$(205) thousand for the three months ended September 30, 2009, compared toincome of $3,739 thousand for the comparable period of 2008, and consistsprimarily of interest expense on convertible notes and debentures, amortizationof discounts on convertible notes and debentures, and the change in mark tomarket valuation of derivative and warrant liabilities. The decrease of $3.9million in interest expense from 2008 to 2009 related to the $4.2 million change in the markto market valuation of derivative and warrant liabilities primarily due to thedecrease in the Company’s stock price at September 30, 2008 from June 30, 2008, while therewas no comparable significant movement in the Company’s stock price at September 30,2009 from June 30, 2009.

 

***Net Income (Loss)***

 

Our net loss was $(1.2)million for the quarter ending September 30, 2009, compared to net incomeof $1.7 million for the quarter ending September 30, 2008, a decrease innet income of $2.9 million.  The decrease in net income from 2008 to 2009was primarily due to the $4.2 million change in the mark to market valuation ofderivative and warrant liabilities primarily due to the decrease in theCompany’s stock price at September 30, 2008 from June 30, 2008,offset by a loss on the cancellation of promissory notes in exchange for 10%Senior Secured Debentures on September 30, 2009 of $0.3 million, and adecrease in operating expenses of $1.2 million as noted above.

 

***Nine Months Ended September 30, 2009, Compared withNine Months Ended September 30, 2008***

 

***Revenues***

 

Revenues were $131thousand and $55 thousand for the periods ended September 30, 2009 and2008, respectively. Revenues increased by $76 thousand, or 138 percent, in thenine months ended September 30, 2009, compared to the same period in 2008.This increase was due to our temporary focus on short term consulting projectswith immediate cash flow.  In the yearended December 31, 2008, and to the date of this report, we alsoexperienced a significant decline in sales of our customer resource managementproduct, which had been introduced in mid-2007.

 

***Cost of Revenue***

 

Cost of revenue includesour costs of hardware, software and other resources used in delivery of ourproducts and services. Cost of revenue was $246 thousand and $459 thousand forthe periods ended September 30, 2009 and 2008, respectively. Cost ofrevenue for the nine months ended September 30, 2009, decreased by $213thousand, or by 46 percent.  The decrease in cost of revenue from 2008 to2009 was primarily attributable to the decreased costs of hosting and Internetbandwidth associated with the deployment of our products and services. Statedas a percentage of revenues, cost of revenue for the nine months ended September 30,2009, was 188 percent and for the corresponding period of 2008 was 835 percent.

 

***Operating Expenses***

 

*Researchand Development*. Research and development expenses include primarily employee and employeerelated expenses. Research and development expenses were $1.4 million and $3.3million for the nine months periods ended September 30, 2009 and 2008,respectively. Stated as a percentage of revenues, research and developmentexpenses for the corresponding periods were 1,066 percent and 6,036 percent,respectively. Research and development expenses decreased by $1.9 million or 58percent, in the nine months ended September 30, 2009, compared to the sameperiod in 2008.  This decrease was primarily due to decreased salary andbenefits expenses for fewer engineers engaged in research and development.

 

30

----

Table ofContents

 

*Salesand Marketing Expenses*.  Sales and marketing expenses include payroll, employeebenefits, and other headcount-related costs associated with sales and marketingpersonnel and travel, advertising, promotions, trade shows, seminars, and otherprograms. Sales and marketing expenses were $877 thousand and $1,315 thousandfor the nine months periods ended September 30, 2009 and 2008,respectively. The $438 thousand, or 33 percent, decrease in sales and marketingexpenses was due to reduced headcount and decreased sales and marketingactivities following the restructuring begun in the quarter ended December 31,2008. Stated as a percentage of revenues, sales and marketing expenses for thecorresponding periods are 669 percent and 2,391 percent, respectively.

 

*Generaland Administrative.* General and administrative expenses include payroll and related employeebenefits, and other headcount-related costs associated with finance,facilities, legal and other administrative expenses. General and administrativeexpenses were $1377 thousand and $1629 thousand for the periods ended September 30,2009 and 2008, respectively. The $252 thousand, or 15 percent, decrease in generaland administrative expense was primarily attributable to decreased hiring ofaccounting, administrative, legal, and compliance personnel and less use ofconsultants and temporary personnel.  Stated as a percentage of revenues,general and administrative expenses for the corresponding periods were 1,051percent and 2,962 percent, respectively.

 

***InterestExpense***

 

Interest expense was $686thousand for the nine months ended September 30, 2009, compared to $2,026thousand for the comparable period of 2008, and consists primarily of interestexpense on convertible notes and debentures, amortization of discounts onconvertible notes and debentures, and changes in the mark to market valuationof derivative and warrant liabilities. The decrease of $1.3 million in interestexpense from 2008 to 2009 related primarily to a non recurring expense in April 2008of $1.0 million related to the beneficial conversion of interest conversion.

 

***Net Loss***

 

Our net loss was $4.7million and $22.2 million for the nine months periods ended September 30,2009 and 2008, respectively, a decrease of $17.5 million, or 79 percent. The decrease in net loss from 2008 to 2009 was primarily due to nonrecurring merger related costs of $13.4 million that occurred in the quarterended June 30, 2008, to the decrease in operating expenses of $2.9 millionas noted above, and to a non recurring expense in 2008 of $1.0 million relatedto the beneficial conversion of interest conversion.

 

**Liquidityand Capital Resources**

 

OnSeptember 30, 2009, we had $287 thousand in cash and cash equivalents, netaccounts receivable of $4 thousand, and prepaid expenses and other currentassets and other receivables of $509 thousand. Our working capital deficit at September 30, 2009, was $4.8million, compared to a deficit of $10.3 million at December 31, 2008. Thedecrease in working capital deficit was due to the reclassification of the January 2008and April 2008 Debentures from short term to long term debt due to therestructuring of the debentures on June 30, 2009, and further discussed in“Note 6 Convertible Notes and Debentures and Embedded Derivative and WarrantLiability” in our financial statements included in this report.

 

Netcash used by operating activities during the nine months ended September 30,2009, was $1,258 thousand, compared to $6.4 million during the nine monthsended September 30, 2008. The primary use of cash from operatingactivities during the nine months ended September 30, 2009, was related topayment of expenses relating to accounting and compliance.

 

Investingactivities did not provide any cash during the nine months ended September 30,2009.  At that date we did not have anysignificant commitments for capital expenditures.

 

Netcash provided by financing activities during the nine months ended September 30,2009, was $1,538 thousand, primarily from the issuance of various promissorynotes and the 10% Senior Secured Debentures. See “ — Recent Developments” above.

 

AtSeptember 30, 2009, we had an other receivable of $500 thousand related to thesale of our 10% Senior Secured Debentures, which was collected subsequent tothe end of the quarter.  We also have aright to require purchasers of our 10% Senior Secured Debentures to purchase upto $1 million of additional debentures, subject to certain conditions.

 

Weneed immediate and substantial cash to continue our operations. Management hasprojected that the combination of cash on hand and proceeds from our otherreceivable of $500 thousand and further investment of $1 million will be sufficientto allow us to continue our operations only through June 2010. If cashreserves are not sufficient to sustain operations, then we plan to raiseadditional capital by selling shares of our capital stock or othersecurities.  However, there are no commitmentsor arrangements for future financings in place at this time and we can give noassurance that such capital will be available on favorable terms, or atall.  We may need additional financingthereafter until we can achieve profitability. We are considering alternativesto address our cash flow situation that include: (1) raising capitalthrough additional sale of our common stock and/or debentures and (2) reducingcash operating expenses to levels that are in line with current revenues.  If we cannot obtain additional financing,then we may be forced to curtail our operations, cease voluntarily filingreports with the SEC, or possibly be forced to evaluate a sale or liquidationof our assets or consider other strategic alternatives such as bankruptcy.  Even if we are successful in raisingadditional 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 

 

31

----

Table ofContents

 

warrantsto purchase 1,080,000 shares of common stock with an exercise price of $1.20per share. In connection with the merger that closed on April 22, 2008,$1.5 million of these notes were converted at $0.75 per share. At the time ofthe merger, all of the warrants had been exercised or expired by their termsupon closing the Merger.

 

Underthe terms of the remaining $1.8 million of the notes that were not converted,periodic principal payments were payable beginning on September 1,2008.  On June 15, 2008, the holdersof these notes agreed to either convert the then-accrued interest to shares ofcommon stock at a rate of one share for each $1.35 of interest owed or to addthe then-accrued interest to the principal, and to waive any default arisingout of our failure to pay the accrued and unpaid interest through June 15,2008.

 

Asof the filing date of this report, none of the required principal payments havenot been made and the Company does not have, or expect to have, cash on hand tomake the payments in the near future; no interest payments have been made forinterest accrued since June 15, 2008. We are in regular communication with the holders of the September 2007notes and none of the holders have demanded payment or exercised other remediesdue to our non-payments, but no assurances can be given that the holders willnot exercise their remedies in the 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, throughthe maturity date of January 31, 2010.

 

On March 2,2009, Enable Growth Partners LP, the holder — with its affiliates - of thesubstantial majority of the January 2008 and April 2008 Debentures,purchased the remainder of the January 2008 Debentures from Hudson BayFund LTD and its affiliate; price terms were not disclosed.  As a result of this transaction, EnableGrowth Partners LP and its affiliates own 100% of the January 2008Debentures.

