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**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

**FORM 10-Q**

 

**x****        ****Quarterly Report Pursuant to Section 13 or 15(d) of theSecurities Exchange Act of 1934**

 

**For the quarterly period ended September 30, 2008**

 

**or**

 

**o**** ****TransitionReport Pursuant to Section 13 or 15(d) of theSecurities Exchange Act of 1934**

 

**For the transition period from           to           **

 

**Commissionfile number 000-51995**

 

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**ETELOS, INC.**

(Exact name of registrant as specified in itscharter)

 

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

 

**(425)458-4510**

(Registrant’s telephone number, including area code)

 

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

 

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

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

 

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

 

Asof December 29, 2008, 23,022,207 shares of the issuer’s common stock, parvalue $0.01 per share, were outstanding.

 

 

 

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**EXPLANATORY NOTE**

** **

On February 8, 2007, Tripath Technology Inc., a Delawarecorporation (“**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 theconfirmed Plan of Reorganization was for Tripath to emerge from the bankruptcyproceeding with no assets and no liabilities as a shell corporation and for allissued and outstanding securities of and interests in Tripath, includingdebentures, stock options (including, but not limited to, all stock optionsgranted to employees), warrants, and other shares of common stock to becanceled and extinguished.

 

On April 23, 2008, Tripath filed a Current Report on Form 8-Kannouncing, among other things, that Etelos-WA, merged with and into Tripath,and that the surviving corporation changed its name to Etelos, Inc. andits fiscal year end to December 31. The effective date of the merger was April 22, 2008, and Etelos, Inc.,as the surviving corporation, will conduct the business and operationspreviously conducted by Etelos-WA.  Inconnection with the merger, all outstanding shares of Etelos-WA common stockwere converted into shares of Etelos, Inc. common stock on a three for oneratio: one share of Etelos Inc. common stock for every three shares of commonstock of Etelos-WA.  Also in connectionwith the merger, (i) all outstanding shares of preferred stock ofEtelos-WA were converted into shares of common stock of Etelos, Inc., (ii) Etelos, Inc.issued an aggregate of 5,010,000 shares of its common stock to the secured andunsecured creditors of Tripath and (iii) all the shares of Tripath werecancelled.  Prior to the merger, Tripathwas a shell corporation and in accordance with the Plan of Reorganization hadno assets or liabilities.  While Tripathacquired all the outstanding preferred and common stock of Etelos-WA, foraccounting purposes, the acquisition has been treated as a recapitalization 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 nine month periods ended September 30,2008 and 2007.

 

Also, on April 23, 2008, Etelos, Inc., formerly Tripath,amended its certificate of incorporation with the state of Delaware to changeits total authorized shares of stock to 300,000,000 shares, of which250,000,000 shares are designated “common stock” with a par value of $0.01 pershare and 50,000,000 shares are designated “preferred stock” with a par valueof $0.01 per share.  The preferred stockmay be issued from time to time in one or more series, each of such series toconsist of such number of shares and to have such terms, rights, powers andpreferences, and the qualifications and limitations with respect thereto, asstated in the resolutions providing for the issue of such series adopted by theboard of directors.

 

Information concerning number of shares outstanding for Etelos, Inc.including the conversion prices and number of shares issuable upon conversionof convertible securities and exercise prices of warrants and stock options andthe number of shares issuable upon exercise of such options and warrants, hasbeen adjusted to reflect the three for one conversion ratio effected inconnection with the merger as if it had occurred at the beginning of thequarter and nine month periods ended September 30, 2008 and 2007, and asof December 31, 2007.

 

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**Etelos, Inc.**

 

**QuarterlyReport on Form 10-Q**

 

**For theThree Months Ended September 30, 2008**

 

TABLE OF CONTENTS

 
| ** **                                  | ** ** | **Page**                                                                                    |
|---------------------------------------------|------------|---------------------------------------------------------------------------------------------|
|                                        |       |                                                                                        |
| **FORWARD  LOOKING STATEMENTS**             |       | i                                                                                           |
|                                        |       |                                                                                        |
| **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 |   | 16 |
|                                        |       |                                                                                        |   |   |
|                                        | Item 3.    | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                 |   | 29 |
|                                        |       |                                                                                        |   |   |
|                                        | Item 4.    | CONTROLS AND  PROCEDURES                                                                    |   | 29 |
|                                        |       |                                                                                        |   |   |
| **PART II —OTHER INFORMATION**    |       | 30                                                                                          |
|                                        |       |                                                                                        |   |   |
|                                        | Item 1.    | LEGAL PROCEEDINGS                                                                           |   | 30 |
|                                        |       |                                                                                        |   |   |
|                                        | Item  1A.  | RISK  FACTORS                                                                               |   | 30 |
|                                        |       |                                                                                        |   |   |
|                                        | Item 2.    | UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                |   | 46 |
|                                        |       |                                                                                        |   |   |
|                                        | Item 3.    | DEFAULTS UPON  SENIOR SECURITIES                                                            |   | 46 |
|                                        |       |                                                                                        |   |   |
|                                        | Item 4.    | SUBMISSION OF  MATTERS TO A VOTE OF SECURITY HOLDERS                                        |   | 46 |
|                                        |       |                                                                                        |   |   |
|                                        | Item 5.    | OTHER INFORMATION                                                                           |   | 46 |
|                                        |       |                                                                                        |   |   |
|                                        | Item  6.   | EXHIBITS                                                                                    |   | 46 |
|                                        |       |                                                                                        |   |   |
| SIGNATURES                                  |       | 47                                                                                          |
|                                        |       |                                                                                        |
| EXHIBIT INDEX                               |       | 48                                                                                          |
|                                             |            |                                                                                             |  |  |  |

 

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**FORWARDLOOKING STATEMENTS**

 

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

 

This Quarterly Report on Form 10-Q contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, or the “**Securities Act**,” and Section 21Eof the Securities Exchange Act of 1934 or the “**ExchangeAct.**”  These forward-lookingstatements are subject to certain risks and uncertainties that could causeactual results to differ materially from historical results or anticipatedresults, including those set forth under the heading “Risk Factors” andelsewhere in, or incorporated by reference into, this report.

 

In some cases, you can identify forward looking statements by termssuch as “may,” “intend,” “might,” “will,” “should,” “could,” “would,” “expect,”“believe,” “anticipate,” “estimate,” “predict,” “potential,” or the negative ofthese terms.  These terms and similarexpressions are intended 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 of eachfactor on our business or the extent to which any factor or combination offactors, or factors we are aware of, may cause actual results to differmaterially from those contained in any forward looking statements.  You are cautioned not to place undue relianceon any forward-looking statements.  Thesestatements represent our estimates and assumptions only as of the date of thisreport.  Except to the extent required byfederal securities laws, we undertake no obligation to update anyforward-looking statement to reflect events or circumstances after the datehereof or to reflect the occurrence of unanticipated events.

 

You should be aware that our actual results could differ materiallyfrom those contained in the forward-looking statements due to a number offactors, including:

 

·                  ourability to obtain future financing or funds when needed;

·                  newcompetitors are likely to emerge and new technologies may further increasecompetition;

·                  ouroperating costs may increase beyond our current expectations and we may beunable to fully implement our current business plan;

·                  ourability to successfully obtain a diverse customer base;

·                  ourability to protect our intellectual property through patents, trademarks,copyrights and confidentiality agreements;

·                  ourability to attract and retain a qualified employee base;

·                  ourability to respond to new developments in technology and new applications ofexisting technology before our competitors;

·                  acquisitions,business combinations, strategic partnerships, divestures, and othersignificant transactions may involve additional uncertainties;

·                  ourability to maintain and execute a successful business strategy; and

·                  weface other risks described from time to time in periodic and current reports wefile with the United States Securities and Exchange Commission, or the “**SEC**.”

 

Other risks and uncertainties include such factors,among others, as market acceptance and market demand for our products andservices, pricing, the changing regulatory environment, the effect of our accountingpolicies, potential seasonality, industry trends, adequacy of our financialresources to execute our business plan, our ability to attract, retain andmotivate key technical, marketing and management personnel, possible disruptionin commercial activities occasioned by terrorist activity and armed conflict,and other risk factors detailed in this report and our other SEC filings.  You should consider carefully the statementsunder “Item 1A. Risk Factors” in “Part II—Other Information” and other sectionsof this report, which address additional factors that could cause our actualresults to differ from those set forth in the forward-looking statements andcould materially and adversely affect our business, operating results andfinancial condition.  All subsequentwritten and oral forward-looking statements attributable to us or personsacting on our behalf are expressly qualified in their entirety by theapplicable cautionary statements.

 

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**PART I - FINANCIAL INFORMATION**

 

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

 

**ETELOS, INC.**

**CONDENSED BALANCE SHEETS**

(inthousands, except share data) 

(Unaudited)

 
| ** **                                                                                                                                                              | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                              | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                                                                                  |       |                         |       |                        |       |
| Current assets:                                                                                                                                                         |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                                                                               |       | $                            | 6          |                        | $          | 928 |   |
| Accounts receivable, net                                                                                                                                                |       | 6                            |       | —                      |       |
| Prepaid expenses and other current assets                                                                                                                               |       | 23                           |       | 20                          |       |
| Total current assets                                                                                                                                                    |       | 35                           |       | 948                         |       |
|                                                                                                                                                                    |       |                         |       |                        |       |
| Property and equipment, net                                                                                                                                             |       | 92                           |       | 50                          |       |
| Other assets                                                                                                                                                            |       | 262                          |       | 41                          |       |
|                                                                                                                                                                    |       |                         |       |                        |       |
| **Total assets**                                                                                                                                                        | ** ** | **$**                        | **389**    | ** **                  | **$**      | **1,039** | ** ** |
|                                                                                                                                                                    |       |                         |       |                        |       |
| LIABILITIES AND STOCKHOLDERS’ DEFICIT                                                                                                                              |       |                         |       |                        |       |
| Current liabilities:                                                                                                                                                    |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                        |       | $                            | 902        |                        | $          | 250 |   |
| Accounts payable related parties                                                                                                                                        |       | 6                            |       | 56                          |       |
| Accrued payroll and related expenses                                                                                                                                    |       | 148                          |       | 514                         |       |
| Other accrued expenses                                                                                                                                                  |       | 410                          |       | 241                         |       |
| Other current liabilities                                                                                                                                               |       | 200                          |       | —                      |       |
| Deferred revenue                                                                                                                                                        |       | 8                            |       | 3                           |       |
| Deferred rent                                                                                                                                                           |       | 6                            |       | —                      |       |
| Current portion notes payable, net of  discounts                                                                                                                        |       | 5,821                        |       | 3,165                       |       |
| Current portion notes payable to related  parties                                                                                                                       |       | 684                          |       | 187                         |       |
| Current portion capital leases                                                                                                                                          |       | 18                           |       | 16                          |       |
| Warrant and derivative liability                                                                                                                                        |       | 6,320                        |       | —                      |       |
| Total current liabilities                                                                                                                                               |       | 14,523                       |       | 4,432                       |       |
|                                                                                                                                                                    |       |                         |       |                        |       |
| Long-term notes payable, net of discounts,  less current portion                                                                                                        |       | —                       |       | 889                         |       |
| Long-term notes payable to related parties,  less currrent portion                                                                                                      |       | —                       |       | 629                         |       |
| Long-term capital leases                                                                                                                                                |       | 24                           |       | 36                          |       |
| Long-term deferred rent                                                                                                                                                 |       | 3                            |       | —                      |       |
|                                                                                                                                                                    |       |                         |       |                        |       |
| Total liabilities                                                                                                                                                       |       | 14,550                       |       | 5,986                       |       |
|                                                                                                                                                                    |       |                         |       |                        |       |
| Commitments and contingencies (Note 13)                                                                                                                                 |       |                         |       |                        |       |
|                                                                                                                                                                    |       |                         |       |                        |       |
| Stockholders’ deficit:                                                                                                                                             |       |                         |       |                        |       |
| Preferred stock, $0.01 par value:  50,000,000 shares authorized with liquidation preferences:                                                                           |       |                         |       |                        |       |
| Series A: 4,166,667 shares authorized;  issued and outstanding - no shares at September 30, 2008, and 22,167 at  December 31, 2007                       |       | —                       |       | —                      |       |
| Series B: 7,500,000 shares authorized;  issued and outstanding - no shares at September 30, 2008, and 40,000 at  December 31, 2007                       |       | —                       |       | —                      |       |
| Series C: 20,000,000 shares  authorized; issued and outstanding - no shares at September 30, 2008, and  1,482,604 at December 31, 2007                   |       | —                       |       | 15                          |       |
| Common stock, $0.01 par value: 250,000,000  shares authorized; issued and outstanding - 23,027,624 at September 30,  2008, and 6,791,313 at December 31, 2007 |       | 230                          |       | 68                          |       |
| Additional paid-in capital                                                                                                                                              |       | 18,196                       |       | 5,404                       |       |
| Accumulated deficit                                                                                                                                                     |       | (32,587                      | )          | (10,434                     | )          |
| Total stockholders’ deficit                                                                                                                                        |       | (14,161                      | )          | (4,947                      | )          |
|                                                                                                                                                                    |       |                         |       |                        |       |
| **Total liabilities and stockholders’ deficit**                                                                                                                    | ** ** | **$**                        | **389**    | ** **                  | **$**      | **1,039** | ** ** |

 

Theaccompanying notes are an integral part of these condensed interim financialstatements

 

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**ETELOS, INC.**

**CONDENSED STATEMENTS OF OPERATIONS**

(in thousands, except per share data)

(Unaudited)

 
| ** **                                                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                      | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                                      | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                                      | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                                                                         |       | $                                | 10         |                            | $          | 84 |   | $ | 55 |   | $ | 295 |   |
| Cost of revenue                                                                                 |       | 211                              |       | 127                             |       | 459 |   | 251 |   |
| Gross profit (loss)                                                                             |       | (201                             | )          | (43                             | )          | (404 | ) | 44 |   |
|                                                                                            |       |                             |       |                            |       |   |   |   |   |
| Operating expenses:                                                                             |       |                             |       |                            |       |   |   |   |   |
| Research and development                                                                        |       | 844                              |       | 852                             |       | 3,320 |   | 1,345 |   |
| Sales and marketing                                                                             |       | 514                              |       | 434                             |       | 1,315 |   | 685 |   |
| General and administrative                                                                      |       | 529                              |       | 322                             |       | 1,629 |   | 508 |   |
| Total operating expenses                                                                        |       | 1,887                            |       | 1,608                           |       | 6,264 |   | 2,538 |   |
|                                                                                            |       |                             |       |                            |       |   |   |   |   |
| Loss from operations                                                                            |       | (2,088                           | )          | (1,651                          | )          | (6,668 | ) | (2,494 | ) |
|                                                                                            |       |                             |       |                            |       |   |   |   |   |
| Other expense                                                                                   |       |                             |       |                            |       |   |   |   |   |
| Merger costs                                                                                    |       | —                           |       | —                          |       | 13,444 |   | — |   |
| Other expense                                                                                   |       | —                           |       | —                          |       | 15 |   | — |   |
| Total other expense                                                                             |       | —                           |       | —                          |       | 13,459 |   | — |   |
|                                                                                            |       |                             |       |                            |       |   |   |   |   |
| Interest (income) expense, net of fair  market value adjustment of financing instruments        |       | (3,739                           | )          | 110                             |       | 2,026 |   | 208 |   |
| Income (loss) before taxes                                                                      |       | 1,651                            |       | (1,761                          | )          | (22,153 | ) | (2,702 | ) |
|                                                                                            |       |                             |       |                            |       |   |   |   |   |
| Provision for income taxes                                                                      |       | —                           |       | —                          |       | — |   | — |   |
|                                                                                            |       |                             |       |                            |       |   |   |   |   |
| **Net income (loss)**                                                                           | ** ** | **$**                            | **1,651**  | ** **                      | **$**      | **(1,761** | **)** | **$** | **(22,153** | **)** | **$** | **(2,702** | **)** |
|                                                                                            |       |                             |       |                            |       |   |   |   |   |
| Basic net income (loss) per share                                                               |       | $                                | 0.05       |                            | $          | (0.36 | ) | $ | (1.34 | ) | $ | (0.68 | ) |
| Diluted net income (loss) per share                                                             |       | $                                | 0.04       |                            | $          | (0.36 | ) | $ | (1.34 | ) | $ | (0.68 | ) |
| Weighted average number of common shares  used in computing basic net income (loss) per share   |       | 34,161                           |       | 4,833                           |       | 16,522 |   | 3,954 |   |
| Weighted average number of common shares  used in computing diluted net income (loss) per share |       | 37,543                           |       | 4,833                           |       | 16,522 |   | 3,954 |   |

 

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

 

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**ETELOS, INC.**

**CONDENSED STATEMENTS OF CASH FLOWS**

(in thousands) 

