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**UNITED STATES**

**SECURITIES 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 June 30, 2010**

 

**or**

 

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

 

**For the transition period from            to**

 

**Commission file number 000-51995**

 

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**ETELOS, INC.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                    | ** ** | **77-0407364**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or  organization) |       | (I.R.S. Employer Identification No.) |

 

| **26828 Maple Valley Highway-#297**      |       |       |
|------------------------------------------|------------|------------|
| **Maple Valley, WA**                     | ** ** | **98038**  |
| (Address of principal executive offices) |       | (Zip Code) |

 

**(425) 458-4510**

(Registrant’s telephone number, including area code)

 

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

 

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

 

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

 

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

 

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

 

Asof June 30, 2010, 24,987,242 shares of the issuer’s common stock, parvalue $0.01 per share, were outstanding.

 

 

 

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**Etelos, Inc.**

 

**Quarterly Report on Form 10-Q**

 

**For the Quarterly Period Ended June 30, 2010**

 

TABLE OF CONTENTS

 
| ** **                                  | ** **                                                                                  | **Page** |
|---------------------------------------------|---------------------------------------------------------------------------------------------|----------|
|                                        |                                                                                        |     |
| **FORWARD LOOKING STATEMENTS**              | 1                                                                                           |
|                                        |                                                                                        |
| **PART I —FINANCIAL INFORMATION** | 2                                                                                           |
|                                        |                                                                                        |     |
| Item 1.                                     | FINANCIAL  STATEMENTS (UNAUDITED)                                                           | 2        |
|                                        |                                                                                        |     |
| Item 2.                                     | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 22       |
|                                        |                                                                                        |     |
| Item 3.                                     | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                 | 35       |
|                                        |                                                                                        |     |
| Item 4.                                     | CONTROLS AND  PROCEDURES                                                                    | 35       |
|                                        |                                                                                        |     |
| **PART II  —OTHER INFORMATION**   | 36                                                                                          |
|                                        |                                                                                        |     |
| Item 1.                                     | LEGAL PROCEEDINGS                                                                           | 36       |
|                                        |                                                                                        |     |
| Item 1A.                                    | RISK FACTORS                                                                                | 38       |
|                                        |                                                                                        |     |
| Item 2.                                     | UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                | 50       |
|                                        |                                                                                        |     |
| Item 6.                                     | EXHIBITS                                                                                    | 50       |
|                                        |                                                                                        |     |
| SIGNATURES                                  |                                                                                        | 51       |
|                                        |                                                                                        |     |
| EXHIBIT INDEX                          |                                                                                        | 52       |

 

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**FORWARDLOOKING STATEMENTS**

 

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

 

ThisQuarterly Report on Form 10-Q contains forward-looking statements withinthe meaning of Section 27A of the Securities Act of 1933, or the “SecuritiesAct,” and Section 21E of the Securities Exchange Act of 1934 or the “ExchangeAct.”  In some cases, you can identifyforward looking statements by terms such as “may,” “intend,” “might,” “will,” “should,”“could,” “would,” “expect,” “believe,” “anticipate,” “estimate,” “predict,” “potential,”or the negative of these terms.  These termsand similar expressions are intended to identify forward-lookingstatements.  Such statements are subjectto certain risks and uncertainties, which could cause actual results to differmaterially from those projected. Examples of forward-looking statementsinclude, but are not limited to, statements we make regarding raisingadditional capital, the acceptance of our products and services by themarketplace and our belief that we have sufficient liquidity to fund ourcurrently planned level of operations through mid-2010. The foregoing is not anexclusive list of all forward-looking statements we make.

 

You should be aware that our actual resultscould differ materially from those contained in the forward-looking statementswe make in this report due to a number of factors that could cause actualresults to differ materially from historical results or anticipated results,including:

 

·                                          our ability to obtain future financing or funds when needed;

·                                          the exercise of rights andremedies by the holders of our outstandingpromissory notes under the terms of which we are currently in default;

·                                          new competitors are likely to emerge and new technologies may furtherincrease competition;

·                                          our operating costs may increase beyond our current expectations and wemay be unable to fully implement our current business plan;

·                                          our ability to successfully obtain a diverse customer base;

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

·                                          our ability to attract and retain a qualified employee base;

·                                          our ability to respond to new developments in technology and newapplications of existing technology before our competitors;

·                                          acquisitions, business combinations, strategic partnerships,divestures, and other significant transactions may involve additionaluncertainties;

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

·                                          the risks described in Item 1A “Risk Factors” of Part II thisreport, which address additional factors that could cause our actual results todiffer from those set forth in the forward-looking statements and couldmaterially and adversely affect our business, operating results and financialcondition.

 

The forward-looking statements in this reportare based upon management’s current expectations and belief, which managementbelieves are reasonable.  In addition, wecannot assess the impact of each factor on our business or the extent to whichany factor or combination of factors, or factors we are aware of, may cause actualresults to differ materially from those contained in any forward lookingstatements.  You are cautioned not toplace undue reliance on any forward-looking statements.  These statements represent our estimates andassumptions only as of the date of this report. Except to the extent required by federal securities laws, we undertakeno obligation to update any forward-looking statement to reflect events orcircumstances after the date hereof or to reflect the occurrence ofunanticipated events.

 

All subsequent written and oral forward-lookingstatements attributable to us or persons acting on our behalf are expresslyqualified in their entirety by the applicable cautionary statements.

 

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** **

**PART I - FINANCIALINFORMATION**

 

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

 

**ETELOS, INC.**

**CONDENSED BALANCE SHEETS**

(in thousands, except share data)(Unaudited)

 
| ** **                                                                                                                                                                       | ** ** | **June 30,   2010** | ** ** | **December 31,   2009** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| ASSETS                                                                                                                                                                           |       |                     |       |                         |       |
| Current assets:                                                                                                                                                                  |       |                     |       |                         |       |
| Cash and cash equivalents                                                                                                                                                        |       | $                        | 40         |                         | $          | 445 |   |
| Accounts receivable, net                                                                                                                                                         |       | 98                       |       | 10                           |       |
| Prepaid expenses and other current assets                                                                                                                                        |       | 17                       |       | 16                           |       |
| Accretion of interest on convertible notes payable                                                                                                                               |       | 85                       |       | 250                          |       |
| Total current assets                                                                                                                                                             |       | 240                      |       | 721                          |       |
|                                                                                                                                                                             |       |                     |       |                         |       |
| Property and equipment, net                                                                                                                                                      |       | 31                       |       | 46                           |       |
| Debt issuance costs                                                                                                                                                              |       | 22                       |       | 30                           |       |
| Other assets                                                                                                                                                                     |       | 2                        |       | 2                            |       |
|                                                                                                                                                                             |       |                     |       |                         |       |
| **Total assets**                                                                                                                                                                 | ** ** | **$**                    | **295**    | ** **                   | **$**      | **799** | ** ** |
|                                                                                                                                                                             |       |                     |       |                         |       |
| LIABILITIES AND STOCKHOLDERS’ DEFICIT                                                                                                                                       |       |                     |       |                         |       |
| Current liabilities:                                                                                                                                                             |       |                     |       |                         |       |
| Accounts payable                                                                                                                                                                 |       | $                        | 889        |                         | $          | 1,120 |   |
| Accounts payable related parties                                                                                                                                                 |       | 53                       |       | 27                           |       |
| Accrued payroll and related expenses                                                                                                                                             |       | 956                      |       | 1,029                        |       |
| Other accrued expenses                                                                                                                                                           |       | 1,230                    |       | 1,229                        |       |
| Deferred revenue                                                                                                                                                                 |       | 17                       |       | 8                            |       |
| Notes payable, net of discounts                                                                                                                                                  |       | 518                      |       | 110                          |       |
| Current portion convertible notes payable                                                                                                                                        |       | 1,614                    |       | 1,764                        |       |
| Current portion notes payable to related parties                                                                                                                                 |       | 68                       |       | 108                          |       |
| Derivative liability                                                                                                                                                             |       | 253                      |       | 315                          |       |
| Total current liabilities                                                                                                                                                        |       | 5,598                    |       | 5,710                        |       |
|                                                                                                                                                                             |       |                     |       |                         |       |
| Long-term convertible notes payable, net of  premiums and discounts, less current portion                                                                                        |       | 7,713                    |       | 7,214                        |       |
| Long-term notes payable to related parties, less  current portion                                                                                                                |       | 286                      |       | 286                          |       |
| Total liabilities                                                                                                                                                                |       | 13,597                   |       | 13,210                       |       |
|                                                                                                                                                                             |       |                     |       |                         |       |
| Commitments and contingencies                                                                                                                                                    |       |                     |       |                         |       |
|                                                                                                                                                                             |       |                     |       |                         |       |
| Stockholders’ deficit:                                                                                                                                                      |       |                     |       |                         |       |
| Preferred stock, $0.01 par value: 50,000,000  shares authorized with liquidation preferences:                                                                                    |       |                     |       |                         |       |
| New Series A: 3,333,333 shares authorized;  issued and outstanding: 666,666 shares at June 30, 2010 and 743,333  shares at December 31, 2009                      |       | 6                        |       | 7                            |       |
| Common stock, $0.01 par value: 250,000,000 shares  authorized; issued and outstanding - 24,987,242 shares at June 30, 2010  and 23,398,143 shares at December 31, 2009 |       | 250                      |       | 234                          |       |
| Additional paid-in capital                                                                                                                                                       |       | 25,745                   |       | 23,903                       |       |
| Accumulated deficit                                                                                                                                                              |       | (39,303                  | )          | (36,555                      | )          |
| Total stockholders’ deficit                                                                                                                                                 |       | (13,302                  | )          | (12,411                      | )          |
|                                                                                                                                                                             |       |                     |       |                         |       |
| **Total liabilities and  stockholders’ deficit**                                                                                                                            | ** ** | **$**                    | **295**    | ** **                   | **$**      | **799** | ** ** |

 

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

 

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**ETELOS, INC.**

**CONDENSED STATEMENTS OF OPERATIONS**

(inthousands, except per share data)

(Unaudited)

 
| ** **                                                                                                | ** ** | **Three Months   Ended** | ** ** | **Three Months   Ended** | ** ** | **Six Months   Ended** | ** ** | **Six Months   Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|--------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                                | ** ** | **June 30,**        | ** ** | **June 30,**        | ** ** | **June 30,**      | ** ** | **June 30,**      | ** ** |
| ** **                                                                                                | ** ** | **2010**                 | ** ** | **2009**                 | ** ** | **2010**               | ** ** | **2009**               | ** ** |
| ** **                                                                                                | ** ** | ** **               | ** ** | ** **               | ** ** | ** **             | ** ** | ** **             | ** ** |
| Revenue                                                                                                   |       | 89                       |       | 69                       |       | 91                     |       | 126                    |       |
| Cost of revenue                                                                                           |       | 13                       |       | 80                       |       | 22                     |       | 172                    |       |
| Gross profit (loss)                                                                                       |       | 76                       |       | (11                      | )          | 69                     |       | (46                    | )          |
|                                                                                                      |       |                     |       |                     |       |                   |       |                   |       |
| Operating expenses:                                                                                       |       |                     |       |                     |       |                   |       |                   |       |
| Research and development                                                                                  |       | 350                      |       | 395                      |       | 614                    |       | 650                    |       |
| Sales and marketing                                                                                       |       | 220                      |       | 248                      |       | 386                    |       | 408                    |       |
| General and administrative                                                                                |       | 435                      |       | 205                      |       | 801                    |       | 1,940                  |       |
| Change in valuation of liability related to  warrants from settlement, financing, and consulting services |       | —                   |       | (2,455                   | )          | —                 |       | (299                   | )          |
| Total operating expenses (income)                                                                         |       | 1,005                    |       | (1,607                   | )          | 1,801                  |       | 2,699                  |       |
|                                                                                                      |       |                     |       |                     |       |                   |       |                   |       |
| Income (loss) from operations                                                                             |       | (929                     | )          | 1,596                    |       | (1,732                 | )          | (2,745                 | )          |
|                                                                                                      |       |                     |       |                     |       |                   |       |                   |       |
| Other expense:                                                                                            |       |                     |       |                     |       |                   |       |                   |       |
| Loss on extinguishment of debt                                                                            |       | —                   |       | (300                     | )          | —                 |       | (300                   | )          |
| Total other expense                                                                                       |       | —                   |       | (300                     | )          | —                 |       | (300                   | )          |
|                                                                                                      |       |                     |       |                     |       |                   |       |                   |       |
| Interest income (expense):                                                                                |       |                     |       |                     |       |                   |       |                   |       |
| Interest expense, net                                                                                     |       | (262                     | )          | (147                     | )          | (386                   | )          | (273                   | )          |
| Amortization of notes discount and debt issuance  costs and accretion of notes premium, net               |       | (391                     | )          | (58                      | )          | (699                   | )          | (72                    | )          |
| Change in valuation of liability relating to embedded  derivatives and warrants                           |       | 53                       |       | 1,819                    |       | 69                     |       | (135                   | )          |
| Total interest income (expense)                                                                           |       | (600                     | )          | 1,614                    |       | (1,016                 | )          | (480                   | )          |
|                                                                                                      |       |                     |       |                     |       |                   |       |                   |       |
| Income (loss) before taxes                                                                                |       | (1,529                   | )          | 2,910                    |       | (2,748                 | )          | (3,525                 | )          |
|                                                                                                      |       |                     |       |                     |       |                   |       |                   |       |
| Provision for income taxes                                                                                |       | —                   |       | —                   |       | —                 |       | —                 |       |
|                                                                                                      |       |                     |       |                     |       |                   |       |                   |       |
| **Net income (loss)**                                                                                     | ** ** | **$**                    | **(1,529** | **)**                    | **$**      | **2,910**              | ** ** | **$**                  | **(2,748** | **)** | **$** | **(3,525** | **)** |
|                                                                                                      |       |                     |       |                     |       |                   |       |                   |       |
| Basic net income (loss) per share                                                                         |       | $                        | (0.06      | )                        | $          | 0.12                   |       | $                      | (0.12      | ) | $ | (0.15 | ) |
| Diluted net income (loss) per share                                                                       |       | $                        | (0.06      | )                        | $          | 0.08                   |       | $                      | (0.12      | ) | $ | (0.15 | ) |
|                                                                                                      |       |                     |       |                     |       |                   |       |                   |       |
| Weighted average number of common shares used in  computing basic net income (loss) per share             |       | 24,778                   |       | 24,069                   |       | 23,894                 |       | 23,896                 |       |
| Weighted average number of common shares used in  computing diluted net income (loss) per share           |       | 24,778                   |       | 38,466                   |       | 23,894                 |       | 23,896                 |       |

 

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

 

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**ETELOS, INC.**

**CONDENSED STATEMENTS OF STOCKHOLDERS’ DEFICIT**

(in thousands, except share data)

(Unaudited)

 
| ** **                                                                          | ** ** | ** **                 | ** ** | ** **            | ** ** | ** **               | ** **     | ** **      | ** ** | ** **             | ** ** | ** **  | ** ** | ** **  | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|--------------------------|----------------|-----------------|------------|------------------------|------------|-------------|------------|-------------|------------|
| ** **                                                                          | ** ** | **Preferred Stock**   | ** ** | ** **            | ** ** | ** **               | ** **     | **Total**       | ** ** | ** **             | ** ** | ** **  | ** ** |
| ** **                                                                          | ** ** | **New Series A** | ** ** | **Common Stock** | ** ** | **Additional Paid** | ** **     | **Accumulated** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                          | ** ** | **Shares**                 | ** ** | **Amount**            | ** ** | **Shares**               | ** **     | **Amount**      | ** ** | **in Capital**    | ** ** | **Deficit** | ** ** | **Deficit** | ** ** |
| ** **                                                                          | ** ** | ** **                 | ** ** | ** **            | ** ** | ** **               | ** **     | ** **      | ** ** | ** **             | ** ** | ** **  | ** ** | ** **  | ** ** |
| **Balance at December 31, 2009**                                               | ** ** | **743,333**                | ** ** | **$**                 | **7**      | ** **               | **23,398,143** | ** **      | **$**      | **234**                | ** ** | **$**       | **23,903** | ** **  | **$**      | **(36,555** | **)** | **$** | **(12,411** | **)** |
|                                                                                |       |                       |       |                  |       |                     |           |            |       |                   |       |        |       |        |       |
| Issuance  of common stock upon conversion of Preferred New Series A            | ** ** | **(76,667**                | **)**      | **(1**                | **)**      | 76,667                   |           | 1               |       | —                 |       | —      | ** ** | **—**  | ** ** |
| Issuance  of common stock for warrants exercised                                    | ** ** | ** **                 | ** ** | ** **            |       | 300,000                  |           | 3               |       | 222                    |       | —      | ** ** | **225**     | ** ** |
| Issuance  of common stock and Series I Warrants with Senior Secured Debentures | ** ** | **—**                 | ** ** | **—**            |       | 375,000                  |           | 3               |       | 133                    |       | —      | ** ** | **136**     | ** ** |
| Issuance  of common stock for other accrued expenses                                | ** ** | **—**                 | ** ** | **—**            |       | 166,667                  |           | 2               |       | 123                    |       | —      | ** ** | **125**     | ** ** |
| Issuance  of common stock upon conversion of notes payable                          | ** ** | **—**                 | ** ** | **—**            |       | 200,000                  |           | 2               |       | 148                    |       | —      | ** ** | **150**     | ** ** |
| Beneficial  Conversion upon issuance of Senior Secured Debentures                   | ** ** | **—**                 | ** ** | **—**            |       | —                   |           | —          |       | 232                    |       | —      | ** ** | **232**     | ** ** |
| Issuance  of common stock for waiver on interest due with Senior Secured Notes      | ** ** | ** **                 | ** ** | ** **            |       | 124,642                  |           | 1               |       | 129                    |       | —      | ** ** | **130**     | ** ** |
| Issuance  of warrants for financing expense                                         | ** ** | **—**                 | ** ** | **—**            |       | —                   |           | —          |       | 128                    |       | —      | ** ** | **128**     | ** ** |
| Issuance  of warrants with promissory notes                                         | ** ** | **—**                 | ** ** | **—**            |       | —                   |           | —          |       | 192                    |       | —      | ** ** | **192**     | ** ** |
| Issuance  of common stock for employees’ compensation                          | ** ** | **—**                 | ** ** | **—**            |       | 346,123                  |           | 4               |       | 269                    |       | —      | ** ** | **273**     | ** ** |
| Issuance  of warrants for consulting agreement                                      | ** ** | **—**                 | ** ** | **—**            |       | —                   |           | —          |       | 9                      |       | —      | ** ** | **9**       | ** ** |
| Stock  Based Compensation                                                           | ** ** | **—**                 | ** ** | **—**            |       | —                   |           | —          |       | 257                    |       | —      | ** ** | **257**     | ** ** |
| Net  Loss                                                                           | ** ** | **—**                 | ** ** | **—**            |       | —                   |           | —          |       | —                 |       | (2,748      | )          | **(2,748**  | **)**      |
| **Balance at June 30, 2010**                                                   | ** ** | **666,666**                | ** ** | **$**                 | **6**      | ** **               | **24,987,242** | ** **      | **$**      | **250**                | ** ** | **$**       | **25,745** | ** **  | **$**      | **(39,303** | **)** | **$** | **(13,302** | **)** |

 

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

 

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**ETELOS, INCORPORATED**

**CONDENSED STATEMENTS OF CASH FLOWS**

(in thousands)

(Unaudited)

 
| ** **                                                                   | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                   | ** ** | **June 30,**    | ** ** |
| ** **                                                                   | ** ** | **2010**             | ** ** | **2009** | ** ** |
|                                                                         |       |                 |       |   |   |
| **Cash flows from operating  activities:**                                   | ** ** | ** **           | ** ** | ** ** | ** ** |
| Net loss                                                                     | ** ** | **$**                | **(2,748** | **)** | **$** | **(3,525** | **)** |
| Adjustments to reconcile net loss to net cash used  in operating activities: | ** ** | ** **           | ** ** | ** ** | ** ** |
| Depreciation and amortization                                                | ** ** | **15**               | ** ** | **19** | ** ** |
| Amortization (accretion) of notes discount  (premium)                        | ** ** | **531**              | ** ** | **72** | ** ** |
| Accretion of interest                                                        | ** ** | **165**              | ** ** | **—** | ** ** |
| Stock based compensation                                                     | ** ** | **257**              | ** ** | **87** | ** ** |
| Consulting expenses paid through issuance of  common stock and warrants      | ** ** | **9**                | ** ** | **1,511** | ** ** |
| Financing fees paid through issuance of common  stock warrants               | ** ** | **128**              | ** ** | **—** | ** ** |
| Waiver fees paid through issuance of common stock                            | ** ** | **130**              | ** ** | **—** | ** ** |
| Change in valuation of embedded derivatives and  warrant liability           | ** ** | **(69**              | **)**      | **(164** | **)** |
| Loss on extinguishment of restructured debentures                            | ** ** | **—**           | ** ** | **300** | ** ** |
| Changes in operating assets and liabilities:                                 | ** ** | ** **           | ** ** | ** ** | ** ** |
| Accounts receivable, net                                                     | ** ** | **(88**              | **)**      | **56** | ** ** |
| Prepaid expenses and other current assets                                    | ** ** | **(1**               | **)**      | **32** | ** ** |
| Other assets                                                                 | ** ** | **—**           | ** ** | **(1** | **)** |
| Accounts payable                                                             | ** ** | **(231**             | **)**      | **195** | ** ** |
| Accounts payables related parties                                            | ** ** | **26**               | ** ** | **(24** | **)** |
| Accrued payroll and related expenses                                         | ** ** | **200**              | ** ** | **525** | ** ** |
| Other accrued expenses                                                       | ** ** | **326**              | ** ** | **311** | ** ** |
| Deferred revenues                                                            | ** ** | **9**                | ** ** | **(59** | **)** |
| **Net cash used in operating  activities**                                   | ** ** | **(1,341**           | **)**      | **(665** | **)** |
| **Cash flows from financing  activities:**                                   | ** ** | ** **           | ** ** | ** ** | ** ** |
| Proceeds from notes payable                                                  | ** ** | **775**              | ** ** | **555** | ** ** |
| Payments of notes payable                                                    | ** ** | **(24**              | **)**      | **—** | ** ** |
| Proceeds from issuance of common stock                                       | ** ** | **225**              | ** ** | **2** | ** ** |
| Proceeds from issuance of preferred stock                                    | ** ** | **—**           | ** ** | **7** | ** ** |
| Proceeds from notes payable to related parties                               | ** ** | **—**           | ** ** | **100** | ** ** |
| Payments of notes payable to related parties                                 | ** ** | **(40**              | **)**      | **—** | ** ** |
| Payment on capital lease                                                     | ** ** | **—**           | ** ** | **(5** | **)** |
| **Net cash provided by financing  activities**                               | ** ** | **936**              | ** ** | **659** | ** ** |
| ** **                                                                   | ** ** | ** **           | ** ** | ** ** | ** ** |
| **Net increase (decrease) in cash  and cash equivalents**                    | ** ** | **(405**             | **)**      | **(6** | **)** |
| ** **                                                                   | ** ** | ** **           | ** ** | ** ** | ** ** |
| **Cash and cash equivalents at  beginning of year**                          | ** ** | **445**              | ** ** | **7** | ** ** |
| ** **                                                                   | ** ** | ** **           | ** ** | ** ** | ** ** |
| **Cash and cash equivalents at end  of period**                              | ** ** | **$**                | **40**     | ** ** | **$** | **1** | ** ** |
| ** **                                                                   | ** ** | ** **           | ** ** | ** ** | ** ** |
| **Supplemental disclosures of cash  flow information:**                      | ** ** | ** **           | ** ** | ** ** | ** ** |
| Cash paid for interest                                                       | ** ** | **—**           | ** ** | **—** | ** ** |
| ** **                                                                   | ** ** | ** **           | ** ** | ** ** | ** ** |
| **Supplemental disclosures of  non-cash financing activities:**              | ** ** | ** **           | ** ** | ** ** | ** ** |
| Reclass of warrants from liability to equity                                 | ** ** | **—**           | ** ** | **799** | ** ** |
| Increase in convertible notes principal                                      | ** ** | **—**           | ** ** | **413** | ** ** |
| Issuance of common stock for employees’ compensation                    | ** ** | **273**              | ** ** | **—** | ** ** |
| Issuance of note payable for other accrued  expenses                         | ** ** | **200**              | ** ** | **—** | ** ** |
| Issuance of common stock for convertible notes and  debentures               | ** ** | **150**              | ** ** | **—** | ** ** |
| Reclass of derivatives from liability to equity                              | ** ** | **—**           | ** ** | **132** | ** ** |
| Issuance of common stock for other accrued  expenses                         | ** ** | **125**              | ** ** | **—** | ** ** |

** **

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

 

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NOTES TO FINANCIAL STATEMENTS

 

***1. Organization***

 

Asused herein, unless the context requires otherwise, the terms “we”, “us”, “our”,the “Company” or “Etelos” refers to Etelos, Inc., the corporation thatsurvived the merger described in Note 1 Organization, below.