 

OnJune 30, 2009, we executed an agreement to restructure our January 2008and April 2008 Convertible 6% Secured Debentures with a principal amountof $5.5 Million.  Under the terms of theagreement, the term of the debentures is extended to December 31, 2012,interest accrual will be at 0% from the date of the agreement until October 1,2010, and all accrued interest as of October 1, 2010, has been added toprincipal to be paid at maturity. Our obligation to make monthly amortizingredemption payments has been terminated; we are required to make semi-annualinterest payments only, beginning January 1, 2011. The registration rightsagreement entered into in conjunction with the debentures has been terminatedand the warrants issued in conjunction with the debentures will be exchangedfor Etelos common stock on 1:1 basis.

 

***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, throughthe maturity date of April 30, 2010.

 

On March 2,2009, Enable Growth Partners LP, the holder — with its affiliates - of thesubstantial majority of the April 2008 Debentures, purchased the remainderof the April 2008 Debentures from Hudson Bay Overseas Fund LTD; priceterms were not disclosed.  As a result ofthis transaction, Enable Growth Partners LP owns 100% of the April 2008Debentures.

 

OnJune 30, 2009, we executed an agreement to restructure our January 2008and April 2008 Convertible 6% Secured Debentures with a principal amountof $5.5 Million.  Under the terms of theagreement, the terms of the debentures are extended to December 31, 2012,interest accrual will be at 0% from the date of the agreement until October 1,2010, and all accrued interest as of October 1, 2010, has been added toprincipal to be paid at maturity. Our obligations to make monthly amortizingredemption payments has been terminated; we are required to make semi-annualinterest payments only, beginning January 1, 2011. The registration rightsagreement entered into in conjunction with the debentures has been terminatedand the warrants issued in conjunction with the debentures will be exchangedfor Etelos common stock on 1:1 basis.

 

***10%Senior Secured Debentures***

 

See “ — RecentDevelopments” above.

 

32

----

Table ofContents

 

***Operating and Capital Leases***

 

Wehave non-cancelable leases for corporate facilities and equipment.  Rent expense under the leases totaled $10thousand and $126 thousand for the nine months ended September 30, 2009and 2008, respectively.  Future minimumrental payments required under non-cancelable leases are as follows for thetwelve months ended December 31:

 
| ** **                                         | ** ** | **Operating  Leases** | ** ** | **Capital  Leases** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|---------------------|------------|
|                                               |       |                  |       |                |       |
| 2010                                               |       | —                |       | 13                  |       |
| 2011                                               |       | —                |       | 13                  |       |
| 2012                                               |       | —                |       | 2                   |       |
| Total minimum lease payments                       |       | $                     | —     |                | $          | 28 |   |
| Less: amount representing interest                 |       |                  |       | (6                  | )          |
| Present value of minimum lease payments            |       |                  |       | 22                  |       |
| Less: current portion of capital lease obligations |       |                  |       | (9                  | )          |
| Long-term capital lease obligations                |       |                  |       | $                   | 13         |   |
|                                                    |            |                       |            |                     |            |  |  |

 

OnOctober 31, 2008, the Company closed its offices in San Mateo,California.  The landlord for thesepremises filed a complaint claiming damages of $659 thousand and other amountsagainst the Company’s predecessor Etelos, Incorporated, a Washingtoncorporation (“Etelos —WA”) in the Superior Court of San Mateo County,California (Case No. CIV 479535).  Adefault judgment was entered for the landlord but the default was set asidebecause the landlord failed to properly serve either the Company or Etelos-WA.The Company is continuing to defend its position.

 

Thelandlord for the Renton, Washington location has notified us that we are indefault of the sublease but has not yet filed any claim against us, but theassertion of such a claim, and the need for us to defend such a claim, isforeseeable.

 

**OffBalance Sheet Arrangements**

 

Wedid not have any off-balance sheet arrangements as of the period ended September 30,2009.

 

**GoingConcern Issue**

 

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

 

Duringthe quarter ended September 30, 2009, we have been unable to generate cashflows sufficient to support our operations and have been dependent on debtraised from qualified 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 throughbridge loans and the private sale of our convertible debentures and preferredstock.  This has provided us with thecash inflows to continue our business plan, but has not resulted in significantimprovement in our financial position. We are considering alternatives toaddress our cash flow situation that include raising capital through additionalsale of our common stock and/or debentures.

 

Thiscould result in substantial dilution of existing stockholders. There can be noassurance that our current financial position can be improved, that we canraise additional working capital, or that we can achieve positive cash flowsfrom operations. Our long-term viability as a going concern is dependent uponour ability to (i) locate sources of debt or equity funding to meetcurrent commitments and near-term future requirements and (ii) achieveprofitability and ultimately generate sufficient cash flow from operations tosustain our continuing operations.

 

**RecentAccounting Pronouncements**

 

During the third quarter of2009, the Company adopted the new Accounting Standards Codification (“ASC”) asissued by FASB.  The ASC has become the authoritative source of US GAAPrecognized by FASB to be applied by non-governmental entities.  The ASC isnot intended to amend or change US GAAP.  The adoption of the ASC did nothave a material impact on the Company’s financial statements.

 

33

----

Table ofContents

 

InOctober 2009, the FASB issued new accounting guidance related to therevenue recognition of multiple element arrangements. The new guidance statesthat if vendor specific objective evidence or third party evidence fordeliverables in an arrangement cannot be determined, companies will be requiredto develop a best estimate of the selling price to separate deliverables andallocate arrangement consideration using the relative selling price method. Theaccounting guidance will be applied prospectively and will become effective forthe Company during the first quarter of fiscal 2011. Early adoption is allowed.The Company is currently evaluating the impact of this accounting guidance onits financial statements.

 

**Item 3.**    QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

** **

Intentionallyomitted pursuant to Item 305(e) of Regulation S-K.

 

**Item 4.**    CONTROLSAND PROCEDURES

** **

Disclosure controls andprocedures are controls and other procedures that are designed to ensure thatthe information required to be disclosed by a company in the reports that itfiles or submits under the Securities and Exchange Act of 1934, or the“Exchange Act,” is recorded, processed, summarized and reported, within thetime periods specified in the rules and forms of the SEC. Disclosurecontrols and procedures include, without limitation, controls and proceduresdesigned to ensure that information required to be disclosed in the reportsthat a company files or submits under the Exchange Act is accumulated andcommunicated to the company’s management, including its principal executiveofficer and principal accounting officer, as appropriate to allow timelydecisions regarding required disclosure.

 

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 September 30, 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 September 30, 2009,because of certain material weaknesses in our internal control over financialreporting.

 

Because of theseweaknesses, we cannot provide reasonable assurances that all informationrequired to be disclosed in our reports filed with the SEC will be accumulatedand communicated to our management to allow for timely decisions regardingrequired disclosure.  Please see the internal control over financialreporting discussion in our Form 10-K that we filed with the SEC on April 29,2009 for more information regarding the weaknesses in our internal control overfinancial reporting.

 

Furthermore, due to theresignation of our vice president and chief financial officer, and thelack of a replacement at this time, we are unable to assure that we haveadequate and appropriate controls in place, or that the controls that we dohave in place are being managed appropriately.  We will attempt to engageadditional appropriate professionals to evaluate and manage our controls assoon as financial resources permit, but there is no assurance when, or if, thatwill be possible in the foreseeable future.

 

**Changes In Internal Controls OverFinancial Reporting.**

 

No changes were made inour internal control over financial reporting or disclosure controls or both,(as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act)during our last fiscal quarter that has materially affected, or is likely tomaterially affect, our internal control over financial reporting.

 

**Limitations On DisclosureControls And Procedures.**

 

Because of the inherentlimitations in all control systems, no evaluation of controls can provideabsolute assurance that all control issues and instances of fraud, if any,within our company have been detected. The design of any system of controls isbased in part upon a cost-benefit analysis and certain assumptions about thelikelihood of future events and any design may not succeed in achieving itsstated goals under all potential future conditions. While our management doesnot believe that our controls will prevent all errors or all instances offraud, our disclosure controls and procedures are designed to provide areasonable assurance of achieving their objectives.

 

**PART II**—**OTHER INFORMATION**

 

**Item 1.****   ****LEGAL PROCEEDINGS**.

 

From time to time,we become subject to various legal proceedings and claims, both asserted andunasserted, that arise in the ordinary course of business. Litigation ingeneral, and securities litigation in particular, can be expensive anddisruptive to normal business operations. Moreover, the results of legalproceedings are difficult to predict. An unfavorable resolution of one or moreof these 

 

34

----

Table ofContents

 

lawsuits wouldmaterially adversely affect our business, results of operations, or financialcondition. We accrue legal costs when incurred. The need to defend any such claims could require payments of legal feesand our limited financial resources could severely impact our ability to defendany such claims.