(Unaudited)

 
| ** **                                                                                 | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                 | ** ** | **September 30,**          | ** ** |
| ** **                                                                                 | ** ** | **2008**                        | ** ** | **2007** | ** ** |
| ** **                                                                                 | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Cash flows from operating activities:**                                                  | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Net loss                                                                                   |       | $                               | (22,153    | ) | $ | (2,702 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |       |                            |       |   |   |
| Depreciation and amortization                                                              |       | 13                              |       | 12 |   |
| Amortization of notes discount                                                             |       | 201                             |       | — |   |
| Amortization of financing fees                                                             |       | 63                              |       | — |   |
| Stock based compensation                                                                   |       | 73                              |       | 151 |   |
| Interest expense paid in common stock                                                      |       | 77                              |       | — |   |
| Beneficial conversion feature                                                              |       | 991                             |       | — |   |
| Change in valuation of liability relating  to embedded derivatives and warrants            |       | 636                             |       | — |   |
| Professional fees paid in common stock                                                     |       | —                          |       | 60 |   |
| Merger costs paid in common stock                                                          |       | 13,177                          |       | — |   |
| Changes in operating assets and  liabilities:                                              |       |                            |       |   |   |
| Accounts receivable, net                                                                   |       | (6                              | )          | 11 |   |
| Prepaid expenses and other current assets                                                  |       | (2                              | )          | (17 | ) |
| Accounts payable                                                                           |       | 651                             |       | 78 |   |
| Accounts payable related parties                                                           |       | (50                             | )          | 78 |   |
| Accrued payroll and related expenses                                                       |       | (366                            | )          | 345 |   |
| Other accrued expenses                                                                     |       | 92                              |       | 76 |   |
| Other current liabilities                                                                  |       | 200                             |       | — |   |
| Deferred revenue                                                                           |       | 5                               |       | 12 |   |
| Deferred rent                                                                              |       | 9                               |       | — |   |
|                                                                                       |       |                            |       |   |   |
| **Net cash used in operating activities**                                                  | ** ** | **(6,389**                      | **)**      | **(1,896** | **)** |
|                                                                                       |       |                            |       |   |   |
| **Cash flows from investing activity:**                                                    |       |                            |       |   |   |
| Purchases of property and equipment                                                        |       | (55                             | )          | — |   |
|                                                                                       |       |                            |       |   |   |
| **Net cash used in investing activity**                                                    | ** ** | **(55**                         | **)**      | **—** | ** ** |
|                                                                                       |       |                            |       |   |   |
| **Cash flows from financing activities:**                                                  |       |                            |       |   |   |
| Proceeds from notes payable                                                                |       | 5,489                           |       | 3,357 |   |
| Proceeds from issuance of common stock                                                     |       | 459                             |       | — |   |
| Payment of fees on financing transactions                                                  |       | (284                            | )          | — |   |
| Payments of notes payable to related  parties                                              |       | (132                            | )          | (6 | ) |
| Payment of capital leases                                                                  |       | (10                             | )          | (10 | ) |
| Net change in line of credit                                                               |       | —                          |       | (449 | ) |
|                                                                                       |       |                            |       |   |   |
| **Net cash provided by financing activities**                                              | ** ** | **5,522**                       | ** ** | **2,892** | ** ** |
| ** **                                                                                 | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Net increase (decrease) in cash and cash  equivalents**                                  | ** ** | **(922**                        | **)**      | **996** | ** ** |
| ** **                                                                                 | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Cash and cash equivalents, beginning of  period**                                        | ** ** | **928**                         | ** ** | **15** | ** ** |
| ** **                                                                                 | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Cash and cash equivalents, end of period**                                               | ** ** | **$**                           | **6**      | ** ** | **$** | **1,011** | ** ** |
|                                                                                       |       |                            |       |   |   |
| **Supplemental disclosure of cash flow  information:**                                     |       |                            |       |   |   |
| Cash paid for interest                                                                     |       | $                               | 126        |   | $ | 33 |   |
|                                                                                       |       |                            |       |   |   |
| **Supplemental disclosure of non-cash  financing activities:**                             |       |                            |       |   |   |
| Record warrants and embedded derivatives as  liabilities                                   |       | $                               | 6,489      |   | $ | — |   |
| Issuance of common stock for convertible  debt                                             |       | $                               | 2,463      |   | $ | — |   |
| Issuance of common stock for interest  conversion                                          |       | $                               | 199        |   | $ | 200 |   |
| Issuance of detachable warrants                                                            |       | $                               | 73         |   | $ | 42 |   |
| Discount on convertible notes                                                              |       | $                               | (104       | ) | $ | 42 |   |
| Issuance of common stock for anti-dilution                                                 |       | $                               | 55         |   | $ | — |   |

 

Theaccompanying notes are an integral part of these condensed interim financialstatements

 

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**NOTES TOCONDENSED FINANCIAL STATEMENTS(Unaudited)**

 

***1.Organization***

 

On February 8, 2007, Tripath Technology Inc., a Delawarecorporation (“Tripath”) filed a voluntary petition for relief under Chapter 11of the Bankruptcy Code. On February 1, 2008, the bankruptcy court issuedan order confirming approval of the Plan of Reorganization, including themerger and the transfer of all of Tripath’s existing assets into a separatebankruptcy estate and the discharge of all of Tripath’s liabilities.  ThePlan of Reorganization 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,all stock options granted to employees), warrants, and other shares of commonstock to be canceled and extinguished.

 

On April 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 in to 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.

 

Prior to the Merger, Tripath was a shell corporation and in accordancewith the Plan of Reorganization had no assets or liabilities.  WhileTripath acquired all the outstanding preferred and common stock of Etelos-WA,for accounting purposes, the acquisition has been treated as a recapitalizationof Etelos-WA with Etelos-WA as the acquirer (a reverse acquisition).  Thehistorical financial statements prior to April 22, 2008, are those ofEtelos-WA and reflect the operations of Etelos-WA for the quarterly and ninemonth periods ended September 30, 2008 and 2007.  Proforma financialinformation giving effect to the acquisition as if the acquisition took placeon January 1, 2007, have not been presented because Etelos-WA acquired notangible or intangible assets, liabilities or any of the business operations ofTripath prior to its emergence from bankruptcy and therefore, the historicaloperations of Tripath are not an indicator of the future operations of Etelos, Inc. The operations of Etelos, Inc. subsequent to the Merger include only thoseof Etelos-WA.

 

The 5,010,000 shares of Etelos, Inc. common stock were valued at$2.63 per share, the estimated fair value of the common stock on the date ofthe Merger, which resulted in a charge to operations of $13.2 million includedin the caption Merger Related Costs in the accompanying Statement ofOperations.  Etelos, Inc. believes that these shares were issuedprimarily for past services provided to Etelos-WA by the secured creditors andthe release of the secured and unsecured creditors claims against Tripath.

 

Information concerning number of shares outstanding for Etelos, Inc.including the conversion prices and number of shares issuable upon conversionof convertible securities and exercise prices of warrants and stock options andthe number of shares issuable upon exercise of the options and warrants, hasbeen adjusted to reflect this stock split as if it had occurred at the beginningof the quarterly and nine month periods ended September 30, 2008 and 2007, andas of December 31, 2007.  Also, the Shareholders’ Deficit section ofthe accompanying Balance Sheet has been adjusted to reflect the legal capitalstructure of Tripath adjusted for the change in authorized shares of common andpreferred stock.

 

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

 

As used herein, unless the context requires otherwise, the terms the “Company,”“we,” “us,” “our” or “Etelos” refers to Etelos, Inc., the corporation thatsurvived the Merger.

 

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Etelos is a developer and distributor of software productivitysolutions that assist business organizations to effectively use WebApplications.  Etelos provides a revolutionary Software-as-a-Service (“SaaS”)ecosystem for building, distributing and using Web Applications, including theEtelos MarketplaceTM,which is a marketplace to deploy and support such Web Applications.  Thepurpose of the Etelos Marketplace is to give businesses choices in applicationsand hosting and support services to cost effectively accomplish theirgoals.  Etelos offers subscriptions to its applications to end usersincluding its Etelos Marketplace and provides software developed by Etelos toenable Marketplace partners to offer their products and services to end usersas a service under a SaaS model.

 

We began operations in 1999 but we did not adopt the SaaS on-demand WebApplications delivery model until 2005. As such, we have a limited operatinghistory in the SaaS industry, including licensing our software, from which toevaluate our business and prospects.  We incurred a net loss of $4.0million for the year ended December 31, 2007, and have an accumulateddeficit of $10.4 million at December 31, 2007.  During the ninemonths ended September 30, 2008, revenue has been limited and revenuederived from SaaS has been minor.  In addition, we have not generated anysignificant revenue from the Etelos Marketplace from licensing or sale ofsubscriptions to our products or services or third-party products orservices.  We cannot assure you that our future planned operations will beimplemented successfully or that we will ever have profits.  Furthermore,we are experiencing the initial costs and uncertainties of a young operatingcompany, including start-up expenditures, unforeseen costs and difficulties,complications, and delays, all of which must be resolved and/or paid withoutthe benefit of a predictable revenue stream.  We cannot be sure that wewill be successful in meeting these challenges and addressing these risks anduncertainties.  If we are unable to do so, then our business will not besuccessful.

 

We maintain the majority of cash balances and all of our short-terminvestments with one financial institution.

 

***3.Basis of Presentation***

 

The accompanying condensed financial statements include our accounts asof September 30, 2008, and December 31, 2007, and for the three andnine months ended September 30, 2008 and 2007.  These condensedfinancial statements have been prepared by us, without audit, pursuant to the rules andregulations of the Securities and Exchange Commission, or SEC. Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America have been condensed or omitted pursuant to such rules andregulations. The December 31, 2007, balance sheet was derived from auditedfinancial statements, but does not include all disclosures required byaccounting principles generally accepted in the United States of America.However, we believe that all disclosures are adequate to make the informationpresented not misleading. The accompanying unaudited condensed financialstatements should be read in conjunction with the audited financial statementsand the notes thereto, included on Form 8-K filed April 23, 2008, andForm 8-K/A filed April 25, 2008, by Tripath.

 

In the opinion of our management, all adjustments (which consist ofnormal recurring adjustments, except as disclosed herein) necessary to fairlypresent our financial position, results of operations and cash flows for theinterim periods presented have been included. The results of operations for thethree and nine months ended September 30, 2008, are not necessarilyindicative of the results to be expected for the full year or for any futureperiods.

 

The preparation of 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 and disclosure of contingent assets and liabilitiesat the date of the financial statements and reported amounts of revenues andexpenses during the reporting period. Actual results could differ from thoseestimates, and such differences could affect the results of operations reportedin future periods and such differences could be material.  The Company has no items of comprehensiveincome to disclose.

 

***4.Going Concern***

 

The financial statements have been prepared by us with the assumptionthat we will continue as a going concern.  We have experienced net lossesof $22.2 million and $4.0 million for the nine months ended September 30,2008, and the year ended December 31, 2007, respectively, and have a totalstockholders’ deficit of $14.2 million, as of September 30, 2008, all ofwhich raise substantial doubt about our ability to continue as a going concern.Our financial statements do not include any adjustments relating to therecoverability and classification of asset carrying amounts or the amount andclassification of liabilities that might arise should we be unable to continueas a going concern.

 

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Management has supported current operations by raising additionaloperating cash through the private sale of convertible debentures and notespayable and preferred stock. This has provided us with the cash inflows tocontinue our business plan, but has not resulted in significant improvement inour financial position or results of operations.  Management also has substantially reducedoperating expenses by termination of employees and other reductions inoperating expenses.  Alternatives we arepursuing to improve our 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 thatour current financial position can be improved, that we can raise additionalworking capital, or that we can achieve positive cash flows from operations.Our long-term viability as a going concern is dependent upon our ability to (1) locatesources of debt or equity funding to meet current commitments and near-termfuture working capital requirements and (2) achieve profitability andultimately generate sufficient cash flow from operations to sustain ourcontinuing operations.

 

Our cash balance including proceeds from our recent debt financings andpreferred stock financing may not be sufficient to fund our operations beyond December 2008. If cash reserves and our credit facility are not sufficient to sustainoperations, then we plan to further reduce operating expenses and/or raiseadditional capital by selling shares of our capital stock or other securities. However, there are no commitments or arrangements for future financingsin place at this time and we can give no assurance that such capital will beavailable on favorable terms, or at all.  We may need additional financingthereafter until we can achieve profitability.  If we cannot, then we willbe forced to curtail our operations or possibly be forced to evaluate a sale orliquidation of our assets.  Even if we are successful in raisingadditional funds, there is no assurance regarding the terms of any additionalinvestment.  Any future financing may involve substantial dilution toexisting investors.

 

***5. Research and Development and Software Development Costs***

 

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

 

Statement of Position 98-1, *Accountingfor Costs of Computer Software Developed or Obtained for Internal Use*(“SOP 98-1”), which applies to SaaS business model, are met for thecapitalization of software development cost.  Under SOP 98-1, softwaredevelopment costs, including costs incurred to purchase third party software,are capitalized beginning when the Company has determined certain factors arepresent, including, among others, that technology exists to achieve theperformance requirements, buy versus internal development decisions have beenmade, and the Company’s management has authorized the funding for the project.Capitalization of software development costs ceases when the software issubstantially complete and is ready for its intended use.  To date, nosoftware development costs incurred have met the criteria set forth in SOP 98-1for capitalization.

 

***6. Revenue Recognition***

 

We distribute Web Applications and our Marketplace Platform as asubscription service using the SaaS or software-on-demand business model andallow third parties to offer their products or services through storefronts inthe Etelos Marketplace, and to advertise on our web site or in our magazine fora fee.  We also license certain of our software products under perpetualand terms licenses.  Revenues are recognized on these service andlicensing transactions using the criteria in SEC Staff Accounting Bulletin 104,*Revenue Recognition in Financial Statements*and SOP 97-2, *Software Revenue Recognition*,respectively, which both provide that revenue may be recognized when all of thefollowing are met:

 

·                  persuasiveevidence of an arrangement exists,

·                  theproduct or service has been delivered,

·                  thefee is fixed or determinable, and

·                  collectionof the resulting receivable is reasonably assured or probable.

 

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For the SaaS business model, persuasive evidence is generally anacceptance 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 the period the SaaS is provided.

 

For software licensed under term or perpetual agreements, persuasiveevidence of an arrangement is evidenced by a binding agreement signed by thecustomer and delivery generally occurs upon delivery of the software to acommon carrier. If a significant portion of a fee is due after our normalpayment terms of typically 30 days, then we recognize revenue as the feesbecome due. If we determine that collection of a fee is not reasonably assured,then we defer the fees and recognize revenue upon cash receipt, provided thatall other revenue recognition criteria are met.

 

Advertising on our web site is recognized as revenue over the periodthe ad appears on our web site and advertising presented in our magazine isrecognized upon publication of the magazine provided the other criteria forrevenue recognition set forth above have been met.

 

Arrangements for which the fees are not deemed reasonably assured forcollection are recognized upon cash collection.

 

***7. Stock Based Compensation***

 

The Company, under SFAS No. 123 (revised 2004), *Share-Based Payment* (“FAS 123R”), isapplying the “modified prospective method” and used the Black-Scholes Mertonmodel to value all new stock based compensation awards granted starting January 1,2006, and for any modification, cancellation, or repurchase of awards grantedprior to January 1, 2006.  As a result, we have recorded compensationcost in the statement of operations based on the fair value of the award forthe requisite service period. FAS 123(R) also requires us to estimateforfeitures in calculating the expense relating to share-based compensation asopposed to only recognizing these forfeitures and the corresponding reductionin expense as they occur. This resulted in $4.1 thousand and $150.8 thousand ofexpense for the quarters ended September 30, 2008 and 2007 respectivelyand $72.9 thousand and $150.8 thousand of expense for the nine months ended September 30,2008 and 2007, respectively.

 

FAS 123(R) requires the cash flows resulting from the tax benefitsresulting from tax deductions in excess of the compensation cost recognized forthose options to be classified as financing cash flows. Due to our lossposition, there were no such tax benefits during the quarters and nine monthperiods ended September 30, 2008 and 2007. Prior to the adoption of FAS123(R), those benefits would have been reported as operating cash flows had wereceived any tax benefits related to stock option exercises.

 

The weighted-average fair value of stock-based compensation is based onthe single option valuation approach and is estimated on the date of grantusing a Black-Scholes Merton based option valuation model. The fair value offorfeitures is an estimate and no dividends have been declared. The fair valueof options granted during the three and nine months ended September 30,2008 and 2007, were calculated based on the following average assumptions:

 
| ** **              | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|-------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **              | ** ** | **Ended September 30**        | ** ** | **Ended September 30**       | ** ** |
| ** **              | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Estimate fair value     |       | $                                       | 4.53       |                                   | $          | — |   | $ | 1.41 |   | $ | — |   |
| Expected lives in years |       | 7                                       |       | —                                 |       | 7 |   | — |   |
| Volatlity               |       | 74.29                                   | %          | 0.00                                   | %          | 59.00 | % | 0.00 | % |
| Risk free interst rate  |       | 3.85                                    | %          | 0.00                                   | %          | 3.26 | % | 0.00 | % |
| Dividend yield          |       | $                                       | —     |                                   | $          | — |   | $ | — |   | $ | — |   |

 

We used estimated volatility of comparable public companies to estimatethe expected volatility used for the Black-Scholes Merton model. The risk-freeinterest rate assumption is based upon the US Treasury yield. We historicallyhave not declared dividends and therefore the dividend yield was assumed to bezero in the model.

 

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The following table summarizes stock option activity under the Company’sstock option plans:

 
| Outstanding at December 31, 2007  |   | 4,093,333 |   |
|----------------------------------------|--------|-----------|--------|
| Granted                                |   | 931,000   |   |
| Exercised                              |   | (3,750    | )      |
| Cancelled                              |   | (539,672  | )      |
| Outstanding at September 30, 2008 |   | 4,480,911 |   |

 

Following the end of the quarter ended September 30, 2008, anadditional 400,330 options were cancelled.