 

Etelos, Incorporated,a Washington corporation (“Etelos-WA”) was the predecessor to the Company.  On April 22, 2008, Etelos-WA merged withTripath Technology Inc., a Delaware corporation (“Tripath”) as part of Tripath’sPlan of Reorganization under Chapter 11 of the Bankruptcy Code (the “Merger”).

 

OnApril 23, 2008, Tripath filed a Current Report on Form 8-Kannouncing, among other things, the Merger, and that the surviving corporationchanged its name to Etelos, Inc. and its fiscal year end toDecember 31.  In connection with the Merger, all outstanding sharesof Etelos-WA common stock were converted into shares of the Company’s commonstock on a three for one ratio: one share of the Company’s common stock forevery three shares of common stock of Etelos-WA.  Also in connection withthe Merger, (i) all outstanding shares of preferred stock of Etelos-WAwere converted into shares of the Company’s common stock, (ii) the Companyissued 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, the Company amended itsarticles of incorporation with the state of Delaware to change its totalauthorized shares of stock to 300,000,000 shares, of which 250,000,000 sharesare designated “Common Stock” with a par value of $0.01 per share and50,000,000 shares are designated “Preferred Stock” with a par value of $0.01per share.  The Preferred Stock may be issued from time to time in one ormore series, each of such series to consist of such number of shares and tohave such terms, rights, powers and preferences, and the qualifications and limitationswith respect thereto, as stated in the resolutions providing for the issue ofsuch series adopted by the board of directors.

 

Prior to the Merger, Tripath was a shellcorporation and in accordance with the Plan of Reorganization had no assets or liabilities. While Tripath acquired all the outstanding preferred and common stock ofEtelos-WA, for accounting purposes, the acquisition was treated as arecapitalization of Etelos-WA with Etelos-WA as the acquirer (a reverseacquisition).  The operations of the Company subsequent to the Mergerinclude only those of Etelos-WA.

 

The5,010,000 shares of the Company’s common stock were valued at $2.63 per share,the estimated fair value of the common stock on the date of the Merger, whichresulted in a charge to operations of $13.2 million in 2008.  The Companybelieves that these shares were issued primarily for past services provided toEtelos-WA by the secured creditors and the release of the secured and unsecuredcreditors claims against Tripath.

 

***2.  Description of Business***

 

Eteloshas a Web Application distribution platform — the Etelos Platform SuiteTM — for Independent Software Vendors (ISVs) andothers to deliver Web Applications and other software and IT products andservices to customers.  Etelos provides aSoftware-as-a-Service (SaaS) ecosystem for building, distributing, and usingWeb Applications, including marketplaces to deploy and support them.  Unlike other cloud computing andPlatform-as-a-Service (PaaS) solutions, Etelos enables ISVs to migrate existingapplications for distribution on the Web or to create new Web Applications,then package, distribute, host, bill, market and support their SaaS-enabledapplications through multiple private label applications marketplaces.

 

Etelos has developed products for WebApplications, which include open standards-based tools for Web developers,businesses and individual users such as the Etelos Application ServerTM (EASTM) and the Etelos Development EnvironmentTM (EDETM). EAS and EDE support many common programming languages and also supportthe English Application Scripting Engine (EASETM), an open standards-based scripting language that we developed.  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.

 

The Company’s business model focuses on boththe development and operation of private-label Web Application marketplaces andthe development and operation of enterprise implementations of the Etelos PlatformSuite, including provision of the professional services required to develop,deploy and operate such marketplaces and other implementations.   Private label marketplaces based on theEtelos Platform Suite are designed to allow ISVs to implement a SaaSdelivery version of their existing applications, whether or not thoseapplications are already Web Applications, and to syndicate the offering ofthose applications on a SaaS basis through multiple private label marketplaces.In these difficult economic times, the Company believes that a variety of ISVshave applications that they want to move to the Web for lower costimplementation, easier, simpler scalability and broader distribution.  TheEtelos Platform Suite also enables Marketplace Partners, includingnon-technology businesses, to have their own private label marketplaces 

 

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and tools to offer Web Applications to betterserve their customers in multiple distribution channels.  Finally, enterprise implementations of theEtelos Platform Suite facilitate Web-based distribution of a wide varietyof Web Applications and other software and IT products through multiplechannels.

 

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

 

*Basisof Presentation*

 

The accompanying condensed financial statementsinclude our accounts as of June 30, 2010, and December 31, 2009, andfor the six months ended June 30, 2010 and 2009. The accompanyingcondensed balance sheet as of December 31, 2009, has been derived from theaudited balance sheet in the Company’s annual report on Form 10-K for thefiscal year ended December 31, 2009. These condensed financial statementshave been prepared by management, without audit, pursuant to the rules andregulations of the Securities and Exchange Commission, or SEC. Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America (“USGAAP”) have been condensed or omitted pursuant tosuch rules and regulations. The Company has performed an evaluation ofsubsequent events through the date of filing of the financial statements.

 

In the opinion of management, all adjustments(which consist of normal recurring adjustments, except as disclosed herein)necessary to fairly present the financial position, results of operations andcash flows for the interim periods presented have been included. The results ofoperations for the six months ended June 30, 2010, are not necessarilyindicative of the results to be expected for the full year or for any futureperiods.

 

The preparation of financial statements inconformity with USGAAP requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andreported amounts of revenues and expenses during the reporting period. Actualresults could differ from those estimates, and such differences could affectthe results of operations reported in future periods and such differences couldbe material.  These financial statementsshould be read in conjunction with the audited financial statements andaccompanying notes included in the Company’s annual report on Form 10-Kfor the fiscal year ended December 31, 2009.  Certain prior period amounts have beenreclassified to conform to the present period presentation.

 

*Concentrationof Credit Risk*

 

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

 

TheCompany’s accounts receivables are derived primarily from customers.  For the six months ended June 30, 2010,two customers accounted for 87% of the Company’s revenue in the period. Twocustomers accounted for 96% of the Company’s accounts receivable as of June 30,2010.

 

*Allowancefor Doubtful Accounts*

 

TheCompany provides, when appropriate, an allowance for doubtful accounts toensure trade receivables are not overstated due to un-collectability. Thecollectability of the Company’s receivables is evaluated based on a variety offactors, including the length of time receivables are past due, indication ofthe customer’s willingness to pay, significant one-time events, and historicalexperience. As of June 30, 2010, and December 31, 2009, the Companydetermined that an allowance for doubtful accounts was not necessary orwarranted.

 

*DeferredRevenue*

 

Deferred revenue representsmoney received or promised but not recognized as revenue because the work hasnot been completed or the software subscription has not been fully delivered,and therefore is deferred until the revenue recognition is appropriate when itis then transferred to the appropriate revenue account.

 

*Propertyand Equipment*

 

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

 

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*FairValue of Financial Instruments*

 

Eteloshave estimated the fair value of the financial instruments using the availablemarket information and valuation methodologies considered to be appropriate andhave determined that the book value of our cash and cash equivalents, accountsreceivables, prepaid expenses and accrued expenses approximate fair value.

 

*Researchand Development and Software Development Costs*

 

Researchand development expenses consist primarily of salaries, payroll taxes,benefits, and related expenditures for technology, software development,project management, and support personnel. Costs related to the research anddevelopment of new products, services and enhancements to existing products areexpensed as provided for by ASC 985-20 “Costs of Software to be Sold, Leased,or Marketed” (ASC 985-20). Under ASC 985-20, costs incurred in the research anddevelopment of new software products are expensed as incurred untiltechnological feasibility is established. Research and development costs arecapitalized beginning when a product’s technological feasibility has beenestablished and ending when the product is available for general release tocustomers. Technological feasibility is reached when the product reaches theworking model stage. To date, products and enhancements have generally reachedtechnological feasibility and have been released for sale at substantially thesame time and all research and development costs have been expensed.

 

ASC350-40 “Internal-Use Software” (ASC 350-40), which applies to SaaS businessmodel, are met for the capitalization of software development cost.  UnderASC 350-40, software development costs, including costs incurred to purchasethird party software, are capitalized beginning when the Company has determinedcertain factors are present, including, among others, that technology exists toachieve the performance requirements, buy versus internal development decisionshave been made, and the Company’s management has authorized the funding for theproject. Capitalization of software development costs ceases when the softwareis substantially complete and is ready for its intended use.  To date, nosoftware development costs incurred have met the criteria set forth in ASC350-40 for capitalization.

 

*RevenueRecognition*

 

Etelosdistributes Web Applications and its Marketplace Platform as a subscriptionservice using the SaaS or software-on-demand business model and allow thirdparties to offer their products or services through storefronts in an EtelosMarketplace, and to advertise on its web site for a fee.  It also licensescertain of its software products under perpetual and term licenses. Revenues are recognized on these service and licensing transactions using thecriteria in ASC 605-10, “Revenue Recognition”, (ASC 605-10) and ASC 985-605, “SoftwareRevenue Recognition” (ASC 985-605), respectively, which both provide that revenuemay be recognized when all of the following are met:

 

·                                          persuasiveevidence of an arrangement exists,

·                                          the product orservice has been delivered,

·                                          the fee isfixed or determinable, and

·                                          collection ofthe resulting receivable is reasonably assured or probable.

 

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

 

Forsoftware licensed under term or perpetual agreements, persuasive evidence of anarrangement is evidenced by a binding agreement signed by the customer anddelivery generally occurs upon delivery of the software to a common carrier. Ifa significant portion of a fee is due after our normal payment terms oftypically 30 days, then we recognize revenue as the fees become due. If theCompany determines that collection of a fee is not reasonably assured, then itdefers the fees and recognizes revenue upon cash receipt, provided that allother revenue recognition criteria are met.

 

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

 

*StockBased Compensation*

 

TheCompany accounts for its stock based compensation in accordance with ASC718-10, “Compensation — Stock Compensation” (ASC 718-10) using the Black-ScholesMerton model to value all stock based compensation awards.  The Companyhas recorded compensation cost in the statement of operations based on the fairvalue of the award for the requisite service period. The Company also estimatesforfeitures 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 $257 thousand and $87 thousand ofexpense for the six months ended June 30, 2010 and 2009, respectively.

 

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ASC718-10 requires the cash flows resulting from the tax benefits resultingfrom tax deductions in excess of the compensation cost recognized for thoseoptions to be classified as financing cash flows. Due to its loss position,there were no such tax benefits during the six months ended June 30, 2010and 2009. Prior to the adoption of ASC 718-10, those benefits would have beenreported as operating cash flows had we received any tax benefits related tostock option exercises.

 

*IncomeTaxes*

 

TheCompany accounts for income taxes in accordance with ASC 740-10, “Income Taxes”(ASC 740-10) which utilizes the liability method of accounting for incometaxes. Deferred tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statementcarrying amount of existing assets and liabilities and their respective taxbases. Deferred tax assets and liabilities are measured using enacted tax ratesexpected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled. Valuation allowances areestablished when necessary to reduce deferred tax assets to the amountsexpected to be realized.  The tax yearsof 2005 through 2009 remain open and subject to examination by appropriategovernmental agencies in the United States.

 

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

 

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

 

TheCompany’s policy is to recognize interest and penalties accrued on anyunrecognized tax benefits as a component of income tax expense.  As of the date of the adoption of ASC740-10-25, the Company did not have any accrued interest or penaltiesassociated with any unrecognized tax benefits, nor was any such interestexpense recognized during the six months ended June 30, 2010 and 2009, orthe year ended December 31, 2009. The Company’s effective tax rate differs from the federal statutory rateprimarily due to increases in its deferred income tax valuation allowance.

 

*NetIncome (Loss) per Share*

 

Basicnet income (loss) per share is computed by dividing the net loss available tocommon stockholders for the period by the weighted average number of shares ofcommon stock outstanding during the period, excluding any unvested restrictedstock that is subject to repurchase. Diluted net income per share is computedusing the weighted average number of common shares and, if dilutive, potential commonshares outstanding during the period. Potential common shares consist ofunvested restricted stock (using the treasury stock method), the incrementalcommon shares issuable upon the exercise of stock options and warrants (usingthe treasury stock method) and the conversion of the Company’s convertiblenotes and debentures (using the if-converted method).  As their effect isantidilutive, 9,085,553 and 82,287 shares of common stock exercisable underoutstanding employee stock options, 10,664,444 and 611,111 shares of commonstock exercisable under outstanding warrants, 13,592,695 and 7,171,708 sharesof common stock issuable upon conversion of the outstanding convertible notespayable and debentures, as of, and for the six months ended June 30, 2010and 2009, respectively, have been excluded from this calculation.  Theaverage exercise price of outstanding employee stock options to purchase theCompany’s common stock is $0.32 and $0.24, respectively, at June 30, 2010and 2009.

 

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The following table sets forth the computationof basic and diluted net loss per share for the periods presented (inthousands, except per share amounts):

 
| ** **                              | ** ** | **For the Three Months** | ** ** | **For the SixMonths** | ** ** |
|-----------------------------------------|------------|-----------------------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | **Ended June 30,**            | ** ** | **Ended June 30,**    | ** ** |
| ** **                              | ** ** | **2010**                                | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Numerator:                              |       |                                    |       |                            |       |   |   |   |   |
| Net income (loss)                       |       | $                                       | (1,529     | )                               | $          | 2,910 |   | $ | (2,748 | ) | $ | (3,525 | ) |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Interest on convertible notes           |       | —                                  |       | 109                             |       | — |   | — |   |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Net income (loss) - diluted             |       | $                                       | (1,529     | )                               | $          | 3,019 |   | $ | (2,748 | ) | $ | (3,525 | ) |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Denominator:                            |       |                                    |       |                            |       |   |   |   |   |
| Weighted average common stock           |       | 24,778                                  |       | 24,069                          |       | 23,894 |   | 23,896 |   |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Covertible notes payable                |       | —                                  |       | 7,172                           |       | — |   | — |   |
| Preferred stock New Series A       |       | —                                  |       | 843                             |       | — |   | — |   |
| Warrants                                |       | —                                  |       | 2,199                           |       | — |   | — |   |
| Options                                 |       | —                                  |       | 4,183                           |       | — |   | — |   |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Weighted average common stock - diluted |       | 24,778                                  |       | 38,466                          |       | 23,894 |   | 23,896 |   |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Net income (loss) per share:            |       |                                    |       |                            |       |   |   |   |   |
| Basic                                   |       | $                                       | (0.06      | )                               | $          | 0.12 |   | $ | (0.12 | ) | $ | (0.15 | ) |
| Diluted                                 |       | $                                       | (0.06      | )                               | $          | 0.08 |   | $ | (0.12 | ) | $ | (0.15 | ) |

 

*Use ofEstimates*

 

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

 

*SegmentReporting*

 

TheCompany has one operating segment because the Company is not organized intomultiple segments for the purpose of making operating decisions or forassessing performance. The chief operating decision maker evaluatesperformance, makes operating decisions, and allocates resources based onfinancial data consistent with the presentation in the accompanying financialstatements.

 

***4. Going Concern***

 

Thefinancial statements have been prepared with the assumption that the Companywill continue as a going concern.  The Company has experienced net lossesof $2.7 million and $3.5 million for the six months ended June 30, 2010and 2009, respectively, and has a total stockholders’ deficit of $13.3 millionand $12.4 million, as of June 30, 2010, and December 31, 2009,respectively, all of which raise substantial doubt about its ability tocontinue as a going concern. The financial statements do not include anyadjustments relating to the recoverability and classification of asset carryingamounts or the amount and classification of liabilities that might arise shouldit be unable to continue as a going concern.

 

Managementhas supported current operations by raising additional operating cash throughthe private sale of convertible debentures and notes payable and preferredstock. This has provided the cash inflows to continue the Company’s businessplan, but has not resulted in significant improvement in its financial positionor results of operations.  Managementalso has substantially reduced operating expenses by termination of employeesand other reductions in operating expenses. Alternatives being pursued to improve the Company’s cash flow used inoperations include (1) raising additional working capital throughadditional sale of preferred stock, common stock and/or debt and(2) reducing cash operating expenses to levels that are in line withcurrent revenues.  The first alternative could result in substantialdilution to existing shareholders. There can be no assurance that the Company’scurrent financial position can be improved, that it can raise additionalworking capital, or that it can achieve positive cash flows from operations.The Company’s long-term viability as a going concern is dependent upon itsability to (1) locate sources of debt or equity funding to meet currentcommitments and near-term future working capital requirements and(2) achieve profitability and ultimately generate sufficient cash flowfrom operations to sustain its continuing operations.

 

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TheCompany’s cash balance including proceeds from its recent debt financings andpreferred stock financing may not be sufficient to fund operations beyond late2010.  If cash reserves are not sufficient to sustain operations, thenmanagement plans to further reduce operating expenses and/or raise additionalcapital by selling shares of capital stock or other securities that couldresult in substantial dilution to existing shareholders.  However, thereare no commitments or arrangements for future financings in place at this timeand the Company can give no assurance that such capital will be available onfavorable terms, or at all.  The Company may need additional financingthereafter until it can achieve profitability.  If it cannot, then it willbe forced to further curtail operations or possibly be forced to evaluate asale or liquidation of assets.  Even if it is successful in raisingadditional funds, there is no assurance regarding the terms of any additionalinvestment.

 

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

 

In January 2010, theFASB issued amended standards that require additional fair value disclosures(Update No. 2010-06). These amended standards require disclosures aboutinputs and valuation techniques used to measure fair value as well asdisclosures about significant transfers, beginning in the first quarter of2010. The Company adopted these amended standards on January 1, 2010, andthere was no impact to the financial statements upon adoption. Additionally,these amended standards require presentation of disaggregated activity withinthe reconciliation for fair value measurements using significant unobservableinputs (Level 3), beginning in the first quarter of 2011. The Company does notexpect these new standards to significantly impact the financial statements.

 

In February 2010, theFASB issued amended guidance (Update No. 2010-09) on subsequent events toalleviate potential conflicts between FASB guidance and SEC requirements. Underthis amended guidance, SEC filers are no longer required to disclose the datethrough which subsequent events have been evaluated in originally issued andrevised financial statements. This guidance was effective immediately and weadopted these new requirements for the period ended March 31, 2010. Theadoption of this guidance did not have a material impact on our financialstatements.

 

In April 2010, the FASBissued amended guidance (Update No. 2010-05) on stock compensation toclarify that employee stock options that have exercise prices denominated inthe currency of any market in which a substantial portion of the entity’sequity securities trade should be classified as equity, assuming all othercriteria for equity classification are met. The amendments in the ASU do notcontain any disclosure requirements incremental to those required by ASC 718.The amendments are effective for fiscal years, and interim periods within thosefiscal years, beginning on or after December 15, 2010, and will be adoptedby recording a cumulative effect adjustment as of the beginning of the fiscalyear in which the amendments are initially applied. Early adoption is permitted.The company expects to adopt this amended guidance on January 1, 2011, anddoes not expect the amended guidance to significantly impact the financialstatements.