 

In June 2008,Kaufman Bros. L.P. filed suit against us in the United States District Courtfor the Southern District of New York (Case No. 80 CV 5716) and sought atemporary restraining order and other extraordinary relief.  The complaintarises out of an advisory services agreement, pursuant to which Kaufman Bros.was to provide us with advisory services in connection with financings andstrategic transactions. We notified Kaufman Bros. that we believed it hadfailed to provide the required services under the agreement, and that we weretherefore entitled to terminate the agreement for cause. In the suit, KaufmanBros. was seeking (i) monetary damages of $400,000 for anticipatory breachof the agreement; (ii) $73,800 in fees allegedly owed in connection with apreviously closed financing transaction; (iii) and injunction prohibitingus from cancelling any shares issued to Kaufman Bros. as compensation, (iv) adeclaration from the court that we are not entitled to a refund of any feespreviously paid to Kaufman Bros., and (v) a declaration that we 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, we have notfully complied with our payment obligations under the settlement agreement but,through the date of filing of this report, Kaufman Bros. has not exercised anyof its remedies for default under the settlement agreement.

 

OnOctober 31, 2008, the Company closed its offices in San Mateo,California.  The landlord for thesepremises filed a complaint claiming damages of $659 thousand and other amountsagainst the Company’s predecessor Etelos, Incorporated, a Washington corporation(“Etelos —WA”) in the Superior Court of San Mateo County, California (Case No. CIV479535).  A default judgment was enteredfor the landlord but the default was set aside because the landlord failed toproperly serve either the Company or Etelos-WA. The Company is continuing todefend 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, in accordance with a Stock Purchase Agreement dated February 29,2008.On June 22, 2009, the Companyfiled a demand for Arbitration with the American Arbitration Association [Case No. 74166 00535 09 LMT] seeking injunctive and other relief, includingrescission of the Employment Agreement and the Stock PurchaseAgreement that it entered into with Mr. Garon.  The demand includesassertions that Mr. Garon misrepresented his employment qualificationsand, *inter alia*, seeks to recoverfrom Mr. Garon 2,383,333 shares of the Company’s common stock thatwere issued in connection with his employment.  Mr. Garon has filed acounter-demand against the Company, certain employees of the Company, andmembers of its Board of Directors seeking declaratory relief, apreliminary injunction, and damages in an amount to be proved at thearbitration.  The Hearing in this matter commencedon November 16, 2009.

 

As part of ourreduction of monthly cash operating expenses during the quarter ending September 30,2008, and continuing after the end of the quarter, we placed all employees onpartial deferrals of salary, 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; the amountof accrued payroll and related expenses payable is $987 thousand, as of thenine months ended September 30, 2009. Two former employees have asserted claims with the California LaborCommission for payment of these unpaid amounts and the assertion of other suchclaims or demands by such employees, or by governmental authorities, isforeseeable.

 

In connection withour reverse merger, multiple financings, and protection of our intellectualproperty, we have incurred substantial accounts payable to law firms thatremain unpaid and overdue.  We have beenin communication with these vendors and expect to enter into negotiated paymentplans with these vendors, and others, but there is no assurance that we will besuccessful in these negotiations, or that we will be able to make payments undersuch plans if and when negotiated. Therefore the assertion of claims by these vendors for these amounts dueand owing could become the subject of claims in litigation.

 

35

----

Tableof Contents

 

**Item 1A.   RISK FACTORS**.

 

Investment in our commonstock involves a high degree of risk. You should carefully consider the risksdescribed below together with all of the other information included in thisreport before making an investment decision. If any of the following risksactually occur, our business, financial condition or results of operationscould suffer. In that case, the market price of our common stock could decline,and you may lose all or part of your investment.

 

***Ourcurrent cash will fund our business as currently planned only through June 2010.We need additional funding or we will be forced to curtail or cease operations.***

 

We need immediate and substantialcash to continue our operations. We currently have no funding commitments,beyond the additional $1 million that we have the right to call in the periodfrom December 15, 2009 through January 15, 2010, under the terms ofthe securities purchase agreement pursuant to which the 10% Senior SecuredDebentures were issued.  Based upon the$500 thousand subsequently received in the period after the nine months ended September 30,2009, and the $1 million commitment, Management has projected that cash on handwill be sufficient to allow us to continue our operations only through June 2010.  Since August 2008, all remainingemployees have been on deferred salary, ranging from 10% to 100% of basesalary; although some payments have been made to these employees from time totime during this period, these employees are owed $987 thousand in accruedsalary and related expenses as of the nine months ended September 30,2009, and there is no assurance that any of these employees will be able tocontinue to work for us on this arrangement. We also need to negotiate payment plans for certain trade payables andthere is a risk that trade creditors will not accept deferred payment andexercise other remedies to collect balances due and owing. We therefore willneed additional funding, either through equity or debt financings, or we willbe forced to curtail or cease operations or consider other strategicalternatives such as bankruptcy.

 

***Ifour business model is not successful, or if we are unable to generate sufficientrevenue to offset our start-up expenditures, then we may not become profitableand you may lose your entire investment in our company.***

 

We incurred a net loss of$4.7 million for the nine months ended September 30, 2009, and $22.2million for the nine months ended September 30, 2008, and have anaccumulated deficit of $34.5 million at September 30, 2009.  We cannot assure you that our future plannedoperations will be implemented successfully or that we will ever haveprofits.  Furthermore, we are experiencingthe initial costs and uncertainties of a young operating company, includingstart-up expenditures, unforeseen costs and difficulties, complications, anddelays, all of which must be resolved and/or paid without the benefit of apredictable revenue stream.  We cannot besure that we will be successful in meeting these challenges and addressingthese risks and uncertainties.  If we areunable to do so, then we may be required to scale back our business, sell orlicense some or all of our technology or assets, or curtail or ceaseoperations.

 

***Ourlimited operating history may not serve as an adequate basis to judge ourfuture prospects and results of operations.***

 

We began our operationsin 1999 but we did not adopt the SaaS on-demand Web Application delivery modeluntil 2005, and we have recently changed our basic business model. Our limitedoperating history in the SaaS industry may not provide a meaningful basis onwhich to evaluate our business. Since our inception our revenues have notalways grown from year to year.  Wecannot assure you that we will achieve our growth targets, or that we willachieve positive cash-flow or profitability, or that we will not incur negativecash flow or net losses in the future. We expect that our operating expenses willincrease as we expand. Any significant failure to realize anticipated revenuegrowth could result in significant operating losses beyond our forecasts. Wewill continue to encounter risks and difficulties frequently experienced bycompanies at a similar stage of development, including our potential failureto:

 

·      maintain and improve our technology;

 

·      expand our product and service offerings and maintainthe high quality of products and services offered;

 

·      sell subscriptions to our products and offerings byour Syndication Partners to sufficient, quality customers to produce revenuesadequate to meet our operating needs;

 

·      manage our expanding operations, including theintegration of any future acquisitions;

 

·      obtain sufficient working capital to support ourexpansion and to fill customers’ orders in time;

 

·      maintain adequate control of our expenses;

 

36

----

Table ofContents

 

·      implement our product development, marketing, sales,and acquisition strategies and adapt and modify them as needed; and/or

 

·      anticipate and adapt to changing conditions in themarkets in which we operate as well as the impact of any changes in governmentregulation, mergers and acquisitions involving our competitors, technologicaldevelopments, and other significant competitive and market dynamics.

 

If we are not successfulin addressing any or all of these risks, then our business may be materiallyand adversely affected.

 

***Wemay encounter substantial competition in our business and our failure tocompete effectively may adversely affect our ability to generate revenue.***

 

We believe that existingand new competitors will continue to improve the design and performance oftheir products and to introduce new products with competitive price andperformance characteristics. We expect that we will be required to continue toinvest in product development and productivity improvements to competeeffectively in our markets. Our competitors could develop better technology ormore efficient products or undertake more aggressive and costly marketingcampaigns than ours, which may adversely affect our marketing strategies andcould have a material adverse effect on our business, results of operations,and financial condition.

 

Our major competitors maybe better able than us to successfully endure downturns in our markets. Inperiods of reduced demand for our products, we can either choose to maintainmarket share by reducing our subscription prices to meet competition or maintainsubscription prices, which likely would result in sacrifice of our marketshare. Sales and overall profitability would be reduced and sustained lossesmay continue in either case. In addition, we cannot be assured that additionalcompetitors will not enter our existing markets, or that we will be able tocompete successfully against existing or new competition.

 

***Wehave a history of operating losses and we may not achieve profitability in thefuture.***

 

Although we haveperiodically shown profits due to mark-to-market accounting anomalies relatedto warrant liability and embedded derivatives, we have never been profitablefrom operations on a quarterly or annual basis since our formation. Ouroperations resulted in a net loss of $4.7 million for the nine months ended September 30,2009, and $22.2 million for the nine months ended September 30, 2008. Asof September 30, 2009, our accumulated deficit was $34.5 million.  We expect to make significant futureexpenditures related to the development and expansion of our business. Inaddition, as a public company, we incur significant legal, accounting, andother expenses that we did not incur as a private company. As a result of theseincreased expenditures, we will have to generate and sustain increased revenueto achieve and maintain future profitability. While our revenue has grown somewhat in recent periods, that growth hasnot been significant and future revenue growth may not be sustainable and wemay not achieve sufficient revenue to achieve or maintain profitability. Wehave incurred and may continue to incur significant losses in the future for anumber of reasons, including due to the other risks described in this report,and we may encounter unforeseen expenses, difficulties, complications, delays,and other unknown factors. Accordingly, we may not be able to achieve ormaintain profitability and we may continue to incur significant losses for theforeseeable future.