 

There was no cash received as a result of options exercised during thequarter ended September 30, 2008. There were no equity instruments grantedunder share-based payment arrangements and therefore there was no cash used tosettle any equity instrument. We do not plan to repurchase any shares duringthe remainder of 2008.

 

***8. Net Loss per Share***

 

Basic net loss per share is computed by dividing the net loss availableto common stockholders for the period by the weighted average number of sharesof common stock outstanding during the period, excluding any unvestedrestricted stock that is subject to repurchase. Diluted net income per share iscomputed using the weighted average number of common shares and, if dilutive,potential common shares outstanding during the period. Potential common sharesconsist of unvested restricted stock (using the treasury stock method), theincremental common shares issuable upon the exercise of stock options andwarrants (using the treasury stock method) and the conversion of the Company’sconvertible notes and debentures (using the if-converted method).  Astheir effect is antidilutive, 4,480,911 shares of common stock exercisableunder outstanding employee stock options, 611,111 shares of common stockexercisable under outstanding warrants, 6,426,074 shares of common stockissuable upon conversion of the outstanding convertible notes payable anddebentures, as of September 30, 2008, have been excluded from thiscalculation.  The average exercise price of outstanding employee stockoptions and warrants to purchase the Company’s common stock is $1.41 and $1.80,respectively, at September 30, 2008.

 

The following table sets forth the computation of basic and diluted netloss per share for the periods presented (in thousands, except per shareamounts):

 
| ** **                                            | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                                            | ** ** | **Ended September 30**        | ** ** | **Ended September 30**       | ** ** |
| ** **                                            | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                            | ** ** | ** **                              | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator:                                            |       |                                    |       |                                   |       |   |   |   |   |
| Net income (loss)                                     |       | $                                       | 1,651      |                                   | $          | (1,761 | ) | $ | (22,153 | ) | $ | (2,702 | ) |
|                                                  |       |                                    |       |                                   |       |   |   |   |   |
| Denominator:                                          |       |                                    |       |                                   |       |   |   |   |   |
| Shares used in computing net income (loss)  per share |       |                                    |       |                                   |       |   |   |   |   |
| Basic                                                 |       | 34,161                                  |       | 4,833                                  |       | 16,522 |   | 3,954 |   |
| Diluted                                               |       | 37,543                                  |       | 4,833                                  |       | 16,522 |   | 3,954 |   |
|                                                  |       |                                    |       |                                   |       |   |   |   |   |
| Net income (loss) per share:                          |       |                                    |       |                                   |       |   |   |   |   |
| Basic                                                 |       | $                                       | 0.05       |                                   | $          | (0.36 | ) | $ | (1.34 | ) | $ | (0.68 | ) |
| Diluted                                               |       | $                                       | 0.04       |                                   | $          | (0.36 | ) | $ | (1.34 | ) | $ | (0.68 | ) |

 

***9.Recently Issued Accounting Standards***

 

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

 

InMarch 2008, the FASB issued SFAS No. 161 (“SFAS 161*”), Disclosures about Derivative Instruments andHedging Activities-an amendment of SFAS No. 133*. This newstandard requires enhanced disclosures for derivative instruments, includingthose used in hedging activities. SFAS 161 is effective for fiscal years andinterim periods beginning after November 15, 2008. We have not yetdetermined the impact, if any, that the adoption of SFAS 161 will have on ourfinancial statements and related disclosures.

 

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In February 2008, the Financial Accounting Standards Board (FASB)issued FASB Staff Position (FSP) No. FAS 157-2, *Effective Date of FASB Statement No. 157*(“FSP FAS 157-2”), which delays the effective date of Statement ofFinancial Accounting Standards (SFAS) No. 157, *Fair Value Measurements* (“SFAS 157”) for allnon-financial assets and non-financial liabilities, except those that arerecognized or disclosed at fair value in the financial statements on a recurringbasis (at least annually) for fiscal years beginning after November 15,2008, and interim periods within those fiscal years for items within the scopeof this FSP. We are currently evaluating the impact of adopting FSPFAS 157-2 for non-financial assets and non-financial liabilities on ourfinancial position, cash flows, and results of operations.

 

In December 2007, the FASB issued SFAS No. 141(R), *Business Combinations* (“FAS 141R”), whichrequires an acquirer to measure the identifiable assets acquired, theliabilities assumed, and any noncontrolling interest in the acquiree at theirfair values on the acquisition date, with goodwill being the excess value overthe net identifiable assets acquired. FAS 141R is effective for financialstatements issued for fiscal years beginning after December 15, 2008.Also, in December 2007, the FASB issued SFAS No. 160, *Noncontrolling Interests in Consolidated FinancialStatements,**an**amendment**ofARB No. 51*  (“FAS 160”), which clarifies that anoncontrolling interest in a subsidiary should be reported as equity in thefinancial statements. The calculation of earnings per share will continue to bebased on income amounts attributable to the parent. FAS 160 is effective forfinancial statements issued for fiscal years beginning after December 15,2008. We are currently evaluating the impact of adopting SFAS 141R andSFAS 160 on our financial position, cash flows, and results of operations.

 

In June 2008, the FASB issued FSP No. EITF 03-6-1, *Determining Whether Instruments Granted inShare-Based Payment Transactions Are Participating Securities* (“FSPEITF 03-6-1”), which requires entities to apply the two-class method ofcomputing basic and diluted earnings per share for participating securitiesthat include awards that accrue cash dividends (whether paid or unpaid) anytime common shareholders receive dividends and those dividends do not need tobe returned to the entity if the employee forfeits the award. FSPEITF 03-6-1 will be effective for the Company on January 1, 2009, andwill require retroactive disclosure. The Company is currently evaluating theimpact of adopting FSP EITF 03-6-1 on its financial position, cash flows,and results of operations.

 

***10. Convertible Notes and Debentures andEmbedded Derivative and Warrant Liability***

 

Convertiblenotes and debentures comprise (in thousands):

 

| ** **                               | ** ** | **September 30,  2008** | ** ** | **December  31, 2007** | ** ** |
|------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| 20% convertible notes                    |       | $                            | —     |                        | $          | 850 |   |
| 6% convertible notes                     |       | 1,764                        |       | 3,326                       |       |
| January 2008 Debentures             |       | 2,000                        |       | —                      |       |
| April 2008 Debentures               |       | 3,500                        |       | —                      |       |
|                                     |       | 7,264                        |       | 4,176                       |       |
| Less discount on long term notes payable |       | (73                          | )          | (16                         | )          |
|                                     |       |                         |       |                        |       |
|                                     |       | $                            | 7,191      |                        | $          | 4,160 |   |

 

*20% Convertible Notes*

 

Duringthe period October 2006 to June 2007, we issued 20 percentconvertible notes with a face value of $850 thousand and detachable warrants topurchase shares of our common stock in exchange for $850 thousand.  As of June 30and September 30, 2008, $750 thousand of the 20 percent convertible noteshave been converted into 1,000,000 shares of the Company’s common stock and thebalance of $100 thousand have been paid in cash.

 

Thedetachable warrants allow the holders to purchase up to 283,333 shares of ourcommon stock at an exercise price of $0.09 per share. During the quarter ended June 30,2008, all of the warrants had been exercised. The warrants were determined tohave*de minimus* value at theissuance date.

 

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*6% Convertible Notes*

 

Duringthe period August 2007 to October 2007, we issued 6 percentconvertible notes with a face value of $3,326 thousand at an original issuediscount of 10 percent with detachable warrants to purchase shares of ourcommon stock in exchange for $3,024 thousand.  These notes mature on March 31,2009, with interest due and payable on February 1, 2008, and on the lastday of each calendar quarter thereafter. We are required to make payments onthe outstanding principal balance beginning September 1, 2008, and on the1st day of each calendar quarter thereafter. The default interestrate is 8 percent. The notes and unpaid interest are convertible into shares ofour common stock at the option of the holder or involuntarily upon theoccurrence of certain financing events. As of September 30, 2008, $1,712 thousand of the face value of the6% convertible notes have been converted to 2,283 thousand shares of theCompany’s common stock and $1,764 thousand remain outstanding.   We have failed to make the required interestand principal payments on the 6 percent convertible notes during the quarterended September 30, 2008, and through the filing date of this report.  Accordingly, we are in default under theterms of the 6 percent convertible notes, which results in all principal andinterest related to the 6 percent convertible notes becoming due and payable tothe holders.  As a result, we haveaccrued interest on the 6 percent convertible notes at the default rate of 8 percentand classified all amounts due related to the 6 percent convertible notes ascurrent liabilities.

 

Inaddition, the purchasers of the 6 percent convertible notes received warrants,which are fully exercisable, to purchase 1,080,000 shares of the Company’scommon stock at an exercise price of $0.12.  The warrants expire August throughOctober 2013, unless they are earlier automatically terminated upon (i) apublic offering of the Company’s common stock, (ii) sale of the Company,or (iii) a change in control.  At June 30 and September 30,2008, all of these warrants had been exercised or expired and none areoutstanding.

 

*January 2008 Debentures*

 

OnJanuary 31, 2008, we issued convertible debentures (“the January 2008Debentures”) with a principal amount of $2 million and detachable warrants topurchase 222,222 shares of our common stock in exchange for $1.9 million. The January 2008 Debentures are due on January 31, 2010, and bearinterest at 6 percent per annum, which is payable semiannually on January 1and July 1, commencing on July 1, 2008.  Monthly principalpayments equal to 1/18th of the principal amount were to begin on September 1,2008.  We have the right to pay interest and monthly principal payments incash, or upon notice to the holders and compliance with certain equity conditions,we can pay all or a portion of any such payment in common stock valued at aprice equal to the lesser of the then effective conversion price (currently$1.35) or 85 percent of the average of the volume weighted average price pershare for our common stock for the 10 consecutive trading days immediatelyprior to the applicable payment date.  The equity conditions that we mustmeet include having a currently effective registration statement covering theshares of common stock issuable upon conversion of the debenture, and havingthe daily dollar trading volume for our common stock exceed $250,000 for eachof the 20 consecutive trading days before the date in question.  The January 2008Debentures and any accrued interest are convertible at anytime at the discretionof the holder at a conversion price per share of $1.35, subject to a cap on thebeneficial ownership of our shares of common stock by the holder and itsaffiliates following such conversion. The conversion price is adjusted upon astock split, reverse stock split, or upon issuance of stock dividends, wherebythe conversion price would be adjusted to ensure that the holder would bereceiving 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 our common stock entitling them to purchase common stock at priceslower than the volume weighted average price on the date issued.

 

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

 

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TheJanuary 2008 Debentures impose certain covenants on us, includingrestrictions against incurring additional indebtedness, creating any liens onour property, amending our certificate of incorporation or bylaws, redeeming orpaying dividends on shares of our outstanding common stock, and entering intocertain related party transactions.  The January 2008 Debentures alsodefine certain events of default, including, without limitation, failure tomake a payment obligation, failure to observe other covenants of the debentureor related agreements (subject to applicable cure periods), breach ofrepresentation or warranty, bankruptcy, default under another significantcontract or credit obligation, delisting of our common stock, a change incontrol, failure to secure and maintain an effective registration statementcovering the resale of the common stock underlying the debentures and thewarrants, or failure to deliver share certificates in a timely manner.  Inthe event of default, the holders of the January 2008 Debentures have theright to accelerate all amounts outstanding under the debentures and demandpayment of a mandatory default amount equal to 130 percent of the amountoutstanding plus accrued interest and expenses. We have failed to make the required interest and principal payments onthe January 2008 Debentures during the quarter ended September 30,2008, and through the filing date of this report.  Accordingly, we are in default under theterms of the January 2008 Debentures, and the holders have the right todemand that the default amount equal to 130% of the amount outstanding plusaccrued interest be paid to the holders. As of the date of this report, none of the holders has elected to exercisetheir rights arising from our default.

 

Debtissuance costs of $85.2 thousand were incurred in conjunction with the issuanceof the January 2008 Debentures, which have been capitalized as OtherAssets and are amortized using the effective interest method.

 

Thedetachable warrants, which are fully exercisable, to purchase 222,222 shares ofour common stock, expire in January 2011 and are exercisable at a price of$1.80 per share, subject to adjustment.  As of September 30, 2008,none of these warrants had been exercised.

 

*April 2008 Debentures*

 

OnApril 22, 2008, we issued convertible debentures (“the April 2008Debentures”) with a principal amount of $3.5 million and detachable warrants topurchase 388,889 shares of our common stock in exchange for $3.4 million. The April 2008 Debentures are due on April 30, 2010, and havethe identical terms and conditions to the January 2008 Debenturesdescribed above. We have failed to make the required interest and principalpayments on the April 2008 Debentures during the quarter ended September 30,2008, and through the filing date of this report.  Accordingly, we are in default under theterms of the April 2008 Debentures, and the holders have the right todemand that the default amount equal to 130% of the amount outstanding plusaccrued interest be paid to the holders. As of the date of this report, none of the holders has elected toexercise their rights arising from our default.

 

Debtissuance costs of $149 thousand were incurred in conjunction with the issuanceof the April 2008 Debentures, which have been capitalized as Other Assetsand are amortized using the effective interest method.

 

Thedetachable warrants, which are fully exercisable, to purchase 388,889 shares ofour common stock, expire in April 2011 and are exercisable at a price of$1.80 per share, subject to adjustment, for the events described above, whichadjust the conversion price of the January 2008 Debentures.  As of September 30,2008, none of these warrants had been exercised.

 

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

 

Ourregistration statement was effective July 31, 2008, which was eight daysafter the deadline in the registration rights agreements. Accordingly, we maybe liable for penalties in the amount of $14.7 thousand, which we have accrued.

 

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*Accounting for Convertible Notes and Debentures, EmbeddedDerivatives and Warrants*

 

TheCompany has evaluated the embedded derivatives included in the 20% and 6%Convertible Notes (the “Convertible Notes”) and the January 2008 and April 2008 Debentures,which are not clearly and closely related to the Convertible Notes and January 2008and April 2008 Debentures, consisting of the conversion features andcertain put and call features described above, under the guidance in Statementof Financial Accounting Standard No. 133 A*ccounting for Derivative Instruments and HedgingActivities* and its related guidance and interpretations (“SFAS 133”)on the issuance date of the Convertible Notes and January 2008 and April 2008Debentures and on each subsequent reporting date.  The purpose of theevaluation is to determine whether the embedded derivatives need to be bifurcated from the debt host and accountedfor as a derivative at their estimated fair value as a liability at thedate of issuance and thereafter, adjusted to estimated fair value with a chargeor credit to the Company’s statement of operations.  SFAS 133 generallyindicates that if the conversion features are (i) indexed to the Company’scapital stock and (ii) would be classified as equity if a freestandingderivative under the guidance in EITF 00-19, *Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock* (“EITF 00-19”), the embedded derivativesneed not be bifurcated from the debt host.  EITF 00-19 generally requires,among other factors, that (i) the Company can settle the derivative incash or its own stock, at its option, (ii) settlement can be made inunregistered shares, and (iii) the Company has sufficient authorizedshares to issue shares of its common stock for all equity instrumentsconvertible to or which can be exercised for its capital stock.  SFAS 133also provides guidance on when put and call features included in a debt hostagreement are not clearly and closely related to the debt host must bebifurcated and recorded as ability.  Only the January 2008 and April 2008Debentures include put and call features.

 

TheCompany concluded that the conversion features embedded in the 6% ConvertibleNotes met the criteria in SFAS 133 at issuance and through April 21, 2008,the day prior to the merger with Tripath, because the conversion to the Company’scommon stock could only be settled in its capital stock, the capital stockcould be unregistered and the sufficiency of the authorized shares was underthe Company’s control as it could control the outcome of a shareholder vote toincrease the authorized shares.  However, on the date of the merger withTripath, April 22, 2008, the Company concluded it no longer had control toensure the sufficiency of its authorized shares of common stock and recordedthe embedded conversion feature in the 6% Convertible Notes with an estimatedfair value of $3,674 thousand and recorded the amount in the line entitled “Warrantand derivative liability” in the accompanying balance sheet.  At September 30,2008, the estimated fair value of the conversion feature was subsequentlyrevalued to $ 2,695 thousand, with the related credit of $ 4,774 thousandincluded in the Company’s condensed statement of operations in interest expensefor the quarter ended September 30, 2008. The credit included in the condensed statement of operations for the ninemonths ended September 30, 2008 related to this derivative totaled $894thousand.  The Company determined theestimated fair value of the conversion feature on April 22, 2008, and September 30,2008, by using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $2.91, $4.00, and$2.00, respectively, per share; terms of .95 years, .75 years, and .50 years,respectively; risk free interest rates of 1.82%, 2.27%, and 1.60%,respectively; and volatility of 47.16%, 56.13%, and 51.3%, respectively.Probabilities were then applied to the outputs using the Matlab Monte CarloSimulation of the Company’s stock prices to arrive at a value for theconversion options.  Accretion charged to interest expense for the 6%Convertible Notes in the quarter and nine months ended September 30, 2008,was $25 thousand and $173 thousand, respectively. Also during the quarter andsix months ended June 30, 2008, the Company recorded a beneficialconversion features related to accrued interest on the 6% Convertible notes,which were or could have been converted to the Company’s common stock, throughthe date the conversion features was recorded, as a liability of $58 thousand.