 

In April 2010,Financial Accounting Standards Board issued updated guidance (Update No. 2010-17)related to Revenue Recognition—Milestone Method. The amendments in this Updateprovide guidance on the criteria that should be met for determining whether themilestone method of revenue recognition is appropriate. A vendor can recognizeconsideration that is contingent upon achievement of a milestone in itsentirety as revenue in the period in which the milestone is achieved only ifthe milestone meets all criteria to be considered substantive. The amendmentsin this Update are effective on a prospective basis for milestones achieved infiscal years, and interim periods within those years, beginning on or after June 15,2010. Early adoption is permitted. The Company does not believe that any suchguidance will have a material effect on the financial position or results ofoperation.

 

TheCompany has considered all other newly issued accounting guidance that isapplicable to its operations and the preparation of its condensed statements,including guidance that the Company have not yet adopted. The Company does notbelieve that any such guidance will have a material effect on its financialposition or results of operation.

 

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

 

Thefollowing table summarizes information relative to the Company’s outstandingconvertible notes and debentures at December 31, 2009 and June 30,2010 (in thousands):

 
| ** **                                                                            | ** ** | **June 30,  2010** | ** ** | **December  31,  2009** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| 6% Convertible Notes                                                                  |       | $                       | 1,614      |                    | $          | 1,764 |   |
| January 2008 Debentures                                                          |       | 2,320                   |       | 2,320                   |       |
| April 2008 Debentures                                                            |       | 4,012                   |       | 4,012                   |       |
| 10% Senior Secured Debentures                                                         |       | 3,375                   |       | 3,000                   |       |
|                                                                                  |       | 11,321                  |       | 11,096                  |       |
| Plus (less) premium (discount) on notes payable                                       |       | (1,994                  | )          | (2,118                  | )          |
|                                                                                  |       |                    |       |                    |       |
|                                                                                  |       | 9,327                   |       | 8,978                   |       |
| Less current portion of convertible notes payable                                     |       | (1,614                  | )          | (1,764                  | )          |
|                                                                                  |       |                    |       |                    |       |
| Long term convertible notes payable, net of  premium (discount), less current portion |       | $                       | 7, 713     |                    | $          | 7,214 |   |

 

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*6% Convertible Notes*

 

Duringthe six months ended June 30, 2010, $150 thousand of the principal amountof 6% convertible notes originally issued in August 2007 were convertedinto 200 thousand shares of the Company’s common stock and $1,614 thousandremain outstanding. The Company did not make the interest and principalpayments on these notes during the six months ended June 30, 2010, andsuch payments have not been made through the date of this report. Accordingly,the Company is in default under the terms of these notes, and all principal andinterest related to these convertible notes is due and payable to the holders.As a result, the Company has accrued interest on these notes at the defaultrate of 8% and classified all amounts due related to these notes as currentliabilities.

 

*10%Senior Secured Debentures*

 

Duringthe six months ended June 30, 2010, in exchange for $375 thousand in cash,the Company issued 10% Senior Secured Debentures with an aggregate principalamount of $375 thousand, warrants to purchase 375,000 shares of the Company’scommon stock, and 375,000 shares of the Company’s common stock to an entityaffiliated with Donald W. Morissette, who, together with his affiliates,beneficially owns more than 10% of the Company’s outstanding common stock.

 

TheCompany failed to make the required interest payments on the 10% Senior SecuredDebentures during the six months ended June 30, 2010, and through the dateof this report.  In April 2010, inexchange for the holders of the 10% Senior Secured Debentures agreeing to waivetheir remedies in the event of this default, the Company’s board of directorsauthorized the Company to issue 124,642 shares of common stock to the holdersof the 10% Senior Secured Debentures for the six months ending June 30,2010.  Under the terms of that agreement, covering all periods throughJuly 1, 2010, the Company continues to accrue interest at the stated interestrate, which interest will be payable at maturity, and to classify the 10%Senior Secured Debentures as long-term liabilities in the Company’s financialstatements.

 

*Embedded Derivatives*

 

TheCompany has evaluated the embedded derivatives included in the 6% Convertible Notes,the January 2008 Debentures, the April 2008 Debentures, and the 10%Senior Secured Debentures, consisting of the conversion features and certainput and call features, under the guidance in ASC 815-10 “Derivatives andHedging” (ASC 815-10) on the issuance date of the various financial instrumentsand on each subsequent reporting date.  The purpose of the evaluation isto determine whether the embedded derivatives need to be bifurcated from thedebt host and accounted for as a derivative at their estimated fair value as aliability at the date of issuance and thereafter, adjusted to estimated fairvalue with a charge or credit to the Company’s statement of operations. ASC 815-10 generally indicates that if the conversion features are(i) indexed to the Company’s capital stock under the guidance in ASC815-40-15, “Derivatives and Hedging — Contracts in Entity’s Own Equity — Scopeand Scope Exceptions” (ASC 815-40-15), and (ii) would be classified asequity if a freestanding derivative under the guidance in ASC 815-40-25 “Derivativesand Hedging — Contracts in Entity’s Own Equity — Recognition” (ASC 815-40-25)then the embedded derivatives need not be bifurcated from the debt host. ASC 815-40-25 generally requires, among other factors, that (i) the Companycan settle the derivative in cash or its own stock, at its option,(ii) settlement can be made in unregistered shares, and (iii) theCompany has sufficient authorized shares to issue shares of its common stockfor all equity instruments convertible to or which can be exercised for itscapital stock.  ASC 815-10 also provides guidance on when put and callfeatures included in a debt host agreement are not clearly and closely relatedto the debt host must be bifurcated and recorded as a liability.  The January 2008,April 2008 and 10% Senior Secured Debentures include put and callfeatures.

 

*Embedded Derivatives — 6% Convertible Notes*

 

Asof June 30, 2010, the Company continues to conclude that the conversionfeatures embedded in the 6% Convertible Notes meet the criteria in ASC 815-10to be accounted for as an equity instrument.

 

*Embedded Derivatives — January 2008 and April 2008Debentures*

 

Asof June 30, 2010, the Company continues to conclude that the conversionfeatures embedded in the January 2008 and April 2008 Debentures meetthe criteria in ASC 815-10 to be accounted for as an equity instrument.

 

Asof June 30, 2010, the Company concluded that the put and call featuresembedded in the January 2008 and April 2008 Debentures continue to benot clearly and closely related to the debt host and therefore should bebifurcated from the debt host and recorded as a liability at their estimatedfair value. The Company determined the net fair value of the put and call as ofJune 30, 2010 to be $91 thousand and $158 thousand for theJanuary 2008 and April 2008 Debentures, respectively, with therelated credit of $2 thousand and $3 thousand, respectively, included in theCompany’s statement of operations in change in valuation of liability relatingto embedded derivatives and warrants for the six months ended June 30,2010. The Company determined the estimated fair value of the put on June 

 

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30,2010, using the Black-Scholes Merton valuation model and the followingassumptions: fair value and exercise price of the put embedded in theJanuary 2008 and April 2008 Debentures equivalent to 130% of theoutstanding principal and accrued interest of $3,016 thousand and $5,216thousand , respectively; term of 2.50 years to the maturity date ofDecember 31, 2012; risk free interest rate of 0.81%; and volatility of19.50% which was determined using the volatility of the Bank Prime LendingRate. The Company determined the estimated fair value of the call on June 30,2010, using the Black-Scholes Merton valuation model and the followingassumptions: fair value and exercise price of the call embedded in theJanuary 2008 and April 2008 Debentures equivalent to 100% of theoutstanding principal and accrued interest of $2,320 thousand and $4,012thousand , respectively; term of 2.50 years to the maturity date ofDecember 31, 2012; risk free interest rate of 0.81%; and volatility of19.50% which was determined using the volatility of the prime rate charged bybanks in the United States.

 

*Embedded Derivatives — 10% Senior Secured Debentures*

 

Uponthe issuance of the 10% Senior Secured Debentures on each of January 25,2010 and March 15, 2010, the Company concluded that the conversionfeatures embedded in the 10% Senior Secured Debentures met the criteria in ASC815-10 to be accounted for as an equity instrument even though the 10% SeniorSecured Debentures include a reset provision on the conversion price and isconsidered non-conventional debt, because the Company has control to ensure thesufficiency of its authorized shares of common stock, as the debentures includea floor on the conversion price adjustment, and because the conversion featuresare not required to be settled in registered shares.  The Company also concluded that the put andcall in the 10% Senior Secured Debentures were embedded derivatives that werenot clearly and closely related to the debt host and therefore should be bifurcatedfrom the debt host and recorded as a liability at their estimated fair value atissuance.

 

TheCompany determined the net fair value of the put and call embedded in the 10%Senior Secured Debentures on January 25, 2010, to be $5 thousand, andrecorded a discount on the debentures that will be amortized as interestexpense over the life of the debentures using the interest method.  The Company determined the estimated fairvalue of the put on January 25, 2010, using the Black-Scholes Mertonvaluation model and the following assumptions: fair value and exercise price ofthe put embedded in the 10% Senior Secured Debentures equivalent to 120% of theoutstanding principal and accrued interest expected to be earned to maturity of$342 thousand; term of 1.67 years to the maturity date of September 30,2011; risk free interest rate of 0.67%; and volatility of 17.66% which wasdetermined using the volatility of the prime rate charged by banks in theUnited States. The Company determined the estimated fair value of the call onJanuary 25, 2010, using the Black-Scholes Merton valuation model and thefollowing assumptions: fair value and exercise price of the call embedded inthe 10% Senior Secured Debentures equivalent to 100% of the outstandingprincipal and accrued interest expected to be earned to maturity of $291,750;term of 1.67 years to the maturity date of September 30, 2011; risk freeinterest rate of 0.67%; and volatility of 17.66% which was determined using thevolatility of the prime rate charged by banks in the United States

 

TheCompany determined the net fair value of the put and call embedded in the 10%Senior Secured Debentures on March 15, 2010 to be $2 thousand, andrecorded a discount on the debentures that will be amortized as interestexpense over the life of the debentures using the interest method.  The Company determined the estimated fairvalue of the put on March 15, 2010, using the Black-Scholes Mertonvaluation model and the following assumptions: fair value and exercise price ofthe put embedded in the 10% Senior Secured Debentures equivalent to 120% of theoutstanding principal and accrued interest expected to be earned to maturity of$169,250; term of 1.54 years to the maturity date of September 30, 2011;risk free interest rate of 0.60%; and volatility of 18.53% which was determinedusing the volatility of the Bank Prime Lending Rate. The Company determined theestimated fair value of the call on March 15, 2010, using theBlack-Scholes Merton valuation model and the following assumptions: fair valueand exercise price of the call embedded in the 10% Senior Secured Debenturesequivalent to 100% of the outstanding principal and accrued interest expectedto be earned to maturity of $144,250; term of 1.54 years to the maturity dateof September 30, 2011; risk free interest rate of 0.60%; and volatility of18.53% which was determined using the volatility of the Bank Prime LendingRate.

 

Asof June 30, 2010, the Company concluded that the put and call featuresembedded in all of the 10% Senior Secured Debentures continue to be not clearlyand closely related to the debt host and therefore should be bifurcated fromthe debt host and recorded as a liability at their estimated fair value. TheCompany determined the net fair value of the puts and calls to be $3 thousandfor all 10% Senior Secured Debentures, with the related credit of $64 thousandincluded in the Company’s statement of operations in change in valuation ofliability relating to embedded derivatives and warrants for the six months endedJune 30, 2010. The Company determined the estimated fair value of the putson June 30, 2010, using the Black-Scholes Merton valuation model and thefollowing assumptions: fair value and exercise price of the puts embedded inthe 10% Senior Secured Debentures equivalent to 120% of the outstandingprincipal and accrued interest of $4,265,000; term of 1.25 years to thematurity date of September 30, 2011; risk free interest rate of 0.39%; andvolatility of 0.00% which was determined using the volatility of the Bank PrimeLending Rate. The Company determined the estimated fair value of the calls on June 30,2010, using the Black-Scholes Merton valuation model and the followingassumptions: fair value and exercise price of the calls embedded in the 10%Senior Secured Debentures equivalent to 100% of the outstanding principal andaccrued interest of $3,590,000; term of 1.25 years to the maturity date ofSeptember 30, 2011; risk free interest rate of 0.39%; and volatility of0.00% which was determined using the volatility of the Bank Prime Lending Rate.

 

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*Warrants Issued in Connection with January 2008 andApril 2008 Debentures*

 

Inconnection with the issuance of the January 2008 and April 2008Debentures, the Company issued warrants to purchase 222,222 and 388,889 shares,respectively, of the Company’s common stock at an exercise price of $1.80 pershare, subject to adjustment, which warrants have a term of three years.

 

Asof June 30, 2010, these warrants remain outstanding and exercisable, andthe Company continues to conclude that these warrants meet the criteria in ASC815-10 to be accounted for as an equity instrument.

 

*Warrants Issued in Connection with 10% Senior SecuredDebentures*

 

Inconnection with the issuance of the 10%Senior Secured**Debenturesin September 2009, the Company issued Series I and Series IIwarrants to purchase 3,000,000 and 2,250,000 shares, respectively, of theCompany’s common stock at exercise prices of $0.60 and $0.01 per share,respectively, subject to adjustment, and with terms of five and seven years,respectively.

 

Inconnection with the issuance of the 10%Senior Secured**Debenturesin January 2010, the Company issued Series I warrants to purchase375,000 shares of the Company’s common stock at an exercise price of $0.60 pershare, subject to adjustment, and with a term date of September 30, 2014.

 

TheCompany evaluated the terms and conditions of the warrants issued with all ofthe 10% Senior Secured**Debentures under the guidance inASC 815-40-25 and ASC 815-40-15 to determine whether the detachable warrantsshould be accounted for as equity or a liability and thereafter adjusted totheir respective estimated fair value at each reporting date.  The Company concluded that the Series Iwarrants issued with the 10% SeniorSecured**Debentures in eachof September 2009 and March 2010 met the criteria in ASC 815-40-25and ASC 815-40-15 at issuance, and therefore, were accounted for as equitybecause the warrants could only be settled by issuance of the Company’s commonstock, the common stock could be unregistered, and the sufficiency of theauthorized shares was under the Company’s control. The Company determined thefair value of the Series I warrants issued in January 2010, to be$103 thousand and recorded a discount on the debentures which will be amortizedas interest expense over the life of such debentures using the interest method.

 

TheCompany determined the estimated fair value of the Series I warrantsissued in January 2010, using the Black-Scholes Merton valuation model andthe following assumptions: fair value of the Company’s common stock of $0.69;exercise price of $0.60; term of 4.67 years; risk free interest rate of 2.23%;and volatility of 37.02%.

 

Asof June 30, 2010, all of the warrants remain outstanding and exercisable,and the Company continues to conclude that such warrants meet the criteria inASC 815-10 to be accounted for as an equity instrument.

 

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

 

Inconnection with the issuance of promissory notes in February, March, andJuly 2009, the Company issued warrants to purchase 26,667, 133,333, and500,000 shares, respectively, of the Company’s common stock at an exerciseprice of $0.75 per share, which warrants have a term of three, three, and fiveyears, respectively.

 

Inconnection with the issuance of promissory notes in April and June 2010,the Company issued warrants to purchase 150,000 and 250,000 shares,respectively, of the Company’s common stock at exercise prices of $0.89 and$0.60 per share, respectively, with the terms of the warrants being five years.

 

TheCompany evaluated the terms and conditions of the warrants issued under theguidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrantsshould be accounted for as equity or a liability and thereafter adjusted totheir respective estimated fair value at each reporting date.  The Company concluded that the warrants metthe criteria in ASC 815-40-25 and ASC 815-40-15 at issuance, and therefore,were accounted for as equity because the warrants could only be settled byissuance of the Company’s common stock, the common stock could be unregistered,and the sufficiency of the authorized shares was under the Company’s control.The Company determined the fair value of the warrants issued in the six monthsended June 30, 2010 to be $192 thousand and recorded a discount on thepromissory notes which will be amortized as interest expense over the life ofsuch debentures using the interest method.

 

TheCompany determined the estimated fair value of the warrants issued with thepromissory notes in the six months ended June 30 2010, using theBlack-Scholes Merton valuation model and the following assumptions: weightedaverage fair value of the Company’s common stock of $0.88; weighted averageexercise price of $0.71; terms of 5 years; weighted average risk free interestrate of 2.10%; and weighted average volatility of 54.34%.

 

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Asof June 30, 2010, these warrants remain outstanding and exercisable, andthe Company continues to conclude that these warrants meet the criteria in ASC815-10 to be accounted for as an equity instrument.

 

*Warrantsissued with New Series A Preferred Stock*

 

Inconnection with the issuance of shares of New Series A Preferred Stock inDecember 2008 and January 2009, the Company issued warrants topurchase 833,333 and 10,000 shares of common stock of the Company,respectively, at an exercise price of $0.75 per share, and a three year term.The lead investor in this financing was Daniel J.A. Kolke, the Company’sfounder, chairman, chief executive officer, acting chief financial officer, andchief technology officer, with participation from two of the Company’sdirectors and other prior investors.

 

Duringthe quarter ended June 30, 2010, 300,000 warrants were exercised andconverted to common stock, in exchange for cash consideration of $225 thousand.

 

Asof June 30, 2010, 543,333 warrants remain outstanding and exercisable, andthe Company continues to conclude that these warrants meet the criteria in ASC815-10 to be accounted for as an equity instrument.

 

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*WarrantIssued in Connection with Litigation Settlement*

 

InDecember 2008, the Company entered into a settlement agreement withKaufman Bros., pursuant to which the Company issued to Kaufman Bros. a warrantto purchase 500,000 shares of the Company’s common stock at an exercise priceof $0.75 per share, which warrant has a term of five years.

 

Asof June 30, 2010, this warrant remains outstanding and exercisable, andthe Company continues to conclude that this warrant meets the criteria in ASC815-10 to be accounted for as an equity instrument.

 

*Warrant Issued in Connection with Consulting Agreements*

 

InMarch 2009, the Company entered into a consulting agreement with SalzwedelFinancial Communications, Inc., pursuant to which the Company issued awarrant to purchase 2,000,000 shares of the Company’s common stock at anexercise price of $0.01 per share, which warrant has a term of five years.

 

InJune 2010, the Company entered into a consulting agreement with ThirdCreek Advisors, LLC., pursuant to which the Company issued a warrant topurchase 25,000 shares of the Company’s common stock at an exercise price of$0.78 per share, which warrant has a term of five years.

 

TheCompany evaluated the terms and conditions of the consulting warrant issuedunder the guidance in ASC 815-40-25 and ASC 815-40-15 to determine whether thewarrant should be accounted for as equity or a liability and thereafteradjusted to its respective estimated fair value at each reporting date.  The Company concluded that the warrant metthe criteria in ASC 815-40-25 and ASC 815-40-15 at issuance, and therefore, wasaccounted for as equity because the warrant could only be settled by issuanceof the Company’s common stock, the common stock could be unregistered, and thesufficiency of the authorized shares was under the Company’s control. TheCompany determined the fair value of the consulting warrant issued in June 2010to be $9 thousand and recorded a consulting expense.

 

TheCompany determined the estimated fair value of the consulting warrant issued inJune 2010, using the Black-Scholes Merton valuation model and thefollowing assumptions: fair value of the Company’s common stock of $0.75;exercise price of $0.78; term of 5 years; risk free interest rate of 1.98%; andvolatility of 54.33%.

 

Asof June 30, 2010, these warrants remain outstanding and exercisable, andthe Company continues to conclude that these warrants meet the criteria in ASC815-10 to be accounted for as equity instruments.

 

*Warrants Issued in Connection with Financing Arrangements*

 

OnMarch 31, 2010, the board of directors authorized a warrant replacementfinancing, whereby holders of existing warrants that paid cash to exercisetheir warrants prior to April 30, 2010, would receive a new warrant insubstantially identical form as the exercised warrant, with an exercise priceequal to the closing price of the Company’s common stock on the date ofexercise.  The deadine for this financingsubsequently was extended to May 31, 2010. In the six months ended June 30, 2010, warrants to purchase 300,000shares of common stock were exercised, and in accordance with the arrangement,warrants to purchase 300,000 shares of common stock were issued.

 

TheCompany evaluated the terms and conditions of the warrants issued under theguidance in ASC 815-40-25 and ASC 815-40-15 to determine whether the warrantsshould be accounted for as equity or a liability and thereafter adjusted totheir respective estimated fair value at each reporting date.  The Company concluded that the warrants metthe criteria in ASC 815-40-25 and ASC 815-40-15 at issuance, and therefore,were accounted for as equity because the warrants could only be settled byissuance of the Company’s common stock, the common stock could be unregistered,and the sufficiency of the authorized shares was under the Company’s control.The Company determined the fair value of the warrants issued in the six monthsended June 30, 2010 to be $128 thousand and recorded a financing expense.

 

TheCompany determined the estimated fair value of the financing warrants issued inthe six months ended June 30 2010, using the Black-Scholes Mertonvaluation model and the following assumptions: weighted average fair value ofthe Company’s common stock of $1.16; weighted average exercise price of $1.16;term of 3 years; weighted average risk free interest rate of 1.50%; andweighted average volatility of 52.87%.

 

Asof June 30, 2010, all of the warrants remain outstanding and exercisable,and the Company continues to conclude that such warrants meet the criteria inASC 815-10 to be accounted for as an equity instrument.