 

***Themarket for on-demand Web Applications may develop more slowly than we expect.***

 

Our success will depend,to a large extent, on the willingness of individuals and SMBs to accepton-demand services for Web Applications that they view as critical to thesuccess of their business. Many businesses have invested substantial effort andfinancial resources to integrate traditional enterprise software into theirbusinesses and may be reluctant or unwilling to switch to a differentapplication or to migrate these applications to on-demand Web Applications.

 

Other factors that mayaffect market acceptance of our Web Applications include our ability to:

 

·      minimize the time and resources required to implementproducts distributed through an Etelos Marketplace;

 

·      maintain high levels of customer satisfaction;

 

·      implement upgrades and other changes to our productswithout disrupting our service; and/or

 

·      provide rapid response time during periods of intenseactivity on customer websites.

 

In addition, marketacceptance of our Web Applications may be affected by:

 

·      the security capabilities, reliability, andavailability of on-demand services;

 

·      customer concerns with entrusting a third party tostore and manage their data, especially confidential or sensitive data;

 

37

----

Table ofContents

 

·      the level of customization or configuration we offer;and/or

 

·      the price, performance, and availability of competingproducts and services.

 

***Themarket for our products may not develop further, or it may develop more slowlythan we expect, either of which would harm our business.***

 

The market in which weparticipate is intensely competitive, and if we do not compete effectively,then our operating results may be harmed. The market for SaaS on-demand Web Applications for business is highlycompetitive and rapidly changing with relatively low barriers to entry. Withthe introduction of new technologies and new market entrants, we expectcompetition to intensify in the future. In addition, pricing pressures andincreased competition generally could result in reduced sales, reduced margins,or the failure of our products to achieve or maintain more widespread marketacceptance. Often we offer products in an Etelos Marketplace that competeagainst existing systems that our potential customers have already made significantexpenditures to install. Competition in our market is based principally uponservice breadth and functionality; service performance, security andreliability; ability to tailor and customize services for a specific company,vertical or industry; ease of use of the service, speed and ease of deployment,integration and configuration; total cost of ownership, including price andimplementation and support costs; professional services implementation; andfinancial resources of the vendor.

 

We face competition fromboth traditional software vendors and other SaaS providers. Many of our actualand potential competitors enjoy substantial competitive advantages over us,such as greater name recognition, longer operating histories, more variedproducts and services, and larger marketing budgets, as well as substantiallygreater financial, technical, and other resources. In addition, many of ourcompetitors have established marketing relationships and access to largercustomer bases, and have major distribution agreements with consultants, systemintegrators, and resellers. If we are not able to compete effectively, then ouroperating results will be harmed.

 

***Ourinability to fund our capital to meet our expenditure requirements mayadversely affect our growth and profitability.***

 

Our continued growth isdependent upon our ability to raise capital from outside sources. Our abilityto obtain financing will depend upon a number of factors, including ourfinancial condition and results of operations, the condition of the economy,and conditions in relevant financial markets. If we are unable to obtain financing, as needed, on a timely basis andon acceptable terms, our financial position, competitive position, growth, and profitabilitymay be adversely affected.  The currentstate of the US and global economy raises substantial doubts, especially aboutour ability to raise the additional capital that we will need to sustain ourbusiness operations.

 

***Wehave reduced our employment force and have challenges meeting our operatingdemands.***

 

We have decreased ournumber of full-time employees from 32 at September 30, 2008, to 11 as of September 30,2009.  All of these remaining employeesare on deferred salary, ranging from 10% to 100% of base salary, and there isno assurance that any of these personnel will be able to continue to work onthis payment arrangement. As of the nine months ended September 30, 2009,accrued salary and related expenses owed to employees was $987 thousand.  Our operating plan has placed, and ouranticipated growth plan is expected to continue to place, a significant strainon our very limited managerial, administrative, operational, financial, andother resources, compounded by these recent reductions in headcount. Althoughwe will be required to continue to improve our operational, financial, andmanagement controls and our reporting procedures it is clear that we may not beable to do so effectively and may not be able to recruit or retain adequate,qualified personnel to meet our operating demands. As such, we may be unable tomanage our expenses effectively in the future, which may negatively impact ourgross margins or operating expenses in any particular quarter.

 

***Ourcustomers are individuals, small and medium-sized businesses, and divisions oflarge companies, which may increase our costs to reach, acquire and retaincustomers.***

 

We market and distributeour products and services and other offerings in Etelos Marketplaces toindividuals, SMBs, and divisions of large companies. To grow our revenuequickly, we must add new customers, sell additional services to existingcustomers, and encourage existing customers to renew their subscriptions.However, selling to and retaining individuals and SMBs can be more difficultthan selling to and retaining large enterprises because SMB customers tend tobe more price sensitive and more difficult to reach with broad marketingcampaigns.  In addition, individuals andSMBs have high churn rates in part because of the nature of their businessesand often lack the staffing to benefit fully from our products.  Further, individuals and SMBs often requirehigher sales, marketing, and support expenditures by vendors that sell to themper revenue dollar generated for those vendors.

 

38

----

Table ofContents

 

***Manyof our customers are price sensitive, and if the prices that we or ourSyndication Partners charge for subscriptions to products or services offeredin an Etelos Marketplace are unacceptable to our customers, then our operatingresults will be harmed.***

 

Many of our customers areprice sensitive, and we have limited experience with respect to determining theappropriate prices for our products or services. In addition, we have nocontrol over prices charged by our Syndication Partners for their products orservices offered in an Etelos Marketplace. As the market for our products orservices matures, or as new competitors introduce new products or services thatcompete with ours, we may be unable to renew agreements with existing customersor attract new customers at the same price or based on the same pricing modelas previously used. As a result, it is possible that competitive dynamics in ourmarket may require us to change pricing models or reduce prices, which couldharm our revenue, gross margin, and operating results.

 

***Wemay not be able to prevent others from unauthorized use of our patents andother intellectual property, which could harm our business and competitiveposition.***

 

Our success depends, inpart, on our ability to protect our proprietary technologies. We own multiplefiled United States and foreign patent applications covering our technology andwe expect to file more U.S. and foreign patent applications in the future. Wehave filed to protect most of those patents in many foreign countries. But theprocess of seeking patent protection can be lengthy and expensive and we cannotassure that our patent applications will result in patents being issued, orthat our existing or future issued patents will be sufficient to provide uswith meaningful protection or commercial advantages.  We also cannot assure that our current orpotential competitors do not have, and will not obtain, patents that willprevent, limit or interfere with our ability to make, use or sell ourtechnology or operate an Etelos Marketplace.

 

***Oursuccess depends in large part on our ability to protect and enforce ourintellectual property rights.***

 

We rely on a combinationof patent, copyright, service mark, trademark, and trade secret laws, as wellas confidentiality procedures and contractual restrictions, to establish andprotect our proprietary rights on a global basis, all of which provide onlylimited protection. We cannot assure you that any patent will issue from ourcurrently pending patent applications in a manner that gives us the protectionthat we seek, if at all, or that any future patents issued to us will not bechallenged, invalidated, or circumvented. Since the filing of some of thesepatent applications may have been, or will be, made after the date of firstsale or disclosure of the subject inventions, patent protection may not beavailable for these inventions outside the United States.  Any patents that may issue in the future maynot provide sufficiently broad protection or they may not prove to beenforceable in actions against alleged infringers. Also, we cannot assure youthat 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 maintainedoperating controls or logs, or initiated or conducted any forensic, codehistory, ‘genealogy’ or other forms of audit, analysis, processes, training, orcode review of software code incorporated into any Etelos product or in otherproducts offered by Syndication Partners in an Etelos Marketplace. We do notreview the intellectual property rights related to products or services offeredby Syndication Partners in an Etelos Marketplace. These products may includecode subject to various forms of ‘open source’, ‘copyleft’, or similar licensesthat require as a condition of modification or distribution of software subjectto such license(s) that (i) such software or other software combinedor distributed with such software be disclosed or distributed in source codeform, or (ii) such software or other software combined or distributed withsuch software, and any related intellectual property, be licensed on aroyalty-free basis, including for the purposes of making additional copies orderivative works of such software.  Thismay adversely affect our ability to patent certain inventions or to license ordistribute certain products - whether by open source license or other form oflicense or right - and may result in liability to unknown parties forinfringement of their patents or other intellectual property rights.

 

***Werequire our Syndication Partners to indemnify us for intellectual propertyclaims but we cannot assure that these agreements will be enforceable.***

 

We endeavor to enter intoagreements with our employees and contractors and agreements with parties withwhom we do business to limit access to and disclosure of our proprietaryinformation. The steps we have taken, however, may not prevent unauthorized useor the reverse engineering of our technology. Moreover, others mayindependently develop technologies that are competitive to ours or infringe ourintellectual property. Enforcement of our intellectual property rights alsodepends on our successful legal actions against these infringers, but theseactions may not be successful, even when our rights have been infringed.  In addition, the legal standards relating tothe validity, enforceability, and scope of protection of intellectual propertyrights in Internet-related industries are uncertain and still evolving.