 

TheCompany concluded that the conversion features embedded in the January 2008Debentures met the criteria in SFAS 133 at issuance and through March 31,2008, and therefore, were not bifurcated from the debt host because theconversion to the Company’s common stock could only be settled in its commonstock, the common stock could be unregistered and the sufficiency of theauthorized shares was under the Company’s control as it could control theoutcome of a shareholder vote to increase the authorized shares.  While weconcluded that the put and call embedded in the January 2008 Debentureswas not clearly and closely related to the debt host, the estimated fair valueof the put and call was determined to be *de minimus* andtherefore was not bifurcated from the debt host.  However, on the date ofthe merger with Tripath, April 22, 2008, the Company concluded it nolonger had control to ensure the sufficiency of its authorized shares of commonstock nor could it settle the conversion feature in unregistered shares andtherefore, recorded the embedded conversion feature and put and call in the January 2008Debentures with an estimated value fair value of $896 thousand and recorded theamount in the line entitled “Warrant and derivative liability” in theaccompanying balance sheet.  At September 30, 2008, the estimatedfair value of the conversion feature was subsequently revalued to $1,194thousand, with the related charge of $616 thousand included in the Company’scondensed statement of operations in interest expense for the quarter ended September 30,2008.  The charge include in thecondensed statement of operations for the nine months ended September 30,2008, related to this derivative totaled $298 thousand. The Company determinedthe estimated fair value of the conversion options on April 22, 2008, and September 30,2008, using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $2.91, $4.00, and$2.00, respectively, per share; terms of 1 year and 1.75 years, 1.2 years and1.6 years, and 1.3 years, respectively; risk free interest rates of 1.84% and2.14%, 2.41% and 2.52%, and 1.85%, respectively; and volatility of 47.16% and48.48%, 49.08% and 48.64%, and 49.3%, respectively.  Probabilities werethen applied to the outputs using the Matlab Monte Carlo Simulation of theCompany’s stock prices to arrive at a value for the conversion options. Accretion charged to interest expense for the January 2008Debentures in the quarter and nine months ended September 30, 2008, was$20 thousand and $40 thousand, respectively.

 

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TheCompany concluded that the embedded conversion features in the April 2008Debentures should be bifurcated from the debt host and recorded as liabilitiesbecause the conversion features must be settled in registered shares and thatdue to the Merger with Tripath, we no longer had control over a shareholdervote to ensure the sufficiency of our authorized shares of common stock. Wealso concluded that the put and call in the April 2008 Debentures wereembedded derivatives and were not clearly and closely related to the debt hostand therefore should be bifurcated from the debt host along with the conversionfeatures and recorded as a liability at their estimated fair value atissuance.  The estimated fair value of the embedded conversion featuresand put and call was $1,057 thousand at April 23, 2008, and recorded inthe line entitled “Warrant and derivative liability” in the accompanyingBalance Sheet. At September 30, 2008, the estimated fair value of theconversion feature was subsequently revalued to $2,081 thousand, with therelated charge of $1,131 thousand included in the Company’s condensed statementof operations in interest expense for the quarter ended September 30,2008.  The charge include in thecondensed statement of operations for the nine months ended September 30,2008, related to this derivative totaled $574 thousand. The resulting discounton the April 2008 Debentures of $2,097 thousand, which included theestimated fair values of the related detachable warrants described below, isaccreted from April 2008, the date of issuance, to April 30, 2010,the maturity date of the April 2008 Debentures, using the interest methodwith the relating charge to interest expense in the Company’s statement ofoperations.  Accretion charged to interest expense for the April 2008 Debenturesin the quarter and nine months ended September 30, 2008, was $480 thousandand $840 thousand.  The Company determined the estimated fair value of theconversion options on April 22 and September 30, 2008, using theBlack-Scholes Merton valuation model and the following assumptions: fair valueof the Company’s common stock of $2.91, $4.00, and $2.00, respectively, pershare; terms of 1 year and 2 years, 1.4 years and 1.8 years, and 1.6 years,respectively; risk free interest rates of 1.87% and 2.24%, 2.47% and 2.58%, and1.91%, respectively; and volatility of 45.76% and 49.00%, 50.29% and  49.64%, and 49.54%, respectively.   Probabilities were then applied to theoutputs using the Matlab Monte Carlo Simulation of the Company’s stock pricesto arrive at a value for the conversion options.

 

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

 

TheCompany concluded that the detachable warrants issued with the January 2008Debentures met the criteria in SFAS 133 at issuance and through March 31,2008, and therefore, were accounted for as equity because the warrants couldonly be settled by issuance of the Company’s common stock, the common stockcould be unregistered, and the sufficiency of the authorized shares was underthe Company’s control as it could control the outcome of a shareholder vote toincrease the authorized shares.  However, on the date of the merger withTripath, April 22, 2008, the Company concluded it no longer had control toensure the sufficiency of its authorized shares of common stock nor could itsettle the warrants in unregistered shares and therefore, recorded theestimated value fair value of the warrants of $320 thousand in the lineentitled “Warrant and embedded derivative liability” in the accompanyingBalance Sheet.  At September 30, 2008, the estimated fair value ofthe warrants was revalued to $156 thousand with the related credit of  $388 thousand included in the Company’scondensed statement of operations for the quarter ended September 30,2008.  The cumulative credit for the ninemonths ended September 30, 2008 included in the condensed statement ofoperations totaled $164 thousand.  TheCompany determined the estimated fair value of the warrants on April 22, June 30,and September 30, 2008, by using the Black-Scholes Merton valuation modeland the following assumptions: fair value of the Company’s common stock of$2.91, $4.00, and $2.00, respectively, per share; terms of 2.5 years, 2.5, and2.4 years, respectively; risk free interest rates of 2.54%, 2.77%, and 2.10%,respectively; and volatility of 47.81%, 49.53%, and 48.89%, respectively.

 

TheCompany concluded that the detachable warrants issued with the April Debenturesdid not meet the criteria in SFAS 133 at issuance because it no longer hadcontrol to ensure the sufficiency of its authorized shares of common stock norcould it settle the warrants in unregistered shares and therefore, recorded theestimated value fair value of the warrants of $590 thousand in the lineentitled “Warrant and embedded derivative liability” in the accompanying BalanceSheet.  At September 30, 2008, the estimated fair value of thewarrants was revalued to $288 thousand with the related credit of $692 thousandincluded in the Company’s condensed statement of operations for the quarterended September 30, 2008.  The cumulativecredit for the nine months ended September 30, 2008, included thecondensed statement of operations, totaled $302 thousand. The Companydetermined the estimated fair value of the warrants on April 22, June 30,and September 30, 2008, by using the Black-Scholes Merton valuation modeland the following assumptions: fair value of the Company’s common stock of$2.91, $4.00, and $2.00, respectively, per share; terms of 3 years, 3 years,and 2.6 years, respectively; risk free interest rates of 2.43%, 2.91%, and2.16%, respectively; and volatility of 49.17%, 49.80%, and 50.14%,respectively.

 

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***11.Notes Payable to Related Parties***

 

We previously entered into a series of unsecured loan transactions withrelatives of Daniel J.A. Kolke, our founder, executive chairman, chiefexecutive officer and chief technology officer.  On December 30,2007, in connection with settlement of these loans, we entered into threeunsecured promissory notes with an aggregate original principal amount of $816thousand, each of which will become collateralized by certain presentlyunidentified assets of the Company if and when Daniel J.A. Kolke is no longeran employee nor a member of our board of directors.  Such securityinterest, if granted, would be subordinated to any and all bank debt orconvertible corporate debt.  These three notes are outstanding and indefault in an aggregate balance of $776 thousand as of September 30,2008.  No demands for payment have beenmade as of the date of this report.

 

***12.Credit Facility***

 

 In October 2007, we entered into a one-year credit facilitywith Bridge Bank which provides for borrowing of up to $250 thousand at anannual interest rate equal to the bank’s prime rate plus 2.5 percent. Thecredit facility was collateralized by substantially all of our assets. Weissued warrants to Bridge Bank to purchase up to 10,417 shares of our commonstock at an exercise price of $1.20 per share in connection with this facility,all of which have expired unexercised.  There was no borrowing under thisfacility during the nine months ended September 30, 2008. The creditfacility subsequently expired in October 2008, in accordance with itsterms, and was not renewed.

 

***13.Contingency***

 

 During the quarter ended June 2008, the Company became awarethat it had not made certain payroll tax filings and had not filed its federaland state income tax returns for calendar and fiscal years 2004, 2005 and 2006,and certain payroll tax filings for calendar and fiscal year 2007. In June 2008,the Company made those filings and paid federal and state payroll withholdingtaxes, including its portion of such payroll taxes and interest and penaltytotaling $572 thousand, relating to 2007.  These amounts were accrued asof December 31, 2006 and 2007 and at March 31, 2008.   However,the Internal Revenue Service has notified the Company that certain payroll taxand income tax filings other than these also have not been filed correctly inprior years.  The Company is in the process of determining whether thesepayroll and income tax returns were filed and if not will either refile thereturns or prepare such returns and make appropriate filings with the InternalRevenue Service.  The Company believes it owes no more state or federalpayroll taxes applicable to prior years and that it owes no federal or stateincome taxes because it had annual losses in each year of operations since itsinception in 1999.  However, because of the uncertainties related to boththe amount and range of loss of this matter, management is unable to make areasonable estimate of the liability that could result from an unfavorableoutcome. As additional information becomes available, the Company will assessits potential liability and revise its estimates.

 

***14.Subsequent Events***

 

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

 

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On September 18, 2008, the employment of Jeffrey L. Garon as our presidentand chief executive officer of the Company was terminated.  On October 19, 2008, Mr. Garonresigned from the Board of Directors.  Wehad entered into an employment agreement dated August 11, 2007, whichprovided certain benefits to Mr. Garon in the event of termination of hisemployment, and granted to us certain rights to repurchase shares issued onbehalf of Mr. Garon pursuant to the employment agreement.  The Company and Mr. Garon have beenengaged in discussions about these benefits and rights, and no final agreementhas been reached as of the filing date of this report.

 

On October 1, 2008, we relocated our headquarters from San Mateo,California to Renton, Washington, and terminated eight employees based inCalifornia.  On October 31, 2008, weclosed our offices in San Mateo, California and abandoned the leased premisesof its former offices there.  Effectiveon October 31, 2008, David S.G. MacKenzie resigned his position as ourvice president and chief financial officer, but he will continue to serve as anadvisor and consultant to us.  We havenot yet appointed any person to serve as our chief financial officer.  On October 31, 2008, we relocated ourheadquarters and abandoned the leased premises of our former offices in Renton,Washington.  In October 2008, weterminated eight more employees employed in both our California and Washingtonoffices.  As we adopted the restructuringplan after September 30, 2008, quarter end, no accruals were made prior tothe adoption of the restructuring plan.

 

As part of our reduction of monthly cash operating expenses during thequarter ended September 30, 2008, and continuing after the end of thequarter, we placed all employees on partial deferrals of salary, ranging from10% to 100% of base salary.  At the endof the quarter, and as of the filing date of this report, this deferral amountremains unpaid, including amounts due to employees in our California office whosubsequently were terminated.

 

On December 3, 2008, we closed a round offinancing for the sale of 766,667 shares of our Series A Preferred Stockat $0.75 per share, for an aggregate purchase price of $575 thousand, andwarrants to purchase 766,667 shares of common stock of the Company, at anexercise price of $0.75 per share, and a three year term.  This financing was led by Daniel J.A. Kolke,our founder, executive chairman, chief executive officer and chief technologyofficer, with participation from two of our directors and other priorinvestors. The holders of the January 2008 Debentures and the April 2008Debentures consented to this financing, but did not participate.

 

**Item2.**                                                         MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

** **

The following discussion of our financial condition and results ofoperations should be read in conjunction with our condensed financialstatements and the related notes and other financial information appearingelsewhere in this report. Readers are also urged to carefully review andconsider the various disclosures made by us which attempt to advise interestedparties of the factors which affect our business, including without limitation,the disclosures made under “Item 1A. Risk Factors” included in Part II ofthis report.

 

**Overview**

 

During the quarter ended September 30, 2008, we had net income of$1.65 million compared to a $1.76 million loss for the quarter ended September 30,2007.  However, this increase of $3.4million, or 194 percent, was due to the application of accounting rules tothe interest expense associated with the embedded derivative of our January 2008Debentures and the April 2008 Debentures and does not accurately reflectour actual operating results.  In fact,for the quarter ended September 30, 2008, we incurred a net operating lossof $2.1 million, and had only $10 thousand in revenue with $1.9 million intotal operating expenses.  Accordingly,we caution readers against placing undue reliance on the net income stated inour financial statements for this period as such amount does not accuratelydepict our current financial condition on an operating basis.

 

Subsequent to the end of the quarter ended September 30, 2008, wehave taken steps intended to improve our operating results, ranging fromreducing monthly cash operating expenses by aggregate workforce reductions ofover 70% and relocating our corporate headquarters to lower cost facilities tochanging the focus of our business model from an end-user-focused model to afocus on enterprise customer sales.

 

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Similar to other companies, we have suffered the effects of the currentadverse economic conditions.  Asdiscussed in more detail elsewhere in this report, we have not been makingrecent payments due and owing on our outstanding debt securities, including ourJanuary 2008 Debentures and April 2008 Debentures.  As a result the holders of such securitiesmay declare us in default and demand that all amounts due thereunder beimmediately paid in cash, and with respect to our January Debentures and April Debentures,the holders may demand that we pay 130 percent of the outstanding principalamount and interest.  If such demand wasmade, we would not currently have the financial resources to make the paymentsowed. In addition, the holders of our January Debentures and April Debenturesmay have the right to foreclose on substantially all of our assets pursuant tothe terms of the security agreement we entered into with such holders and theywould have the right to take possession of our assets and operate ourbusiness.  Though we are in regularcommunication with the holders of our outstanding debt securities, and none ofthem have demanded payment or exercised other remedies due to our currentdefault under such securities, we can give no assurances that the holders willnot exercise their remedies in the future.

 

We need immediateand substantial cash to continue our operations. Management has projected thatthe combination of cash on hand will be sufficient to allow us to continue ouroperations only through December 2008, and only if the holders of ouroutstanding debt securities do not demand payment of such securities orexercise other remedies. If cash reserves are not sufficient to sustainoperations, then we plan to raise additional capital by selling shares of ourcapital stock or other securities. However, there are no commitments or arrangements for future financingsin place at this time and we can give no assurance that such capital will beavailable on favorable terms, or at all. If we cannot obtain financing, then we may be forced to curtail ouroperations, cease voluntarily filing reports with the SEC, or possibly beforced to evaluate a sale or liquidation of our assets, or consider strategicalternatives such as bankruptcy.  Even ifwe are successful in raising additional funds, there is no assurance regardingthe terms of any additional investment and any such investment or otherstrategic alternative would likely substantially dilute or eliminate theinterests of our stockholders.

 

***Business***

 

We offer a Web app distribution platform delivering Web apps forbusinesses.  We provide 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, we enable software manufacturers tomigrate existing applications or create new applications, then package,distribute, host, bill, market and support their SaaS enabled applications withtheir own private label applications marketplace.

 

We have developed products for Web Applications, which include openstandards-based tools for Web developers, businesses and individual users suchas the Etelos Application ServerTM (EASTM) and the EtelosDevelopment 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 scripting language developed by us.  In order to support broader adoption of ourproducts, EASE and other components of the EDE are made available to developersat market appropriate pricing.  This isdone to support the development of new Web Applications and the migration ofexisting Web Applications into the Etelos ecosystem where there are tools andother support mechanisms for the marketing, distribution, and support of theseapplications.  We generally receive atransaction fee or subscription fee for transactions that occur within theEtelos ecosystem via the Etelos Marketplace and, under Storefront OperatingAgreements, share that revenue with Marketplace partners, calculated as apercentage of gross revenues from the sale of subscriptions to Marketplacepartner products and service in the Etelos Marketplace.

 

The Etelos Marketplace supports and encourages communities ofdevelopers, distributors, and consumers to expand their offerings, collaborateon new ideas and improvements, and provide scalable solutions using WebApplications available to others.

 

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**Recent Developments**

 

***Launch of Etelos Platform Suite****TM*

 

Following the end of the quarter ended September 30, 2008, on November 6,2008, we announced changes to our business model to focus on the sales andoperation of private label application marketplaces, including provision of theprofessional services required to develop, deploy and operate suchmarketplaces, and the launch of offerings of the Etelos Platform SuiteTM.   There are four components to the Etelos PlatformSuiteTM:

 

·                  TheSaaS Enterprise Platform enables technology providers to move their non-Webapplication or service to web-based SaaS distribution;

·                  TheSaaS Marketplace Platform lets technology providers market their Webapplications and developer kits on a SaaS platform;

·                  TheSaaS Distributor Platform allows tech companies and service providers todistribute additional Web applications and services to customers on a SaaSplatform; and

·                  TheSaaS Syndication Platform lets SaaS providers distribute their Web applicationsthrough a network of multiple marketplaces.

 

Focusing our attention on our Etelos Platform SuiteTMrepresents a fundamental shift for our business, as it focuses on enablingenterprises to implement their own SaaS applications and private labelmarketplaces, as well as syndicated distribution channels for multipleapplications.  With the launch of theEtelos Platform SuiteTM, we believe that our larger partners willwant to have their own marketplaces and tools to manage distribution channels.Additionally, in these difficult economic times, we believe that they will haveapplications that they need to move to the Web for lower cost implementation,broader distribution, and scalability.

