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** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

**FORM 10-Q**

 

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

 

**For the quarterly period ended March 31, 2010**

 

**or**

 

**o****         Transition Report Pursuant to Section 13or 15(d) of the Securities 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 asspecified in its charter)

 

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

 

**(425) 458-4510**

(Registrant’s telephone number, including areacode)

 

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

 

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

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company. See the definitions of “large accelerated filer”, “acceleratedfiler” and “smaller reporting 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 |

 

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

 

As of March 31, 2010, 24,116,477 shares of theissuer’s common stock, par value $0.01 per share, were outstanding.

 

 

 

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**Etelos, Inc.**

 

**Quarterly Report on Form 10-Q**

 

**For the Quarterly Period Ended March 31, 2010**

 

TABLE OF CONTENTS

 
| ** **                                   | **Page**                                                                                    |
|----------------------------------------------|---------------------------------------------------------------------------------------------|
|                                         |                                                                                        |
| **FORWARD  LOOKING STATEMENTS**              | 1                                                                                           |
|                                         |                                                                                        |
| **PART I  —FINANCIAL INFORMATION** | 3                                                                                           |
|                                         |                                                                                        |
| Item  1.                                     | FINANCIAL STATEMENTS  (UNAUDITED)                                                           | 3 |
|                                         |                                                                                        |   |
| Item 2.                                      | MANAGEMENT’S DISCUSSION  AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 24 |
|                                         |                                                                                        |   |
| Item 3.                                      | QUANTITATIVE AND  QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                 | 40 |
|                                         |                                                                                        |   |
| Item 4.                                      | CONTROLS AND  PROCEDURES                                                                    | 40 |
|                                         |                                                                                        |
| **PART II  —OTHER INFORMATION**    | 41                                                                                          |
|                                         |                                                                                        |
| Item 1.                                      | LEGAL PROCEEDINGS                                                                           | 41 |
|                                         |                                                                                        |   |
| Item  1A.                                    | RISK FACTORS                                                                                | 42 |
|                                         |                                                                                        |   |
| Item  6.                                     | EXHIBITS                                                                                    | 59 |
|                                         |                                                                                        |
| SIGNATURES                                   | 60                                                                                          |
|                                         |                                                                                        |
| EXHIBIT INDEX                                | 61                                                                                          |

 

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**FORWARD LOOKING STATEMENTS**

 

In this report,unless the context indicates otherwise, the terms “Etelos,” “Company,” “we,” “us,”and “our” refer to Etelos, 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.  Theseterms and similar expressions are intended to identify forward-lookingstatements.  Such statements are subjectto certain risks and uncertainties, which could cause actual results to differmaterially from those projected. Examples of forward-looking statements include, butare not limited to, statements we make regarding raising additional capital,the acceptance of our products and services by the marketplace and our beliefthat we have sufficient liquidity to fund our currently planned level ofoperations through mid-2010. The foregoing is not an exclusive list of allforward-looking statements we make.

 

You should beaware that our actual results could differ materially from those contained inthe forward-looking statements we make in this report due to a number offactors that could cause actual results to differ materially from historicalresults or anticipated results, including:

 

·                                          our ability to obtain future financing orfunds when needed;

·                                          the exercise of rights and remedies by the holders of our outstanding promissorynotes under the terms of which we are currently in default;

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

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

·                                          our ability to successfully obtain adiverse customer base;

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

·                                          our ability to attract and retain aqualified employee base;

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

·                                          acquisitions, business combinations, strategicpartnerships, divestures, and other significant transactions may involveadditional uncertainties;

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

·                                          the risks described in Item 1A “RiskFactors” of Part II this report, which address additional factors thatcould cause our actual results to differ from those set forth in theforward-looking statements and could materially and adversely affect ourbusiness, operating results and financial condition.

 

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Theforward-looking statements in this report are based upon management’s currentexpectations and belief, which management believes are reasonable.  In addition, we cannot assess the impact ofeach factor on our business or the extent to which any factor or combination offactors, or factors we are aware of, may cause actual results to differ materiallyfrom those contained in any forward looking statements.  You are cautioned not to place undue relianceon any forward-looking statements.  Thesestatements represent our estimates and assumptions only as of the date of thisreport.  Except to the extent required byfederal securities laws, we undertake no obligation to update anyforward-looking statement to reflect events or circumstances after the datehereof or to reflect the occurrence of unanticipated events.

 

All subsequentwritten and oral forward-looking statements attributable to us or personsacting on our behalf are expressly qualified in their entirety by theapplicable cautionary statements.

 

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**PART I—FINANCIAL INFORMATION**

 

**ITEM 1. - FINANCIAL STATEMENTS**

 

**ETELOS,INC.**

**CONDENSEDBALANCE SHEETS**

(in thousands,except share data)