 

39

----

Table ofContents

 

***Assertionsby third parties that we infringe their intellectual property, whethersuccessful or not, could subject us to costly and time-consuming litigation orexpensive licenses.***

 

The software andtechnology industries are characterized by the existence of a large number ofpatents, copyrights, trademarks, and trade secrets and by frequent litigationbased on allegations of infringement or other violations of intellectualproperty rights. As we face increasing competition, the possibility ofintellectual property rights claims against us may grow; the costs of defendingagainst such claims can be very large. Our technologies may not be able towithstand any third-party claims or rights against their use. Additionally,many of our partner and product agreements require us to indemnify ourcustomers for certain third-party intellectual property infringement claims,which could increase our costs as a result of defending such claims and mayrequire that we pay damages or purchase expensive licenses, if there were anadverse ruling related to any such claims. These types of claims could harm ourrelationships with our customers, may deter future customers from subscribingto our services, or could expose us to litigation for these claims. Even if weare not a party to any litigation between a customer and a third party, anadverse outcome in any such litigation could make it more difficult for us todefend our intellectual property in any subsequent litigation in which we are anamed party.

 

Any intellectual propertyrights claim against our customers, or us, with or without merit, could betime-consuming, expensive to litigate or settle, and could divert managementattention and financial resources. An adverse determination also could preventus from offering our products to our customers and may require that we procureor develop substitute services that do not infringe.

 

For any intellectualproperty rights claim against us or against our Marketplace Partners orcustomers, we may have substantial direct and indirect costs.  Direct costs can include a requirement to paydamages or stop using technology found to be in violation of a third party’srights. We may have to purchase a license for the technology, which may not beavailable on reasonable terms, if at all, may significantly increase ouroperating expenses, or may require us to restrict our business activities inone or more respects. As a result, we may also be required to developalternative non-infringing technology, which could require significant effortand expense.  Substantial indirect costsalso may be expected in the form of diversion of development and managementresources in strategic planning for legal, technology, and business defenses tosuch claims.

 

***Werely on our management team and need additional personnel to grow our business,and the loss of one or more key employees or our inability to attract andretain qualified personnel could harm our business.***

 

Our success and futuregrowth depends to a significant degree on the skills and continued services ofour management team, especially Daniel J.A. Kolke, our interim Chief ExecutiveOfficer, Acting Chief Financial Officer, and Chairman of the Board. The loss ofthe services of any member of our management team for any reason may have amaterial adverse effect on our business and prospects.  We do not maintain key man insurance on anymembers of our management team, including Mr. Kolke.

 

Subsequent to thetermination of our former Chief Executive Officer, we significantly andmaterially reduced our management team and have not hired replacements for themanagement team in the positions of Vice President and Chief Financial Officer,Vice President — Marketing, Vice President Corporate Development, and VicePresident — Human Resources, as well as several other Director-level positions,primarily in non-technical positions throughout the Company.  We did not fill these positions in the periodending September 30, 2009, and we have not filled any of these positionsto the date of this report.

 

Our future success alsodepends on our ability to attract, retain and motivate highly skilledtechnical, managerial, sales, marketing and service and support personnel,including members of our management team. Competition for sales, marketing, andtechnology development personnel is particularly intense in the software andtechnology industries. As a result, we may be unable to successfully attract orretain qualified personnel. Our inability to attract and retain the necessarypersonnel could harm our business.

 

***If wedo not effectively expand and train our sales force and our services andsupport teams, then we may be unable to add new customers and retain existingcustomers.***

 

We plan to expand oursales force and our services and support teams to increase our customer baseand revenue. We believe that there is significant competition for sales,service, and support personnel with the skills and technical knowledge that werequire. Our ability to achieve significant revenue growth will depend, inpart, on our success in recruiting, training, and retaining sufficient numbersof personnel to support our growth. New hires require significant training and,in most cases, take significant time before they achieve full productivity. Ourrecent hires and planned hires may not become as productive as we expect and wemay be unable to hire or retain sufficient numbers of qualified individuals inthe markets where we do business. If these expansion efforts are not successfulor do not generate a corresponding increase in revenue, then our business willbe harmed.

 

***If weare unable to cost-effectively market and distribute our products to our targetcustomers, then our ability to grow our revenue quickly and become profitablewill be harmed.***

 

Our quarterly operatingresults may fluctuate in the future. As a result, we may fail to meet or exceedthe expectations of research analysts or investors, which could cause our stockprice to decline. Also period-to-period comparisons of our operating resultsmay not be meaningful. You should not rely on the results of one quarter as anindication of future performance.

 

40

----

Table ofContents

 

Fluctuations in ourquarterly operating results may be due to a number of factors, including therisks and uncertainties discussed elsewhere in this report. Fluctuations in ourquarterly operating results could cause our stock price to decline rapidly, maylead analysts to change their long-term model for valuing our common stock,could cause us to face short-term liquidity issues, may impact our ability toretain or attract key personnel, or cause other unanticipated issues. If ourquarterly operating results fall below the expectations of research analysts orinvestors, then the price of our common stock could decline substantially.

 

***Weuse third-party data centers to support our services. Any disruption of serviceat these facilities could interrupt or delay our ability to deliver our serviceto our customers.***

 

We host many of ourservices and serve a significant number of our customers from third-party datacenter facilities with Network OS, located in the greater Seattle Washingtonarea. We do not control the operation of these facilities. These facilities maybe vulnerable to damage or interruption from earthquakes, hurricanes, floods,fires, terrorist attacks, power losses, telecommunications failures, andsimilar events. These facilities also could be subject to break-ins, computerviruses, sabotage, intentional acts of vandalism and other misconduct. Theoccurrence of a natural disaster or an act of terrorism, a decision to closethe facilities without adequate notice, or other unanticipated problems couldresult in lengthy interruptions in our services.

 

We owe substantialamounts to our data center facility providers and they have no obligation tocontinue their services or renew their agreements with us on commerciallyreasonable terms, or at all. If we are unable to renew our agreements with anyfacility provider on commercially reasonable terms, then we may experienceincreased costs or downtime in connection with the transfer to a new datacenter facility.

 

Any errors, defects,disruptions, or other performance problems with our services could harm ourreputation and may damage our customers’ businesses. Interruptions in ourservices might reduce our revenue, cause us to issue credits to customers,subject us to potential liability, cause customers to terminate theirsubscriptions, and harm our renewal rates.

 

***Anysignificant fluctuation in price of servers or related support may have amaterial adverse effect on the cost of our products and services.***

 

The prices of servers andrelated support are subject to market conditions and generally we do not, anddo not expect to, have long-term contracts with our suppliers for those items.While these items are generally available and we have not experienced anyshortage in the past, we cannot assure you that the necessary servers orsupport will continue to be available to us at prices currently in effect oracceptable to us. The prices for these items have varied significantly in the pastand may vary significantly in the future. Numerous factors, most of which arebeyond our control, influence prices of servers and related support. Thesefactors include general economic conditions, industry capacity utilization,vendor backlogs and delays and other uncertainties.

 

We may not be able toadjust our product prices, especially in the short-term, to recover costincreases in these items. Our future profitability may be adversely affected tothe extent we are unable to pass on higher server and support related costs toour customers.

 

***Wemay become liable to our customers and lose customers if we have defects ordisruptions in our products and services or if we provide poor service.***

 

Because we deliverproducts as a service through an Etelos Marketplace, errors or defects in theWeb Applications underlying the service, or a failure of our hostinginfrastructure may make the service unavailable to our customers. Because ourcustomers use the products to manage critical aspects of their business, anyerrors, defects, disruptions in service, or other performance problems with theproducts, whether in connection with the day-to-day operation of the products,upgrades or otherwise, could damage our customers’ businesses. If we have anyerrors, defects, disruptions in service, or other performance problems with theproducts, then customers could elect not to renew their subscriptions or delayor withhold payment to us. As a result, we could lose future sales or customersmay make warranty claims against us or our Syndication Partners, which couldresult in an increase in our provision for doubtful accounts, an increase incollection cycles for accounts receivable, or costly litigation.

 

***Ifour security measures are breached and unauthorized access is obtained to acustomer’s data, then we may incur significant liabilities, our service may beperceived as not being secure, and customers may curtail or stop using ourproducts.***

 

The products and serviceswe offer in an Etelos Marketplace involve the storage of large amounts of ourcustomers’ sensitive and proprietary business information. If our securitymeasures are breached as a result of third-party action, employee error,malfeasance, or otherwise, and someone obtains unauthorized access to ourcustomers’ data, then we could incur significant liability to our Syndicationand Marketplace Partners, our customers, and to individuals or businesses whoseinformation was being stored by our customers, our business may suffer and ourreputation may be damaged. Because techniques used to obtain unauthorizedaccess to, or to sabotage, systems change frequently and generally are notrecognized until launched against a target, we may be unable to anticipatethese techniques or to implement adequate preventive measures. If an actual orperceived breach of our security occurs, then the market perception of theeffectiveness of our security measures could be harmed and we could lose salesand customers.