 

Although we have long enabled applications to be distributed via theWeb, we believe this new offering will expose the core platform to enterprisesfor greater benefit to their end users. On the surface, this signifies adeparture from a core direct marketing focus of offering multiple productsthrough a single portal in the Etelos MarketplaceTM. We will beginsupplying software developers and vendors with their own custom implementationof a SaaS Marketplace and platforms for distribution and channel management oftheir products, as well as products developed by others.

 

On November 6, 2008, we launched, in partnership with NuOz, aSeattle, Washington-based Internet service provider, a private labelmarketplace for MTP, a software reselling company. MTP will use the EtelosPlatform SuiteTM to support broader distribution of Web applicationsto their existing customer and partner base. NuOz will launch a DistributionMarketplace for its own VOIP phone services as well as hosting and Internetservice products. NuOz also will syndicate applications from third-partysoftware vendors and Etelos Syndication Partners.

 

***Corporate Changes***

 

During, as well as after the quarter ended, we took various steps toreduce monthly cash operating expenses and bring our expenses closer in linewith available working capital and anticipated revenues goals, including areduction in our workforce and the relocation of our corporate headquartersfrom San Mateo, California, to space that we were already leasing in Renton,Washington, and then again to a lower cost space. For more informationregarding the reduction in force and the relocation of our corporateheadquarters, please see “Note 14. Subsequent Events” to our financialstatements included in Item 1 of Part 1 of this report.

 

As part of our reduction of monthly cash operating expenses during thequarter ended September 30, 2008, and continuing after the end of thequarter, we placed all employees on partial deferrals of salary, ranging from10% to 100% of base salary.  At the endof the quarter, and as of the filing date of this report, the amount of thisdeferral, which has been accrued, remains unpaid, including amounts due toemployees in our California office who subsequently were terminated.

 

We also had a number of changes in our executive management team.  On September 18, 2008, Jeffrey L. Garon’semployment as our president and chief executive officer was terminated, and weappointed Daniel J.A. Kolke as our interim chief executive officer.  Mr. Kolke, who founded Etelos in 1999,had been and continues to be the chairman of our board of directors and ourchief technology officer. Mr. Garon subsequently resigned from our boardof directors on October 19, 2008. Effective October 31, 2008, David S.G. MacKenzie resigned as ourvice president and chief financial officer, but he will continue to serve as anadvisor and consultant to us.

 

In addition to Mr. Garon’s resignation from our board ofdirectors, another director, Gregory Ruff also resigned, during thequarter.  We appointed Andrew I. Liu andRobert L. Thordarson to our board of directors. During the quarter, we also appointed Larry D. DeBower to our board ofdirectors; however, Mr. DeBower subsequently resigned during the quarter,though he continues to provide consulting services to us.

 

Certain of the steps we have taken to reduce monthly cash operatingexpenses, including the termination of employment of our employees and theabandonment of office facilities, may result in claims against us from theaffected parties.  See the risk factorentitled, “We may be subject to other legal claims” contained in Item 1A of Part 2of this report.

 

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***Recent Financings***

 

*Series A Financing*

 

On December 3, 2008, we closed a round of financing for the saleof 766,667 shares of our Series A Preferred Stock at $0.75 per share, foran aggregate purchase price of $575 thousand, and warrants to purchase 766,667shares of common stock of the Company, at an exercise price of $0.75 per share,and a three year term.  This financingwas led by Daniel J.A. Kolke, our founder, chairman, chief executive officerand chief technology officer, with participation from two of our directors andother prior investors. The holders of the January 2008 Debentures and the April 2008Debentures consented to this financing, but did not participate.

 

*April 2008 Debentures*

 

On April 22, 2008, we entered into a securities purchase agreementwith two unaffiliated institutional investors for the sale of original issuediscount 6 percent convertible debentures and common stock purchasewarrants.  We refer to these debenturesas our April 2008 Debentures.  Inthis transaction we issued an aggregate of $3.5 million principal amount ofdebentures and warrants to purchase an aggregate of up to 388,889 shares of ourcommon stock.  The warrants have a termof five years and an exercise price of $1.80 per share, subject to adjustment,including full-ratchet anti-dilution protection.  This transaction resulted in net proceeds tous of $3.4 million.

 

For a more detailed discussion of our April 2008 Debentures,please see the discussion under the caption “April 2008 Debentures” under “Note10. Convertible Notes and Debentures and Embedded Derivative and WarrantLiability” to our financial statements contained in “Item 1. FinancialStatements,” of this report.

 

*January 2008 Debentures*

 

On January 31, 2008, we entered into a securities purchaseagreement with three unaffiliated institutional investors for the sale of 6percent secured convertible debentures and common stock purchase warrants.  We refer to these debentures as our January 2008Debentures.  In this transaction weissued an aggregate of $2.0 million principal amount of debentures and warrantsto purchase an aggregate of 222,222 shares of our common stock.  This transaction resulted in net proceeds tous of $1.9 million.

 

The warrants are three year warrants to purchase shares of our commonstock at a price of $1.80 per share, subject to adjustment, includingfull-ratchet anti-dilution protection. As of September 30, 2008, none of these warrants had beenexercised.

 

For a more detailed discussion of our January 2008 Debentures,please see the discussion under the caption “January 2008 Debentures”under “Note 10. Convertible Notes and Debentures and Embedded Derivative andWarrant Liability” to our financial statements contained in “Item 1. FinancialStatements,” of this report.

 

**Critical Accounting Policies Involving ManagementEstimates and Assumptions**

** **

Our discussion and analysis of our financial condition and results ofoperations is based on our financial statements.  In preparing our financial statements inconformity with accounting principles generally accepted in the United States,we must make a variety of estimates and assumptions that affect the reportedamounts of assets and liabilities, the disclosure of contingent assets andliabilities, and the reported amounts of revenues and expenses.  We have identified the following accountingpolicies that we believe require application of management’s most subjectivejudgments, often requiring the need to make estimates about the effect ofmatters that are inherently uncertain and may change in subsequent periods.

 

*Allowance for Doubtful Accounts*

 

We provide, when appropriate, an allowance for doubtful accounts toensure that our trade receivables are not overstated due to un-collectability.The collectability of our accounts receivables is evaluated based on a varietyof factors, including the length of time receivables are past due, indicationof the customer’s willingness to pay, significant one-time events andhistorical experience.  We have notrecorded an allowance for doubtful accounts at this time as we believe all ouraccounts receivable will be collected.

 

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*Revenue Recognition*

 

We provide 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 theEtelos 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 Securities and Exchange Commission Staff AccountingBulletin 104, *“Revenue Recognition in Financial Statements”*(SAB 104) and SOP 97-2, *“Software RevenueRecognition”*, (SOP 97-2) respectively, which both provide thatrevenue may be recognized when all of the following criteria are met:

 

·                  persuasiveevidence of an arrangement exists,

·                  theproduct or service has been delivered,

·                  thefee is fixed or determinable, and

·                  collectionof the resulting receivable is reasonably assured or probable.

 

We must first determine whether SAB 104 or SOP 97-2 applies to ourrevenue transactions.  We then determineif the criteria above have been met by assessing the SAB 104 and SOP 97-2 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.

·                  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 significant contract interpretation is sometimes required to determine theappropriate accounting for these transactions including: (1) whether anarrangement exists; (2) how the arrangement consideration should beallocated among potential multiple elements; (3) when to recognize revenueon the deliverables; (4) whether all elements of the arrangement have beendelivered; (5) whether the arrangement should be reported gross as aprincipal versus net as an agent; (6) whether we receive a separatelyidentifiable benefit from the purchase arrangements with our customer for whichwe can reasonably estimate fair value; and (7) whether the arrangementshould be characterized as revenue or a reimbursement of costs incurred. Inaddition, our revenue recognition policy requires an assessment as to whethercollection is reasonably assured, which inherently requires us to evaluate thecreditworthiness of our customers. Changes in judgments on these assumptionsand estimates could materially impact the timing or amount of revenuerecognition.

 

*Internal Use Software*

 

Under SFAS NO. 86, *Accounting for Costs ofComputer Software to be Sold, Leased or Otherwise Marketed* (“SFAS 86”),costs incurred in the research and development of new software products areexpensed as incurred until technological feasibility is established.  Alternatively, Statement of Position 98-1, *Accounting for Costs of Computer Software Developed or Obtained forInternal Use* (“SOP 98-1”), applies to software development coststhat are not related to software to be sold, licensed, leased or otherwisemarketed as a separate product or as part of a product or process and arewithin the scope of SFAS 86.  Under SOP98-1, software development costs incurred for software that is only usedinternally, including costs incurred to purchase third party software, arecapitalized beginning when the Company has determined certain factors arepresent, including among others, that technology exists to achieve theperformance requirements, buy versus internal development decisions have beenmade, and the Company’s management has authorized the funding for theproject.  We must determine whether SFAS86 or SOP 98-1 is applicable to our software development costs.  We must than determine when softwarecapitalization should begin and cease and what costs under the applicablestandard can be capitalized.  Both ofthese tasks involves considerable judgment and can result in material differentamounts of software being capitalized and have a significant impact on ourreported results of operations.  To date,because we plan to license all our software products, we have determined thatthe provisions of SFAS 86 should be applied to the cost of our productdevelopment.  As products andenhancements have generally reached technological feasibility and have beenreleased for sale at substantially the same time, all research and developmentcosts have been expensed.

 

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*Stock-Based Compensation Expense*

 

Effective January 1, 2006, we adopted SFAS 123R using the modifiedprospective method and therefore have not restated prior periods’ results.Under the fair value recognition provisions of SFAS 123R, we recognizestock-based compensation expense net of an estimated forfeiture rate andtherefore only recognize compensation cost for those shares expected to vestover the service period of the award. Calculating stock-based compensation expense requires the input ofhighly subjective assumptions, including the expected term of the stock-basedawards, stock price volatility, and the pre-vesting option forfeiture rate. Weestimate the expected life of options granted based on historical exercisepatterns, which we believe are representative of future behavior. We estimatethe volatility of our common stock on the date of grant based on the historicalvolatility of other publicly traded companies in our industry. The assumptionsused in calculating the fair value of stock-based awards represent our bestestimates, but these estimates involve inherent uncertainties and theapplication of management judgment. As a result, if factors change and we usedifferent assumptions, our stock-based compensation expense could be materiallydifferent in the future. In addition, we are required to estimate the expectedforfeiture rate, as well as the probability that performance conditions thataffect the vesting of certain awards will be achieved, and only recognizeexpense for those shares expected to vest. We estimate the forfeiture ratebased on historical experience of our stock-based awards that are granted,exercised, and cancelled. If our actual forfeiture rate is materially differentfrom our estimate, the stock-based compensation expense could be significantlydifferent from what we have recorded in the current period. The quarter ended September 30,2008, was a highly volatile period for the economy on a global basis, duringwhich period the Company found it necessary to take drastic measures to reduceoperating expenses, but the likelihood of success of these efforts cannot bepredicted.  Therefore the forfeiture ratein the quarter ended September 30, 2008, and for the period up to thefiling date of this report, was very high. It is not known whether this forfeiture rate will be maintained in thefuture; management will continue to monitor its estimates.

 

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

 

The Company evaluates the embedded derivatives included in the debtinstruments it issues under the guidance in Statement of Financial AccountingStandard No. 133 *Accounting for DerivativeInstruments and Hedging Activities* and its related guidance andinterpretations (“SFAS 133”) on the issuance date of the debt and on eachsubsequent reporting date to determine whether such embedded derivatives areclearly and closely related to the debt host. The purpose of the evaluation is to determine whether the 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 theCompany’s statement of operations.  SFAS133 generally indicates that if the conversion features are (i) indexed tothe Company’s capital stock and (ii) would be classified as equity if afreestanding derivative under the guidance in EITF 00-19, *Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock* (“EITF 00-19”), then the embedded derivativesneed not be bifurcated from the debt host. We also evaluate the warrants issued with the debt under EITF 00-19 todetermine whether the proceeds allocated to the warrants or the fair value ofthe warrants should be recorded as equity or a liability, respectively, and ifa liability adjusted to fair value with a charge or credit to the Company’sstatement of operations.  EITF 00-19generally requires, among other factors, that (i) the Company can settlethe derivative in cash or its own stock, at its option, (ii) settlementcan be made in unregistered shares, and (iii) the Company has sufficientauthorized shares to issue shares of its common stock for all equityinstruments convertible to or which can be exercised for its capitalstock.  SFAS 133 also provides guidanceon when put and call features included in a debt host agreement are not clearlyand closely related to the debt host and must be bifurcated and recorded asliability.  The guidance in SFAS 133 iscomplex and it has many interpretations. Accordingly, we must use judgment to apply and interpret this guidanceas well as ensure we have applied the correct guidance.

 

If the embedded derivatives or warrants must be recorded as aliability, then we must make certain assumptions to value the embeddedderivative.  This includes computing thediscounted net present value (DNPV) of the debt and making assumptions aboutinterest rates, probabilities of outcomes, volatility, fair value of theCompany’s stock prior to its merger with Tripath, and discount rates.  The discount factor is the Company’s estimateof the appropriate rate of return that an investor would expect from a similardebenture not taking into consideration the conversion feature orwarrants.  All of these assumptions havea material impact on the value attributed to the derivative or warrant.

 

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Our analysis and judgment will vary from quarter to quarter, based uponthe Company’s stock price, which has been highly volatile.  For example, as was the case in the quarterended September 30, 2008, despite the facts that, in this period and up tothe date of this report, the Company had minimal revenues, over $2.0 million inoperating expenses, terminated over 70% of its employees, and, like many othercompanies, experienced the effects of the unusual volatility of the globalbusiness climate in this period, the impact of these accounting rules onthe financial statements show that the Company had net income of $1.65 thousandin the quarter ended September 30, 2008. Our financial statements for this period might be fundamentallymisleading as a result of this anomaly and therefore should not be relied uponby any person as an accurate depiction of the financial condition of theCompany on an operating basis.

 

**Results of Operations**

 

As discussed in more detail below, during the quarter ended September 30,2008, we had net income of $1.65 million compared to a $1.76 million loss, forthe quarter ended September 30, 2007. However, this increase of $3.4 million, or 194 percent, was due to theapplication of accounting rules to the interest expense associated withthe embedded derivative of our January 2008 Debentures and the April 2008Debentures and does not accurately reflect our actual operating results.  In fact, for the quarter ended September 30,2008, we incurred a net loss of $2.1 million, only had $10 thousand in revenueand $1.9 million in total operating expenses. Accordingly, we caution readers against placing undue reliance on thenet income stated in our financial statements for this period as such amountdoes not accurately depict our current financial condition on an operatingbasis.

 

**Fluctuations in Operating Results**

 

**Three Months Ended September 30, 2008,Compared with Three Months Ended September 30, 2007**

 

We are in the early stages of our operations. Our results of operationsare likely to fluctuate from period to period. We anticipate that our quarterly and annual results of operations willbe impacted for the foreseeable future by several factors, including the timingand volume of sales of our products.  Dueto these factors, each of which will have a substantial impact on our futureoperations, we believe that the period-to-period comparisons of our operatingresults are not a good indication of our future performance.

 

***Revenues***

 

Revenues were $10 thousand and $84 thousand for quarters ended September 30,2008 and 2007, respectively. Revenues decreased by $74 thousand, or 88 percent,in the three months ended September 30, 2008, compared to same period in2007.  The decrease in revenues is due inpart to reductions in revenues from the sale of newsletters and related hostingservices and a one-time sale of software in June 2007.

 

***Cost of Revenue***

 

Cost of revenue includes our costs of hardware, software and otherresources used in delivery of our products and services. Cost of revenue was$211 thousand and $127 thousand for the quarters ended September 30, 2008 and2007, respectively. Cost of revenue for the third quarter of 2008 increased by$84 thousand, or by 66 percent.  Theincrease in cost of revenue from 2007 to 2008 was primarily attributable to theincreased costs of hosting and Internet band-width associated with thedeployment of our products and services. Stated as a percentage of revenues,cost of revenue for the third quarter of 2008 was 2,111 percent and for thecorresponding period of 2007 was 151 percent.

 

***Operating Expenses***

 

*Research and Development.*  Research and development expenses includeprimarily employee and employee related expenses. Research and developmentexpenses were $844 thousand and $852 thousand for the quarters ended September 30,2008 and 2007, respectively. Stated as a percentage of revenues, research anddevelopment expense for the corresponding periods was 8,440 percent and 1,014percent, respectively.  Research anddevelopment expenses decreased by $8 thousand or by less than 1 percent, in thethird quarter of 2008 compared to the same period in 2007.  This decrease was primarily due to reductionin engineers for research and development.

 

*Sales and Marketing Expenses.*  Sales and marketing expenses include payroll,employee benefits, and other headcount-related costs associated with sales andmarketing personnel and travel, advertising, promotions, trade shows, seminars,and other programs. Sales and marketing expenses were $514 thousand and $434thousand for the quarters ended September 30, 2008 and 2007, respectively.The $80 thousand, or 18 percent, increase in sales and marketing expense wasdue to increased focus on marketing activities such as blogging and publicrelations. Stated as a percentage of revenues, sales and marketing expense forthe corresponding periods was 5,140 percent and 517 percent, respectively.