 

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Thefollowing is a summary of the movement related to embedded derivativesliabilities during the six months ended June 30, 2010 (in thousands):

 
| ** **                                                                    | ** ** | **Embedded  derivatives** | ** ** |
|-------------------------------------------------------------------------------|------------|---------------------------|------------|
|                                                                          |       |                      |       |
| Balance as of  December 31, 2009                                         |       | $                         | 315        |   |
|                                                                          |       |                      |       |
| Fair value of embedded derivatives issued with 10%  Senior Secured Debentures |       | 7                         |       |
| Change in marked-to-market value of  January 2008 Debentures             |       | (2                        | )          |
| Change in marked-to-market value of  April 2008 Debentures               |       | (3                        | )          |
| Change in marked-to-market value of 10% Senior  Secured Debentures            |       | (64                       | )          |
|                                                                          |       |                      |       |
| Balance as of June 30, 2010                                              |       | $                         | 253        |   |

 

***7. Notes Payable to RelatedParties***

 

The Company previously entered into a series ofloan transactions with the parents and two brothers of Mr. Daniel J.A.Kolke, the Company’s founder, chairman, chief executive officer, acting chieffinancial officer, and chief technology officer.  In connection withsettlement of these loans, the Company issued three unsecured promissory notesin the aggregate principal amount of $815.8 thousand which will become securedby certain of the Company’s presently unidentified assets if and whenMr. Kolke is no longer neither an employee nor a member of the Company’s****board of directors. The unsecuredpromissory notes bear interest at 7.5 percent. On December 22, 2009, the board of directors, with Daniel J.A.Kolke abstaining, approved the issuance of 434,754 shares of common stock ofthe Company to Daniel and Selma Kolke, as payment of 45% of principal and 100%of accrued interest due on their note as of December 31, 2009, at a valueof $0.75 per share, or approximately $326 thousand.  The aggregate amount outstanding as of June 30,2010, under all of these promissory notes was $353 thousand.

 

In December 2009, the Company entered intoa promissory note with Daniel J.A. Kolke in the principal amount of $40thousand, bearing interest of 6% per annum. All principal on this note was paid in full in January 2010.

 

***8. Notes Payable***

 

In February 2010, the Company issued anunsecured note of $200 thousand in partial settlement of litigation related toreal property the Company leased in San Mateo, California.  The note bears interest of 6% and is due onJune 30, 2011. Accrued interest due on June 30, 2010, has been paidand monthly payments of principal of $16,667 along with accrued interest beginon July 31, 2010. The Company subsequently failed to make the intialmonthly payment in the amount of $16,667, due on July 31, 2010, under theterms of the note.

 

In April 2010, and in June 2010, theCompany entered into two secured promissory notes with Enable Growth Partners,LP, in the principal amounts of $150 thousand and $250 thousand respectively,each for a term of six months, with interest at 10% per annum.  In connection with each of the promissorynotes, the Company also issued five year warrants to purchase 150,000 and250,000 shares, respectively, of the Company’s common stock at an exerciseprice of $0.89 and $0.60 respectively. Enable Growth Partners, LP is an affiliate of Enable Capital Management,LLC, which entity and its affiliates beneficially owns more than 10% of theCompany’s common stock.

 

***9. Equity***

 

*CommonStock*

 

TheCompany has 24,987,242 shares of common stock outstanding as of June 30,2010, from a total of 250,000,000 authorized shares.

 

*PreferredStock*

 

The Company had 743,333 shares of NewSeries A Preferred Stock par value of $0.01 per share outstanding atDecember 31, 2009, from a total of 3,333,333 authorized shares. During thesix months ended June 30, 2010, 76,667 shares of New Series APreferred Stock were converted into common stock.

 

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Therights, preferences, and privileges of the New Series A Preferred stockare as follows:

 

*Voting Rights. *The NewSeries A Preferred Stock and common stock vote as a single class upon anymatter submitted to the stockholders for a vote and the holder of each share ofSeries A Preferred Stock has the right to one vote for each share ofcommon stock into which such share of Series A Preferred Stock could thenbe converted.

 

*Liquidation. *The NewSeries A Preferred Stock is entitled to a liquidation preference beforeany distribution or payment is made in respect to the common stock of 120% ofthe stated value.  All remaining assetsof the Company, if any, shall be distributed to the holders of common stock.

 

*Conversion. *Each share ofNew Series A Preferred Stock is convertible, at the option of the holder,into the number of fully paid and nonassessable shares of common stockdetermined by dividing the stated value of $0.75 per share by the thenapplicable conversion price, which is currently $0.75 per share.

 

*Warrants*

 

Asof June 30, 2010, warrants to purchase up to 10,664,444 shares of ourcommon stock were exercisable as set forth in the following table:

 
| **Issue Date** | ** ** | **# of Shares of  Common Stock  subject to  Warrants** | ** ** | **Exercise price** | ** ** | **Expiration date** | ** ** |
|---------------------|------------|------------------------------------------------------------------|------------|-------------------------|------------|--------------------------|------------|
|                |       |                                                             |       |                    |       |                     |       |
| Jan-08              |       | 222,222                                                          |       | $                       | 1.80       |                     | Jan-11     |   |
| Apr-08              |       | 388,889                                                          |       | $                       | 1.80       |                     | Apr-11     |   |
| Dec-08              |       | 533,333                                                          |       | $                       | 0.75       |                     | Dec-11     |   |
| Dec-08              |       | 500,000                                                          |       | $                       | 0.75       |                     | Dec-13     |   |
| Feb-09              |       | 36,667                                                           |       | $                       | 0.75       |                     | Feb-12     |   |
| Mar-09              |       | 2,000,000                                                        |       | $                       | 0.01       |                     | Mar-12     |   |
| Mar-09              |       | 133,333                                                          |       | $                       | 0.75       |                     | Mar-12     |   |
| Jul-09              |       | 500,000                                                          |       | $                       | 0.75       |                     | Jul-14     |   |
| Sep-09              |       | 3,375,000                                                        |       | $                       | 0.60       |                     | Sep-14     |   |
| Sep-09              |       | 2,250,000                                                        |       | $                       | 0.01       |                     | Sep-16     |   |
| Apr-10              |       | 150,000                                                          |       | $                       | 0.89       |                     | Apr-15     |   |
| Apr-10              |       | 66,667                                                           |       | $                       | 1.35       |                     | Apr-13     |   |
| Apr-10              |       | 100,000                                                          |       | $                       | 1.37       |                     | Apr-13     |   |
| May-10              |       | 24,000                                                           |       | $                       | 0.97       |                     | May-13     |   |
| May-10              |       | 109,333                                                          |       | $                       | 0.90       |                     | May-13     |   |
| Jun-10              |       | 25,000                                                           |       | $                       | 0.78       |                     | Jun-15     |   |
| Jun-10              |       | 250,000                                                          |       | $                       | 0.60       |                     | Jun-15     |   |
| Total               |       | 10,664,444                                                       |       |                    |       |                     |       |

 

TheCompany determined the estimated fair value of its warrants issued by using theBlack-Scholes Merton model. See discussion, *supra*, Note6.  The average exercise price ofoutstanding warrants to purchase the Company’s common stock is $0.48 at June 30,2010.

 

*Sharesreserved*

 

Asof June 30, 2010, the Company has the following shares of Common Stockreserved:

 
| Options Issued                |   | 9,085,553  |   |
|-------------------------------|--------|------------|--------|
| Option Plan Available         |   | 4,355,864  |   |
| Debenture Conversion(s)       |   | 13,592,695 |   |
| Debenture Interest Conversion |   | 260,158    |   |
| Warrants Issued               |   | 10,664,444 |   |
| Total                         |   | 37,958,714 |   |

 

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

 

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

 
| **Options**                           | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price  Per  Share** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|---------------------------------------|------------|------------|------------|--------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at December 31, 2009 |       | 9,547,998  |       | $                                                      | 0.32       |                                                | 8.9        |                            | $          | 4,175 |   |
| Granted                               |       | 100,000    |       | $                                                      | 0.75       |                                                |       |                            |       |   |
| Exercised                             |       | —     |       | $                                                      | —     |                                                |       |                            |       |   |
| Canceled                              |       | (562,445   | )          | $                                                      | 0.49       |                                                |       |                            |       |   |
| Outstanding at June 30, 2010     |       | 9,085,553  |       | $                                                      | 0.32       |                                                | 8.32       |                            | $          | 4,015 |   |
| Exercisable at June 30, 2010     |       | 4,404,810  |       | $                                                      | 0.19       |                                                | 7.71       |                            | $          | 2,499 |   |
| Unvested at June 30, 2010        |       | 4,680,743  |       | $                                                      | 0.43       |                                                | 8.90       |                            | $          | 1,516 |   |

 

Aggregateintrinsic value was determined based upon the closing price of the Company’scommon stock price on June 30, 2010, of $0.75 per share. The averageexercise price of outstanding employee stock options to purchase the Company’scommon stock is $0.32 at June 30, 2010.

 

Nooptions were exercised during the six months ended June 30, 2010. Therewere no equity instruments granted under share-based payment arrangements andtherefore there was no cash used to settle any equity instrument. The Companydoes not plan to repurchase any shares during the upcoming annual period.

 

***11. Restructuring***

 

On October 1, 2008, the Company relocatedits headquarters from San Mateo, California to Renton, Washington andterminated eight employees based in California. On October 31, 2008, the Company closed its offices in San Mateo,California and abandoned the leased premises of its former offices there.  Effective on October 31, 2008, DavidS.G. MacKenzie resigned his position as vice president and chief financialofficer and the Company has not yet appointed any person to serve separately asits chief financial officer.  OnOctober 31, 2008, the Company relocated its headquarters and abandoned thesubleased premises of its former offices in Renton, Washington.  In October 2008, the Company terminatedeight more employees employed in both its California and Washingtonoffices.  In connection with thisrestructuring plan, the Company has accrued or incurred one-time restructuringcosts in the amount of $632 thousand during the quarter and year endedDecember 31, 2008.  In 2009, theCompany revised these restructuring costs based on updated information fromsettlements entered into with the landlord of the San Mateo leased premises andthe Company’s former chief executive officer.

 

As part of its reduction of monthly cashoperating expenses during the quarter ended September 30, 2008, andcontinuing through the date of this report, the Company placed all employees onpartial deferrals of salary, ranging from 10% to 100% of base salary andaccrued these deferrals.  At June 30,2010, and as of the date of this report, a portion of this deferral amountremains unpaid, including amounts due to former employees who were employed inthe Company’s California office.

 

The following summarizes the Company’srestructuring charges:

 
| ** **                      | ** ** | **Office &  Equipment  Leases** | ** ** | **Employee  Termination  Costs** | ** ** | **Other** | ** ** | **Total** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|----------------------------------|------------|-----------|------------|-----------|------------|
|                            |       |                                     |       |                             |       |      |       |      |       |
| Balance: December 31, 2009 |       | $                                        | 633        |                             | $          | —    |       | $         | 73         |   | $ | 706 |   |
|                            |       |                                     |       |                             |       |      |       |      |       |
| Less: Payments                  |       | (391                                     | )          | —                           |       | —    |       | (391      | )          |
|                            |       |                                     |       |                             |       |      |       |      |       |
| Balance: June 30, 2010     |       | $                                        | 242        |                             | $          | —    |       | $         | 73         |   | $ | 315 |   |

 

Theabove restructuring cost liabilities as of June 30, 2010 are included inOther Accrued Expenses in the Company’s balance sheet.

 

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OnOctober 31, 2008, the Company closed its offices in San Mateo, California.In December 2008, the landlord for these premises filed a complaintclaiming damages of $659 thousand and other amounts against the Company’spredecessor Etelos, Incorporated, a Washington corporation (“Etelos —WA”)in the Superior Court of San Mateo County, California (Case No. CIV479535). The parties went to mediation in January 2010 and subsequentlyentered into a settlement agreement, including a release of claims, in whichthe Company agreed: (a) to pay $66,000 in cash within 30 days, (b) toissue a promissory note in the principal amount of $200,000, which bears 6%interest, and is payable in 12 monthly payments beginning in July 2010,and (c) to issue shares of common stock of the Company equal to $125,000in value, based upon the closing price of the common stock on January 6,2010.  The settlement agreement andpromissory note were executed and delivered on February 8, 2010, and166,667 shares subsequently were delivered on March 1, 2010.  The $66,666 payment was made on April 6,2010. The Company subsequently failed to make the intial monthly payment in theamount of $16,667, due on July 31, 2010,under the terms of the promissory note delivered as part of the settlementagreement. The promissory note is in default but the holder of the note hastaken no action to enforce any of its remedies for default under the promissorynote.

 

***12. Commitments and Contingencies***

 

**FinancingObligations**

 

Thefollowing is a summary of the maturity schedule of our convertible notes anddebentures obligations as of June 30, 2010:

 
| **Year  ended June 30,** | ** ** | **Convertible  Notes and  Debentures** | ** ** | **Notes  Payable** | ** ** | **Total** | ** ** |
|-------------------------------|------------|----------------------------------------|------------|--------------------|------------|-----------|------------|
| 2010                          |       | $                                      | 1,614      |               | $          | 753       |       | $ | 2,367 |   |
| 2011                          |       | 3,375                                  |       | —             |       | 3,375     |       |
| 2012                          |       | 6,332                                  |       | —             |       | 6,332     |       |
| 2013                          |       | —                                 |       | —             |       | —    |       |
| 2014 and thereafter           |       | —                                 |       | 286                |       | 286       |       |
| Total                         |       | $                                      | 11,321     |               | $          | 1,039     |       | $ | 12,360 |   |

 

**Operatingand Capital Leases**

 

All capital leases were paid off in full duringthe year ended December 31, 2009.

 

**OtherCommitments**

 

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

 

Inpartial settlement of approximately $273 thousand of an aggregate $688 thousandin unpaid salaries due and owing to current employees of the Company as ofDecember 31, 2009, the board of directors authorized on March 31,2010, the registration of 500,000 shares of common stock previously reservedunder the Company’s 2009 Equity Incentive Plan as partial payment of up to 50%of the amount of unpaid salary due and owing to each current employee. Of those500,000 shares, 346,123 were issued at an effective price of $0.79 per share,under the registration statement filed on April 9, 2010.

 

**Contingencies**

 

On October 31, 2008, the Company relocatedit Washington offices and abandoned the sub-leased premises of its formeroffices in Renton, Washington. The sublease for these premises ran throughJune 2010.  On March 5, 2010,the prime landlord filed a complaint for breach of contract and successorliability. (King County (WA) Superior Court No. 10-2-09385-1 KNT). OnMarch 26, 2010, the Company filed an answer and counterclaim and assertedaffirmative defenses against the prime landlord, including that the primelandlord is not a party to the sublease for the premises.  Subsequently, on April 8, 2010, thesub-landlord served a third party complaint against the Company relating to thesame subleased premises, in a proceeding filed against the sub-landlord by theprime landlord (King County (WA) Superior Court No. 10-2-09840-2 KNT), inwhich the sub-landlord asserted affirmative defenses and counterclaims againstthe prime landlord, including that, beginning in December 2008, thepremises were unusable due to water damage and lack of maintenance or repairsby the prime landlord. No further procedural or substantive steps have beentaken by any of the various parties.  TheCompany has accrued the rent expense according to the terms of the sublease asrestructuring charges since 2008 and the liability balance remains unpaid andaccrued as of June 30, 2010.

 

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OnApril 5, 2010, the Company was served with a summons and complaint forbreach of contract and unjust enrichment by Lakebay Technologies LLC  (King County (WA) Superior CourtNo. 10-2-10054-7). The Company moved to compel arbitration in accordancewith a written agreement and that motion was granted on July 26, 2010; nofurther procedural or substantive steps have been taken by either party. Asthis matter is still in its early stages, management cannot estimate or projectits outcome.

 

OnJune 11, 2010, the Company received a written demand from Northwest Nexus, Inc.dba Network OS under the provisions of an agreement dated effective March 15,2009.  The Company subsequently wasserved with a summons and complaint (King County (WA) Superior CourtNo. 10-2-24420-4 KNT) on July 14, 2010.  The Company subsequently filed an answer andmultiple counterclaims in this matter and no further procedural or substantivesteps have been taken by either party. As this matter is still in its early stages,management cannot estimate or project its outcome.

 

***13. Subsequent Events***

 

TheCompany failed to make the intial monthly payment in the amount of $16,666.67,due on July 31, 2010, under the terms of the promissory note delivered aspart of the settlement agreement with the former landlord of its offices in SanMateo, California. The promissory note is in default but the holder of the notehas taken no action to enforce any of its remedies for default under thepromissory note.

 

TheCompany failed to make the required interest payments on the 10% Senior SecuredDebentures on July 1, 2010, and through the date of this report.  In exchange for the holders of the 10% SeniorSecured Debentures agreeing to waive their remedies in the event of thisdefault, the Company’s board of directors, in April 2010, authorized theCompany to issue shares of common stock to the holders of the 10% SeniorSecured Debentures in consideration of their agreement to waive the default. Under the terms of that agreement, the Company continues to accrueinterest at the stated interest rate, which interest will be payable atmaturity, and to classify the 10% Senior Secured Debentures as long-termliabilities in the Company’s financial statements. The Company will issue140,628 shares in satisfaction of the waiver of the interest payment not madeon July 1, 2010 in accordance with this agreement.

 

In August 2010, the Company entered into asecured promissory notes with Enable Growth Partners, LP, in the principalamount of $50 thousand, for a term of six months, with interest at 10% perannum.  In connection with the promissorynotes the Company also issued five year warrants to purchase 50,000 shares ofthe Company’s common stock at an exercise price of $0.64. Enable GrowthPartners, LP is an affiliate of Enable Capital Management, LLC, which entityand its affiliates beneficially owns more than 10% of the Company’s commonstock.

 

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**Item2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

 

**Overview**

 

The following discussion of our financialcondition and results of operations should be read in conjunction with ourcondensed financial statements and the related notes and other financialinformation appearing elsewhere in this report. Readers are also urged tocarefully review and consider the various disclosures we make regarding thefactors that affect our business, including without limitation, the disclosuresmade under “Item 1A. Risk Factors” included in Part II of this report.

 

***Business***

 

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

 

We have developed products for WebApplications, which include open standards-based tools for Web developers,businesses and individual users such as the Etelos Application ServerTM (EASTM) and the Etelos Development EnvironmentTM (EDETM).  EAS and EDE support manycommon programming languages and also support our English Application ScriptingEngine (EASETM), an open standards-based scriptinglanguage we developed.  In order tosupport broader adoption of our products, EASE and other components of the EDEare made available to developers at market appropriate pricing.  This is done to support the development ofnew Web Applications and the migration of existing Web Applications into theEtelos ecosystem where there are tools and other support mechanisms for themarketing, distribution, and support of these applications.

 

Our business model focuses on both thedevelopment and operation of private-label Web Application marketplaces and thedevelopment and operation of enterprise implementations of the Etelos PlatformSuite, including provision of the professional services required to develop,deploy and operate such marketplaces or implementations.   Private label marketplaces based on theEtelos Platform Suite are designed to allow ISVs to implement a SaaSdelivery version of their existing applications, whether or not thoseapplications are already Web Applications, and to syndicate the offering ofthose applications on a SaaS basis through multiple private labelmarketplaces.  In these difficulteconomic times, the Company believes that a variety of ISVs have applicationsthat they want to move to the Web for lower cost implementation, easier,simpler scalability and broader distribution.  The Etelos PlatformSuite also enables Marketplace Partners, including non-technologybusinesses, to have their own private label marketplaces and tools to offer WebApplications to better serve their customers in multiple distributionchannels.  Finally, we have recentlybegun to develop and deliver enterprise implementations of the Etelos Platform Suite tofacilitate Web-based distribution of a wide variety of Web Applications andother software and IT products through multiple channels.

 

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Although we have long enabled applications tobe distributed via the Web, we believe that our shift away from a directmarketing focus to providing professional services and tools to ISVs and otherswill have four major benefits for our business. These benefits are as follows:

 

·                  This strategy will expose the core Etelos platform to more ISVs forgreater benefit to their end users and the creation of a larger pool ofapplications for syndication.

·                  The development and operation of third party-branded marketplacesshifts the financial expense and operational burdens of sales and marketing toend users to Marketplace Partners that better know their customers and arebetter capitalized to support necessary sales and marketing activities.

·                  This two-pronged go-to-market strategy for private label Webapplication marketplaces is offered on a revenue-sharing basis, which reducesbarriers to acceptance by eliminating up front costs for Syndication Partnersto offer their products through multiple Marketplace Partners, and by payingMarketplace Partners only for sales success.

·                  This approach allows us to focus on our core competency in developmentand operation of online marketplaces, while better managing limited financialand other resources.

 

In addition to revenues from consultingservices, we receive a transaction fee or subscription fee for transactionsthat occur within the private-label Web application marketplaces.  Most customers in these marketplaces pay asubscription fee, which we share with Syndication Partners and MarketplacePartners; this revenue share is calculated as a percentage of gross revenuesfrom the sale of subscriptions to Syndication Partner offerings inprivate-label Web application marketplaces operating on the Etelos PlatformSuite.

 

Our enterprise implementations of the EtelosPlatform Suite for Web-based distribution of a wide variety of IT productsthrough multiple channels are offered on a more traditional model of paymentsfor licensing, ongoing support, and consulting services.

 

***History***

 

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

 

On February 8, 2007, Tripath TechnologyInc., a Delaware corporation filed a voluntary petition for relief under Chapter11 of the Bankruptcy Code. On February 1, 2008, the bankruptcy courtissued an order confirming approval of Tripath’s plan of reorganization,including the merger and the transfer of all of Tripath’s existing assets intoa separate bankruptcy estate and the discharge of all of Tripath’sliabilities.  The plan of reorganizationalso contemplated the merger of Etelos, Incorporated with and intoTripath.

 

On April 22, 2008, we completed the mergerwith and into Tripath, changed the name of the surviving entity toEtelos, Inc., and changed our fiscal year end to December 31.

 

***Recent Developments***

 

***Financings***

 

On June 30, 2009, we restructured theconvertible 6% secured debentures we issued in January 2008 andApril 2008 in the principal amount of $5.5 million. Under the terms of therestructuring, the terms of the debentures were extended to December 31,2012, interest accrues at 0% from the date of the restructuring untilOctober 1, 2010, and at 6% thereafter. All accrued but unpaid interest as ofJune 30, 2009, and interest due to be earned to September 30, 2010under the original terms of the debentures was added to the principal amountand is payable on the date of maturity. Our obligation to make monthly amortizing redemption payments wasterminated; we will make semi-annual interest payments only. We also agreed toterminate the registration rights agreement entered into with the debenturesand to to exchange for no cash consideration, all or a portion of the warrantsissued in connection with these debentures for shares of our Common Stock, at aratio of one share of common stock for each share of common stock underlyingsuch warrant being exchanged.