 
| ** **                                                                                                                                                                        | ** ** | **March 31,  2010** | ** ** | **December 31,  2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                        | ** ** | **(Unaudited)**          | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                                                                                            |       |                     |       |                        |       |
| Current  assets:                                                                                                                                                                  |       |                     |       |                        |       |
| Cash  and cash equivalents                                                                                                                                                        |       | $                        | 12         |                        | $          | 445 |   |
| Accounts  receivable, net                                                                                                                                                         |       | 46                       |       | 10                          |       |
| Prepaid  expenses and other current assets                                                                                                                                        |       | 13                       |       | 16                          |       |
| Accretion  of interest on convertible notes payable                                                                                                                               |       | 169                      |       | 250                         |       |
| Total  current assets                                                                                                                                                             |       | 240                      |       | 721                         |       |
|                                                                                                                                                                              |       |                     |       |                        |       |
| Property  and equipment, net                                                                                                                                                      |       | 39                       |       | 46                          |       |
| Debt  issuance costs                                                                                                                                                              |       | 26                       |       | 30                          |       |
| Other  assets                                                                                                                                                                     |       | 2                        |       | 2                           |       |
|                                                                                                                                                                              |       |                     |       |                        |       |
| **Total assets**                                                                                                                                                                  | ** ** | **$**                    | **307**    | ** **                  | **$**      | **799** | ** ** |
|                                                                                                                                                                              |       |                     |       |                        |       |
| LIABILITIES  AND STOCKHOLDERS’ DEFICIT                                                                                                                                       |       |                     |       |                        |       |
| Current  liabilities:                                                                                                                                                             |       |                     |       |                        |       |
| Accounts  payable                                                                                                                                                                 |       | $                        | 875        |                        | $          | 1,120 |   |
| Accounts  payable related parties                                                                                                                                                 |       | 34                       |       | 27                          |       |
| Accrued  payroll and related expenses                                                                                                                                             |       | 1,149                    |       | 1,029                       |       |
| Other  accrued expenses                                                                                                                                                           |       | 1,042                    |       | 1,229                       |       |
| Deferred  revenue                                                                                                                                                                 |       | 50                       |       | 8                           |       |
| Current  portion convertible notes payable, net of discounts                                                                                                                      |       | 1,689                    |       | 1,764                       |       |
| Current  portion notes payable                                                                                                                                                    |       | 241                      |       | 110                         |       |
| Current  portion notes payable to related parties                                                                                                                                 |       | 68                       |       | 108                         |       |
| Derivative  liability                                                                                                                                                             |       | 306                      |       | 315                         |       |
| Total  current liabilities                                                                                                                                                        |       | 5,454                    |       | 5,710                       |       |
|                                                                                                                                                                              |       |                     |       |                        |       |
| Long-term  convertible notes payable, net of premiums and discounts, less current  portion                                                                                        |       | 7,433                    |       | 7,214                       |       |
| Long-term  note payable                                                                                                                                                           |       | 50                       |       | —                      |       |
| Long-term  notes payable to related parties, less current portion                                                                                                                 |       | 286                      |       | 286                         |       |
|                                                                                                                                                                              |       |                     |       |                        |       |
| Total  liabilities                                                                                                                                                                |       | 13,223                   |       | 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 March 31, 2010 and 743,333 shares at December 31, 2009                      |       | 6                        |       | 7                           |       |
| Common  stock, $0.01 par value: 250,000,000 shares authorized; issued and outstanding  -24,116,477 shares at March 31, 2010 and 23,398,143 shares at  December 31, 2009 |       | 241                 |       | 234                    |       |
| Additional  paid-in capital                                                                                                                                                       |       | 24,611                   |       | 23,903                      |       |
| Accumulated  deficit                                                                                                                                                              |       | (37,774                  | )          | (36,555                     | )          |
| Total  stockholders’ deficit                                                                                                                                                 |       | (12,916                  | )          | (12,411                     | )          |
|                                                                                                                                                                              |       |                     |       |                        |       |
| **Total liabilities and stockholders’ deficit**                                                                                                                              | ** ** | **$**                    | **307**    | ** **                  | **$**      | **799** | ** ** |

 

The accompanyingnotes are an integral part of these condensed interim financial statements.

 

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**ETELOS,INC.**

**CONDENSEDSTATEMENTS OF OPERATIONS**

(in thousands,except per share data)

(Unaudited)

 
| ** **                                                                                                 | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                 | ** ** | **March 31,**     | ** ** |
| ** **                                                                                                 | ** ** | **2010**               | ** ** | **2009** | ** ** |
| ** **                                                                                                 | ** ** | ** **             | ** ** | ** ** | ** ** |
| Revenue                                                                                                    |       | 2                      |       | 58 |   |
| Cost  of revenue                                                                                           |       | 9                      |       | 93 |   |
| Gross  loss                                                                                                |       | (7                     | )          | (35 | ) |
|                                                                                                       |       |                   |       |   |   |
| Operating  expenses:                                                                                       |       |                   |       |   |   |
| Research  and development                                                                                  |       | 264                    |       | 255 |   |
| Sales  and marketing                                                                                       |       | 166                    |       | 160 |   |
| General  and administrative                                                                                |       | 366                    |       | 1,736 |   |
| Change  in valuation of liability related to warrants from settlement, financing, and  consulting services |       | —                 |       | 2,155 |   |
| Total  operating expenses                                                                                  |       | 796                    |       | 4,306 |   |
|                                                                                                       |       |                   |       |   |   |
| Loss  from operations                                                                                      |       | (803                   | )          | (4,341 | ) |
|                                                                                                       |       |                   |       |   |   |
| Interest  income (expense):                                                                                |       |                   |       |   |   |
| Interest  expense, net                                                                                     |       | (124                   | )          | (127 | ) |
| Amortization  of notes discount and debt issuance costs and accretion of notes premium, net                |       | (308                   | )          | (13 | ) |
| Change  in valuation of liability relating to embedded derivatives and warrants                            |       | 16                     |       | (1,954 | ) |
| Total  interest income (expense)                                                                           |       | (416                   | )          | (2,094 | ) |
|                                                                                                       |       |                   |       |   |   |
| Loss  before taxes                                                                                         |       | (1,219                 | )          | (6,435 | ) |
|                                                                                                       |       |                   |       |   |   |
| Provision  for income taxes                                                                                |       | —                 |       | — |   |
|                                                                                                       |       |                   |       |   |   |
| **Net loss**                                                                                               | ** ** | **$**                  | **(1,219** | **)** | **$** | **(6,435** | **)** |
|                                                                                                       |       |                   |       |   |   |
| Basic  and diluted net loss                                                                                |       | $                      | (0.05      | ) | $ | (0.28 | ) |
|                                                                                                       |       |                   |       |   |   |
| Weighted  average number of common shares used in computing basic and diluted net loss  per share          |       | 23,726                 |       | 23,367 |   |

 

The accompanyingnotes are an integral part of these condensed interim financial statements.