 

41

----

Table ofContents

 

***If weare unable to develop new products or services, distribute our products orservices into new markets, or add Syndication Partners to offer their productsor services for distribution in an Etelos Marketplace, then our revenue growthwill be harmed and we may not be able to achieve profitability.***

 

Our ability to attractnew customers and to increase revenue from existing customers will depend inlarge part on our ability to enhance and improve our existing products and toadd new Marketplace Partners and new Syndication Partners to offer theirproducts and services and distribute into new markets. The success of anyenhancement or new Syndication Partner offering depends on several factors,including the timely completion, introduction, and market acceptance of theenhancement, product or service. Any new product or service offered by aSyndication Partner or that we develop or acquire may not be introduced in atimely or cost-effective manner and may not achieve the broad market acceptancenecessary to generate significant revenue. Any new markets into which weattempt to distribute our products or services may not be receptive. If we areunable to successfully develop or acquire new products or services, enhance ourexisting products and services to meet customer requirements, or distribute ourproducts and services into new markets, then our revenue will not grow asexpected and we may not be able to achieve profitability.

 

***If wefail to maintain proper and effective internal controls or are unable toremediate the material weakness in our internal controls, then our ability toproduce accurate and timely financial statements could be impaired andinvestors’ views of us could be harmed.***

 

Ensuring that we haveadequate internal financial and accounting controls and procedures in place sothat we can produce accurate financial statements on a timely basis is a costlyand time-consuming effort that needs to be re-evaluated frequently. Ourinternal control over financial reporting is a process designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements in accordance with generally acceptedaccounting principles.

 

During our audit for theyear ended December 31, 2008, we identified material weaknesses in ourinternal controls. The material weaknesses relate to the absence of specificpolicies and procedures for some accounting functions and the need for accountingpersonnel who possess the skill sets necessary to operate and report as apublic company, and specifically the skills necessary to ensure that adequatereview of critical account reconciliations is performed and that supportingdocumentation is complete, accurate, and in accordance with generally acceptedaccounting principles. Our financial position and limited resources make itdifficult for us to address these weaknesses. If we fail to address these material weaknesses or if additionalmaterial weaknesses in our internal controls are discovered in the future, thenwe may fail to meet our future reporting obligations, our financial statementsmay contain material misstatements and the price of our common stock maydecline.

 

Implementing anyappropriate changes to our internal controls may distract our officers andemployees, entail substantial costs to modify our existing processes, and addpersonnel and take significant time to complete. These changes may not,however, be effective in maintaining the adequacy of our internal controls, andany failure to maintain that adequacy, or consequent inability to produceaccurate financial statements on a timely basis, could increase our operatingcosts and harm our business. In addition, investors’ perceptions that ourinternal controls are inadequate or that we are unable to produce accuratefinancial statements on a timely basis may harm our stock price and make itmore difficult for us to effectively market and distribute our products andservices to new and existing customers.

 

***Materialdefects or errors in the software we use to deliver our products and servicesand the offerings by our Marketplace and Syndication Partners could harm ourreputation, result in significant costs to us, and impair our ability todistribute our services.***

 

The Web Applicationsunderlying the offerings in an Etelos Marketplace are inherently complex andmay contain material defects or errors, particularly when first introduced orwhen new versions or enhancements are released. We have, from time to time,found defects in our products and services, and new errors in our existingsoftware and services may be detected in the future. We have no actualknowledge, but we reasonably expect that the products and services offered byour Syndication Partners may have similar errors and/or defects. Any errors ordefects that cause interruptions to the availability of our services and theservices for our Marketplace Partners could result in:

 

·      a reduction in sales or delay in market acceptance ofservices from us or our Marketplace Partners;

 

·      sales credits or refunds to our customers andcustomers of our Marketplace Partners;

 

·      loss of existing customers and difficulty inattracting new customers;

 

·      diversion of development resources;

 

·      harm to our reputation, or the reputation of ourMarketplace Partners; and/or

 

·      increased warranty and insurance costs.

 

42

----

Table of Contents

 

After the release of ourservices, defects or errors may also be identified from time to time by ourinternal team, our Marketplace and Syndication Partners, and by our customers.The costs incurred in correcting any material defects or errors in suchproducts or services may be substantial and could harm our operating results.

 

***Governmentregulation of the Internet and e-commerce is evolving, and unfavorable changesor our failure to comply with regulations could harm our operating results.***

 

As Internet commercecontinues to evolve, increasing regulation by super-national, federal, state orlocal government agencies becomes more likely. Increased regulation in the areaof data privacy, and laws and regulations applying to the solicitation,collection, processing, or use of personal or consumer information could affectour customers’ ability to use and share data, potentially reducing demand forWeb-based applications and restricting our ability to store, process, and shareour customers’ data. In addition, taxation of services provided over theInternet or other charges imposed by government agencies or by privateorganizations for accessing the Internet may also be imposed. Any regulationimposing greater fees for Internet access or use or restricting informationexchange over the Internet could result in a decline in the use of the Internetand the viability of Web-based services, which could harm our business andoperating results.

 

***Privacyconcerns and laws or other regulations may reduce the effectiveness of ourproducts and services and harm our business.***

 

Our customers can use theproducts and services offered in an Etelos Marketplace to store personal oridentifying information regarding their customers and contacts. Super-national,federal, state and other government bodies and agencies have adopted or areconsidering adoption of laws and regulations regarding the collection, use, anddisclosure of personal information obtained from consumers and otherindividuals. The costs of compliance with, and other burdens imposed by, suchlaws and regulations that are applicable to the businesses of our customers maylimit the use and adoption of our products and services and reduce overalldemand.

 

In addition to governmentactivity, privacy advocacy groups and the technology and other industries areconsidering various new, additional, or different self-regulatory standardsthat may place additional burdens on us and our Marketplace and Syndication Partners.If the gathering of personal information were to be curtailed, then Web-basedapplications would be less effective, which may reduce demand for the productsand services offered in an Etelos Marketplace and harm our business.

 

***Ouroperating results may be harmed if we are required to collect taxes for oursubscription services in jurisdictions where we have not historically done so.***

 

We have not collected anysales or other taxes from our customers or remitted any such taxes to anytaxing jurisdiction where we may be required to do so. We have begun ananalysis of this issue but to date have not made any accrual for any potentialliability.  In addition, additionaltaxing jurisdictions at various local, national and super-national levels mayseek to impose sales or other tax collection obligations on us.  We have not recorded sales or other taxliabilities for the quarters ended June 30, 2009 or 2008, in respect ofsales or other tax liabilities in any jurisdiction. A successful assertion thatwe should be collecting sales or other taxes on our service could result insubstantial tax liabilities for past sales, discourage customers frompurchasing our products, or otherwise harm our business and operating results.

 

***Changesin financial accounting standards or practices may cause adverse, unexpectedfinancial reporting fluctuations, and harm our operating results.***

 

A change in accountingstandards or practices could harm our operating results and may even affect ourreporting of transactions completed before the change is effective. Newaccounting pronouncements and varying interpretations of accountingpronouncements have occurred and may occur in the future. Changes to existing rules orthe questioning of current practices may harm our operating results or the waywe conduct our business.

 

***Wemay expand by acquiring or investing in other companies, which may divertmanagement’s attention, result in additional dilution to our stockholders, andconsume resources that are necessary to operate and sustain our business.***

 

Although we have noongoing negotiations or current agreements or commitments for any acquisitions,our business strategy may include acquiring complementary products, services,technologies, or businesses. We also may enter into relationships with otherbusinesses to expand our product or service offerings or our ability to provideservice in foreign jurisdictions, which could involve preferred or exclusivelicenses, additional channels of distribution, discount pricing, investments inother companies, or other 

 

43

----

Table of Contents

 

strategies. Negotiatingthese transactions can be time-consuming, difficult, and expensive, and ourability to close these transactions may often be subject to approvals that arebeyond our control. Consequently, these transactions, even if undertaken andannounced, may not close.

 

An acquisition,investment, or business relationship may result in unforeseen operatingdifficulties and expenditures. In particular, we may encounter difficultiesassimilating or integrating the businesses, technologies, products, servicesofferings, personnel, or operations of the acquired companies, particularly ifthe key personnel of the acquired company choose not to work for us, thetarget’s software is not easily adapted to work with ours, or we are unable toretain the customers of any acquired business due to changes in management orotherwise. Acquisitions may also disrupt our business, divert our resources,and require significant management attention that would otherwise be availablefor operation and development of our business. Moreover, the anticipatedbenefits of any acquisition, investment, or business relationship may not berealized or we may be exposed to unknown liabilities. For one or more of thosetransactions, we may:

 

·      issue additional equity securities that would diluteour stockholders;

 

·      use cash that we may need in the future to operate ourbusiness;

 

·      incur debt on terms unfavorable to us or that we areunable to repay;

 

·      incur large charges or substantial liabilities;

 

·      encounter difficulties retaining key employees of theacquired company or integrating diverse software codes or business cultures;and/or

 

·      become subject to adverse tax consequences,substantial depreciation, or deferred compensation charges.

 

Any of these risks couldharm our business and operating results.