 

On September 29, 2009, we entered into asecurities purchase agreement with three accredited investors for the sale of10% senior secured convertible debentures in the aggregate principal amount of$2.0 million. In this transaction, in addition to the debentures, weissued to the investors warrants to purchase 3,000,000 shares of ourcommon stock with an exercise price of $0.60 per share, a warrant to purchase2,250,000 shares of our common stock with an exercise price of $0.01 per share,and 750,000 shares of our restricted common stock. One of the investorspaid part of its subscription amount through the cancellation of approximately$1.2 million of short-term indebtedness we owed to such investor.  The securities purchase agreement furtherprovided that we had the right, subject to certain conditions, to require theinvestors to purchase an aggregate of $1.0 million in additional principalamount of debentures.  We exercised thatright on December 15, 2009, and issued an additional $1.0 million ofdebentures to the investors on that date.

 

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OnJanuary 25, 2010, we entered into a securities purchase agreement with anentity affiliated with Donald W. Morissette, who, together with his affiliates,beneficially owns more than 10% of our outstanding common stock, for the saleof a 10% senior secured convertible debenture, identical to the debentures weissued in September 2009, in the principal amount of $250 thousand.

 

Inthis transaction, in addition to the debentures, we issued a warrant topurchase 375,000 shares of our common stock with an exercise price of $0.60 pershare and 375,000 shares of our restricted common stock. The securitiespurchase agreement further provided that we had the right, subject to certain conditions,to require the investor to purchase an additional debenture in the principalamount of $125 thousand between March 15 and 31, 2010. We exercised thatright on March 15, 2010, and issued an additional debenture in theprincipal amount of $125 thousand to an entity affiliated withMr. Morissette.  See “MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS —Liquidity and Capital Resources” below for a description of the terms of all ofour outstanding debentures.

 

OnMarch 31, 2010, our board of directors authorized a warrant replacementfinancing, whereby holders of existing warrants that paid cash to exercisetheir warrants prior to April 30, 2010, would receive a new warrant insubstantially identical form as the exercised warrant, with an exercise priceequal to the closing price of our common stock on the date of exercise.  The deadine for this financing subsequentlywas extended to May 31, 2010.  Inthe six months ended June 30, 2010, warrants to purchase 300,000 shares ofcommon stock were exercised, resulting in our receipt of proceeds in the amountof $225 thousand, prior to May 31, 2010.

 

In April 2010, and in June 2010, weentered into two secured promissory notes with Enable Growth Partners, LP, inthe principal amounts of $150 thousand and $250 thousand respectively, each fora term of six months, with interest at 10% per annum.  In connection with each of the promissorynotes, we also issued five year warrants to purchase 150,000 and 250,000shares, respectively, of the Company’s common stock at an exercise price of$0.89 and $0.60 respectively.  EnableGrowth Partners, LP is an affiliate of Enable Capital Management, LLC, whichentity and its affiliates beneficially owns more than 10% of our common stock.

 

Wefailed to make the required interest payments on the 10% Senior SecuredDebentures during the six months ended June 30, 2010, and through the dateof this report.  In exchange for theholders of the 10% Senior Secured Debentures agreeing to waive their remediesin the event of this default, our board of directors, in April 2010,authorized us to issue 124,642 shares of common stock to the holders of the 10%Senior Secured Debentures in consideration of their agreement to waive thedefault, for the interest due by the quarter ending March 31, 2010. Under the terms of that agreement, covering all periods throughJuly 1, 2010, we continue to accrue interest at the stated interest rate,which interest will be payable at maturity, and to classify the 10% SeniorSecured Debentures as long-term liabilities in our financial statements. Wewill issue an additional 140,628 shares in satisfaction of the waiver of theinterest payment not made on July 1, 2010, in accordance with thisagreement.

 

***Business***

 

In late 2008, we announced changes to ourbusiness model to focus on the sales and operation of private label Webapplication marketplaces, including provision of the professional servicesrequired to develop, deploy and operate such marketplaces, and the launch of offeringsof the Etelos Platform SuiteTM.  That change in ourbusiness model has been further expanded to include enterprise implementationsof the Etelos Platform Suite to facilitate Web-based distribution of awide variety of Web Applications and other software and IT products throughmultiple channels.

 

The Etelos Platform Suite focuses onenabling Independent Software Vendors (ISVs) to implement SaaS delivery oftheir existing applications, whether or not those applications are already WebApplications, and syndicating the offering of those applications throughmultiple private label marketplaces. In these difficult economic times, webelieve that a variety of ISVs will have applications that they need to move tothe Web for lower cost implementation, easier, simpler scalability, and broaderdistribution.  The Etelos Platform Suite also enables MarketplacePartners, including non-technology businesses, to have their own private labelmarketplaces and tools to offer SaaS Web Applications to better serve their customersin multiple distribution channels.

 

Although we have long enabled applications tobe distributed via the Web, our shift away from a core direct marketing focusof offering multiple products through a single portal in the Etelos Marketplacewill have four major benefits for our business. First, this offering willexpose the core platform to more ISVs for greater benefit to their end usersand the creation of a larger pool of applications for syndication. Second, thedevelopment and operation of third party-branded marketplaces shifts thefinancial expense and operational burdens of sales and marketing to end usersto Marketplace Partners that better know their customers and are bettercapitalized to support necessary sales and marketing activities.  Third,because this two-pronged go-to-market strategy is offered on a revenue-sharingbasis, it fundamentally reduces barriers to acceptance by eliminating up frontcosts for Syndication Partners to offer their products through multipleMarketplace Partners, and by charging Marketplace Partners only for salessuccess.  Finally, this shift allows usto focus on our core competency in development and operation of onlinemarketplaces, while better managing limited financial and other resources.

 

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Our enterprise implementations of the EtelosPlatform Suite for Web-based distribution of a wide variety of IT productsthrough multiple channels are offered on a more traditional model of paymentsfor licensing, ongoing support, and consulting services.  This new approach continues our disciplinedfocus on our core competency in development and operation of implementationsbased upon our core technology and better management of limited financial andother resources.

 

We have launched multiple third party privatelabeled marketplaces,including marketplaces for third parties not traditionallyregarded as technology providers.  We expect to make further suchannouncements reflecting this shift during the coming months but we do not havean estimate or projection of how, or when, or if, the benefits, if any, of thisshift will be reflected in our operating results.

 

In the quarter ended December 31, 2009,and subsequently, we resolved a number of significant litigation items in amanner that we believe was generally favorable to the Company.  These matters asserted claims against theCompany in the aggregate amount of approximately $2.5 million, and were settledfor cash and note payments in the aggregate amount of approximately $400thousand, payable over the next 6-16 months, and the issuance of 346,667 sharesof common stock of the Company, valued at approximately $218 thousand.  In one of these matters, we repurchased andretired 2.4 million shares of our common stock - approximately 10% of theissued and outstanding shares for approximately $175 thousand.  See “LEGAL PROCEEDINGS” below.

 

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Inpartial settlement of approximately $273 thousand of an aggregate $688 thousandin unpaid salaries due and owing to current employees of the Company as ofDecember 31, 2009, the board of directors authorized the registration of500,000 shares of common stock previously reserved under the Company’s 2009Equity Incentive Plan as partial payment of up to 50% of the amount of unpaidsalary due and owing to each current employee. Of those 500,000 shares, 346,123 shares are to be issued at an effectiveprice of $0.79 per share, under the registration statement filed onApril 9, 2010.

 

***Industry Background***

 

The1990s saw the widespread adoption among large enterprises of packaged businessmanagement applications that automated a variety of departmental functions,such as accounting, finance, order and inventory management, human resources,sales, and customer support. These sophisticated applications required significantcash outlays for the initial purchase and for ongoing maintenance and support.In addition, these applications were internally managed and maintained byenterprise customers, requiring increasingly large staffs to support complexinformation technology infrastructures. Most importantly, the applicationsgenerally were provided by multiple vendors, with each application providingonly a departmental view of the enterprise. To gain an enterprise-wide view,organizations attempted to tie together their various incompatible packagedapplications through long, complex, and costly integration efforts. Many ofthese attempts failed, in whole or in part, often after significant delay andexpense. As a consequence, many large enterprises have transitioned frommultiple point products to comprehensive, integrated business managementsuites, such as those offered by Oracle and SAP, as their core businessmanagement platforms.

 

Small-to-Mediumsized Businesses (SMBs), which we define as businesses with up to 1,000employees, have application software requirements that are similar, in manyrespects, to large enterprises because their core business processes aresubstantially the same. These requirements include the integration ofback-office activities, such as managing payroll and tracking inventory;front-office activities, including order management and customer support; and,increasingly, sophisticated e-commerce capabilities. According to a 2006forecast for the CRM market and 2007 forecasts for the ERP and supply chainmanagement, or SCM, markets from Gartner, Inc., companies in North Americaspent approximately $13.7 billion on ERP, CRM, and SCM software applications in2006, of which SMBs accounted for $4.4 billion, or 32 percent. Gartner projectsthat SMB spending on these applications will grow 8.7 percent annually from2006 to 2010, compared to 5.7 percent for large businesses.

 

SMBsare generally less capable than large enterprises of performing the costly,complex, and time-consuming integration of multiple point products from one ormore vendors. As a result, a comprehensive business suite may providecomparatively greater benefits and value for the SMB customer. Suites designedfor, and broadly adopted by, large enterprises to provide a comprehensive, integratedplatform for managing these core business processes generally are not wellsuited to SMBs due to the complexity and cost of such applications.

 

Recently,SMBs have begun to benefit from the development of the on-demand SaaS model.SaaS uses the Internet to provide users with access to software applicationsfrom a centrally hosted computing facility through a web browser. SaaSeliminates the costs associated with installing and maintaining applicationswithin the customer’s information technology infrastructure. On-demandapplications are generally licensed for a monthly, quarterly or annualsubscription fee, as opposed to on-premise enterprise applications thattypically require the payment of a much larger, upfront license fee. As aresult, on-demand applications require substantially less initial and ongoinginvestment in software, hardware and implementation services and lower ongoingsupport and maintenance, making them more affordable for SMBs.

 

Todate, the on-demand software model has been applied to a variety of types ofbusiness software applications, including CRM, security, accounting, humanresources management, messaging, and others, and it has been broadly adopted bya wide variety of businesses. IDC estimates worldwide on-demand enterprisesoftware vendor revenues were approximately $3.7 billion in 2006 and that theywill grow 32 percent annually through 2011 to $14.8 billion.

 

WhileSaaS applications have enabled SMBs to benefit from enterprise-classcapabilities, most are still products that require extensive, costly, andtime-consuming integration to work with other applications. SMBs generally havebeen unable to implement a comprehensive set of business management products atan affordable level of cost that will enable them to run their businesses usinga single system of records, provide real-time views of their operations, and bereadily customizable and rapidly deployed and implemented, especially in ageographically dispersed organization.

 

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***EtelosTM Products and Services***

 

Wehave developed and offer a range of products and services for developers andfor consumers of Web Applications.  Ourproduct offerings are all based upon the Etelos Platform SuiteTM.

 

The Etelos Platform Suite allows thirdparties to use our software technology and our services to develop applicationsfor Web-based distribution and to operate private label marketplaces.  We began working with third parties onprivate label solutions in 2008 and our first customers launched their privatelabel marketplaces in 2009.  We recentlyhave expanded our offerings to include enterprise implementations of the EtelosPlatform Suite that facilitate Web-based distribution of a wide variety ofWeb Applications and other software and IT products through multiple channels.

 

There are four components to the EtelosPlatform Suite:

 

·                                          The Application Platform enables technology providers to migrate theirnon-Web application or service to Web-based SaaS distribution;

·                                          The Marketplace Platform enables third parties to offer a variety ofWeb Applications and services in a third party-private label marketplace;

·                                          The Distribution Platform allows technology companies and serviceproviders to distribute Web Applications and other software and IT products andrelated services to customers on a Web-based platform; and

·                                          The Syndication Platform lets SaaS providers distribute their WebApplications and services through a network of third party-private labelmarketplaces.

 

TheEtelos Platform Suite allows our ISV customers to use our tools andexperience in the SaaS market to move their existing applications to the Webfor lower cost implementation, easier, simpler scalability, and broaderdistribution.  The Etelos Platform Suite also enables MarketplacePartners, including non-technology businesses, to have their own private labelmarketplaces and tools that offer Web Applications, as well as other softwareand IT products and related services, to better serve their customers inmultiple distribution channels.

 

Wealso have developed repeatable, cost-effective consulting and implementationservices to assist our customers with the development and operation of privatelabel marketplaces, as well as customized implementations of the EtelosPlatform Suite.

 

Ourconsulting and implementation methodology leverages the nature of our on-demandWeb Application software architecture, the industry-specific expertise of ourprofessional services employees, and the design of private-label Webapplication marketplaces operating on the Etelos Platform Suite. Thesemethodologies are used to simplify, reduce costs and expedite implementation.Because our Web Applications are on-demand, our professional servicesconsultants can remotely configure many applications for most situations. Ourconsulting and implementation services are generally offered on a fixed price basis.

 

Ourtechnical support organization, with all personnel located in the UnitedStates, offers support via the Web 24 hours a day, seven days a week. Oursystem allows for skills-based and time zone-based routing to address generaland technical inquiries across all aspects of our services. For our directcustomers and development partners, we offer tiered customer support programsdepending upon the service needs of both our and their customers’ WebApplications. Support contracts typically have a one-year term. For customerswho purchase Web Applications through distribution partners, we attempt toassure a quality customer experience by providing primary product support.

 

***Etelos Benefits***

 

The advantages of our products and servicesare:

 

OpenStandards.  Products distributed in a private-labelmarketplace generally are developed on open standards.  This foundationmakes the products easy to develop, easy to adopt and integrate with other WebApplications, and easy to swap or modify to meet specific customer needs. The use of open standards for business applications distinguishes the productsin these marketplaces not only from comprehensive product suites from suchvendors of proprietary software as Microsoft, Oracle, and SAP, but also fromproducts offered by other SaaS vendors such as salesforce.com or NetSuite, thatrequire developers of Web Applications to adopt a high-cost proprietaryfoundation for their products, resulting in higher costs to both developers andtheir customers.

 

On-DemandDelivery Model. The Etelos Platform Suite enables delivery ofWeb Applications over the Internet as a license-based or subscription basedservice using a SaaS model, making end-user adoption easy and scalabilitysimple.  The SaaS delivery model also eliminates the need for end-usercustomers to buy and maintain on-premise hardware and software. Productsdistributed in private label marketplaces based on the Etelos Platform Suite aredesigned to be reliable, scalable and secure. The architecture of the Etelos PlatformSuite enables end user customers to maintain very high levels ofavailability, scale easily as their businesses grow while providing a safe andsecure environment for business-critical data and applications.

 

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LowTotal Cost of Ownership. The SaaS delivery model and each differentWeb Application’s ease of use and configurability aids in helping tosignificantly reduce implementation and maintenance costs of hardware, softwareand services. The Etelos Platform Suite  virtually eliminates the need fordedicated software development or information technology support personnel.End-user customers subscribe to products through a private label marketplacefor a monthly fee based on the number of users and the products theyselect.  Subscription fees paid to us periodically, typically monthly,tend to be significantly less than typical upfront costs paid by businesses topurchase product licenses from other providers. Our on-demand delivery modelvirtually eliminates ongoing maintenance and upgrade costs associated with atypical distributed infrastructure. Because Web Applications distributed in aMarketplace based on the Etelos Platform Suite are developed on openstandards and delivered over the Internet, any desired customization can behighly targeted, and therefore usually performed at lower cost to ISVs.

 

RapidImplementation. The Internet-based on-demand delivery modelimplemented by a Marketplace based on the Etelos Platform Suite enablesremote deployment and eliminates many of the steps and costs typicallyassociated with on-premise installations. ISV Syndication Partners and theirend-user customers can implement offerings themselves, or work with ourprofessional services organization to meet their specific needs.

 

Security,Control and Choice.  The combination of open standards andInternet-based on-demand delivery and support provides customers with securityfor their important business data, control over the use and portability of thatdata, and flexibility and freedom of choice in Web Applications that providebuilt-in quality and scalability as solutions to specific business needs.

 

Wegenerate sales through both indirect and direct approaches. Most selling ofsubscriptions for Web Applications and Hosting is done over the Internet. Sales of custom products and Professional Services tend to be direct. Ourdirect sales team consists of professionals in various locations in the UnitedStates, including resellers, with additional development, distribution, andbusiness relationships being pursued in North America, Europe, and theAsia-Pacific region.

 

Thesales cycle typically ranges from days to months, and can vary based on thescope of the proposed implementation, the scope of any customization desired,and the scope of any professional services required to meet specific customerrequirements.

 

Wetailor our marketing efforts around relevant application categories, customersizes, and customer industries. As part of our marketing strategy, we haveestablished a number of key programs and initiatives, including online andsearch engine advertising, email campaigns, web based seminars, product launchevents and marketing support from development and distribution partners.

 

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

 

Ourdiscussion and analysis of our financial condition and results of operations isbased on our financial statements.  Inpreparing our financial statements in conformity with accounting principlesgenerally accepted in the United States, we must make a variety of estimatesand assumptions that affect the reported amounts of assets and liabilities, thedisclosure of contingent assets and liabilities, and the reported amounts ofrevenues and expenses.  We have identifiedthe following accounting policies that we believe require application ofmanagement’s most subjective judgments, often requiring the need to makeestimates about the effect of matters that are inherently uncertain and maychange in subsequent periods.

 

***Allowance for Doubtful Accounts***

 

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

 

***Revenue Recognition***

 

Weprovide Web Applications as a subscription service using theSoftware-as-a-Service (SaaS) or software-on-demand business model and allowthird parties to offer their products and service through Storefronts in anEtelos Marketplace.  We also license oursoftware under perpetual and term licenses. Revenues are recognized on these service and licensing transactionsusing the criteria in ASC 605-10, “Revenue Recognition” (ASC 605-10) and ASC985-605, “Software Revenue Recognition”, (ASC 985-605) respectively, which bothprovide that revenue may be recognized when all of the following criteria aremet:

 

·                  Persuasive evidence of an arrangement exists,

·                  The product or service has been delivered,

·                  The fee is fixed or determinable, and

·                  Collection of the resulting receivable isreasonably assured or probable.

 

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Wemust first determine whether ASC 605-10 or ASC 985-605 applies to our revenuetransactions.  We than determine if thecriteria above have been met by assessing the ASC 605-10 and ASC 985-605 andtheir various interpretations in view of the agreements and other documentationrelated to the revenue transactions.  Theinterpretation of the agreements often requires considerable judgment as wellas determining what accounting literature is appropriate and how thatliterature should be applied.  If ourstandard agreements are used to establish evidence of the arrangement, then ourrevenue is generally recognized as follows:

 

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

 

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.

 

Wealso have entered into separate technical support agreements for regularsupport and maintenance of customer-specific implementations of the EtelosPlatform Suite.  These agreements coverspecified periods and the fee revenue from these agreements is recognized onlyin the current period.

 

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

 

***Internal Use Software***

 

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

 

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***Stock-Based Compensation Expense***

 

Underthe fair value recognition provisions of ASC 718-10, we recognize stock-basedcompensation expense net of an estimated forfeiture rate and therefore onlyrecognize compensation cost for those shares expected to vest over the serviceperiod of the award.  Calculatingstock-based compensation expense requires the input of highly subjectiveassumptions, including the expected term of the stock-based awards, stock pricevolatility, and the pre-vesting option forfeiture rate. We estimate theexpected life of options granted based on historical exercise patterns, whichwe believe are representative of future behavior. We estimate the volatility ofour common stock on the date of grant based on the historical volatility ofother publicly traded companies in our industry. The assumptions used incalculating the fair value of stock-based awards represent our best estimates,but these estimates involve inherent uncertainties and the application ofmanagement judgment. As a result, if factors change and we use differentassumptions, our stock-based compensation expense could be materially differentin the future. In addition, we are required to estimate the expected forfeiturerate, as well as the probability that performance conditions that affect thevesting of certain awards will be achieved, and only recognize expense forthose shares expected to vest. We estimate the forfeiture rate based onhistorical experience of our stock-based awards that are granted, exercised,and cancelled. If our actual forfeiture rate is materially different from ourestimate, the stock-based compensation expense could be significantly differentfrom what we have recorded in the current period. Beginning in the quarterended December 31, 2008, and continuing in the quarter ended June 30,2010, the global economy has been highly volatile and, during this period, theCompany found it necessary to take drastic measures to reduce operatingexpenses, but the likelihood of success of these efforts cannot bepredicted.  Therefore the forfeiture ratein the quarter ended December 31, 2008, was very high.  The forfeiture rate declined substantiallyduring the six months ended June 30, 2010, but it is not known whetherthis forfeiture rate will be maintained in the future; management will continueto monitor its estimates.

 

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

 

Weevaluate the embedded derivatives included in the debt instruments we issueunder the guidance in ASC 815-10 “Derivatives and Hedging” (ASC 815-10) on theissuance date of the debt and on each subsequent reporting date to determinewhether such embedded derivatives are clearly and closely related to the debthost.  The purpose of the evaluation is todetermine whether the embedded derivatives, which are not clearly and closelyrelated to the debt host, need to be bifurcated from the debt host andaccounted for as a derivative at their estimated fair value as a liability orasset at the date of issuance and thereafter, adjusted to estimated fair valuewith a charge or credit to our statement of operations. ASC 815-10 generallyindicates that if the conversion features are (i) indexed to the Company’scapital stock under the guidance in ASC 815-40-15 “Derivatives and Hedging —Contracts in Entity’s Own Equity — Scope and Scope Exceptions” (ASC 815-40-15)and (ii) would be classified as equity if a freestanding derivative underthe guidance in ASC 815-40-25 “Derivatives and Hedging — Contracts in Entity’sOwn Equity — Recognition” (ASC 815-40-25), then the embedded derivatives neednot be bifurcated from the debt host.  Wealso evaluate the warrants issued with the debt under ASC 815-40-25 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 our statement ofoperations. ASC 815-40-25 generally requires, among other factors, that(i) the Company can settle the derivative in cash or its own stock, at itsoption, (ii) settlement can be made in unregistered shares, and(iii) the Company has sufficient authorized shares to issue shares of itscommon stock for all equity instruments convertible to or which can beexercised for its capital stock. ASC 815-10 also provides guidance on when putand call features included in a debt host agreement are not clearly and closelyrelated to the debt host and must be bifurcated and recorded as liability.  The guidance in ASC 815-10 is complex and ithas many interpretations.  Accordingly,we must use judgment to apply and interpret this guidance as well as ensure wehave applied the correct guidance.