 

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**ETELOS,INC.**

**CONDENSEDSTATEMENTS OF STOCKHOLDERS’ DEFICIT**

(in thousands, exceptshare data)

(Unaudited)

 
| ** **                                                                          | ** ** | **Preferred  Stock**   | ** ** | ** **        | ** ** | ** **           | ** **     | **Total**       | ** ** | ** **             | ** ** | ** **  | ** ** |
|-------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------|------------|----------------------|----------------|-----------------|------------|------------------------|------------|-------------|------------|
| ** **                                                                          | ** ** | **New  Series A** | ** ** | **Common  Stock** | ** ** | **Additional  Paid** | ** **     | **Accumulated** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                          | ** ** | **Shares**             | ** ** | **Amount**        | ** ** | **Shares**           | ** **     | **Amount**      | ** ** | **in  Capital**        | ** ** | **Deficit** | ** ** | **Deficit** | ** ** |
| ** **                                                                          | ** ** | ** **             | ** ** | ** **        | ** ** | ** **           | ** **     | ** **      | ** ** | ** **             | ** ** | ** **  | ** ** | ** ** | ** ** |
| **Balance at December 31, 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 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                          | ** ** | **—**             | ** ** | **—**        |       | 100,000              |           | 1               |       | 74                     |       | —      | ** ** | **75** | ** ** |
| Beneficial  Conversion upon issuance of Senior Secured Debentures                   | ** ** | **—**             | ** ** | **—**        |       | —               |           | —          |       | 232                    |       | —      | ** ** | **232** | ** ** |
| Stock  Based Compensation                                                           | ** ** | **—**             | ** ** | **—**        |       | —               |           | —          |       | 146                    |       | —      | ** ** | **146** | ** ** |
| Net  Loss                                                                           | ** ** | **—**             | ** ** | **—**        |       | —               |           | —          |       | —                 |       | (1,219      | )          | **(1,219** | **)** |
| **Balance at March 31, 2010**                                                  | ** ** | **666,666**            | ** ** | **$**             | **6**      | ** **           | **24,116,477** | ** **      | **$**      | **241**                | ** ** | **$**       | **24,611** | ** ** | **$** | **(37,774** | **)** | **$** | **(12,916** | **)** |

 

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

 

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**ETELOS, INCORPORATED**

**CONDENSED STATEMENTS OF CASH FLOWS**

(in thousands)

(Unaudited)

 
| ** **                                                                   | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                   | ** ** | **March 31,**     | ** ** |
| ** **                                                                   | ** ** | **2010**               | ** ** | **2009** | ** ** |
|                                                                         |       |                   |       |   |   |
| **Cash flows from operating activities:**                                    | ** ** | ** **             | ** ** | ** ** | ** ** |
| Net  loss                                                                    | ** ** | **$**                  | **(1,219** | **)** | **$** | **(6,435** | **)** |
| Adjustments  to reconcile net loss to net cash used in operating activities: | ** ** | ** **             | ** ** | ** ** | ** ** |
| Depreciation  and amortization                                               | ** ** | **7**                  | ** ** | **10** | ** ** |
| Amortization  (accretion) of notes discount (premium)                        | ** ** | **223**                | ** ** | **13** | ** ** |
| Accretion  of interest                                                       | ** ** | **81**                 | ** ** | **—** | ** ** |
| Stock  based compensation                                                    | ** ** | **146**                | ** ** | **44** | ** ** |
| Consulting  expenses paid through issuance of common stock and warrants      | ** ** | **—**             | ** ** | **1,511** | ** ** |
| Change  in valuation of embedded derivatives and warrant liability           | ** ** | **(16**                | **)**      | **4,110** | ** ** |
| Changes  in operating assets and liabilities:                                | ** ** | ** **             | ** ** | ** ** | ** ** |
| Accounts  receivable, net                                                    | ** ** | **(36**                | **)**      | **50** | ** ** |
| Prepaid  expenses and other current assets                                   | ** ** | **3**                  | ** ** | **(49** | **)** |
| Accounts  payable                                                            | ** ** | **(245**               | **)**      | **6** | ** ** |
| Accounts  payables related parties                                           | ** ** | **7**                  | ** ** | **(25** | **)** |
| Accrued  payroll and related expenses                                        | ** ** | **120**                | ** ** | **398** | ** ** |
| Other  accrued expenses                                                      | ** ** | **138**                | ** ** | **152** | ** ** |
| Deferred  revenues                                                           | ** ** | **42**                 | ** ** | **(3** | **)** |
| **Net cash used in operating activities**                                    | ** ** | **(749**               | **)**      | **(218** | **)** |
| **Cash flows from investing activities:**                                    | ** ** | ** **             | ** ** | ** ** | ** ** |
| Purchases  of property and equipment                                         | ** ** | **—**             | ** ** | **—** | ** ** |
| **Net cash used in investing activities**                                    | ** ** | **—**             | ** ** | **—** | ** ** |
| **Cash flows from financing activities:**                                    | ** ** | ** **             | ** ** | ** ** | ** ** |
| Proceeds  from notes payable                                                 | ** ** | **375**                | ** ** | **170** | ** ** |
| Payments  of notes payable                                                   | ** ** | **(19**                | **)**      | **—** | ** ** |
| Proceeds  from issuance of common stock                                      | ** ** | **—**             | ** ** | **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                                                    | ** ** | **—**             | ** ** | **(2** | **)** |
| **Net cash provided by financing activities**                                | ** ** | **316**                | ** ** | **277** | ** ** |
| ** **                                                                   | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Net increase (decrease) in cash and cash equivalents**                     | ** ** | **(433**               | **)**      | **59** | ** ** |
| ** **                                                                   | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Cash and cash equivalents at beginning of year**                           | ** ** | **445**                | ** ** | **7** | ** ** |
| ** **                                                                   | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Cash and cash equivalents at end of period**                               | ** ** | **$**                  | **12**     | ** ** | **$** | **66** | ** ** |
| ** **                                                                   | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Supplemental disclosures of cash flow information:**                       | ** ** | ** **             | ** ** | ** ** | ** ** |
| Cash  paid for interest                                                      | ** ** | **—**             | ** ** | **—** | ** ** |
| ** **                                                                   | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Supplemental disclosures of non-cash financing activities:**               | ** ** | ** **             | ** ** | ** ** | ** ** |
| Issuance  of note payable for other accrued expenses                         | ** ** | **200**                | ** ** | **—** | ** ** |
| Issuance  of common stock for other accrued expenses                         | ** ** | **125**                | ** ** | **—** | ** ** |
| Issuance  of common stock for convertible notes and debentures               | ** ** | **75**                 | ** ** | **—** | ** ** |
| Issuance  of warrants and embedded derivatives as liabilities                | ** ** | **7**                  | ** ** | **120** | ** ** |