 

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*General and Administrative.*  General and administrative expenses includepayroll and related employee benefits, and other headcount-related costsassociated with finance, facilities, legal and other administrative expenses.General and administrative expenses were $529 thousand and $322 thousand forthe quarters ended September 30, 2008 and 2007, respectively. The $207thousand, or 64 percent, increase in general and administrative expense wasprimarily attributable to increased hiring of accounting, administrative, legaland compliance personnel and greater use of consultants and temporary personnelas we worked to complete the reverse merger and prepare our infrastructure andconduct our activities to support being a public company.  Stated as a percentage of revenues, generaland administrative expense for the corresponding periods was 5,290 percent and383 percent, respectively.

 

***Interest Expense***

 

Net interest expense was ($3,739) thousand for the quarter ended September 30,2008, compared to $110 thousand for the comparable period of 2007. The decreasein interest expense was due to the application of accounting rules to theembedded derivative in the multiple rounds of convertible debt financingcompleted during the first half of 2008.

 

***Net Income***

 

Our net income was $1.65 million compared to a $1.76 million loss, forthe quarters ended September 30, 2008 and 2007, respectively, an increaseof $3.41 million, or 194 percent.  Thisincrease from 2007 to 2008 was primarily due to the application of accounting rules tothe interest expense associated with the embedded derivative in the January 2008Debentures and the April 2008 Debentures and does not accurately reflectthe Company’s actual financial condition on an operating basis.

 

**Nine Months Ended September 30, 2008,Compared with Nine Months Ended September 30, 2007**

 

***Revenues***

 

Revenues were $55 thousand and $295 thousand for periods ended September 30,2008 and 2007, respectively. Revenues decreased by $240 thousand, or 81percent, in the nine months ended September 30, 2008, compared to sameperiod in 2007.  The decrease in revenuesis due in part to reductions in revenues generated from the sale of newslettersand related hosting services and a one-time sale of software in June 2007.    In the period ended September 30,2008, and to the date of this report, we also experienced a significant declinein sales of our customer resource management product, which had been introducedin mid-2007.

 

***Cost of Revenue***

 

Cost of revenue includes our costs of hardware, software and otherresources used in delivery of our products and services. Cost of revenue was$459 thousand and $251 thousand for the periods ended September 30, 2008and 2007, respectively. Cost of revenue for the first nine months of 2008increased by $208 thousand, or by 83 percent. The increase in cost of revenue from 2007 to 2008 was primarilyattributable to the increased costs of hosting and Internet bandwidthassociated with the deployment of our products and services. Stated as apercentage of revenues, cost of revenue for the first nine months of 2008 was835 percent and for the corresponding period of 2007 was 85 percent.

 

***Operating Expenses***

 

*Research and Development.*  Research and development expenses includeprimarily employee and employee related expenses. Research and developmentexpenses were $3,320 thousand and $1,345 thousand for the periods ended September 30,2008 and 2007, respectively. Stated as a percentage of revenues, research anddevelopment expense for the corresponding periods was 6,036 percent and 456percent, respectively.  Research anddevelopment expenses increased by $1,975 thousand or by 147 percent, in thefirst nine months of 2008, compared to the same period in 2007.  This increase was primarily due to additionalhiring of engineers and higher competitive wage rates for those engineers forresearch and development.

 

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*Sales and Marketing Expenses.*  Sales and marketing expenses include payroll,employee benefits, and other headcount-related costs associated with sales andmarketing personnel and travel, advertising, promotions, trade shows, seminars,and other programs. Sales and marketing expenses were $1,315 thousand and $685thousand for the periods ended September 30, 2008 and 2007, respectively.The $630 thousand, or 92 percent, increase in sales and marketing expense wasdue to increased hiring of sales and marketing personnel and increased focus onsales and marketing activities. Stated as a percentage of revenues, sales andmarketing expense for the corresponding periods was 2,391 percent and 232percent, respectively.

 

*General and Administrative.*  General and administrative expenses includepayroll and related employee benefits, and other headcount-related costsassociated with finance, facilities, legal and other administrative expenses.General and administrative expenses were $1,629 thousand and $508 thousand forthe periods ended September 30, 2008 and 2007, respectively. The $1,121thousand, or 221 percent, increase in general and administrative expense wasprimarily attributable to increased hiring of accounting, administrative,legal, and compliance personnel and greater use of consultants and temporarypersonnel to support being a public company. Stated as a percentage of revenues, general and administrative expensefor the corresponding periods was 2,962 percent and 172 percent, respectively.

 

***Other Expense***

 

Net other expense for the nine months ended September 30, 2008, is$13.5 million, of which $13.4 million is related to the costs associated withcompleting the Merger with Tripath. The costs include the value of 5,010,000shares of Etelos common stock paid to Tripath creditors, which were valued on April 22,2008, at $2.63 per share for a total cost of $13.2 million. The remainingexpense consists of legal, accounting and other professional fees paid tocomplete the Merger. There were no similiar costs in 2007.

 

***Interest Expense***

 

Net interest expense was $2.03 million for the nine months ended September 30,2008, compared to $208 thousand for the comparable period of 2007. The increasein interest expense was primarily due to multiple rounds of convertible debtfinancing completed during 2007 and the first half of 2008.  The anomalous results in the quarter ended September 30,2008, are netted against the expense booked in the prior quarter, therebymitigating the distortion of the impact of these accounting rules on thefinancial statements show of the Company in the quarter ended September 30,2008.

 

***Net Loss***

 

Our net loss was $22.2 million and $2.7 million for the periods ended September 30,2008 and 2007, respectively, an increase of $19.5 million, or 722 percent.  The increase in net loss from 2007 to 2008was primarily due to decreased revenue and increased salaries and general andadministrative expenses and other employee-related costs incurred during aperiod of transition in which we were deeply involved in preparations forcompleting the reverse merger process, in addition to the Merger and interestcharges explained above.

 

**Liquidityand Capital Resources**

 

On September 30, 2008, we had $6 thousand in cash and cashequivalents, net accounts receivable of $6 thousand, and prepaid expenses andother current assets of $23 thousand. Our working capital deficit at September 30,2008, was $14.2 million, compared to a deficit of $4.9 million at September 30,2007. The increase in working capital deficit is mainly attributable to thewarrant and derivative liability recorded in June 2008 and furtherdiscussed above in “Note 10- Convertible Notes and Debentures and EmbeddedDerivative and Warrant Liability.”

 

Net cash used in operating activities during the nine month periodended September 30, 2008, was $6.4 million, compared to $1.9 during theperiod ended September 30, 2007. The primary use of cash from operatingactivities during the first nine months of 2008 was the net loss of $22.2million, including merger-related expenses of $13.2 million.

 

Net cash provided by financing activities for first nine months of 2008was $5.5 million, primarily from the issuance of our January 2008Debentures and our April 2008 Debentures, further discussed above in “Note10 — Convertible Notes and Debentures and Embedded Derivative and WarrantLiability.”

 

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We are currently in default of our September 2007 notes, January 2008Debentures and April 2008 Debentures for failure to make payments whendue.  The aggregate principal and accruedinterest currently due under these debt securities as of the quarter ended September 30,2008, is $3.6 million.  Our January 2008Debentures and April 2008 Debentures are secured by substantially all ofour assets.  If the holders of ouroutstanding debt securities determine to demand payment and we haveinsufficient cash to make the required payments, as is currently the case, theholders could force a sale of our assets for their benefit. Under suchcircumstances, we may need to cease operations or file for protection fromclaims of our creditors under the federal bankruptcy laws.

 

We need immediateand substantial cash to continue our operations. Subsequent to the end of theperiod, we sold shares of Series A Preferred Stock and warrants, raising anaggregate of $545 thousand. We have continued our operations on the basis of thiscapital raise. Management has projected that existing cash on hand will besufficient to allow us to continue our operations only through December 2008,and only if the holders of our outstanding debt securities do not demandpayment of such securities or exercise other remedies. If cash reserves are notsufficient to sustain operations, then we plan to raise additional capital byselling shares of our capital stock or other securities.  However, there are no commitments orarrangements for future financings in place at this time and we can give noassurance that such capital will be available on favorable terms, or at all.  We may need additional financing thereafteruntil we can achieve profitability.  Ifwe cannot obtain additional financing, then we may be forced to curtail ouroperations, cease voluntarily filing reports with the SEC, or possibly beforced to evaluate a sale or liquidation of our assets or consider otherstrategic alternatives such as bankruptcy. Even if we are successful in raising additional funds, there is noassurance regarding the terms of any additional investment and any suchinvestment or other strategic alternative would likely substantially dilute oreliminate the interests of our stockholders.

 

**Commitments and Contingencies**

 

**September 2007 Notes**

 

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

 

Under the terms of the remaining $1.8 million of the notes that werenot converted, principal payments began being payable on September 1,2008, and will continue to be payable on the last day of each calendar quarter,and interest payments began being payable beginning February 1, 2008. On June 15,2008, the holders of these notes agreed to either convert the then-accruedinterest to shares of common stock at a rate of one share for each $1.35 ofinterest owed or to add the then-accrued interest to the principal, and towaive any default arising out of our failure to pay the accrued and unpaidinterest through June 15, 2008.

 

The principal payment amounts remaining on our September 2007notes are scheduled to be paid as follows (in thousands):

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

 

Assuming principal payments are made in accordance with the scheduleset forth above, the amount of interest to be paid through the March 31,2009, maturity date is $55.9 thousand with respect to our September 2007notes, or on average, $3.1 thousand per month.

 

As of the filing date of this report, the September 2008 principalpayments have not been made and the Company does not have, or expect to have,cash on hand to make the December 2008 payment; no interest payments havebeen made for interest accrued since June 15, 2008.  We are in regular communication with theholders of the September 2007 notes and none of the holders have demandedpayment or exercised other remedies due to our non-payments, but no assurancescan be given that the holders will not exercise their remedies in the future.

 

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**January 2008 Debentures**

 

In January 2008, we issued our January 2008 Debentures withan aggregate principal amount of $2.0 million. Under the terms of thesedebentures, we were to begin making monthly redemption payments on September 1,2008.  The maturity date of thesedebentures is January 31, 2010.  Thetotal monthly principal payment amounts on our January 2008 Debentures arescheduled to be paid as follows:

 

**MonthlyPrincipal Payment Amount (in thousands)**

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

 

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

 

As of the filing date of this report, we have not made any of thepayments due and we do not have, or expect to have, cash on hand to make thepast payments due or any payments due in the near future.  We are in regular communication with theholders of the January 2008 Debentures and none of the holders havedemanded payment or exercised other remedies due to our non-payment, but noassurances can be given that the holders will not exercise their remedies inthe future.

 

**April 2008 Debentures**

 

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

 

**MonthlyPrincipal Payment Amount (in thousands)**

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

 

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

 

As of the filing date of this report, we have not made any of thepayments due and we do not have, or expect to have, cash on hand to make thepast due payments or any payments due in the near future. We are in regularcommunication with the holders of the April 2008 Debentures and none ofthe holders have demanded payment or exercised other remedies due to ournon-payment, but no assurance can be given that the holders will not exercisetheir remedies in the future.

 

Because we do not meet the equity conditions that would permit us topay interest and monthly principal payments due in respect of our January 2008and April 2008 Debentures in stock, our only option at this time is tomake these payments in cash, which we currently do not have the financialresources to do.  We are evaluating otherequity financing opportunities, the proceeds of which could be used to repaythe debentures, but we have no commitments or arrangements in place for futurefinancing at this time and we can give no assurance that such financing will beavailable on favorable terms, or at all.

 

Because we have failed to make payments when due on our September 2007notes and our January 2008 Debentures and April 2008 Debentures, weare currently in default under such securities. The holders of such securities may demand that all amounts duethereunder be immediately paid in cash, and with respect to our January Debenturesand April Debentures, the holders may demand that we pay 130 percent ofthe outstanding principal amount and the interest rate accrues at a rate equalto the lesser of 18% per annum or the maximum rate permitted under applicablelaw.  If such demand was made, then wewould not currently have the financial resources to make the paymentsowed.  In addition, the holders of our January Debenturesand April Debentures may have the right to foreclose on substantially allof our assets pursuant to the terms of the security agreement we entered intowith such holders and they would have the right to take possession of ourassets and operate our business. Although we are in regular communication with the holders of ouroutstanding debt securities and none of them have demanded payment or exercisedother remedies due to our current default under such securities, we can give noassurance that the holders will not make such demands or exercise theirremedies in the future.

 

**Operating and Capital Leases**

 

We have non-cancelable leases for corporate facilities andequipment.  Rent expense under the leasestotaled $184.5 thousand and $89 thousand for the periods ended September 30,2008 and 2007, respectively.  Futureminimum rental payments required under non-cancelable leases are as follows forthe twelve months ended September 30:

 
| ** **                                          | ** ** | **Operating  Leases** | ** ** | **Capital  Leases** | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|---------------------|------------|
|                                                |       |                  |       |                |       |
| 2009                                                |       |                  | $          | 241                 |       | $ | 21 |   |
| 2010                                                |       |                  | 54         |                | 13         |   |
| 2011                                                |       |                  | 6          |                | 13         |   |
| 2012                                                |       |                  | 5          |                | 2          |   |
| 2013                                                |       |                  | 2          |                | —     |   |
| Total minimum lease payments                        |       | $                     | 308        |                | $          | 49 |   |
| Less: amount representing interest                  |       |                  |       | (7                  | )          |
| Present value of minimum lease payments             |       |                  |       | 42                  |       |
| Less: current portion of capital lease  obligations |       |                  |       | (18)                | )          |
| Long-term capital lease obligations                 |       |                  |       | $                   | 24         |   |

 

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On October 31, 2008, we closed our offices in San Mateo,California and abandoned the leased premises of our offices there. Also on October 31,2008, we relocated our Washington offices and abandoned the leased premises ofour former offices in Renton, Washington. The landlord for the San Mateo, California leased premises has asserteda claim against us but that claim is in negotiation and not yet the subject oflitigation.  The landlord for the Renton,Washington location has not yet asserted any claim, but the assertion of suchclaims, and the need for us to defend such claims, is foreseeable.

 

We did not have any off-balance sheet arrangements as of the ninemonths ended September 30, 2008, nor do we have any as of the date of thisreport.

 

**Going Concern Issue**

 

We remain dependent on outside sources of funding until our results ofoperations provide positive cash flows. Our independent auditors issued a going concern explanatory paragraph intheir report dated April 22, 2008. With our current level of funding,substantial doubt exists about our ability to continue as a going concern.

 

During the quarter ended September 30, 2008, we have been unableto generate cash flows sufficient to support our operations and have beendependent on debt and equity raised from qualified individual investors.

 

These factors raise substantial doubt about our ability to continue asa going concern.  The financialstatements contained herein do not include any adjustments relating to therecoverability and classification of recorded asset amounts or amounts andclassification of liabilities that might be necessary should we be unable tocontinue in existence.  Our ability tocontinue as a going concern is dependent upon our ability to generatesufficient cash flows to meet our obligations on a timely basis, to obtainadditional financing as may be required, and ultimately to attain profitableoperations.  However, there is noassurance that profitable operations or sufficient cash flows will occur in thefuture.

 

We have supported current operations by raising additional operatingcash through 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: (1) raising capital throughadditional sale of our common stock and/or debentures and (2) reducingcash operating expenses to levels that are in line with current revenues.

 

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

 

**Recent Accounting Pronouncements**

 

In May 2008, the FASB issued SFAS No. 162 (“SFAS 162”), *The Hierarchy of Generally Accepted AccountingPrinciples*.  SFAS 162 identifies the sources of accountingprinciples and the framework for selecting principles to be used in thepreparation of financial statements of nongovernmental entities that arepresented in conformity with generally accepted accounting principles in theUnited States.  SFAS 162 was effective on November 15, 2008 and uponadoption of SFAS 162 there was no material impact on our financial statements.

 

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InMarch 2008, the FASB issued SFAS No. 161 (“SFAS 161*”), Disclosures about Derivative Instruments andHedging Activities-an amendment of SFAS No. 133*. This new standardrequires enhanced disclosures for derivative instruments, including those usedin hedging activities. SFAS 161 is effective for fiscal years and interimperiods beginning after November 15, 2008. We have not yet determined theimpact, if any, that the adoption of SFAS 161 will have on our financialstatements and related disclosures.

 

In February 2008, the Financial AccountingStandards Board (FASB) issued FASB Staff Position (FSP) No. FAS 157-2, *Effective Date of FASB Statement No. 157*(“FSP FAS 157-2”), which delays the effective date of Statement of FinancialAccounting Standards (SFAS) No. 157, *FairValue Measurements* (“SFAS 157”) for all non-financial assets andnon-financial liabilities, except those that are recognized or disclosed atfair value in the financial statements on a recurring basis (at least annually)for fiscal years beginning after November 15, 2008, and interim periodswithin those fiscal years for items within the scope of this FSP. We arecurrently evaluating the impact of adopting FSP FAS 157-2 for non-financialassets and non-financial liabilities on our financial position, cash flows, andresults of operations.

 

In December 2007, the FASB issued SFAS No. 141(R),*Business Combinations* (“FAS 141R”),which requires an acquirer to measure the identifiable assets acquired, theliabilities assumed, and any noncontrolling interest in the acquiree at theirfair values on the acquisition date, with goodwill being the excess value overthe net identifiable assets acquired. FAS 141R is effective for financialstatements issued for fiscal years beginning after December 15, 2008.Also, in December 2007, the FASB issued SFAS No. 160, *Noncontrolling Interests in Consolidated FinancialStatements,**an**amendment**ofARB No. 51* (“FAS 160”), which clarifies that a noncontrollinginterest in a subsidiary should be reported as equity in the financialstatements. The calculation of earnings per share will continue to be based onincome amounts attributable to the parent. FAS 160 is effective for financialstatements issued for fiscal years beginning after December 15, 2008. Weare currently evaluating the impact of adopting SFAS 141R and SFAS 160 on ourfinancial position, cash flows, and results of operations.