 

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

 

Our analysis and judgment may vary from quarterto quarter and changes in estimates may result in significant increases ordecreases in expenses.  Moreover, becauseof the relative size of our operations and the number of stock options andderivative instruments we have issued, income and expenses associated withchanges in the value of outstanding derivative securities historically have hadan overshadowing impact on our financial results.  Consequently, our net income or loss for anyparticular period may not be indicative of the Company’s performance for thatperiod as a result of the application of such accounting rules, and thereforeshould not be relied upon by any person as an accurate depiction of the truefinancial condition of the Company.

 

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**Resultsof Operations**

 

***Three Months Ended June 30, 2010,Compared with Three Months Ended June 30, 2009***

 

***Revenues***

 

Revenueswere $89 thousand and $69 thousand for the three months ended June 30,2010 and 2009, respectively. Revenues increased by $20 thousand, or 29 percent,in the three months ended June 30, 2010, compared to the same period in2009.  This increase was due to our shiftin focus to enterprise implementations of the Etelos Platform Suite.

 

***Cost of Revenue***

 

Costof revenue includes our costs of hardware, software and other resources used indelivery of our products and services. Cost of revenue was $13 thousand and $80thousand for the three months ended June 30, 2010 and 2009, respectively.Cost of revenue for the three months ended June 30, 2010, decreased by $67thousand, or by 84 percent.  The decrease in cost of revenue was primarilyattributable to the decreased costs of hosting and Internet bandwidthassociated with the deployment of our products and services, due to the changesin our business model. Stated as a percentage of revenues, cost of revenue forthe three months ended June 30, 2010, was 15 percent and for thecorresponding period of 2009 was 116 percent.

 

***Operating Expenses***

 

*Research and Development*.  Research anddevelopment expenses include primarily employee and employee related expenses.Research and development expenses were $350 thousand and $395 thousand for thethree months ended June 30, 2010 and 2009, respectively. Stated as apercentage of revenues, research and development expenses for the correspondingperiods were 393 percent and 572 percent, respectively. Research anddevelopment expenses decreased by $45 thousand or by 11 percent, in the threemonths ended June 30, 2010, compared to the same period in 2009. This decrease was primarily due to decreased salary and benefits expensesbecause of reduction in the number of personnel engaged in research anddevelopment.

 

*Sales and Marketing Expenses*.  Sales and marketingexpenses include payroll, employee benefits, and other headcount-related costsassociated with sales and marketing personnel and travel, advertising,promotions, trade shows, seminars, and other programs. Sales and marketingexpenses were $220 thousand and $248 thousand for the three months ended June 30,2010 and 2009, respectively. The $28 thousand, or 11 percent, decrease in salesand marketing expenses was primarily due to decreased salary and benefitsexpenses because of reduction in the number of personnel engaged in sales andmarketing.  Stated as a percentage ofrevenues, sales and marketing expenses for the corresponding periods was 247percent and 359 percent, respectively.

 

*General and Administrative.*  General andadministrative expenses include payroll and related employee benefits, andother headcount-related costs associated with finance, facilities, legal andother administrative expenses. General and administrative expenses were $435thousand and $205 thousand for the three months ended June 30, 2010 and2009, respectively. The $230 thousand, or 112 percent, increase was due toincreased outside legal counsel expense in connection with both litigation andcompliance. Stated as a percentage of revenues, general and administrativeexpense for the corresponding periods was 489 percent and 297 percent, respectively.

 

***Interest Expense***

 

Interest expense was ($600)thousand for the three months ending  June 30,2010, compared to $1,614 thousand income for the comparable period of 2009, andconsists primarily of interest expense on convertible notes and debentures,amortization of discounts on convertible notes and debentures, and the changein mark-to-market valuation of derivative and warrant liabilities. The increaseof $2,214 thousand in interest expense from 2009 to 2010 primarily related tothe absence of major changes in valuation of embedded derivative and warrantliabilities because our stock price was more stable in 2010.

 

***Net Loss***

 

Ournet loss was $1.5 million for the three months ending June 30, 2010,compared to net gain of $2.9 million for the three months ending June 30,2010, a increase of $4.4 million.  The increased loss from 2009 to 2010was primarily due to the decrease in valuation income between the two periods.

 

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***Six Months Ended June 30, 2010,Compared with Six Months Ended June 30, 2009***

 

***Revenues***

 

Revenueswere $91 thousand and $126 thousand for the six months ended June 30, 2010and 2009, respectively. Revenues decreased by $35 thousand, or 28 percent, inthe six months ended June 30, 2010, compared to the same period in2009.  This decrease in the six monthsperiod was due to our earlier primary focus on the implementation oflonger-term projects without immediate cash flow.

 

***Cost of Revenue***

 

Costof revenue includes our costs of hardware, software and other resources used indelivery of our products and services. Cost of revenue was $22 thousand and$172 thousand for the six months ended June 30, 2010 and 2009,respectively. Cost of revenue for the six months ended June 30, 2010,decreased by $150 thousand, or by 87 percent.  The decrease in cost ofrevenue was attributable to the decreased costs of hosting and Internetbandwidth associated with the deployment of our products and services, due tothe changes in our business model. Stated as a percentage of revenues, cost ofrevenue for the six months ended June 30, 2010, was 24 percent and for thecorresponding period of 2009 was 137 percent.

 

***Operating Expenses***

 

*Research and Development*.  Research anddevelopment expenses include primarily employee and employee related expenses.Research and development expenses were $614 thousand and $650 thousand for thesix months ended June 30, 2010 and 2009, respectively. Stated as apercentage of revenues, research and development expenses for the correspondingperiods were 675 percent and 516 percent, respectively. Research anddevelopment expenses decreased by $36 thousand or by 6 percent, in the sixmonths ended June 30, 2010, compared to the same period in 2009. This decrease was primarily due to decreased salary and benefits expensesbecause of reduction in the number of personnel engaged in research anddevelopment.

 

*Sales and Marketing Expenses*.  Sales and marketingexpenses include payroll, employee benefits, and other headcount-related costsassociated with sales and marketing personnel and travel, advertising,promotions, trade shows, seminars, and other programs. Sales and marketingexpenses were $386 thousand and $408 thousand for the six months ended June 30,2010 and 2009, respectively. The $22 thousand, or 5 percent, decrease in salesand marketing expenses was primarily due to decreased salary and benefitsexpenses because of reduction in the number of personnel engaged in sales andmarketing.  Stated as a percentage ofrevenues, sales and marketing expenses for the corresponding periods was 424percent and 324 percent, respectively.

 

*General and Administrative.*  General andadministrative expenses include payroll and related employee benefits, andother headcount-related costs associated with finance, facilities, legal andother administrative expenses. General and administrative expenses were $801thousand and $1,940 thousand for the six months ended June 30, 2010 and2009, respectively. The $1,139 thousand, or 59 percent, decrease was primarilyattributable to a one time expense in the quarter ended March 31, 2009regarding a consulting agreement paid by the issuance of shares and warrantsvalued at approximately $1.5 million, offset by an increase of approximately$100 thousand due to the use of consultants and temporary personnel foraccounting, administrative and legal purposes. Stated as a percentage of revenues, general and administrative expensefor the corresponding periods was 880 percent and 1,540 percent, respectively.

 

***Interest Expense***

 

Interest expense was $1,016thousand for the six months ending  June 30,2010, compared to $480 thousand for the comparable period of 2009, and consistsprimarily of interest expense on convertible notes and debentures, amortizationof discounts on convertible notes and debentures, and the change inmark-to-market valuation of derivative and warrant liabilities. The increase of$536 thousand in interest expense from 2009 to 2010 primarily related to theamortization of notes discount and debt issuance costs related to therestructuring of the January 2008 and April 2008 Debentures in June 2009.

 

***Net Loss***

 

Ournet loss was $2.7 million for the six months ending June 30, 2010,compared to net loss of $3.5 million for the six months ending June 30,2010, a decrease of $0.8 million.  The decrease from 2009 to 2010 wasprimarily due to the $4.2 million change in the mark-to-market valuation ofderivative and warrant liabilities primarily due to the decrease in the Company’sstock price at March 31, 2009, from December 31, 2008, and a decreasein operating expenses of $898 thousand as noted above.

 

**Liquidityand Capital Resources**

 

OnJune 30, 2010, we had $40 thousand in cash and cash equivalents, netaccounts receivable of $98 thousand, and prepaid expenses and other currentassets and other receivables of $17 thousand. Our working capital deficit at June 30, 2010, was $5.4 million,compared to a deficit of $5.0 million at December 31, 2009. The increasein working capital deficit was due to payment obligations of structuredliabilities in addition to our recurring quarterly operating expenses.

 

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Netcash used by operating activities during the six months ended June 30,2010, was $1,341 thousand, compared to $665 thousand during the six monthsended June 30, 2009. The primary use of cash from operating activitiesduring the six months ended June 30, 2010, was related to payment ofexpenses relating to accounting and compliance.

 

Investingactivities did not provide any cash during the six months ended June 30,2010 and 2009.  June 30, 2010, we did nothave any commitments for capital expenditures.

 

Netcash provided by financing activities during the six months ended June 30,2010, was $936 thousand, primarily from the issuance of various promissorynotes and exercise of Warrants to purchase our common stock. See “ — RecentDevelopments” above.

 

Weneed immediate and substantial cash to continue our operations. Management hasprojected that the cash on hand will be sufficient to allow us to continue ouroperations only through late 2010. If cash reserves are not sufficient tosustain operations, then we plan to raise additional capital by selling sharesof 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 financing thereafter until we can achieveprofitability. We are considering alternatives to address our cash flowsituation that include: (1) raising capital through additional sale of ourcommon stock and/or debentures and (2) reducing cash operating expenses tolevels that are in line with current revenues. If we cannot obtain additional financing, then we may be forced to curtailour operations, 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.

 

***September 2007 Notes***

 

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

 

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

 

Asof the filing date of this report, none of the required principal payments havebeen made and we do not have, or expect to have, cash on hand to make thepayments in the near future; no interest payments have been made for interestaccrued since June 15, 2008.  We arein regular communication with the holders of the September 2007 notes andnone of the holders have demanded payment or exercised other remedies due toour non-payments, but no assurances can be given that the holders will notexercise their remedies in the future.

 

***January 2008 Debentures***

 

InJanuary 2008, we issued our January 2008 Debentures with an aggregateprincipal amount of $2.0 million. Under the terms of these debentures, we wereto begin making monthly redemption payments on September 1, 2008, throughthe maturity date of January 31, 2010.

 

On March 2, 2009, Enable Growth PartnersLP purchased the January 2008 Debentures then held by Hudson Bay Fund LTDand its affiliate; price terms were not disclosed.  As a result of this transaction, EnableGrowth Partners LP and its affiliates own all of the January 2008Debentures.

 

OnJune 30, 2009, we executed an agreement to restructure ourJanuary 2008 Debentures; see “April 2008 Debentures” below.

 

***April 2008 Debentures***

 

InApril 2008, we issued our April 2008 Debentures with an aggregateprincipal amount of $3.5 million. Under the terms of these debentures, we wereto begin making monthly redemption payments on November 1, 2008, throughthe maturity date of April 30, 2010.

 

On March 2, 2009, Enable Growth PartnersLP purchased the April 2008 Debentures then held by Hudson Bay OverseasFund LTD; price terms were not disclosed. As a result of this transaction, Enable Growth Partners LP owns all ofthe April 2008 Debentures.

 

OnJune 30, 2009, we executed an agreement to restructure ourJanuary 2008 and April 2008 Debentures, which have an aggregateprincipal amount of $5.5 million.  Underthe terms of the agreement, the terms of the debentures were extended toDecember 31, 2012, interest accrual will be at 0% from the date of theagreement until October 1, 2010, and all accrued interest as ofOctober 1, 2010, has been added to principal to be paid at maturity. Ourobligations to make monthly amortizing redemption payments has been terminated;we are required to make semi-annual interest payments only, beginningJanuary 1, 2011. The registration rights agreement entered 

 

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intoin connection with the debentures was terminated and we agreed to exchange, forno cash consideration, all or a portion of the warrants issued in connectionwith these debentures for shares of our Common Stock, at a ratio of one shareof common stock for each share of common stock underlying such warrant beingexchanged.

 

***10% Senior Secured Debentures***

 

See“ — Recent Developments” above.

 

***Operating and Capital Leases***

 

Alloperating and capital leases were paid off in full during the year endedDecember 31, 2009.

 

**OffBalance Sheet Arrangements**

 

Wedid not have any off-balance sheet arrangements as of the period ended June 30,2010.

 

**GoingConcern Issue**

 

Weremain dependent on outside sources of funding until our results of operationsprovide positive cash flows.  Ourindependent auditors issued a going concern explanatory paragraph in theirreport dated March 17, 2010. With our current level of funding,substantial doubt exists about our ability to continue as a going concern.

 

Duringthe quarter ended June 30, 2010, we have been unable to generate cashflows sufficient to support our operations and have been dependent onadditional debt raised from qualified investors and other financing activities.

 

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

 

Wehave supported current operations by raising additional operating cash throughbridge loans and the private sale of our convertible debentures and preferredstock.  This has provided us with thecash inflows to continue our business plan, but has not resulted in significantimprovement in our financial position. We are considering alternatives toaddress our cash flow situation that include raising capital through additionalsale of our common stock and/or debentures.

 

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

 

**Recent Accounting Pronouncements**

 

In January 2010, theFASB issued amended standards that require additional fair value disclosures(Update No. 2010-06). These amended standards require disclosures aboutinputs and valuation techniques used to measure fair value as well asdisclosures about significant transfers, beginning in the first quarter of2010. The Company adopted these amended standards on January 1, 2010, andthere was no impact to the financial statements upon adoption. Additionally,these amended standards require presentation of disaggregated activity withinthe reconciliation for fair value measurements using significant unobservableinputs (Level 3), beginning in the first quarter of 2011. The Company does notexpect these new standards to significantly impact the financial statements.

 

In February 2010, theFASB issued amended guidance (Update No. 2010-09) on subsequent events toalleviate potential conflicts between FASB guidance and SEC requirements. Underthis amended guidance, SEC filers are no longer required to disclose the datethrough which subsequent events have been evaluated in originally issued andrevised financial statements. This guidance was effective immediately and weadopted these new requirements for the period ended March 31, 2010. Theadoption of this guidance did not have a material impact on our financialstatements.

 

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In April 2010, the FASBissued amended guidance (Update No. 2010-05) on stock compensation toclarify that employee stock options that have exercise prices denominated inthe currency of any market in which a substantial portion of the entity’sequity securities trade should be classified as equity, assuming all othercriteria for equity classification are met. The amendments in the ASU do notcontain any disclosure requirements incremental to those required by ASC 718.The amendments are effective for fiscal years, and interim periods within thosefiscal years, beginning on or after December 15, 2010, and will be adoptedby recording a cumulative effect adjustment as of the beginning of the fiscalyear in which the amendments are initially applied. Early adoption ispermitted. The company expects to adopt this amended guidance on January 1,2011, and does not expect the amended guidance to significantly impact thefinancial statements.

 

In April 2010,Financial Accounting Standards Board issued updated guidance (Update No. 2010-17)related to Revenue Recognition—Milestone Method. The amendments in this Updateprovide guidance on the criteria that should be met for determining whether themilestone method of revenue recognition is appropriate. A vendor can recognizeconsideration that is contingent upon achievement of a milestone in itsentirety as revenue in the period in which the milestone is achieved only ifthe milestone meets all criteria to be considered substantive. The amendmentsin this Update are effective on a prospective basis for milestones achieved infiscal years, and interim periods within those years, beginning on or after June 15,2010. Early adoption is permitted. The Company does not believe that any suchguidance will have a material effect on the financial position or results ofoperation.

 

TheCompany has considered all other newly issued accounting guidance that isapplicable to its operations and the preparation of its condensed statements,including guidance that the Company have not yet adopted. The Company does notbelieve that any such guidance will have a material effect on its financialposition or results of operation.

 

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

 

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

 

**Item4.**    **CONTROLS AND PROCEDURES**

 

Disclosure controls and procedures are controlsand other procedures that are designed to ensure that the information requiredto be disclosed by a company in the reports that it files or submits under theSecurities and Exchange Act of 1934, or the “Exchange Act,” is recorded,processed, summarized and reported, within the time periods specified in therules and forms of the SEC. Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed in the reports that a company files or submits underthe Exchange Act is accumulated and communicated to the company’s management,including its principal executive officer and principal accounting officer, asappropriate to allow timely decisions regarding required disclosure.

 

We carried out an evaluation, under thesupervision and with the participation of our management, including our chiefexecutive officer and chief financial officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures as of June 30,2010, the end of the period covered by this report. Based on that evaluation,our chief executive officer and chief financial officer concluded that ourdisclosure controls and procedures were not effective at the reasonableassurance level as of June 30, 2010, because of certain materialweaknesses in our internal control over financial reporting.

 

Because of these weaknesses, we cannot providereasonable assurances that all information required to be disclosed in ourreports filed with the SEC will be accumulated and communicated to ourmanagement to allow for timely decisions regarding required disclosure. Please see the internal control over financial reporting discussion in ourForm 10-K that we filed with the SEC on April 29, 2009 for moreinformation regarding the weaknesses in our internal control over financialreporting.

 

Furthermore, due to the resignation of our vicepresident and chief financial officer, and the lack of a replacement atthis time, we are unable to assure that we have adequate and appropriatecontrols in place, or that the controls that we do have in place are beingmanaged appropriately.  We will attempt to engage additional appropriateprofessionals to evaluate and manage our controls as soon as financialresources permit, but there is no assurance when, or if, that will be possiblein the foreseeable future.

 

**Changes In Internal Controls OverFinancial Reporting.**

 

During 2009, we engaged outside consultantswith technical accounting knowledge and expertise to advise and ensure thepreparation of our financial statements in accordance with GAAP, withparticular emphasis on certain complex or non-routine transactions.  Nevertheless, our ability to remediate allweaknesses is substantially impaired by our limited financial resources.

 

During the six months ended June 30, 2010,in the process of reviewing our internal controls over financial accounting, wereassigned certain duties of personnel in order to more appropriately segregatecertain financial accounting functions.

 

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**Limitations On DisclosureControls And Procedures.**

 

Because of the inherent limitations in allcontrol systems, no evaluation of controls can provide absolute assurance thatall control issues and instances of fraud, if any, within our company have beendetected. The design of any system of controls is based in part upon acost-benefit analysis and certain assumptions about the likelihood of futureevents and any design may not succeed in achieving its stated goals under allpotential future conditions. While our management does not believe that ourcontrols will prevent all errors or all instances of fraud, our disclosurecontrols and procedures are designed to provide a reasonable assurance ofachieving their objectives.

 

**PART II**—**OTHER INFORMATION**

 

**Item1.    LEGAL PROCEEDINGS**.

 

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

 

OnDecember 31, 2009, we settled a judgment in the matter of Kaufman Bros.,L.P. v. Etelos, Inc. in the Supreme Court of the State of New York, NewYork County, in the approximate amount of $186,000, for $93,000 in cash,payable in 5 installments with the final installment due June 1, 2010, andthe issuance of 200,000 shares of restricted common stock. The last installmentpayment has not been made, as of the date of this report.  The settlement further permits Kaufman Bros.to sell up to 180,000 shares from July 1, 2010, through March 2011 torecover the remaining $93,373 of the settlement; the additional 20,000 sharesare designated for payment of attorneys’ fees in the event of a default in thenote payments.  After payment in full of the note payments, if there is nodefault giving rise to a claim for attorneys’ fees, those 20,000 shares will bereturned to the Company and cancelled. After Kaufman Bros. recovers the remaining $93,373 from the sale of someor all of the 180,000 shares, any remaining shares will be repurchased by theCompany for $0.01 and cancelled; after March 2011, any balance due on theremaining amount of the settlement will be discharged and any unsold shareswill be repurchased by the Company at $0.01 per share and cancelled.

 

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OnOctober 31, 2008, the Company closed its offices in San Mateo, California.In December 2008, the landlord for these premises filed a complaintclaiming damages of $659 thousand and other amounts against the Company’spredecessor Etelos, Incorporated, a Washington corporation (“Etelos —WA”)in the Superior Court of San Mateo County, California (Case No. CIV479535). The parties subsequently entered into a settlement agreement,including a release of claims, in which the Company agreed: (a) to pay$66,000 in cash within 30 days, (b) to issue a promissory note in theprincipal amount of $200,000, which bears 6% interest, and is payable in 12monthly payments beginning in July 2010, and (c) to issue shares ofcommon stock of the Company equal to $125,000 in value, based upon the closingprice of the common stock on January 6, 2010.  The settlement agreement and promissory notewere executed and delivered on February 8, 2010, and 166,667 sharessubsequently were delivered on March 1, 2010.  The $66,666 payment was made on April 6,2010.  However, the Company subsequentlyfailed to make the intial monthly payment in the amount of $16,667, due on July 31,2010, under the terms of the promissory note delivered as part of thesettlement agreement. The promissory note is in default but the holder of thenote has taken no action to enforce any of its remedies for default under thepromissory note.