 

The accompanying notesare an integral part of these condensed interim financial 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 theCompany.  On April 22, 2008,Etelos-WA merged with Tripath Technology Inc., a Delaware corporation (“Tripath”)as part of Tripath’s Plan of Reorganization under Chapter 11 of the BankruptcyCode (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 to December 31. In connection with the Merger, all outstanding shares of Etelos-WA common stockwere converted into shares of the Company’s common stock on a three for oneratio: one share of the Company’s common stock for every three shares of commonstock of Etelos-WA.  Also in connection with the Merger, (i) alloutstanding shares of preferred stock of Etelos-WA were converted into sharesof the Company’s common stock, (ii) the Company issued an aggregate of5,010,000 shares of its common stock to the secured and unsecured creditors ofTripath and (iii) all the shares of Tripath Technology were cancelled.Also on April 23, 2008, the Company amended its articles of incorporationwith the state of Delaware to change its total authorized shares of stock to300,000,000 shares, of which 250,000,000 shares are designated “Common Stock”with a par value of $0.01 per share and 50,000,000 shares are designated “PreferredStock” with a par value of $0.01 per share.  The Preferred Stock may be issuedfrom time to time in one or more series, each of such series to consist of suchnumber of shares and to have such terms, rights, powers and preferences, andthe qualifications and limitations with respect thereto, as stated in theresolutions providing for the issue of such series adopted by the board ofdirectors.

 

Prior to the Merger, Tripath was a shell corporationand in accordance with the Plan of Reorganization had no assets orliabilities.  While Tripath acquired all the outstanding preferred andcommon stock of Etelos-WA, for accounting purposes, the acquisition was treatedas a recapitalization 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 delivering Web Applications forbusinesses.  Etelos provides aSoftware-as-a-Service (SaaS) ecosystem for building, distributing, and usingWeb Applications, including a marketplace to deploy and support them.  Unlike other cloud computing and Platform-as-a-Service(PaaS) solutions, Etelos enables software manufacturers to migrate existingapplications or create new applications, then package, distribute, host, bill,market and support their SaaS enabled applications through multiple privatelabel applications marketplaces.

 

Etelos has developedproducts for Web Applications, which include open standards-based tools for Webdevelopers, businesses and individual users such as the Etelos ApplicationServerTM (EASTM)and the Etelos Development EnvironmentTM (EDETM).  EAS and EDE support many common programminglanguages and 

 

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also support the EnglishApplication 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 the sales andoperation of private-label Web application marketplaces, including provision ofthe professional services required to develop, deploy and operate suchmarketplaces, and the launch of offerings of the Etelos Platform SuiteTM.   The EtelosPlatform Suite is designed to allow Independent Software Vendors (ISVs) toimplement a SaaS delivery version of their existing applications, whether ornot those applications are already Web Applications, and to syndicate the offeringof those applications through multiple private label marketplaces. In thesedifficult economic times, the Company believes that a variety of ISVs will haveapplications that they need to move to the Web for lower cost implementation,easier, simpler scalability and broader distribution.  The Etelos PlatformSuite also enables Marketplace Partners, including non-technologybusinesses, to have their own private label marketplaces and tools to offerSaaS Web Applications to better serve their customers in multiple distributionchannels.

 

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

 

*Basis of Presentation*

 

The accompanyingcondensed financial statements include our accounts as of March 31, 2010,and December 31, 2009, and for the three months ended March 31, 2010and 2009. The accompanying condensed balance sheet as of December 31,2009, has been derived from the audited balance sheet in the Company’s annualreport on Form 10-K for the fiscal year ended December 31, 2009.These condensed financial statements have been prepared by management, withoutaudit, pursuant to the rules and regulations of the Securities andExchange Commission, or SEC. Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America (“USGAAP”) havebeen condensed or omitted pursuant to such rules and regulations. TheCompany has performed an evaluation of subsequent events through the date offiling of the financial statements.