 

***Wemay be subject to other legal claims.***

 

In June 2008,Kaufman Bros. L.P. filed suit against us in the United States District Courtfor the Southern District of New York (Case No. 80 CV 5716) and sought atemporary restraining order and other extraordinary relief.  The complaintarose out of an advisory services agreement, pursuant to which Kaufman Bros.was to provide us with advisory services in connection with financings and strategictransactions. We notified Kaufman Bros. that we believed it had failed toprovide the required services under the agreement, and that we were thereforeentitled to terminate the agreement for cause. In the suit, Kaufman Bros. wasseeking (i) monetary damages of $400,000 for anticipatory breach of theagreement; (ii) $73,800 in fees allegedly owed in connection with apreviously closed financing transaction; (iii) and injunction prohibitingus from cancelling any shares issued to Kaufman Bros. as compensation, (iv) adeclaration from the court that we are not entitled to a refund of any feespreviously paid to Kaufman Bros., and (v) a declaration that we 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, we have notfully complied with our payment obligations under the settlement agreement but,through the date of filing of this report, Kaufman Bros. has not exercised anyof its remedies for default under the settlement agreement.

 

OnOctober 31, 2008, the Company closed its offices in San Mateo,California.  The landlord for thesepremises filed a complaint claiming damages of $659 thousand and other amountsagainst the Company’s predecessor Etelos, Incorporated, a Washingtoncorporation (“Etelos —WA”) in the Superior Court of San Mateo County,California (Case No. CIV 479535).  Adefault judgment was entered for the landlord but the default was set asidebecause the landlord failed to properly serve either the Company or Etelos-WA.The Company is continuing to defend its position.

 

44

----

Table of Contents

 

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, in accordance with a Stock Purchase Agreement dated February 29,2008.On June 22, 2009, the Companyfiled a demand for Arbitration with the American Arbitration Association [Case No. 74166 00535 09 LMT] seeking injunctive and other relief, includingrescission of the Employment Agreement and the Stock PurchaseAgreement that it entered into with Mr. Garon.  The demand includesassertions that Mr. Garon misrepresented his employment qualificationsand, *inter alia*, seeks to recoverfrom Mr. Garon 2,383,333 shares of the Company’s common stock thatwere issued in connection with his employment.  Mr. Garon has filed acounter-demand against the Company, certain employees of the Company, andmembers of its Board of Directors seeking declaratory relief, apreliminary injunction, and damages in an amount to be proved at thearbitration.  The Hearing in this matteris scheduled to begin on November 16, 2009.

 

On October 1,2008, we relocated our headquarters from San Mateo, California to Renton,Washington, and terminated eight employees based in California. In October 2008,we terminated eight more employees employed in both our California andWashington offices.  Two former employeeshave asserted claims with the California Labor Commission for payment of theseunpaid amounts and the assertion of other such claims or demands by suchemployees, or by governmental authorities, is foreseeable.

 

As part of our reductionof monthly cash operating expenses during the quarter ended December 31,2008, and continuing after the end of the quarter ended September 30,2009, and to the filing date of this report, we placed all employees on partialdeferrals of salary, ranging from 10% to 100% of base salary.  At the end of the quarter, until the filingdate of this report, this deferral amount remains unpaid, including amounts dueto employees who subsequently were terminated. Two former employees haveasserted claims with the California Labor Commission for payment of theseunpaid amounts and the assertion of such claims or demands by such employees, orby other governmental authorities, is foreseeable.

 

In connection with ourreverse merger, multiple financings, and protection of our intellectualproperty, we have incurred substantial accounts payable to law firms thatremain unpaid and overdue.  We have beenin communication with these vendors and expect to enter into negotiated paymentplans with these vendors, and others, but there is no assurance that we will besuccessful in these negotiations, or that we will be able to make paymentsunder such plans if and when negotiated. Therefore the assertion of claims by these vendors for these amounts dueand owing could become the subject of claims in litigation.

 

***Ourofficers, directors, and affiliates control us through their positions andstock ownership and their interests may differ from other stockholders.***

 

As of September 30,2009, our officers, directors, and affiliates beneficially own approximately 72percent of our common stock and 60 percent of our preferred stock. As a result,if they act together, they are able to influence the outcome of stockholdervotes on various matters, including the election of directors and extraordinarycorporate transactions, including business combinations. This concentrationcould also have the effect of delaying or preventing a change in control thatcould otherwise be beneficial to our stockholders. The interests of ourofficers, directors, and affiliates may differ from other stockholders.Furthermore, the current ratios of ownership of our common stock reduce thepublic float and liquidity of our common stock, which can in turn affect themarket price of our common stock.

 

***Weare responsible for the indemnification of our officers and directors.***

 

Our articles ofincorporation and bylaws provide for the indemnification of our directors,officers, employees, and agents, and, under certain circumstances, againstcosts and expenses incurred by them in any litigation to which they become aparty arising from their association with or activities on our behalf.Consequently, we may be required to expend substantial funds to satisfy theseindemnity obligations.

 

***Themarket price of our securities could be adversely affected by sales ofregistered and restricted securities.***

 

Actual sales or theprospect of future sales of shares of our common stock pursuant to a prospectusor under Rule 144 may have a depressive effect upon the price of, andmarket for, our common stock.  As of September 30,2009, 24,826,360 shares of our common stock were issued and outstanding, ofwhich 18,017,624 are “restricted securities” and under some circumstances may,in the future, be under a registration under the Securities Act or incompliance with Rule 144 adopted under the Securities Act.  In general, under Rule 144, subject tothe satisfaction of other conditions, a person who has beneficially ownedrestricted shares of common stock for at least one year is entitled to sell,within any three month period, a number of shares that does not exceed thegreater of 1 percent of the total number of outstanding shares of the sameclass; or if the common stock is quoted on NASDAQ or a stock exchange, theaverage weekly trading volume during the four calendar weeks immediatelypreceding the sale.  We cannot predictwhat effect, if any, that sales of shares of common stock, or the availabilityof these shares for sale, will have on the market prices prevailing from timeto time.  Nevertheless, the possibilitythat substantial amounts of common stock may be sold in the public market mayadversely effect prevailing prices for our common stock and could impair ourability to raise capital in the future through the sale of equity securities.

 

45

----

Table of Contents

 

***Thesale of the shares of our common stock acquired in private placements couldcause the price of our common stock to decline.***

 

The purchasers of our January 2008and April 2008 Debentures and related warrants, as well as the holders ofour other outstanding convertible notes, may, subject to compliance with Rule 144,rely on the provisions of Rule 144 to resell the shares of our commonstock acquired upon 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 and ata price that we might otherwise wish to effect sales.

 

In addition, inconnection with our January 2008 and April 2008 Debentures and 10%Senior Secured Debentures, in the aggregate, we owe a total of $8.3 millionprincipal amount of these convertible debentures, convertible into 8,690,695 sharesof our common stock, and warrants to purchase an additional 5,861,111 shares ofour common stock. The conversion or exercise into our common stock could resultin a substantial increase in the number of shares in our public float.  Depending upon market liquidity at the time aresale of our common stock is made by the investors in such private placements,such sale could cause the trading price of our common stock to decline.  In addition, the sale of a substantial numberof shares of our common stock, or anticipation of such sales, could make itmore difficult for us to sell equity or equity-related securities in the futureat a time and at a price that we might otherwise wish to effect sales.

 

***Wehave significant indebtedness and agreed to certain restrictions in connectionwith the debentures may impair our ability to issue additional debt or equity.***

 

We have incurred $8.3million of long term convertible debt, including $6.3 million in principalamount of indebtedness as a result of the issuance of our January 2008 andApril 2008 Debentures, and $2.0 million in principal amount ofindebtedness as a result of the issuance of our 10% Senior Secured Debentures.Our January 2008 and April 2008 Debentures and 10% Senior SecuredDebentures impose significant covenants on us, some of which may impair ourability to issue additional debt or equity, if necessary.

 

Our ability to complywith these provisions may be affected by changes in our business condition orresults of our operations, or other events beyond our control.  We have breached certain of these covenantsand are in a default under the debentures, which permits the holders thereof toaccelerate the maturity of the debentures and demand repayment in full.  Such actions by such holders could impair ourability to operate or cause us to seek bankruptcy protection.

 

***If weneed additional financing in the future and are required to issue securitieswhich are priced at less than the conversion price of our debentures or theexercise price of warrants sold in our recent private placements, it willresult in additional dilution.***

 

Our January 2008 andApril 2008 Debentures and 10% Senior Secured 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 10% Senior Secured Debentures and or theexercise price of the warrants.  If thiswere to occur, current investors, other than the investors in our recentprivate placements, would sustain material dilution in their ownershipinterest.

 

***Anti-takeoverprovisions contained in our amended and restated certificate of incorporationand amended and restated bylaws, as well as provisions of Delaware law, couldimpair a takeover attempt.***

 

Our amended and restatedcertificate of incorporation, amended and restated bylaws and Delaware lawcontain provisions that could have the effect of rendering more difficult ordiscouraging an acquisition deemed undesirable by our board of directors. Ourcorporate governance documents include provisions:

 

·      authorizing blank check preferred stock, which couldbe issued with voting, liquidation, dividend, and other rights superior to ourcommon stock;

 

·      limiting the liability of, and providingindemnification to, our directors and officers;

 

·      limiting the ability of our stockholders to call andbring business before special meetings;

 

·      requiring advance notice of stockholder proposals forbusiness to be conducted at meetings of our stockholders and for nominations ofcandidates for election to our board of directors;

 

·      controlling the procedures for the conduct andscheduling of board and stockholder meetings; and

 

·      limiting, generally, the filling of vacancies or newlycreated seats on the board to our board of directors then in office.