 

On October 31, 2008, the Company relocatedits Washington offices and abandoned the sub-leased premises of its formeroffices in Renton, Washington. The sublease for these premises runs throughJune 2010.  On March 5, 2010,the prime landlord filed a complaint for breach of contract and successorliability. (King County (WA) Superior Court No. 10-2-09385-1 KNT). OnMarch 26, 2010, the Company filed an answer and counterclaim and assertedaffirmative defenses against the prime landlord, including that the prime landlordis not a party to the sublease for the premises.  Subsequently, on April 8, 2010, thesub-landlord served a third party complaint against the Company relating to thesame subleased premises, in a proceeding filed against the sub-landlord by theprime landlord (King County (WA) Superior Court No. 10-2- 09840-2 KNT), inwhich the sub-landlord asserted affirmative defenses and counterclaims againstthe prime landlord, including that, beginning in December 2008, thepremises were unusable due to water damage and lack of maintenance or repairsby the prime landlord.  No furtherprocedural or substantive steps have been taken by any of the various parties.

 

OnApril 5, 2010, the Company was served with a summons and complaint forbreach of contract and unjust enrichment by Lakebay Technologies LLC  (King County (WA) Superior CourtNo. 10-2-10054-7). The Company moved to compel arbitration in accordancewith a written agreement and that motion was granted on July 26, 2010; nofurther procedural or substantive steps have been taken by either party. Asthis matter is still in its early stages, management cannot estimate or projectits outcome.

 

OnJune 11, 2010, the Company received a written demand from Northwest Nexus, Inc.dba Network OS under the provisions of an agreement dated effective March 15,2009.  The Company subsequently wasserved with a summons and complaint (King County (WA) Superior CourtNo. 10-2-24420-4 KNT) on July 14, 2010.  The Company subsequently filed an Answer andmultiple counterclaims in this matter and no further procedural or substantivesteps have been taken by either party. As this matter is still in its earlystages, management cannot estimate or project its outcome.

 

Aspart of our reduction of monthly cash operating expenses during the quarterended December 31, 2008, and continuing after the end of the quarter, weplaced all employees in Washington and California on partial deferrals ofsalary, ranging from 10% to 100% of base salary. At the end of that quarter,until the filing date of this report, a major portion of this deferral amountand all related taxes remains unpaid, but accrued, including amounts due toemployees who subsequently were terminated.

 

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

 

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**Item 1A.   RISK FACTORS**.

 

Investment in our common stock involves a highdegree of risk. You should carefully consider the risks described belowtogether with all of the other information included in this report beforemaking an investment decision. If any of the following risks actually occur,our business, financial condition or results of operations could suffer. Inthat case, the market price of our common stock could decline, and you may loseall or part of your investment.

 

***Our current cash will fund ourbusiness as currently planned only through late 2010. We need additionalfunding or we will be forced to curtail or cease operations.***

 

We need immediate and substantial cash tocontinue our operations. Management has projected that cash on hand will besufficient only to allow us to continue our operations through late 2010.  We are presently engaged in activediscussions for additional investments by existing and prospective investorsbut we currently have no funding commitments. We have not made required payments under our outstanding debt securitiesand the holders of our outstanding debt securities have the right to demandpayment of the amounts currently due under such securities or exercise theirother remedies, such as foreclosing on our assets.  We also need to make payments and negotiatepayment plans for certain notes payable and other payables and there is a riskthat trade creditors will not accept deferred payment and may exercise otherremedies to collect balances due and owing. We therefore will need additionalfunding, either through equity or debt financings, or we will be forced tocurtail or cease operations or consider other strategic alternatives such asbankruptcy.

 

***We have a substantially reducedemployment force and have challenges meeting our operating demands.***

 

We have decreased our number of full-timeemployees from 46 at June 30, 2008, to 11 as of June 30, 2010.  All except the two lowest paid currentemployees are being paid less than full salary, ranging from 97% to 74% of netsalary, and there is no assurance that any of these personnel will be able tocontinue 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.

 

***We have a history of losses andare currently carrying a net loss.  Ifour business model is not successful, or if we are unable to generatesufficient revenue to offset our expenditures, then we may not becomeprofitable and you may lose your entire investment in our company.***

 

We have not been profitable on an annual orquarterly basis since our formation.  Weincurred net losses of $2.7 million and $3.5 million for the six months ended June 30,2010 and 2009, respectively, and have an accumulated deficit of $36.6 millionat December 31, 2009 and $39.3 million at June 30, 2010.  Although our revenue has slightly increasedand our costs of sales and expenses have decreased, our growth has beeninsignificant and future revenue growth may not be sustainable and we may notachieve sufficient revenue to achieve or maintain profitability.  We have incurred and may continue to incursignificant losses in the future, for a number of reasons including the otherrisks described in this report, and we may encounter unforeseen expenses,difficulties, complications, delays, and other unknown factors.  Accordingly we may not be able to achieve ormaintain profitability and we may continue to incur significant losses in theforeseeable future. These losses may require us to scale back our business,sell or license some or all of our technology or assets, or curtail or ceaseoperations.

 

***Our limited operatinghistory may not serve as an adequate basis to judge our future prospects andresults of operations.***

 

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

 

·                  maintainand improve our technology;

 

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

 

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

 

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

 

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

 

·                  maintainadequate control of our expenses;

 

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

 

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

 

If we are not successful in addressing any orall of these risks, then our business may be materially and adversely affected.

 

***We may encountersubstantial competition in our business and our failure to compete effectivelymay adversely affect our ability to generate revenue.***

 

We believe that existing and new competitorswill continue to improve the design and performance of their products and tointroduce new products with competitive price and performance characteristics.We expect that we will be required to continue to invest in product developmentand productivity improvements to compete effectively in our markets. Ourcompetitors could develop better technology or more efficient products orundertake more aggressive and costly marketing campaigns than ours, which mayadversely affect our marketing strategies and could have a material adverseeffect on our business, results of operations, and financial condition.

 

Our major competitors may be better able thanus to successfully endure downturns in our markets. In periods of reduceddemand for our products, we can either choose to maintain market share byreducing our subscription prices to meet competition or maintain subscriptionprices, which likely would result in sacrifice of our market share. Sales andoverall profitability would be reduced and sustained losses may continue ineither case. In addition, we cannot be assured that additional competitors willnot enter our existing markets, or that we will be able to compete successfullyagainst existing or new competition.

 

***The market for on-demandWeb Applications may develop more slowly than we expect.***

 

Our success will depend, to a large extent, onthe willingness of individuals and SMBs to accept on-demand services for WebApplications that they view as critical to their success. Many businesses haveinvested substantial effort and financial resources to integrate traditionalenterprise software into their businesses and may be reluctant or unwilling toswitch to a different application or to migrate these applications to on-demandWeb Applications.  Our marketplacepartners have experienced slower than expected takeup rates by their end-usercustomers for offerings through their private label marketplaces and revenuesfrom sales through these private label marketplaces have been insignificant.

 

Other factors that may affect market acceptanceof our Web Applications include our ability to:

 

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

 

·                  maintainhigh levels of customer satisfaction;

 

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

 

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

 

In addition, market acceptance of our WebApplications may be affected by:

 

·                  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.

 

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***Our inability to fund ourcapital to meet our expenditure requirements may adversely affect our growthand profitability.***

 

Our continued growth is dependent upon ourability to raise capital from outside sources. Our ability to obtain financingwill depend upon a number of factors, including our financial condition andresults of operations, the condition of the economy, and conditions in relevantfinancial markets.  If we are unable toobtain financing, as needed, on a timely basis and on acceptable terms, ourfinancial position, competitive position, growth, and profitability may beadversely affected.  The current state ofthe US and global economy raises substantial doubts, especially about ourability to raise the additional capital that we will need to sustain ourbusiness operations.

 

***Our customers areindividuals, small and medium-sized businesses, and divisions of largecompanies, which may increase our costs to reach, acquire and retain customers.***

 

We market and distribute our products andservices and other offerings in Etelos Marketplaces to individuals, SMBs, anddivisions of large companies. To grow our revenue quickly, we must add newcustomers, sell additional services to existing customers, and encourageexisting customers to renew their subscriptions. However, selling to andretaining individuals and SMBs can be more difficult than selling to andretaining large enterprises because SMB customers tend to be more pricesensitive and more difficult to reach with broad marketing campaigns.  In addition, individuals and SMBs have high churnrates in part because of the nature of their businesses and often lack thestaffing to benefit fully from our products. Further, individuals and SMBs often require higher sales, marketing, andsupport expenditures by vendors that sell to them per revenue dollar generatedfor those vendors.

 

***Many of our customers areprice sensitive, and if the prices that we or our Syndication Partners chargefor subscriptions to products or services offered in an Etelos Marketplace areunacceptable to our customers, then our operating results will be harmed.***

 

Many of our customers are price sensitive, andwe have limited experience with respect to determining the appropriate pricesfor our products or services. In addition, we have no control over pricescharged by our Syndication Partners for their products or services offered inan Etelos Marketplace. As the market for our products or services matures, oras new competitors introduce new products or services that compete with ours,we may be unable to renew agreements with existing customers or attract newcustomers at the same price or based on the same pricing model as previouslyused. As a result, it is possible that competitive dynamics in our market mayrequire us to change pricing models or reduce prices, which could harm ourrevenue, gross margin, and operating results.

 

***We may not be able toprevent others from unauthorized use of our patents and other intellectualproperty, which could harm our business and competitive position.***

 

Our success depends, in part, on our ability toprotect our proprietary technologies. We rely on a combination of patent,copyright, trademark, and trade secret laws, as well as confidentialityprocedures and contractual restrictions, to establish and protect ourintellectual property rights on a global basis, all of which provide onlylimited protection.

 

We own multiple filed United States and foreignpatent applications covering our technology and we expect to file more U.S. andforeign patent applications in the future. We have filed to protect most ofthose patents in many foreign countries. But the process of seeking patentprotection can be lengthy and expensive. We cannot assure you that any patent will issue from our currentlypending patent applications in a manner that gives us the protection that weseek, if at all, or that any future patents issued to us will not bechallenged, invalidated, or circumvented. Since the filing of some of thesepatent applications may have been, or will be, made after the date of firstsale or disclosure of the subject inventions, patent protection may not beavailable for these inventions outside the United States.  Any patents that may issue in the future maynot provide sufficiently broad protection or they may not prove to beenforceable in actions against alleged infringers. Also, we cannot assure youthat any future service mark or trademark registrations will be issued forpending or future applications or that any registered service marks ortrademarks will be enforceable or provide adequate protection of our domesticand foreign proprietary rights.

 

We do not analyze the software that wedistribute from our ISV Syndication Partners to determine the adequacy of theirintellectual property rights.  We havenot maintained operating controls or logs, or initiated or conducted any forensic,code history, ‘genealogy’ or other forms of audit, analysis, processes,training, or code review of software code incorporated into any Etelos productor in other products offered by our ISV Syndication Partners in any EtelosMarketplace. These products may include code subject to various forms of ‘opensource’, ‘copyleft’, or similar licenses that require as a condition ofmodification or distribution of software subject to such license(s) that(i) such software or other software combined or distributed with suchsoftware be disclosed or distributed in source code form, or (ii) suchsoftware or other software combined or distributed with such software, and anyrelated intellectual property, be licensed on a royalty-free basis, includingfor the purposes of making additional copies or derivative works of suchsoftware.  This may adversely affect ourability to patent certain inventions or to license or distribute certainproducts - whether by open source license or other form of license or right -and may result in liability to unknown parties for infringement of theirpatents or other intellectual property rights.

 

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***We require our SyndicationPartners to indemnify us for intellectual property claims but we cannot assurethat these agreements will be enforceable.***

 

We endeavor to enter into agreements with ouremployees and contractors and agreements with parties with whom we do businessto limit access to and disclosure of our proprietary information. The steps wehave taken, however, may not prevent unauthorized use or the reverseengineering of our technology. Moreover, others may independently develop technologiesthat are competitive to ours or infringe our intellectual property.

 

Enforcement of our intellectual property rightsalso depends on our successful legal actions against these infringers, butthese actions may not be successful, even when our rights have beeninfringed.  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 thirdparties that we infringe their intellectual property, whether successful ornot, could subject us to costly and time-consuming litigation or expensivelicenses.***

 

The software and technology industries arecharacterized by the existence of a large number of patents, copyrights,trademarks, and trade secrets and by frequent litigation based on allegationsof infringement or other violations of intellectual property rights. As we faceincreasing competition, the possibility of intellectual property rights claimsagainst us may grow; the costs of defending against such claims can be verylarge. Our technologies may not be able to withstand any third-party claims orrights against their use. Additionally, many of our partner and productagreements require us to indemnify our customers for certain third-partyintellectual property infringement claims, which could increase our costs as aresult of defending such claims and may require that we pay damages or purchaseexpensive licenses, if there were an adverse ruling related to any such claims.These types of claims could harm our relationships with our customers, maydeter future customers from subscribing to our services, or could expose us tolitigation for these claims. Even if we are not a party to any litigationbetween a customer and a third party, an adverse outcome in any such litigationcould make it more difficult for us to defend our intellectual property in anysubsequent litigation in which we are a named party.

 

Any intellectual property rights claim againstour customers, or us, with or without merit, could be time-consuming, expensiveto litigate or settle, and could divert management attention and financialresources. An adverse determination also could prevent us from offering ourproducts to our customers and may require that we procure or develop substituteservices that do not infringe.

 

For any intellectual property rights claimagainst us or against our Marketplace Partners or customers, we may havesubstantial direct and indirect costs. Direct costs can include a requirement to pay damages or stop usingtechnology found to be in violation of a third party’s rights. We may have topurchase a license for the technology, which may not be available on reasonableterms, if at all, may significantly increase our operating expenses, or mayrequire us to restrict our business activities in one or more respects. As aresult, we may also be required to develop alternative non-infringingtechnology, which could require significant effort and expense.  Substantial indirect costs also may beexpected in the form of diversion of development and management resources instrategic planning for legal, technology, and business defenses to such claims.

 

***We rely on our managementteam and need additional personnel to grow our business, and the loss of one ormore key employees or our inability to attract and retain qualified personnelcould harm our business.***

 

Our success and future growth depends to asignificant degree on the skills and continued services of our management team,especially Daniel J.A. Kolke, our interim Chief Executive Officer, Acting ChiefFinancial Officer, and Chairman of the Board. The loss of the services of anymember of our management team for any reason may have a material adverse effecton our business and prospects.  We do notmaintain key man insurance on any members of our management team, includingMr. Kolke. Subsequent to the termination of our former Chief ExecutiveOfficer, we significantly and materially reduced our management team and havenot hired replacements for the management team in the positions of VicePresident and Chief Financial Officer, Vice President — Marketing, VicePresident Corporate Development, and Vice President — Human Resources, as wellas several other Director-level positions, primarily in non-technical positionsthroughout the Company.  We did not fillthese positions in the period ending June 30, 2010, and we have not filledany of these positions to the date of this report.

 

Our future success also depends on our abilityto attract, retain and motivate highly skilled technical, managerial, sales,marketing and service and support personnel, including members of ourmanagement team. Competition for sales, marketing, and technology developmentpersonnel is particularly intense in the software and technology industries. Asa result, we may be unable to successfully attract or retain qualifiedpersonnel. Our inability to attract and retain the necessary personnel couldharm our business.

 

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***If we do not effectivelyexpand and train our sales force and our services and support teams, then wemay be unable to add new customers and retain existing customers.***

 

We plan to expand our sales force and ourservices and support teams to increase our customer base and revenue. Webelieve that there is significant competition for sales, service, and supportpersonnel with the skills and technical knowledge that we require. Our abilityto achieve significant revenue growth will depend, in 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 notgenerate a corresponding increase in revenue, then our business will be harmed.

 

***We do not have a dedicated salesteam and our revenues and operating results are substantially dependent onthird-party resellers.***

 

We do not have a dedicated sales team.  Our chief executive officer and otheremployees attempt to identify sales opportunities and, when such opportunitiesmaterialize, attempt to market and sell our products.  We are substantially dependent uponthird-party resellers to market and sell our products and to generate end-usercustomers.  We have one agreement inplace at this time with a third-party reseller to market and sell our products,and that reseller has several additional reseller agreements in place.  We have no control over the amount of timeand resources these third-party resellers dedicate to marketing and selling ourproducts.  The loss of any third-partyreseller may significantly reduce our revenues. There is no assurance that we can add additional resellers or replaceour current reseller with other resellers or an in-house sales team in theevent we lose our reseller or the reseller devotes inadequate time andresources to selling our products.  Tothe extent we distribute or license our products or services directly toend-user customers, we may be in competition with our resellers. In response tofuture direct sales strategies or for other business reasons, our resellers mayfrom time to time choose to resell our competitors’ products in addition to, orin place of, our products. Our revenues and financial condition may beadversely affected if our reseller stops marketing and selling our products orif the reseller is not able to generate end-user customers to purchase ourproducts.

 

***Our operating results may besubject to fluctuations that could increase the volatility of the price of ourCommon Stock.***

 

Our operating results may fluctuate in thefuture. As a result, we may fail to meet or exceed the expectations of researchanalysts or investors, which could cause our stock price to decline. Alsoperiod-to-period comparisons of our operating results may not be meaningful.You should not rely on the results of one quarter as an indication of futureperformance.

 

Fluctuations in our quarterly operating resultsmay be due to a number of factors, including the risks and uncertaintiesdiscussed elsewhere in this report. Fluctuations in our quarterly operatingresults could cause our stock price to decline rapidly, may lead analysts tochange their long-term model for valuing our common stock, could cause us toface short-term liquidity issues, may impact our ability to retain or attractkey personnel, or cause other unanticipated issues. If our quarterly operatingresults fall below the expectations of research analysts or investors, then theprice of our common stock could decline substantially.

 

***We use third-party datacenters to support our services. Any disruption of service at these facilitiescould interrupt or delay our ability to deliver our service to our customers.***

 

We host many of our services and serve asignificant number of our customers from third-party data center facilities. Wedo not control the operation of these facilities. These facilities may bevulnerable to damage or interruption from earthquakes, hurricanes, floods,fires, terrorist attacks, power losses, telecommunications failures, andsimilar events. These facilities also could be subject to break-ins, computerviruses, sabotage, intentional acts of vandalism and other misconduct. Theoccurrence of a natural disaster or an act of terrorism, a decision to closethe facilities without adequate notice, or other unanticipated problems couldresult in lengthy interruptions in our services.

 

Any errors, defects, disruptions, or otherperformance problems with our services could harm our reputation and may damageour customers’ businesses. Interruptions in our services might reduce ourrevenue, cause us to issue credits to customers, subject us to potentialliability, cause customers to terminate their subscriptions, and harm ourrenewal rates.

 

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***Any significantfluctuation in price of servers or related support may have a material adverseeffect on the cost of our products and services.***

 

The prices of servers and related support aresubject to market conditions and generally we do not, and do not expect to,have long-term contracts with our suppliers for those items. While these itemsare generally available and we have not experienced any shortage in the past,we cannot assure you that the necessary servers or support will continue to beavailable to us at prices currently in effect or acceptable to us. The pricesfor these items have varied significantly in the past and may varysignificantly in the future. Numerous factors, most of which are beyond ourcontrol, influence prices of servers and related support. These factors includegeneral economic conditions, industry capacity utilization, vendor backlogs anddelays and other uncertainties.

 

We may not be able to adjust our productprices, especially in the short-term, to recover cost increases in these items.Our future profitability may be adversely affected to the extent we are unableto pass on higher server and support related costs to our customers.

 

***We may become liable toour customers and lose customers if we have defects or disruptions in ourproducts and services or if we provide poor service.***

 

Because we deliver products as a servicethrough an Etelos Marketplace, errors or defects in the Web Applicationsunderlying the service, or a failure of our hosting infrastructure may make theservice unavailable to our customers. Because our customers use the products tomanage critical aspects of their business, any errors, defects, disruptions inservice, or other performance problems with the products, whether in connectionwith the day-to-day operation of the products, upgrades or otherwise, coulddamage our customers’ businesses. If we have any errors, defects, disruptionsin service, or other performance problems with the products, then customerscould elect not to renew their subscriptions or delay or withhold payment tous. As a result, we could lose future sales or customers may make warrantyclaims against us or our Syndication Partners, which could result in anincrease in our provision for doubtful accounts, an increase in collectioncycles for accounts receivable, or costly litigation.

 

***Material defects or errors in thesoftware we use to deliver our products and services and the offerings by ourMarketplace and Syndication Partners could harm our reputation, result insignificant costs to us, and impair our ability to distribute our services.***

 

The Web Applications offered in an EtelosMarketplace are inherently complex and may contain material defects or errors,particularly when first introduced or when new versions or enhancements arereleased. We have, from time to time, found defects in our products andservices, and new errors in our existing software and services may be detectedin the future. We have no actual knowledge, but we reasonably expect that theproducts and services offered by our Syndication Partners may have similarerrors and/or defects. Any errors or defects that cause interruptions to theavailability of our services and the services for our Marketplace Partnerscould result in:

 

·                  a reduction in sales or delay in market acceptance of services from usor our Marketplace Partners;

·                  sales credits or refunds to our customers and customers of ourMarketplace Partners;

·                  loss of existing customers and difficulty in attracting new customers;

·                  diversion of development resources;

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

·                  increased warranty and insurance costs.

 

After the release of our services, defects orerrors may also be identified from time to time by our internal team, ourMarketplace and Syndication Partners, and by our customers. The costs incurredin correcting any material defects or errors in such products or services maybe substantial and could harm our operating results.

 

***If our security measuresare breached and unauthorized access is obtained to a customer’s data, then wemay incur significant liabilities, our service may be perceived as not beingsecure, and customers may curtail or stop using our products.***

 

The products and services we offer in an EtelosMarketplace involve the storage of large amounts of our customers’ sensitiveand proprietary business information. If our security measures are breached asa result of third-party action, employee error, malfeasance, or otherwise, andsomeone obtains unauthorized access to our customers’ data, then we could incursignificant liability to our Syndication and Marketplace Partners, ourcustomers, and to individuals or businesses whose information was being storedby our customers, our business may suffer and our reputation may be damaged.Because techniques used to obtain unauthorized access to, or to sabotage,systems change frequently and generally are not recognized until launchedagainst a target, we may be unable to anticipate these techniques or toimplement adequate preventive measures. If an actual or perceived breach of oursecurity occurs, then the market perception of the effectiveness of oursecurity measures could be harmed and we could lose sales and customers.