 

In the opinion ofmanagement, all adjustments (which consist of normal recurring adjustments,except as disclosed herein) necessary to fairly present the financial position,results of operations and cash flows for the interim periods presented havebeen included. The results of operations for the quarter ended March 31,2010, are not necessarily indicative of the results to be expected for the fullyear or for any future periods.

 

The preparation offinancial statements in conformity with USGAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and reported amounts of revenues and expenses duringthe reporting period. Actual results could differ from those estimates, andsuch differences could affect the results of operations reported in futureperiods and such differences could be material. These financial statements should be read in conjunction with theaudited financial statements and accompanying notes included in the Company’sannual report on Form 10-K for the fiscal year ended December 31,2009.  Certain prior period amounts havebeen reclassified to conform to the present period presentation.

 

*Concentration of Credit Risk*

 

Financialinstruments that potentially subject the Company to concentration of creditrisk consist primarily of cash, cash equivalents, and accounts receivable.  Cash and cash equivalents are maintained infederally-insured 

 

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banksin the United States of America. Deposits in such banks may exceed federally-insured limits and besubject to the current risks and uncertainties of dealing with such banks.Etelos maintains the majority of cash balances and all short-term investmentswith one financial institution.

 

TheCompany’s accounts receivables are derived primarily from customers.  For the three months ended March 31,2010, no single customer accounted for more than 10% of the Company’s revenuein the period. Two customers accounted for 91% of the Company’s accountsreceivable as of March 31, 2010.

 

*Allowance for Doubtful Accounts*

 

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

 

*Deferred Revenue*

 

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.

 

*Property and Equipment*

 

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

 

*Fair Value of Financial Instruments*

 

Thecarrying value of financial instruments, which include cash, accountsreceivable, accounts payable, accrued expenses, and accrued liabilities,approximates the fair value for these financial instruments because of theirshort-term maturities and the relatively stable interest rate environment.

 

*Research and Development and Software Development Costs*

 

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

 

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

 

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incurredto purchase third party software, are capitalized beginning when the Companyhas determined certain factors are present, including, among others, thattechnology exists to achieve the performance requirements, buy versus internaldevelopment decisions have been made, and the Company’s management hasauthorized the funding for the project. Capitalization of software developmentcosts ceases when the software is substantially complete and is ready for itsintended use.  To date, no software development costs incurred have metthe criteria set forth in ASC 350-40 for capitalization.

 

*Revenue Recognition*

 

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 thatrevenue may be recognized when all of the following are met:

 

·                                          persuasive evidence of anarrangement exists,

·                                          the product or service hasbeen delivered,

·                                          the fee is fixed ordeterminable, and

·                                          collection of the resultingreceivable is reasonably assured or probable.

 

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

 

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

 

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

 

*Stock Based Compensation*

 

TheCompany accounts for its stock based compensation in accordance with ASC718-10, “Compensation — Stock Compensation” (ASC 718-10) using theBlack-Scholes Merton model to value all stock based compensation awards. The Company has recorded compensation cost in the statement of operations basedon the fair value of the award for the requisite service period. The Companyalso estimates forfeitures in calculating the expense relating to share-basedcompensation as opposed to only recognizing these forfeitures and thecorresponding reduction in expense as they occur. This resulted in $146thousand and $44 thousand of expense for the three months ended March 31,2010 and 2009, respectively.

 

ASC718-10 requires the cash flows resulting from the tax benefits resultingfrom tax deductions in excess of the compensation cost recognized for thoseoptions to be classified as financing cash flows. Due to its loss

 

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position,there were no such tax benefits during the three months ended March 31,2010 and 2009. Prior to the adoption of ASC 718-10, those benefits would havebeen reported as operating cash flows had we received any tax benefits relatedto stock option exercises.

 

*Income Taxes*

 

TheCompany accounts for income taxes in accordance with ASC 740-10, “Income Taxes”(ASC 740-10) which utilizes the liability method of accounting for incometaxes. Deferred tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statementcarrying amount of existing assets and liabilities and their respective taxbases. Deferred tax assets and liabilities are measured using enacted tax ratesexpected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled. Valuation allowances areestablished when necessary to reduce deferred tax assets to the amountsexpected to be realized.  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 three months ended March 31, 2010 and 2009,or the 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.

 

*Net Income (Loss) per Share*

 

Basicnet income (loss) per share is computed by dividing the net loss available tocommon stockholders for the period by the weighted average number of shares ofcommon stock outstanding during the period, excluding any unvested restrictedstock that is subject to repurchase. Diluted net income per share is computedusing the weighted average number of common shares and, if dilutive, potentialcommon shares outstanding during the period. Potential common shares consist ofunvested restricted stock (using 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, 9,547,998 and 4,794,830 shares of common stock exercisable underoutstanding employee stock options, 10,239,444 and 4,114,444 shares of commonstock exercisable under outstanding warrants, 13,921,802 and 6,426,074 sharesof common stock issuable upon conversion of the outstanding convertible notespayable and debentures, as of, and for the three months ended March 31,2010 and 2009, respectively, have been excluded from this calculation. The average exercise price of outstanding employee stock options to purchasethe Company’s common stock is $0.32 and $0.24, respectively, at March 31,2010 and 2009. 