 

In June 2008, the FASB issued FSP No. EITF 03-6-1,*Determining Whether Instruments Granted inShare-Based Payment Transactions Are Participating Securities* (“FSPEITF 03-6-1”), which requires entities to apply the two-class method ofcomputing basic and diluted earnings per share for participating securitiesthat include awards that accrue cash dividends (whether paid or unpaid) anytime common shareholders receive dividends and those dividends do not need tobe returned to the entity if the employee forfeits the award. FSP EITF 03-6-1will be effective for the Company on January 1, 2009, and will requireretroactive disclosure. The Company is currently evaluating the impact ofadopting FSP EITF 03-6-1 on its financial position, cash flows, and results ofoperations.

 

**Item3.**                                                           QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

** **

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

 

**Item4.**                                                           CONTROLS ANDPROCEDURES

** **

(a) Disclosure controls and procedures are controls and otherprocedures that are designed to ensure that information required to bedisclosed in our reports filed pursuant to the Exchange Act is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms and that such information is accumulated and communicatedto our management, including our chief executive officer and chief financialofficer, as appropriate, to allow for timely decisions regarding requireddisclosure.

 

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

 

As required by Exchange Act Rule 13a-15(b), we carried out anevaluation, under the supervision and with the participation of our management,including our chief executive officer and acting chief financial officer, ofthe effectiveness of the design and operation of our disclosure controls andprocedures as of September 30, 2008, the end of the period covered by thisreport. Based on that evaluation, our chief executive officer and acting chieffinancial officer concluded that our disclosure controls and procedures wereeffective at the reasonable assurance level as of September 30, 2008.

 

(b)  We did not make any changes in our internal controls overfinancial reporting (as defined in Rules 13A-15(f) and 15d-15 of theExchange Act) during our most recent fiscal quarter that has materiallyaffected, or is likely to material affect, our internal control over financialreporting.

 

However,following the end of the quarter ended September 30, 2008, our vicepresident and chief financial officer resigned, effective October 31,2008.   He has remained an advisor andconsultant to us, though the date of this report.   However, we have not yet appointed anyperson to serve as our chief financial officer and, due to our limitedfinancial resources and the risks related to our ability to continue as a goingconcern, there is no assurance that such an appointment can be made, if at all,in the near future.  Our chief executiveofficer is currently serving as our acting chief financial officer.  Therefore, we are unable to assure that wehave adequate and appropriate controls in place, or that the controls that wedo have in place are being managed appropriately.  We will attempt to engage additionalappropriate expertise to evaluate and manage our controls as soon as financialresources permit, but there is no assurance when, or if, that will be possiblein the foreseeable future.

 

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**PART II**—**OTHER INFORMATION**

 

**Item 1.****                                                           LEGALPROCEEDINGS.**

** **

From time to time, we become subject to various legal proceedings andclaims, both asserted and unasserted, that arise in the ordinary course ofbusiness. Litigation in general, and securities litigation in particular, canbe expensive and disruptive to normal business operations. Moreover, theresults of legal proceedings are difficult to predict. An unfavorableresolution of one or more of these lawsuits would materially adversely affectour business, results of operations, or financial condition. We accrue legalcosts when incurred.  The need to defendany such claims could require payments of legal fees and our limited financialresources could severely impact our ability to defend any 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. 08 CV 5716) and sought atemporary restraining order and other extraordinary relief.  The complaint arose out of an advisoryservices agreement, pursuant to which Kaufman Bros. was to provide us withadvisory services in connection with financings and strategictransactions.  We notified Kaufman Bros.that we believed it had failed to provide the required services under theagreement, and that we were therefore entitled to terminate the agreement forcause. In the suit, Kaufman Bros. was seeking (i) monetary damages of$400,000 for anticipatory breach of the agreement; (ii) $73,800 in feesallegedly owed in connection with a previously closed financing transaction; (iii) aninjunction prohibiting us from cancelling any shares issued to Kaufman Bros. ascompensation, (iv) a declaration from the court that we are not entitledto a refund of any fees previously paid to Kaufman Bros., and (v) adeclaration that we are obligated to pay Kaufman Bros. a commission on anyfinancing or transaction that we enter into within 18 months following thetermination of the agreement. On July 15, 2008, Kaufman Bros. voluntarilyfiled a notice 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 agrees topay to Kaufman Bros. $210,000, in twelve monthly installments of $17,500; (ii) theCompany issues 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.

 

**ITEM 1A****                                               RISKFACTORS.**

 

Investment in our common stock involves a high degree of risk. Youshould carefully consider the risks described below together with all of theother information included in this report before making an investment decision.If any of the following risks actually occur, our business, financial conditionor results of operations could suffer. In that case, the market price of ourcommon stock could decline, and you may lose all or part of your investment.

 

***Our current cash will fund our business as currently planned onlythrough December 2008. We need additional funding or we will be forced tocurtail or cease operations.***

 

We need immediate and substantial cash to continue our operations. Wecurrently have no funding commitments. Management has projected that cash onhand will be sufficient to allow us to continue our operations only through December 2008.  We have not made required payments under ouroutstanding debt secutrities and the holders of our outstanding debt securitieshave the right to demand payment of the amounts currently due under suchsecurities or exercise their other remedies, such as foreclosing on our assets.We therefore will need additional funding, either through equity or debtfinancings, or we will be forced to curtail or cease operations or considerother strategic alternatives such as bankruptcy.

 

***We have a limited operating history, have experienced significantexpenditures related to funding our initial product development, and arecurrently carrying a net loss.  If ourbusiness 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.***

 

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We began our operations in 1999 but we did not adopt the SaaS on-demandWeb Applications delivery model until 2005, and changed our business model inthe period after the end of the quarter ended September 30, 2008. As such,we have a limited operating history in the SaaS industry in general, and evenmore limited experience with our new business model, from which to evaluate ourbusiness and prospects.  We incurred anet loss of $22.2 million for the nine months ended September 30, 2008,and $4.0 million for the year ended December 31, 2007, and have anaccumulated deficit of $14.2 million at September 30, 2008.  We cannot assure you that our future plannedoperations will be implemented successfully or that we will ever haveprofits.  Furthermore, we areexperiencing the initial costs and uncertainties of a young operating company,including start-up expenditures, unforeseen costs and difficulties, complications,and delays, 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.

 

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

 

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

 

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

 

In addition, as a result of being in default under our January Debenturesand April Debentures, the holders may have the right to foreclose onsubstantially all of our assets pursuant to the terms of the security agreementwe entered into with such holders and they would have the right to takepossession of our assets and operate our business.  Though we are in regular communication withthe holders of our outstanding debt securities, and none of them have demandedpayment or exercised other remedies due to our current default under suchsecurities, we can give no assurances that the holders will not exercise theirremedies in the future.

 

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

 

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

 

·                  maintainand improve our technology;

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

·                  sellour products to sufficient, quality customers to produce revenues adequate tomeet our operating needs;

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

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

·                  maintainadequate control of our expenses;

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

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

 

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

 

***Our limited operating history makes it difficult to evaluate ourcurrent business and future prospects, and may increase the risk of yourinvestment.***

 

Our limited operating history may make it difficult to evaluate ourcurrent business and our future prospects. We have encountered and willcontinue to encounter risks and difficulties frequently experienced by growingcompanies in rapidly changing industries. If we do not address these riskssuccessfully, then our business will be harmed.

 

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

 

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

 

Our major competitors may be better able than us to successfully enduredownturns in our markets. In periods of reduced demand for our products, we caneither choose to maintain market share by reducing our selling prices to meetcompetition or maintain selling prices, which likely would result in sacrificeof our market share. Sales and overall profitability would be reduced andsustained losses may continue in either case. In addition, we cannot be assuredthat additional competitors will not enter our existing markets, or that wewill be able to compete successfully against existing or new competition.

 

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

 

We have not been profitable on a quarterly or annual basis since ourformation. Our operations resulted in a net loss of $22.2 million for the ninemonths ended September 30, 2008 and $4.0 million and $1.5 million for theyears 2007 and 2006, respectively. As of December 31, 2007, ouraccumulated deficit was $10.4 million and at September 30, 2008, ouraccumulated deficit was $14.2 million. We expect to make significant futureexpenditures related to the development and expansion of our business. Inaddition, as a public company, we will 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 grownsomewhat in recent periods, that growth has not been significant and futurerevenue growth may not be sustainable and we may not achieve sufficient revenueto achieve or maintain profitability. We have incurred and may continue toincur significant losses in the future for a number of reasons, including dueto the other risks described in this report, and we may encounter unforeseenexpenses, difficulties, complications, delays, and other unknown factors.Accordingly, we may not be able to achieve or maintain profitability and we maycontinue to incur significant losses for the foreseeable future.

 

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

 

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

 

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

 

·                  minimizethe time and resources required to implement products from the EtelosMarketplace;

·                  maintainhigh levels of customer satisfaction;

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

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

 

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

 

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

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

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

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

 

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

 

The market in which we participate is intensely competitive, and if wedo not compete effectively, then our operating results may be harmed.

 

The market for SaaS on-demand Web Applications for business is newhighly competitive and rapidly changing with relatively low barriers to entry.With the 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 the Etelos Marketplace that competeagainst existing systems that our potential customers have already madesignificant expenditures to install. Competition in our market is basedprincipally upon service breadth and functionality; service performance,security and reliability; ability to tailor and customize services for aspecific company, vertical or industry; ease of use of the service, speed andease of deployment, integration and configuration; total cost of ownership,including price and implementation and support costs; professional servicesimplementation; and financial resources of the vendor.

 

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

 

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

 

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

 

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

 

We have decreased our number of full-time employees from 46 at June 30,2008, to 14 as of December 31, 2008. All these employees are on deferred salary, ranging from 10% to 100% ofbase salary, and there is no assurance that any of these personnel will be ableto continue to work on this payment arrangement. Our operating plan has placed,and our anticipated growth plan is expected to continue to place, a significantstrain on our very limited managerial, administrative, operational, financial,and other resources, compounded by these recent reductions in headcount.Although we will be required to continue to improve our operational, financial,and management controls and our reporting procedures it is clear that we maynot be able to do so effectively and may not be able to recruit or retainadequate, qualified personnel to meet our operating demands. As such, we may beunable to manage our expenses effectively in the future, which may negativelyimpact our gross margins or operating expenses in any particular quarter.

 

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

 

We market and sell our products and services and other offerings in theEtelos Marketplace to individuals, SMBs, and divisions of large companies. Togrow our revenue quickly, we must add new customers, sell additional servicesto existing customers, 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.

 

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

 

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

 

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

 

Our success depends, in part, on our ability to protect our proprietarytechnologies. We own five (5) filed United States patent applicationscovering our technology and we expect to file more U.S. patent applications inthe future. We have filed to protect most of those patents in many foreigncountries. But the process of seeking patent protection can be lengthy andexpensive and we cannot assure that our patent applications will result inpatents being issued, or that our existing or future issued patents will besufficient to provide us with meaningful protection or commercial advantages.

 

We also cannot assure that our current or potential competitors do nothave, and will not obtain, patents that will prevent, limit or interfere withour ability to make, use or sell our technology or operate the EtelosMarketplace.

 

***Our success depends in large part on our ability to protect and enforceour intellectual property rights.***

 

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

 

We have not maintained operating controls or logs, or initiated orconducted any forensic, code history, ‘genealogy’ or other forms of audit,analysis, processes, training, or code review of software code incorporatedinto any Etelos product or in other products offered by others in the EtelosMarketplace. We do not review the intellectual property rights related toproducts or services offered by Marketplace partners in the Etelos Marketplace.These products may include code subject to various forms of ‘open source’, ‘copyleft’,or similar licenses that require as a condition of modification or distributionof software subject to such license(s) that (i) such software orother software combined or distributed with such software be disclosed ordistributed in source code form, or (ii) such software or other softwarecombined or distributed with such software, and any related intellectualproperty,  be licensed on a royalty-freebasis, including for the purposes of making additional copies or derivativeworks of such software.  This mayadversely 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.

 

***We require our Etelos Marketplace partners to indemnify us forintellectual property claims but we cannot assure that these agreements will beenforceable.***

 

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

 

***Assertions by third parties that we infringe their intellectual property,whether successful or not, could subject us to costly and time-consuminglitigation or expensive licenses.***

 

The software and technology industries are characterized by theexistence of a large number of patents, copyrights, trademarks, and trade secretsand by frequent litigation based on allegations of infringement or otherviolations of intellectual property rights. As we face increasing competition,the possibility of intellectual property rights claims against us may grow; thecosts of defending against such claims can be very large. Our technologies maynot be able to withstand any third-party claims or rights against their use.Additionally, many of our partner and product agreements require us toindemnify our customers for certain third-party intellectual propertyinfringement claims, which could increase our costs as a result of defendingsuch claims and may require that we pay damages or purchase expensive licenses,if there were an adverse ruling related to any such claims. These types of claimscould harm our relationships with our customers, may deter future customersfrom subscribing to our services, or could expose us to litigation for theseclaims. Even if we are not a party to any litigation between a customer and athird party, an adverse outcome in any such litigation could make it moredifficult for us to defend our intellectual property in any subsequentlitigation in which we are a named party.

 

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

 

For any intellectual property rights claim against us or against ourMarketplace partners or customers, we may have substantial direct and indirectcosts.  Direct costs can include arequirement to pay damages or stop using technology found to be in violation ofa third party’s rights. We may have to purchase a license for the technology,which may not be available on reasonable terms, if at all, may significantlyincrease our operating expenses, or may require us to restrict our businessactivities in one or more respects. As a result, we may also be required todevelop alternative non-infringing technology, which could require significanteffort and expense.  Substantial indirectcosts also may be expected in the form of diversion of development andmanagement resources in strategic planning for legal, technology, and businessdefenses to such claims.

 

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

 

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

 

Subsequent to the termination of our former Chief Executive Officer, wesignificantly and materially reduced our management team and have not hiredreplacements for the management team in the positions of Vice President andChief Financial Officer, Vice President — Marketing, Vice President CorporateDevelopment, and Vice President — Human Resources, as well as several otherDirector-level positions, primarily in non-technical positions throughout theCompany.  We do not plan or expect tofill any of these positions in the quarter ending December 31, 2008.

 

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

 

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

 

We plan to continue to expand our sales force and our services andsupport teams to increase our customer base and revenue. We believe that thereis significant competition for sales, service, and support personnel with theskills and technical knowledge that we require. Our ability to achievesignificant revenue growth will depend, in large part, on our success inrecruiting, training, and retaining sufficient numbers of personnel to supportour growth. New hires require significant training and, in most cases, takesignificant time before they achieve full productivity. Our recent hires andplanned hires may not become as productive as we expect and we may be unable tohire or retain sufficient numbers of qualified individuals in the markets wherewe do business. If these expansion efforts are not successful or do not generatea corresponding increase in revenue, then our business will be harmed.

 

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

 

Our quarterly operating results may fluctuate in the future. As aresult, we may fail to meet or exceed the expectations of research analysts orinvestors, which could cause our stock price to decline.

 

Our quarterly operating results may fluctuate as a result of a varietyof factors, many of which are outside of our control. 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.

 

We believe that our quarterly revenue and operating results may varysignificantly in the future and that period-to-period comparisons of ouroperating results may not be meaningful. You should not rely on the results ofone quarter as an indication of future performance.

 

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

 

We host many of our services and serve a significant number of ourcustomers from either of two third-party data center facilities with NetworkOS, located in the greater Seattle Washington area. We do not control theoperation of these facilities. These facilities may be vulnerable to damage orinterruption from earthquakes, hurricanes, floods, fires, terrorist attacks,power losses, telecommunications failures, and similar events. These facilitiesalso could be subject to break-ins, computer viruses, sabotage, intentionalacts of vandalism and other misconduct. The occurrence of a natural disaster oran act of terrorism, a decision to close the facilities without adequatenotice, or other unanticipated problems could result in lengthy interruptionsin our services.

 

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

 

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

 

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

 

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

 

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We may not be able to adjust our product prices, especially in theshort-term, to recover cost increases in these items. Our future profitabilitymay be adversely affected to the extent we are unable to pass on higher serverand support related costs to our customers.

 

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

 

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

 

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

 

The products and services we offer in the Etelos Marketplace involvethe storage of large amounts of our customers’ sensitive and proprietarybusiness information. If our security measures are breached as a result ofthird-party action, employee error, malfeasance, or otherwise, and someoneobtains unauthorized access to our customers’ data, then we could incursignificant liability to our Marketplace partners, our customers, and toindividuals or businesses whose information was being stored by our customers,our business may suffer and our reputation may be damaged. Because techniquesused to obtain unauthorized access to, or to sabotage, systems changefrequently and generally are not recognized until launched against a target, wemay be unable to anticipate these techniques or to implement adequatepreventive measures. If an actual or perceived breach of our security occurs,then the market perception of the effectiveness of our security measures couldbe harmed and we could lose sales and customers.