 

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***If we are unable todevelop new products or services, distribute our products or services into newmarkets, or add Syndication Partners to offer their products or services fordistribution in an Etelos Marketplace, then our revenue growth will be harmedand we may not be able to achieve profitability.***

 

Our ability to attract new customers and toincrease revenue from existing customers will depend in large part on ourability to enhance and improve our existing products and to add new MarketplacePartners and new Syndication Partners to offer their products and services anddistribute into new markets. The success of any enhancement or new SyndicationPartner offering depends on several factors, including the timely completion,introduction, and market acceptance of the enhancement, product or service. Anynew product or service offered by a Syndication Partner or that we develop oracquire may not be introduced in a timely or cost-effective manner and may notachieve the broad market acceptance necessary to generate significant revenue.Any new markets into which we attempt to distribute our products or servicesmay not be receptive. If we are unable to successfully develop or acquire newproducts or services, enhance our existing products and services to meetcustomer requirements, or distribute our products and services into newmarkets, then our revenue will not grow as expected and we may not be able toachieve profitability.

 

***If we fail to maintainproper and effective internal controls or are unable to remediate the materialweakness in our internal controls, then our ability to produce accurate andtimely financial statements could be impaired and investors’ views of us couldbe harmed.***

 

Ensuring that we have adequate internalfinancial and accounting controls and procedures in place so that we canproduce accurate financial statements on a timely basis is a costly andtime-consuming effort that needs to be re-evaluated frequently. Our internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements in accordance with generally accepted accountingprinciples.

 

During our audit for the years endedDecember 31, 2008 and 2009, we identified material weaknesses in ourinternal controls. The material weaknesses relate to the absence of specificpolicies and procedures for some accounting functions and the need for accountingpersonnel who possess the skill sets necessary to operate and report as apublic company, and specifically the skills necessary to ensure that adequatereview of critical account reconciliations is performed and that supportingdocumentation is complete, accurate, and in accordance with generally acceptedaccounting principles. Our financial position and limited resources make itdifficult for us to address these weaknesses. If we fail to address these material weaknesses or if additionalmaterial weaknesses in our internal controls are discovered in the future, thenwe may fail to meet our future reporting obligations, our financial statementsmay contain material misstatements and the price of our common stock maydecline.

 

Implementing any appropriate changes to ourinternal controls may distract our officers and employees, entail substantialcosts to modify our existing processes, and add personnel and take significanttime to complete. These changes may not, however, be effective in maintainingthe adequacy of our internal controls, and any failure to maintain thatadequacy, or consequent inability to produce accurate financial statements on atimely basis, could increase our operating costs and harm our business. Inaddition, investors’ perceptions that our internal controls are inadequate orthat we are unable to produce accurate financial statements on a timely basismay harm our stock price and make it more difficult for us to effectivelymarket and distribute our products and services to new and existing customers.

 

***Government regulation ofthe Internet and e-commerce is evolving, and unfavorable changes or our failureto comply with regulations could harm our operating results.***

 

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

 

***Privacy concerns and lawsor other regulations may reduce the effectiveness of our products and servicesand harm our business.***

 

Our customers can use the products and servicesoffered in an Etelos Marketplace to store personal or identifying informationregarding their customers and contacts. Super-national, federal, state andother government bodies and agencies have adopted or are considering adoptionof laws and regulations regarding the collection, use, and disclosure ofpersonal information obtained from consumers and other individuals. The costsof compliance with, and other burdens imposed by, such laws and regulationsthat are applicable to the businesses of our customers may limit the use andadoption of our products and services and reduce overall demand.

 

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In addition to government activity, privacyadvocacy groups and the technology and other industries are considering variousnew, additional, or different self-regulatory standards that may placeadditional burdens on us and our Marketplace and Syndication Partners. If thegathering of personal information were to be curtailed, then Web-basedapplications would be less effective, which may reduce demand for the productsand services offered in an Etelos Marketplace and harm our business.

 

***Our operating results maybe harmed if we are required to collect taxes for our subscription services injurisdictions where we have not historically done so.***

 

We have not collected any sales or other taxesfrom our customers or remitted any such taxes to any taxing jurisdiction wherewe may be required to do so. We have begun an analysis of this issue but todate have not made any accrual for any potential liability.  In addition, additional taxing jurisdictionsat various local, national and super-national levels may seek to impose salesor other tax collection obligations on us. We have not recorded sales or other tax liabilities for any priorperiods, including the current periods, in respect of sales or other taxliabilities in any jurisdiction. A successful assertion that we should becollecting sales or other taxes on our service could result in substantial taxliabilities for past sales, discourage customers from purchasing our products,or otherwise harm our business and operating results.

 

***Changes in financialaccounting standards or practices may cause adverse, unexpected financialreporting fluctuations, and harm our operating results.***

 

A change in accounting standards or practicescould harm our operating results and may even affect our reporting oftransactions completed before the change is effective. New accountingpronouncements and varying interpretations of accounting pronouncements haveoccurred and may occur in the future. Changes to existing rules or thequestioning of current practices may harm our operating results or the way weconduct our business.

 

***We may expand by acquiringor investing in other companies, which may divert management’s attention,result in additional dilution to our stockholders, and consume resources thatare necessary to operate and sustain our business.***

 

Although we have no ongoing negotiations orcurrent agreements or commitments for any acquisitions, our business strategymay include acquiring complementary products, services, technologies, orbusinesses. We also may enter into relationships with other businesses toexpand our product or service offerings or our ability to provide service inforeign jurisdictions, which could involve preferred or exclusive licenses,additional channels of distribution, discount pricing, investments in othercompanies, or other strategies. Negotiating these transactions can betime-consuming, difficult, and expensive, and our ability to close thesetransactions may often be subject to approvals that are beyond our control.Consequently, these transactions, even if undertaken and announced, may notclose.

 

An acquisition, investment, or businessrelationship may result in unforeseen operating difficulties and expenditures.In particular, we may encounter difficulties assimilating or integrating thebusinesses, technologies, products, services offerings, personnel, oroperations of the acquired companies, particularly if the key personnel of theacquired company choose not to work for us, the target’s software is not easilyadapted to work with ours, or we are unable to retain the customers of anyacquired business due to changes in management or otherwise. Acquisitions mayalso disrupt our business, divert our resources, and require significantmanagement attention that would otherwise be available for operation anddevelopment of our business. Moreover, the anticipated benefits of anyacquisition, investment, or business relationship may not be realized or we maybe exposed to unknown liabilities. For one or more of those transactions, wemay:

 

·                  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 andoperating results.

 

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***We may be subject to otherlegal claims.***

 

Wehave entered into litigation settlement agreements that include promissorynotes payable over several months in 2010-2011. There is a risk that we may not be able to pay these obligations as theybecome due and that the parties to these notes may exercise their rights torecover the amounts of these notes, and other remedies.

 

OnDecember 31, 2009, we settled a judgment in the matter of Kaufman Bros.,L.P. v. Etelos, Inc. in the Supreme Court of the State of New York, NewYork County, in the approximate amount of $186,000, for $93,000 in cash,payable in 5 installments with the final installment due June 1, 2010, andthe issuance of 200,000 shares of restricted common stock. The last installmentpayment has not been made, as of the date of this report.  The settlement further permits Kaufman Bros.to sell up to 180,000 shares from July 1, 2010, through March 2011 torecover the remaining $93,373 of the settlement; the additional 20,000 sharesare designated for payment of attorneys’ fees in the event of a default in thenote payments.  After payment in full of the note payments, if there is nodefault giving rise to a claim for attorneys’ fees, those 20,000 shares will bereturned to the Company and cancelled. After Kaufman Bros. recovers the remaining $93,373 from the sale of someor all of the 180,000 shares, any remaining shares will be repurchased by theCompany for $0.01 and cancelled; after March 2011, any balance due on theremaining amount of the settlement will be discharged and any unsold shareswill be repurchased by the Company at $0.01 per share and cancelled.

 

As part of our reduction of monthly cashoperating expenses during the quarter ended September 30, 2008, andcontinuing after the end of the quarter ended June 30, 2010, and to thefiling date of this report, we placed most employees on partial deferrals ofsalary, ranging from 3% to 26% of base salary. At the end of the quarter, until the filing date of this report, asubstantial portion of this deferral amount remains unpaid, including amountsdue to employees who subsequently were terminated. Two former employees haveasserted claims with the California Labor Commission for payment of theseunpaid amounts and the assertion of such claims or demands by other terminatedor current employees, or by other governmental authorities, is foreseeable.

 

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OnOctober 31, 2008, the Company closed its offices in San Mateo, California.In December 2008, the landlord for these premises filed a complaintclaiming damages of $659 thousand and other amounts against the Company’spredecessor Etelos, Incorporated, a Washington corporation (“Etelos —WA”)in the Superior Court of San Mateo County, California (Case No. CIV479535). The parties subsequently entered into a settlement agreement,including a release of claims, in which the Company agreed: (a) to pay$66,000 in cash within 30 days, (b) to issue a promissory note in theprincipal amount of $200,000, which bears 6% interest, and is payable in 12monthly payments beginning in July 2010, and (c) to issue shares ofcommon stock of the Company equal to $125,000 in value, based upon the closingprice of the common stock on January 6, 2010.  The settlement agreement and promissory notewere executed and delivered on February 8, 2010, and 166,667 sharessubsequently were delivered on March 1, 2010.  The $66,666 payment was made on April 6,2010.  However, the Company subsequentlyfailed to make intial monthly payment in the amount of $16,667, due on July 31,2010, under the terms of the promissory note delivered as part of thesettlement agreement. The promissory note is in default but the holder of thenote has taken no action to enforce any of its remedies for default under thepromissory note.

 

On October 31, 2008, the Company relocatedit Washington offices and abandoned the sub-leased premises of its formeroffices in Renton, Washington. The sublease for these premises runs throughJune 2010.  On March 5, 2010,the prime landlord filed a complaint for breach of contract and successorliability. (King County (WA) Superior Court No. 10-2-09385-1 KNT). On March 26,2010, the Company filed an answer and counterclaim and asserted affirmativedefenses against the prime landlord, including the fact that the prime landlordis not a party to the sublease for the premises.  Subsequently, on April 8, 2010, thesub-landlord served a third party complaint against the Company relating to thesame subleased premises, in a proceeding filed against the sub-landlord by theprime landlord (King County (WA) Superior Court No. 10-2- 09840-2 KNT), inwhich the sub-landlord asserted affirmative defenses and counterclaims againstthe prime landlord, including the fact that, beginning in December 2008,the premises were unusable due to water damage and lack of maintenance orrepairs by the prime landlord. No further procedural or substantive steps havebeen taken by any of the various parties.

 

OnApril 5, 2010, the Company was served with a summons and complaint forbreach of contract and unjust enrichment by Lakebay Technologies LLC.  (King County (WA) Superior CourtNo. 10-2-10054-7). The Company moved to compel arbitration in accordancewith a written agreement and that motion was granted on July 26, 2010; nofurther procedural or substantive steps have been taken by either party.  As this matter is still in its early stages,management cannot estimate or project its outcome.

 

OnJune 11, 2010, the Company received a written demand from Northwest Nexus, Inc.dba Network OS under the provisions of an agreement dated effective March 15,2009.  The Company subsequently wasserved with a summons and complaint (King County (WA) Superior CourtNo. 10-2-24420-4 KNT) on July 14, 2010.  The Company subsequently filed an Answer andmultiple counterclaims in this matter and no further procedural or substantivesteps have been taken by either party. As this matter is still in its earlystages, management cannot estimate or project its outcome.

 

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

 

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

 

As of June 30, 2010, our officers,directors, and affiliates beneficially own approximately 72 percent of ourcommon stock and 60 percent of our preferred stock. As a result, if they acttogether, they are able to influence the outcome of stockholder votes onvarious matters, including the election of directors and extraordinarycorporate transactions, including business combinations. This concentrationcould also have the effect of delaying or preventing a change in control thatcould otherwise be beneficial to our stockholders. The interests of ourofficers, directors, and affiliates may differ from other stockholders.Furthermore, the current ratios of ownership of our common stock reduce thepublic float and liquidity of our common stock, which can in turn affect themarket price of our common stock.

 

***We are responsible for theindemnification of our officers and directors.***

 

Our articles of incorporation and bylawsprovide for the indemnification of our directors, officers, employees, andagents, and, under certain circumstances, against costs and expenses incurredby them in any litigation to which they become a party arising from theirassociation with or activities on our behalf. Consequently, we may be requiredto expend substantial funds to satisfy these indemnity obligations.

 

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***The sale of the shares ofour common stock acquired in private placements could cause the price of ourcommon stock to decline.***

 

The purchasers of our January 2008 andApril 2008 Debentures and related warrants, as well as the holders of ourother outstanding convertible notes, may, subject to compliance withRule 144, rely on the provisions of Rule 144 to resell the shares ofour common stock acquired upon the conversion and exercise of suchsecurities.  We have no way of knowingwhether or when such shares may be sold. Depending upon market liquidity at the time, a sale of shares by suchinvestors at any given time could cause the trading price of our common stockto decline.  The sale of substantialnumber of shares of our common stock, or anticipation of such sales, could makeit more difficult for us to sell equity or equity-related securities in thefuture at a time and at a price that we might otherwise wish to effect sales.

 

In addition, in connection with ourJanuary 2008 and April 2008 Debentures and 10% Senior Secured Debentures,in the aggregate, we owe a total of $9.7 million principal amount of theseconvertible debentures, convertible into 11,440,695 shares of our common stock,and warrants to purchase an additional 6,236,111 shares of our common stock.The conversion or exercise into our common stock could result in a substantialincrease in the number of shares in our public float.  Depending upon market liquidity at the time aresale of our common stock is made by the investors in such private placements,such sale could cause the trading price of our common stock to decline.  In addition, the sale of a substantial numberof shares of our common stock, or anticipation of such sales, could make itmore difficult for us to sell equity or equity-related securities in the futureat a time and at a price that we might otherwise wish to effect sales.

 

***We have significant indebtedness.***

 

We have incurred $9.7 million in principalamount of indebtedness as a result of the issuance of our 10% Senior SecuredDebentures, January 2008 and April 2008 Debentures.  The debentures impose significantrequirements on us, including, among others, requirements that we pay interestand other charges on the debentures.  Ourability to comply with these provisions may be affected by changes in ourbusiness condition or results of our operations, or other events beyond ourcontrol.

 

***Certain covenants we agreed to inconnection with the debentures may impair our ability to issue additional debtor equity.***

 

Our September 2009, January 2008 andApril 2008 Debentures impose significant 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. These covenants and restrictions may impairour ability to issue additional debt or equity, if necessary.

 

***If we need additionalfinancing in the future and are required to issue securities which are pricedat less than the conversion price of our debentures or the exercise price ofwarrants sold in our recent private placements, it will result in additionaldilution.***

 

Our September 2009, January 2008 andApril 2008 Debentures and the related warrants contain provisions thatwill require us to reduce the conversion price and exercise price, as the casemay be, if we issue additional securities while such debentures or warrants areoutstanding which contain purchase prices, conversion prices or exercise pricesless than the conversion price of our September 2009, January 2008 orApril 2008 Debentures or the exercise price of the warrants.  If this were to occur, current investors,other than the investors in our recent private placements, would sustainmaterial dilution in their ownership interest.

 

***Anti-takeover provisionscontained in our amended and restated certificate of incorporation and amendedand restated bylaws, as well as provisions of Delaware law, could impair atakeover attempt.***

 

Our amended and restated certificate ofincorporation, amended and restated bylaws and Delaware law contain provisionsthat could have the effect of rendering more difficult or discouraging anacquisition deemed undesirable by our board of directors. Our corporategovernance documents include provisions:

 

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

 

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

 

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

 

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

 

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

 

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

 

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These provisions, alone or together, coulddelay hostile takeovers and changes in control or changes in our management.

 

Any provision of our amended and restatedcertificate of incorporation or bylaws or Delaware law that has the effect ofdelaying or deterring a change in control could limit the opportunity for ourstockholders to receive a premium for their shares of our common stock, andcould also affect the price that some investors are willing to pay for ourcommon stock.

 

***We may issue additionalshares of our capital stock, including through convertible debt securities, tofinance future operations or complete a business combination, which wouldreduce the equity interest of our stockholders and could cause a change incontrol of our ownership.***

 

Although we have no commitments as of the dateof this report to issue any additional securities, we may issue a substantialnumber of additional shares of our common stock or preferred stock, or acombination of both, including through convertible debt securities, to financefuture operations.  We may not be able toobtain additional 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 ofour common stock or any number of shares of preferred stock, including uponconversion of any debt securities, may:

 

·                  significantlyreduce the equity interest of our current stockholders;

 

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

 

·                  adverselyaffect prevailing market prices for our common stock.

 

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

 

·                  developor enhance our products and services;

 

·                  continueto expand our development, sales and marketing organizations;

 

·                  acquirecomplementary technologies, products or businesses;

 

·                  expandoperations;

 

·                  hire,train and retain employees; and/or

 

·                  respondto competitive pressures or unanticipated working capital requirements.

 

Although we have no commitments as of the datehereof to issue any additional securities, we may issue a substantial number ofadditional shares of our common stock or preferred stock, or a combination ofboth, including through convertible debt securities, to finance futureoperations or complete a business combination. The issuance of additional shares of our common stock or any number ofshares of preferred stock, including upon conversion of any debt securities:

 

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

 

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

 

The 2007 Stock Incentive Plan and all optionsissued under the 2007 Stock Incentive Plan contain provisions for accelerationof all unvested options in the event of a change of control, which might be adisincentive to acquisition of the Company as a liquidation strategy.

 

The 2009 Equity Incentive Plan and the 2007Stock Incentive Plan and all options currently issued thereunder and optionsgranted outside such plan provides for accelerated vesting of all unvestedoptions in the event of a change of control. This may be regarded as both a disincentive to acquisition of theCompany as a liquidation strategy and a barrier to retention of key employeesfollowing a change-of-control acquisition and therefore make such anacquisition more costly or difficult, and therefore an unattractive strategicoption, for a prospective acquirer.

 

***We have never paiddividends on our capital stock and we do not anticipate paying any cashdividends in the foreseeable future.***

 

We have paid no cash dividends on any of ourclasses of capital stock to date and we currently intend to retain our futureearnings, if any, to fund the development and growth of our business.  In addition, the terms of the Notes prohibitus from making any dividend payment or distribution to holders of our commonstock while any portion of the Notes remain outstanding.  As a result, capital appreciation, if any, ofour common stock will be your sole source of gain for the foreseeable future.

 

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***Our securities are thinlytraded on the Over-the-Counter Bulletin Board, which may not provide liquidityfor our investors.***

 

Our common stock is quoted on theOver-the-Counter Bulletin Board. The Over-the-Counter Bulletin Board is aninter-dealer, over-the-counter market that provides significantly lessliquidity than the NASDAQ Stock Market or other national or regional exchanges.Securities traded on the Over-the-Counter Bulletin Board are usually thinlytraded, highly volatile, have fewer market makers, and are not followed byanalysts.

 

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

 

***Investors must contact abroker-dealer to trade Over-the-Counter Bulletin Board securities. As a result,you may not be able to buy or sell our common stock at the times that you maywish.***

 

Even though our common stock is quoted on theOver-the-Counter Bulletin Board, the Over-the-Counter Bulletin Board may notpermit our investors to sell securities when and in the manner that they wish.Because there are no automated systems for negotiating trades on theOver-the-Counter Bulletin Board, they are conducted via telephone. In times ofheavy market volume, the limitations of this process may result in asignificant increase in the time it takes to execute investor orders.Therefore, when investors place market orders to buy or sell a specific numberof shares at the current market price it is possible for the price of a stockto go up or down significantly during the lapse of time between placing amarket order and its execution.

 

***Our stock price may bevolatile and you may not be able to sell your shares for more than what youpaid.***

 

Our stock price is likely to be subject tosignificant volatility and you may not be able to sell shares of common stockat or above the price you paid for them. The market price of the common stockcould continue to fluctuate in the future in response to various factorsincluding, but not limited to: quarterly variations in operating results; ourability to control costs and improve cash flow; announcements of technologicalinnovations or new products by us or our competitors; changes in investorperceptions; and new products or produce enhancements by us or our competitors.The stock market in general has continued to experience volatility, which mayfurther affect our stock price. As such, you may not be able to resell yourshares of common stock at or above the price you paid for them.

 

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

 

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

 

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

 

During the quarter endedJune 30, 2010, the Company issued 300,000 shares of common stock andwarrants to purchase 300,000 shares of common stock, in accordance with theterms of the warrant replacement financing approved by the board of directorson March 31, 2010.   The shares andwarrants were issued to four accredited investors in exchange for theirexercise of warrants previously issued to them in conjunction with theirprevious purchases of the Company’s New Series A Preferred Stock. 

 

During the quarter endedJune 30, 2010, the Company issued 124,642 shares of common stock to theholders of the 10% Senior Secured Debentures in exchange for their waiver ofdefault in the payment of interest due on the 10% Senior Secured Debentures.

 

During the six months endedJune 30, 2010, the Company issued 200,000 shares of common stock to aholder of the 6% Convertible Notes, in exchange for the cancellation of$150,000 of the 6% Convertible Notes.

 

Each of these transactionswas completed as a private placement under Section 4(2) of theSecurities Act of 1933, as amended, and was therefore exempted from theregistration requirements of that act.

 

 

**Item6.   EXHIBITS**

 

See the exhibit index immediately following thesignature page of this report.

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
| ** **             | **ETELOS,  INC.**                                         |
|------------------------|-----------------------------------------------------------|
|                   |                                                      |
|                   |                                                      |
|                   | /s/ Daniel J.A. Kolke                                     |
| Date:  August 13, 2010 | Daniel J.A. Kolke, Chief Executive Officer                |
|                   | (Duly Authorized Officer and Principal Executive Officer) |

 

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**EXHIBITINDEX**

 
| **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     |
|----|--------|-----------------------------|
| ** |   | Furnished  with this Report |

 

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