 

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

 
| ** **                              | ** ** | **For the Three Months********Ended March 31,** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                              | ** ** | **2010**                                                                 | ** ** | **2009** | ** ** |
|                                    |       |                                                                     |       |   |   |
| Numerator:                              |       |                                                                     |       |   |   |
| Net income (loss)                       |       | $                                                                        | (1,219     | ) | $ | (6,435 | ) |
|                                    |       |                                                                     |       |   |   |
| Net income (loss) - diluted             |       | $                                                                        | (1,219     | ) | $ | (6,435 | ) |
|                                    |       |                                                                     |       |   |   |
| Denominator:                            |       |                                                                     |       |   |   |
| Weighted average common stock           |       | 23,726                                                                   |       | 23,367 |   |
|                                    |       |                                                                     |       |   |   |
| Weighted average common stock - diluted |       | 23,726                                                                   |       | 23,367 |   |
|                                    |       |                                                                     |       |   |   |
| Net income (loss) per share:            |       |                                                                     |       |   |   |
| Basic                                   |       | $                                                                        | (0.05      | ) | $ | (0.28 | ) |
| Diluted                                 |       | $                                                                        | (0.05      | ) | $ | (0.28 | ) |

 

*Use of Estimates*

 

Thepreparation of the financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. Actual results could differ from those estimates.

 

*Segment Reporting*

 

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

 

***4. Going Concern***

 

Thefinancial statements have been prepared with the assumption that the Companywill continue as a going concern.  The Company has experienced net lossesof $1.2 million and $6.4 million for the three months ended March 31, 2010and 2009, respectively, and has a total stockholders’ deficit of $12.9 millionand $12.4 million, as of March 31, 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.

 

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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 through additionalsale of preferred stock, common stock and/or debt and (2) reducing cashoperating expenses to levels that are in line with current revenues.  Thefirst alternative could result in substantial dilution to existingshareholders. There can be no assurance that the Company’s current financialposition can be improved, that it can raise additional working capital, or thatit can achieve positive cash flows from operations. The Company’s long-termviability as a going concern is dependent upon its ability to (1) locatesources of debt or equity funding to meet current commitments and near-termfuture working capital requirements and (2) achieve profitability andultimately generate sufficient cash flow from operations to sustain itscontinuing operations.

 

TheCompany’s cash balance including proceeds from its recent debt financings andpreferred stock financing may not be sufficient to fund operations beyond mid2010.  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 October 2009, the FinancialAccounting Standards Board (“FASB”) issued new standards forrevenue recognition with multiple deliverables. These new standards impact thedetermination of when the individual deliverables included in a multiple-elementarrangement may be treated as separate units of accounting. Additionally, thesenew standards modify the manner in which the transaction consideration isallocated across the separately identified deliverables by no longer permittingthe residual method of allocating arrangement consideration. These newstandards are required to be adopted in the first quarter of 2011; however,early adoption is permitted. The Company does not expect these new standards tosignificantly impact the financial statements.

 

In October 2009, theFASB issued new standards for the accounting for certain revenue arrangementsthat include software elements. These new standards amend the scope ofpre-existing software revenue guidance by removing from the guidancenon-software components of tangible products and certain software components oftangible products. These new standards are required to be adopted in the firstquarter of 2011; however, early adoption is permitted. The Company does notexpect these new standards to significantly impact the financial statements.

 

InJanuary 2010, the FASB issued amended standards that require additionalfair value disclosures. 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.

 

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In February 2010, theFASB issued amended guidance on subsequent events to alleviate potentialconflicts between FASB guidance and SEC requirements. Under this amendedguidance, SEC filers are no longer required to disclose the date through whichsubsequent events have been evaluated in originally issued and revisedfinancial statements. This guidance was effective immediately and we adoptedthese new requirements for the period ended March 31, 2010. The adoptionof this guidance did not have a material impact on our financial statements.

 

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

 

The following tablesummarizes information relative to the Company’s outstanding convertible notesand debentures at December 31, 2009 and March 31, 2010 (inthousands):

 
| ** **                                                                            | ** ** | **March 31,  2010** | ** ** | **December   31,  2009** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------|------------|-------------------------------|------------|
| 6% Convertible Notes                                                                  |       | $                        | 1,689      |                          | $          | 1,764 |   |
| January 2008 Debentures                                                          |       | 2,320                    |       | 2,320                         |       |
| April 2008 Debentures                                                            |       | 4,012                    |       | 4,012                         |       |
| 10% Senior Secured Debentures                                                         |       | 3,375                    |       | 3,000                         |       |
|                                                                                  |       | 11,396                   |       | 11,096                        |       |
| Plus (less) premium (discount) on notes payable                                       |       | (2,274                   | )          | (2,118                        | )          |
|                                                                                  |       |                     |       |                          |       |
|                                                                                  |       | 9,122                    |       | 8,978                         |       |
| Less current portion of convertible notes payable                                     |       | (1,689                   | )          | (1,764                        | )          |
|                                                                                  |       |                     |       |                          |       |
| Long term convertible notes payable, net of  premium (discount), less current portion |       | $                        | 7,433      |                          | $          | 7,214 |   |

 

*6%Convertible Notes*

 

During the quarter ended March 31,2010, $75 thousand of the principal amount of 6% convertible notes originallyissued in August 2007 were converted into 100 thousand shares of theCompany’s common stock and $1,689 thousand remain outstanding. The Company didnot make the interest and principal payments on these notes during the quarterended March 31, 2010, and such payments have not been made through thedate of this report. Accordingly, the Company is in default under the terms ofthese notes, and all principal and interest related to these convertible notesis due and payable to the holders. As a result, the Company has accruedinterest on these notes at the default rate of 8% and classified all amountsdue related to these notes as current liabilities.