 

46

----

Table of Contents

 

These provisions, aloneor together, could delay hostile takeovers and changes in control or changes inour management.

 

Any provision of ouramended and restated certificate of incorporation or bylaws or Delaware lawthat has the effect of delaying or deterring a change in control could limitthe opportunity for our stockholders to receive a premium for their shares ofour common stock, and could also affect the price that some investors arewilling to pay for our common stock.

 

***Wemay issue additional shares of our capital stock, including through convertibledebt securities, to finance future operations or complete a businesscombination, which would reduce the equity interest of our stockholders andcould cause a change in control of our ownership.***

 

Although we have nocommitments as of the date of this report to issue any additional securities,we may issue a substantial number of additional shares of our common stock orpreferred stock, or a combination of both, including through convertible debtsecurities, to finance future operations. We may not be able to obtain additional debt or equity financing onfavorable terms, if at all.  If we engagein debt financing, then we may be required to accept terms that restrict ourability to incur additional indebtedness and force us to maintain specifiedliquidity or other ratios.

 

Further, the issuance ofadditional shares of our common stock or any number of shares of preferredstock, including upon conversion of any debt securities, may:

 

·      significantly reduce the equity interest of ourcurrent stockholders;

 

·      cause a change in control if a substantial number ofour shares of common stock or voting preferred stock are issued, which mayaffect, among other things, our ability to use our net operating losscarry-forwards, if any, and could also result in a change in management; and/or

 

·      adversely affect prevailing market prices for ourcommon stock.

 

If we need additional capital and cannot raise it onacceptable terms, we may not be able to, among other things:

 

·      develop or enhance our products and services;

 

·      continue to expand our development, sales andmarketing organizations;

 

·      acquire complementary technologies, products orbusinesses;

 

·      expand operations;

 

·      hire, train and retain employees; and/or

 

·      respond to competitive pressures or unanticipatedworking capital requirements.

 

Although we have nocommitments as of the date hereof to issue any additional securities, we mayissue a substantial number of additional shares of our common stock orpreferred stock, or a combination of both, including through convertible debtsecurities, to finance future operations or complete a businesscombination.  The issuance of additionalshares of our common stock or any number of shares of preferred stock,including upon conversion of any debt securities:

 

·      may significantly reduce the equity interest of ourcurrent stockholders; and

 

·      will likely cause a change in control if a substantialnumber of our shares of common stock or voting preferred stock are issued andcould also result in a change in management; and/or may adversely affectprevailing market prices for our common stock.

 

The 2007 Stock IncentivePlan and all options issued under the 2007 Stock Incentive Plan containprovisions for acceleration of all unvested options in the event of a change ofcontrol, which might be a disincentive to acquisition of the Company as aliquidation strategy.

 

47

----

Table of Contents

 

The 2007 Stock IncentivePlan and all options currently issued thereunder and options granted outsidesuch plan provides for accelerated vesting of all unvested options in the eventof a change of control, which is defined as an acquisition by a single personof more than 50 percent of the total combined voting power of all of ouroutstanding securities. This may be regarded as a barrier to retention of keyemployees following a change-of-control acquisition and therefore make such anacquisition more costly or difficult, and therefore an unattractive strategicoption, for a prospective acquiror.

 

***Wehave never paid dividends on our capital stock and we do not anticipate payingany cash dividends in the foreseeable future.***

 

We have paid no cashdividends on any of our classes of capital stock to date and we currentlyintend to retain our future earnings, if any, to fund the development andgrowth of our business.  In addition, theterms of the Notes prohibit us from making any dividend payment or distributionto holders of our common stock while any portion of the Notes remainoutstanding.  As a result, capitalappreciation, if any, of our common stock will be your sole source of gain forthe foreseeable future.

 

***Oursecurities may be thinly traded on the Over-the-Counter Bulletin Board, whichmay not provide liquidity for our investors.***

 

Our common stock isquoted on the Over-the-Counter Bulletin Board. The Over-the-Counter BulletinBoard is an inter-dealer, over-the-counter market that provides significantlyless liquidity than the NASDAQ Stock Market or other national or regionalexchanges. Securities traded on the Over-the-Counter Bulletin Board are usuallythinly traded, highly volatile, have fewer market makers, and are not followedby analysts.

 

The SEC’s order handlingrules, which apply to NASDAQ-listed securities, do not apply to securitiesquoted on the Over-the-Counter Bulletin Board. Quotes for stocks included onthe Over-the-Counter Bulletin Board may not be listed in newspapers. Therefore,prices for securities traded solely on the Over-the-Counter Bulletin Board maybe difficult to obtain and holders of our securities may be unable to reselltheir securities at or near their original acquisition price, or at any price.

 

***Investorsmust contact a broker-dealer to trade Over-the-Counter Bulletin Boardsecurities. As a result, you may not be able to buy or sell our common stock atthe times that you may wish.***

 

Even though our commonstock is quoted on the Over-the-Counter Bulletin Board, the Over-the-CounterBulletin Board may not permit our investors to sell securities when and in themanner that they wish. Because there are no automated systems for negotiatingtrades on the Over-the-Counter Bulletin Board, they are conducted viatelephone. In times of heavy market volume, the limitations of this process mayresult in a significant increase in the time it takes to execute investororders. Therefore, when investors place market orders to buy or sell a specificnumber of shares at the current market price it is possible for the price of astock to go up or down significantly during the lapse of time between placing amarket order and its execution.

 

***Ourstock price may be volatile and you may not be able to sell your shares formore than what you paid.***

 

Our stock price is likelyto be subject to significant volatility and you may not be able to sell sharesof common stock at or above the price you paid for them. The market price ofthe common stock could continue to fluctuate in the future in response tovarious factors including, but not limited to: quarterly variations inoperating results; our ability to control costs and improve cash flow;announcements of technological innovations or new products by us or ourcompetitors; changes in investor perceptions; and new products or produceenhancements 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.

 

***Ourcommon stock is likely to be subject to penny stock rules***

 

Our common stock issubject to Rule 15g-1 through 15g-9 under the Exchange Act, which imposescertain sales practice requirements on broker-dealers which sell our commonstock to persons other than established customers and “accredited investors”(generally, individuals with net worths in excess of $1 million or annualincomes exceeding $200 thousand (or $300 thousand together with theirspouses)).  For transactions covered bythis rule, a broker-dealer must make a special suitability determination forthe purchaser and have received the purchaser’s written consent to thetransaction prior to the sale.  This rule adverselyaffects the ability of broker-dealers to sell our common stock and purchasersof our common stock to sell their shares of such common stock.  Additionally, our common stock is likely tobe subject to the SEC regulations for “penny stock.”  Penny stock includes any equity security thatis not listed on a national exchange and has a market price of less than $5.00per share, subject to certain exceptions. The regulations require that prior to any non-exempt buy/selltransaction in a penny stock, a disclosure schedule set forth by the SECrelating to the penny stock market must be delivered to the purchaser of suchpenny stock.  This disclosure mustinclude the amount of commissions payable to both the broker-dealer and theregistered representative and current price quotations for the commonstock.  The regulations also require thatmonthly statements be sent to holders of penny stock which disclose recentprice information for the penny stock and information of the limited market forpenny stocks.  These requirements adverselyaffect the market liquidity of our common stock.

 

**Item 6.   EXHIBITS**

 

See the exhibit indeximmediately following the signature page of this report.

 

48

----

Table of Contents

 

**SIGNATURES**

** **

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
| ** **                    | **ETELOS,  INC.**                                          |
|-------------------------------|------------------------------------------------------------|
|                          |                                                       |
|                          |                                                       |
|                          | /s/ Daniel J.A.  Kolke                                     |
| Date:  November 19, 2009 | Daniel J.A.  Kolke, Chief Executive Officer                |
|                          | (Duly Authorized  Officer and Principal Executive Officer) |

 

49

----

Table of Contents

 

**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                          |
|----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.1 (1)              |       | Form of  10% Senior Secured Debenture issued in connection with September 2009  financing                                                                                                                      |
| 4.2 (2)              |       | Form of  Warrant issued in connection with September 2009 financing, with an  exercise price of $0.60 per share                                                                                                |
| 4.3 (1)              |       | Form of  Warrant issued in connection with September 2009 financing with an  exercise price of $0.01 per share                                                                                                 |
| 10.1(1)              |       | Securities  Purchase Agreement dated September 29, 2009                                                                                                                                                             |
| 10.2(1)              |       | Security  Agreement dated September 29, 2009                                                                                                                                                                        |
| 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                                                        |

 

----

| *   | Filed  with this report                                                                              |
|-----|------------------------------------------------------------------------------------------------------|
| **  | Furnished  with this Report                                                                          |
| (1) | Incorporated  by reference to the Registrant’s Form 8-K filed on September 30,  2009. |
| (2) | Incorporated by  reference to the Registrant’s Form 8-K filed on July 1, 2009         |

 

50

----