 

***If we are unable to develop new products or services, sell our productsor services into new markets, or add Marketplace partners to offer theirproducts or services in the Etelos Marketplace, then our revenue growth will beharmed and we may not be able to achieve profitability.***

 

Our ability to attract new customers and to increase revenue fromexisting customers will depend in large part on our ability to enhance andimprove our existing products and to add new Marketplace partners to offerthese products and services introduce new products and services and sell intonew markets. The success of any enhancement or new product or service dependson several factors, including the timely completion, introduction, and marketacceptance of the enhancement, product or service. Any new product or serviceoffered by a Marketplace partner or that we develop or acquire may not beintroduced in a timely or cost-effective manner and may not achieve the broadmarket acceptance necessary to generate significant revenue. Any new marketsinto which we attempt to sell our products or services may not be receptive. Ifwe are unable to successfully develop or acquire new products or services,enhance our existing products and services to meet customer requirements, orsell our products and services into new markets, then our revenue will not growas expected and we may not be able to achieve profitability.

 

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

 

Ensuring that we have adequate internal financial and accountingcontrols and procedures in place so that we can produce accurate financialstatements on a timely basis is a costly and time-consuming effort that needsto be re-evaluated frequently. Our internal control over financial reporting isa process designed to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements in accordancewith generally accepted accounting principles. We are in the process ofdocumenting, reviewing, and improving our internal controls and procedures forcompliance with Section 404 of the Sarbanes-Oxley Act of 2002, or theSarbanes-Oxley Act, which requires annual management assessment of theeffectiveness of our internal control over financial reporting and a report byour independent auditors addressing this assessment. We will be testing ourinternal controls for the year ending December 31, 2008, and, as part ofthat documentation and testing, identifying areas for further attention andimprovement.

 

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During our review for the year ended December 31, 2007, weidentified a material weakness in our internal controls. The material weaknessrelates to the need for accounting personnel who possess the skill setsnecessary to operate and report as a public company, and specifically theskills necessary to ensure that adequate review of critical accountreconciliations is performed and that supporting documentation is complete,accurate, and in accordance with generally accepted accounting principles. Werecruited and are continuing to recruit additional finance and accountingpersonnel to address this observation, but many of those personnel have beenterminated or have resigned from the Company. We believe we made progress inaddressing this material weakness and expect to complete the remediation in thenext six to fifteen months, but that will be dependent upon recruitingadditional, qualified personnel. If our recruiting efforts are unsuccessful, orif our remediation efforts are insufficient to address the material weakness ortake longer than we expect, or if additional material weaknesses in ourinternal controls are discovered in the future, then we may fail to meet ourfuture reporting obligations, our financial statements may contain materialmisstatements and the price of our common stock may decline.

 

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

 

***Material defects or errors in the software we use to deliver ourproducts and services and the offerings by our Marketplace partners could harmour reputation, result in significant costs to us, and impair our ability tosell our services.***

 

The Web Applications underlying the products and services offered inthe Etelos Marketplace are inherently complex and may contain material defectsor errors, particularly when first introduced or when new versions orenhancements are released. We have, from time to time, found defects in ourproducts and services, and new errors in our existing software and services maybe detected in the future. We have no actual knowledge, but we reasonablyexpect that the products and services offered by our Marketplace partners mayhave similar errors and/or defects. Any errors or defects that cause interruptionsto the availability of our services could result in:

 

·                  areduction in sales or delay in market acceptance of our services;

·                  salescredits or refunds to our customers;

·                  lossof existing customers and difficulty in attracting new customers;

·                  diversionof development resources;

·                  harmto our reputation; and/or

·                  increasedwarranty and insurance costs.

 

After the release of our services, defects or errors may also beidentified from time to time by our internal team our Marketplace partners, andby our customers. The costs incurred in correcting any material defects orerrors in such products or services may be substantial and could harm ouroperating results.

 

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

 

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

 

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

 

Our customers can use the products and services offered in the EtelosMarketplace to store personal or identifying information regarding theircustomers and contacts. Super-national, federal, state and other government bodiesand agencies have adopted or are considering adoption of laws and regulationsregarding the collection, use, and disclosure of personal information obtainedfrom consumers and other individuals. The costs of compliance with, and otherburdens imposed by, such laws and regulations that are applicable to thebusinesses of our customers may limit the use and adoption of our products andservices and reduce overall demand.

 

In addition to government activity, privacy advocacy groups and thetechnology and other industries are considering various new, additional, ordifferent self-regulatory standards that may place additional burdens on us andour Marketplace partners. If the gathering of personal information were to becurtailed, then Web-based applications would be less effective, which mayreduce demand for the products and services offered in the Etelos Marketplaceand harm our business.

 

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

 

We have not collected any sales or other taxes from our customers orremitted any such taxes to any taxing jurisdiction where we may be required todo so. We have begun an analysis of this issue but to date have not made anyaccrual for any potential liability.  Inaddition, additional taxing jurisdictions at various local, national andsuper-national levels may seek to impose sales or other tax collectionobligations on us.  We have not recordedsales or other tax liabilities for the years ended December 31, 2007 or2006, in respect of sales or other tax liabilities in any jurisdiction. Asuccessful assertion that we should be collecting sales or other taxes on ourservice could result in substantial tax liabilities for past sales, discouragecustomers from purchasing our products, or otherwise harm our business andoperating results.

 

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

 

A change in accounting standards or practices could harm our operatingresults and may even affect our reporting of transactions completed before thechange is effective. New accounting pronouncements and varying interpretationsof accounting pronouncements have occurred and may occur in the future. Changesto existing rules or the questioning of current practices may harm ouroperating results or the way we conduct our business.

 

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

 

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

 

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

 

·                  issueadditional equity securities that would dilute our stockholders;

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

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

·                  incurlarge charges or substantial liabilities;

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

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

 

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

 

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***We may be subject to taxes and penalties regarding past tax years.***

 

To date, we have not filed all required federal or state income andfranchise tax returns or paid or accrued any amounts for taxes that might bedue on such returns.  Although we believethe amounts due in this respect are de minimus, because we have incurredsubstantial operating losses which we believe will exceed, in the aggregate,all operating income, no assurances can be given in this regard.  Further, we are in arrears in payment ofemployment related taxes to various tax authorities. We are in contact withthose authorities and are making payments to bring these matters current. The estimatedamounts due in this respect have been accrued and are included in our auditedfinancial statements for the period ending December 31 2007, and in ourunaudited financial statements to the period ending September 30, 2008. However,no assurances can be given that we will not be assessed additional penalties orinterest for failing to make these payments when due.

 

***We may 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. 08 CV 5716) seeking 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) an 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 the agreement.On July 15, 2008, Kaufman Bros. voluntarily filed a notice of dismissalwithout prejudice. Settlement discussions were unsuccessful and, on July 31,2008, Kaufman Bros. re-filed substantially the same claims in the Supreme Courtof 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 agrees to pay to Kaufman Bros. $210,000,in twelve monthly installments of $17,500; (ii) the Company issues toKaufman Bros. warrants to purchase 500,000 shares of the Company’s common stockat an exercise price of $0.75 per share, which warrants have a term of fiveyears; (iii) the Company and Kaufman Bros. agreed immediately to terminateall provisions, terms and conditions of the advisory services agreement andexchanged mutual releases; and (iv) Kaufman Bros. agreed to dismiss thepending lawsuit in the Supreme Court of New York, without prejudice. Failure toperform the obligations under the settlement agreement could result in ajudgment against the Company.

 

On September 18, 2008, the employment of Jeffrey L. Garon aspresident and chief executive officer of the Company was terminated. Mr. Garonhad an Employment Agreement dated August 11, 2007, which provided certainbenefits to Mr. Garon in the event of termination of his employment, andgranted us certain rights to repurchase shares issued of behalf of Mr. Garonpursuant to his employment agreement.  Weand Mr. Garon have been engaged in discussions about these benefits andrights, but no final agreement has been reached as of the filing date of thisreport.  No litigation has been filed atthis time.

 

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

 

As part of our reduction of monthly cash operating expenses during thequarter ended September 30, 2008, and continuing after the end of thequarter, we placed all employees on partial deferrals of salary, ranging from10% to 100% of base salary.  At the endof the quarter, until the filing date of this report, this deferral amountremains unpaid, including amounts due to employees who subsequently wereterminated.  On December 17, 2008,we received notice that one employee has filed a claim with the CaliforniaLabor Commissioner; that claim is the subject of a conference currentlyscheduled for December 22, 2008. No other employee has asserted a claim ordemand for immediate payment of these unpaid amounts but the assertion of suchclaims or demands by such employees, or by other governmental authorities, isforeseeable.

 

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On October 31, 2008, we closed our offices in San Mateo,California and abandoned the leased premises of our offices there. Also on October 31,2008, we relocated our Washington offices and abandoned the leased premises ofour former offices in Renton, Washington. The landlord for the San Mateo, California leased premises has asserteda claim against us but that claim is in negotiation and not yet the subject oflitigation.  The landlord for the Renton,Washington location has not yet asserted any claim, but the assertion of suchclaims, and the need for us to defend such claims, is foreseeable.

 

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

 

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

 

As of September 30, 2008, our officers, directors, and affiliatesbeneficially own approximately 75.5 percent of our common 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 our officers,directors, and affiliates may differ from other stockholders. Furthermore, thecurrent ratios of ownership of our common stock reduce the public float andliquidity of our common stock which can in turn affect the market price of ourcommon stock.

 

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

 

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

 

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

 

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

 

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In addition, in connection with our January 2008 and April 2008Debentures, in the aggregate, we issued a total of $5.5 million principalamount of convertible debentures, convertible into 4,074,074 shares of ourcommon stock, and warrants to purchase an additional 611,111 shares of ourcommon stock.  We have agreed to registerfor resale by the investors the shares of common stock issuable upon theconversion of the debentures and the exercise of the warrants we issued inthose private placements.  We are alsoregistering for resale 586,667 shares of common stock issuable upon conversionof notes issued in September 2007. The conversion or exercise into our common stock and the registration ofthat common stock could result in a substantial increase in the number ofshares in our public float.  Dependingupon market liquidity at the time a resale of our common stock is made by theinvestors in such private placements, such sale could cause the trading priceof our common stock to decline.  Inaddition, the sale of a substantial number of 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.

 

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

 

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

 

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

 

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

 

Our January 2008 and April 2008 Debentures impose significantcovenants on us, some of which may impair our ability to issue additional debtor equity, if necessary.  For example,the investors in our April 2008 Debentures have the right to participatein any financing we undertake through the date that is the 12 month anniversaryof the effectiveness of the registration statement we agreed to file for there-sale of our shares of common stock issuable upon conversion and exercise ofour April 2008 Debentures.

 

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

 

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

 

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

 

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

 

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

 

Actual sales or the prospect of future sales of shares of our commonstock pursuant to a prospectus or under Rule 144 may have a depressiveeffect upon the price of, and market for, our common stock.  As of September 30, 2008, 23,027,624shares of our common stock were issued and outstanding, of which 18,017,624 are“restricted securities” and under some circumstances may, in the future, be soldunder a registration under the Securities Act or in compliance with Rule 144adopted under the Securities Act.  BecauseTripath was a shell company at the time of our merger, under Rule 144 holders ofour restricted stock are generally unable to rely upon Rule 144 until April 22,2009.  At that time, holders of ourrestricted stock will become elligible to sell their restricted shares underRule 144 (subject to value limitations, in the case of affiliates).  We cannot predict what effect, if any, thatsales of shares of common stock, or the availability of these shares for sale,will have on the market prices prevailing from time to time.  Nevertheless, the possibility thatsubstantial 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.

 

In addition to the 18,017,624 shares of “restricted securities” thatwere issued and outstanding as of September 30, 2008, we have aregistration statement that registers for resale an aggregate of 1,906,557shares of our common stock. The additional overhang represented by theseregistered securities could also have a depressive effect on the public tradingprice of our common stock.

 

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

 

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

 
| · |   | authorizing  blank check preferred stock, which could be issued with voting, liquidation,  dividend, and other rights superior to our common stock;                                         |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · |   | limiting the  liability of, and providing indemnification to, our directors and officers;                                                                                                   |
| · |   | limiting the  ability of our stockholders to call and bring business before special  meetings;                                                                                              |
| · |   | requiring  advance notice of stockholder proposals for business to be conducted at  meetings of our stockholders and for nominations of candidates for election  to our board of directors; |
| · |   | controlling the  procedures for the conduct and scheduling of board and stockholder meetings;  and                                                                                          |
| · |   | limiting,  generally, the filling of vacancies or newly created seats on the board to  our board of directors then in office.                                                               |

 

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

 

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

 

***Significant amounts of our outstanding common stock will be availablefor resale into the market, which could potentially cause the market price ofour common stock to drop significantly, even if our business is doing well.***

 

As of September 30, 2008, we had 23,027,624 shares of common stockissued and outstanding held by approximately 145 shareholders of record,including 5,010,000 shares that were issued pursuant to the court-approved planof reorganization.  The shares issuedunder the plan of reorganization are freely tradable securities.  The market price of our common stock coulddrop significantly if the holders of these shares sell them or are perceived bythe market as intending to sell them in an excessive amount relative to themarket demand for our shares. An excessive sale of our shares may result in asubstantial decline in the price of our common stock and limit our ability toraise capital, even if our business is doing well.

 

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

 

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

 
| · |   | significantly  reduce the equity interest of our current stockholders;                                                                                                                                                                                                                    |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · |   | cause a change  in control if a substantial number of our shares of common stock or voting  preferred stock are issued, which may affect, among other things, our ability  to use our net operating loss carry-forwards, if any, and could also result  in a change in management; and/or |
| · |   | adversely affect  prevailing market prices for our common stock.                                                                                                                                                                                                                          |

 

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

 
| · |   | develop or  enhance our products and services;                                   |
|--------|--------|----------------------------------------------------------------------------------|
| · |   | continue to  expand our development, sales and marketing organizations;          |
| · |   | acquire  complementary technologies, products or businesses;                     |
| · |   | expand  operations;                                                              |
| · |   | hire, train and  retain employees; and/or                                        |
| · |   | respond to  competitive pressures or unanticipated working capital requirements. |

 

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

 
| · |   | may  significantly reduce the equity interest of our current stockholders;                                                                                                                  |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · |   | will likely  cause a change in control if a substantial number of our shares of common  stock or voting preferred stock are issued and could also result in a change  in management; and/or |
| · |   | may adversely  affect prevailing market prices for our common stock.                                                                                                                        |

 

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

 

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

 

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***We have never paid dividends on our capital stock and we do notanticipate paying any cash dividends in the foreseeable future.***

 

We have paid no cash dividends on any of our classes of capital stockto date and we currently intend to retain our future earnings, if any, to fundthe development and growth of our business. In addition, the terms of the Notes prohibit us from making any dividendpayment or distribution to holders of our common stock while any portion of theNotes remain outstanding.  As a result,capital appreciation, if any, of our common stock will be your sole source ofgain for the foreseeable future.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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***We will incur increased costs and demands upon management as a resultof complying with the laws and regulations affecting public companies, whichcould harm our operating results.***

 

As a public company, we will incur significant legal, accounting, andother expenses that we did not incur as a private company, including costsassociated with public company reporting requirements. We also have incurredand will incur costs associated with current corporate governance requirements,including requirements under Section 404 and other provisions of theSarbanes-Oxley Act, as well as rules implemented by the SEC. The expensesincurred by public companies for reporting and corporate governance purposeshave increased dramatically. We expect these rules and regulations tosubstantially increase our legal and financial compliance costs and to makesome activities more time-consuming and costly. We are unable to currentlyestimate these costs with any degree of certainty. We also expect these new rules andregulations may make it more difficult and more expensive for us to obtaindirector and officer liability insurance, and we may be required to acceptreduced policy limits and coverage or incur substantially higher costs toobtain the same or similar coverage than used to be available. As a result, itmay be more difficult for us to attract and retain qualified individuals toserve on our board of directors or as our executive officers.

 

**Item2.**                                   UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

** **

None.

 

**Item3.**                                   DEFAULTSUPON SENIOR SECURITIES.

** **

We are currently in default of our September 2007 notes, January 2008Debentures and April 2008 Debentures for failure to make payments whendue.  See Note 10 to the accompanyingunaudited condensed financial statements. As of the filing date of this report,the aggregate outstanding amount due under such notes totaled $3.6 million,including principal and accrued but unpaid interest, however the holders ofsuch debt securities have not elected to exercise their rights to demandpayment as of the filing date of this report.

 

**Item4.**                                   SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS.

** **

None.

 

**Item5.**                                   OTHERINFORMATION.

** **

None.

 

**Item6.**                                   EXHIBITS.

** **

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

 

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** **

**SIGNATURES**

** **

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

 

 
|                         | **ETELOS, INC.**                                           |
|------------------------------|------------------------------------------------------------|
|                         | ** **                                                 |
|                         | ** **                                                 |
|                         | /s/ Daniel J.A. Kolke                                      |
| Date: December 31, 2008 | Daniel J.A. Kolke, Chief  Executive Officer                |
|                         | (Duly  Authorized Officer and Principal Executive Officer) |

 

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                          |
|----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1*                |       | Certification of  Principal Executive Officer pursuant to Rule 13a-14(a) or  15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2*                |       | Certification of  Principal Financial Officer pursuant to Rule 13a-14(a) or  15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1*                |       | Certification of  Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                        |
| 32.2*                |       | Certification of  Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                        |

 

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| * | Filed with this  report |
|---|-------------------------|

 

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