 

*10% Senior Secured Debentures*

 

During the quarter ended March 31,2010, in exchange for $375 thousand in cash, the Company issued a 10% SeniorSecured Debentures with an aggregate principal amount of $375 thousand, awarrant to purchase 375,000 shares of the Company’s common stock, and 375,000shares of the Company’s common stock to an entity affiliated with Donald W.Morissette, who, together with his affiliates, beneficially owns more than 10%of the Company’s outstanding common stock.

 

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TheCompany failed to make the required interest payments on the 10% Senior SecuredDebentures during the quarter ended March 31, 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, the Company’s board of directors, in April,authorized the Company to issue 50,484 shares of common stock to the holders ofthe 10% Senior Secured Debentures in consideration of their agreement to waivethe default, for the quarter ending March 31, 2010.  Under the termsof that agreement, covering all periods through July 1, 2010, the Companycontinues to accrue interest at the stated interest rate, which interest willbe payable at maturity, and to classify the 10% Senior Secured Debentures aslong-term liabilities in the Company’s financial statements.

 

*EmbeddedDerivatives*

 

The Company has evaluatedthe embedded derivatives included in the 6% Convertible Notes, the January 2008Debentures, the April 2008 Debentures, and the 10% Senior SecuredDebentures, consisting of the conversion features and certain put and callfeatures, under the guidance in ASC 815-10 “Derivatives and Hedging” (ASC815-10) on the issuance date of the various financial instruments and on eachsubsequent reporting date.  The purpose of the evaluation is to determinewhether the embedded derivatives need to be bifurcated from the debt host andaccounted for as a derivative at their estimated fair value as a liability atthe date of issuance and thereafter, adjusted to estimated fair value with acharge or credit to the Company’s statement of operations.  ASC 815-10generally indicates that if the conversion features are (i) indexed to theCompany’s capital stock under the guidance in ASC 815-40-15, “Derivativesand Hedging — Contracts in Entity’s Own Equity — Scope and Scope Exceptions”(ASC 815-40-15), and (ii) wouldbe classified as equity if a freestanding derivative under the guidance in ASC815-40-25 “Derivatives and Hedging — Contracts in Entity’s Own Equity —Recognition” (ASC 815-40-25) then the embedded derivatives need not bebifurcated from the debt host.  ASC 815-40-25 generally requires, amongother factors, that (i) the Company can settle the derivative in cash orits own stock, at its option, (ii) settlement can be made in unregisteredshares, and (iii) the Company has sufficient authorized shares to issueshares of its common stock for all equity instruments convertible to or whichcan be exercised for its capital stock.  ASC 815-10 also provides guidanceon when put and call features included in a debt host agreement are not clearlyand closely related to the debt host must be bifurcated and recorded as aliability.  The January 2008, April 2008 and 10% Senior SecuredDebentures include put and call features.

 

*EmbeddedDerivatives — 6% Convertible Notes*

 

As of March 31,2010, the Company continues to conclude that the conversion features embeddedin the 6% Convertible Notes meet the criteria in ASC 815-10 to be accounted foras an equity instrument.

 

*EmbeddedDerivatives — January 2008 and April 2008 Debentures*

 

As of March 31,2010, the Company continues to conclude that the conversion features embeddedin the January 2008 and April 2008 Debentures meet the criteria inASC 815-10 to be accounted for as an equity instrument.

 

As of March 31,2010, the Company concluded that the put and call features embedded in the January 2008and April 2008 Debentures continue to be not clearly and closely relatedto the debt host and therefore should be bifurcated from the debt host andrecorded as a liability at their estimated fair value. The Company determinedthe net fair value of the put and call as of March 31, 2010 to be $90thousand and $155 thousand for the January 2008 and April 2008Debentures, respectively, with the related credit of $3 thousand and $6thousand, respectively, included in the Company’s statement of operations ininterest expense for the quarter ended March 31, 2010. The Companydetermined the estimated fair value of the put on March 31, 2010, usingthe Black-Scholes Merton valuation model and the following assumptions: fairvalue and exercise price of the put embedded in the January 2008 and April 2008Debentures equivalent to 130% of the outstanding principal and 

 

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accrued interest of $3,016thousand and $5,216 thousand , respectively; term of 2.75 years to the maturitydate of December 31, 2012; risk free interest rate of 1.46%; andvolatility of 16.78% which was determined using the volatility of the BankPrime Lending Rate. The Company determined the estimated fair value of the callon March 31, 2010, using the Black-Scholes Merton valuation model and thefollowing assumptions: fair value and exercise price of the call embedded inthe January 2008 and April 2008 Debentures equivalent to 100% of theoutstanding principal and accrued interest of $2,320 thousand and $4,012thousand , respectively; term of 2.75 years to the maturity date of December 31,2012; risk free interest rate of 1.46%; and volatility of 16.78% which wasdetermined using the volatility of the prime rate charged by banks in theUnited States.

 

*EmbeddedDerivatives — 10% Senior Secured Debentures*

 

Upon the issuance of the10% Senior Secured Debentures on each of January 25, 2010 and March 15,2010, the Company concluded that the conversion features embedded in the 10%Senior Secured Debentures met the criteria in ASC 815-10 to be accounted for asan equity instrument even though the 10% Senior Secured Debentures include areset provision on the conversion price and is considered non-conventionaldebt, because the Company has control to ensure the sufficiency of itsauthorized shares of common stock, as the debentures include a floor on theconversion price adjustment, and because the conversion features are notrequired to be settled in registered shares. The Company also concluded that the put and call in the 10% SeniorSecured Debentures were embedded derivatives that were not clearly and closelyrelated to the debt host and therefore should be bifurcated from the debt hostand recorded as a liability at their estimated fair value at issuance.

 

The Company determinedthe net fair value of the put and call embedded in the 10% Senior SecuredDebentures on January 25, 2010, to be $5 thousand, and recorded a discounton the debentures that will be amortized as interest expense over the life ofthe debentures using the interest method. The Company determined the estimated fair value of the put on January 25,2010, using the Black-Scholes Merton valuation model and the followingassumptions: fair value and exercise price of the put embedded in the 10%Senior Secured Debentures equivalent to 120% of the outstanding principal andaccrued interest expected to be earned to maturity of $342 thousand; term of1.67 years to the maturity date of September 30, 2011; risk free interestrate of 0.67%; and volatility of 17.66% which was determined using thevolatility of the prime rate charged by banks in the United States. The Companydetermined the estimated fair value of the call on January 25, 2010, usingthe Black-Scholes Merton valuation model and the following assumptions: fairvalue and exercise price of the call embedded in the 10% Senior SecuredDebentures equivalent to 100% of the outstanding principal and accrued interestexpected to be earned to maturity of $291,750; term of 1.67 years to thematurity date of September 30, 2011; risk free interest rate of 0.67%; andvolatility of 17.66% which was determined using the volatility of the primerate charged by banks in the United States

 

The Company determinedthe net fair value of the put and call embedded in the 10% Senior SecuredDebentures on March 15, 2010 to be $2 thousand, and recorded a discount onthe debentures that will be amortized as interest expense over the life of thedebentures using the interest method. The Company determined the estimated fair value of the put on March 15,2010, using the Black-Scholes Merton valuation model and the followingassumptions: fair value and exercise price of the put embedded in the 10% SeniorSecured Debentures equivalent to 120% of the outstanding principal and accruedinterest expected to be earned to maturity of $169,250; term of 1.54 years tothe maturity date of September 30, 2011; risk free interest rate of 0.60%;and volatility of 18.53% which was determined using the volatility of the BankPrime Lending Rate. The Company determined the estimated fair value of the callon March 15, 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 $144,250;term of 1.54 years to the maturity date of September 30, 2011; risk freeinterest rate of 0.60%; and volatility of 18.53% which was determined using thevolatility of the Bank Prime Lending Rate.

 

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As of March 31,2010, the Company concluded that the put and call features embedded in all ofthe 10% Senior Secured Debentures continue to be not clearly and closelyrelated to the debt host and therefore should be bifurcated from the debt hostand recorded as a liability at their estimated fair value. The Companydetermined the net fair value of the puts and calls to be $61 thousand for all10% Senior Secured Debentures, with the related credit of $7 thousand includedin the Company’s statement of operations in interest expense for the quarterended March 31, 2010. The Company determined the estimated fair value ofthe puts on March 31, 2010, using the Black-Scholes Merton valuation modeland the following assumptions: fair value and exercise price of the putsembedded in the 10% Senior Secured Debentures equivalent to 120% of theoutstanding principal and accrued interest of $4,725,000; term of 1.5 years tothe maturity date of September 30, 2011; risk free interest rate of 0.87%;and volatility of 17.22% which was determined using the volatility of the BankPrime Lending Rate. The Company determined the estimated fair value of thecalls on March 31, 2010, using the Black-Scholes Merton valuation modeland the following assumptions: fair value and exercise price of the callsembedded in the 10% Senior Secured Debentures equivalent to 100% of theoutstanding principal and accrued interest of $4,050,000; term of 1.5 years tothe maturity date of September 30, 2011; risk free interest rate of 0.87%;and volatility of 17.22% which was determined using the volatility of the BankPrime Lending Rate.

 

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

 

In connection with theissuance of the January 2008 and April 2008 Debentures, the Companyissued warrants to purchase 222,222 and 388,889 shares, respectively, of theCompany’s common stock at an exercise price of $1.80 per share, subject toadjustment, which warrants have a term of three years.

 

As of March 31,2010, these warrants remain outstanding and exercisable, and the Companycontinues to conclude that these warrants meet the criteria in ASC 815-10 to beaccounted for as an equity instrument.

 

*WarrantsIssued in Connection with 10% Senior Secured Debentures*

 

In connection with theissuance of the 10% Senior Secured**Debentures in September 2009,the Company issued Series I and Series II warrants to purchase3,000,000 and 2,250,000 shares, respectively, of the Company’s common stock atexercise prices of $0.60 and $0.01 per share, respectively, subject toadjustment, and with terms of five and seven years, respectively.

 

In connection with theissuance of the 10% Senior Secured**Debentures in January 2010,the Company issued Series I warrants to purchase 375,000 shares of the Company’scommon stock at an exercise price of $0.60 per share, subject to adjustment,and with a term date of September 30, 2014.

 

The Company evaluated theterms and conditions of the warrants issued with all of the 10% Senior Secured**Debentures under the guidance in ASC 815-40-25 andASC 815-40-15 to determine whether the detachable warrants should be accountedfor as equity or a liability and thereafter adjusted to their respectiveestimated fair value at each reporting date. The Companyconcluded that the Series I warrants issued with the 10% Senior Secured**Debentures in each of September 2009 and March 2010met the 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 Series I warrants issued in January 2010,to be $103 thousand and recorded a discount on the debentures with which willbe amortized as interest expense over the life of such debentures using theinterest method.

 

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The Company determinedthe estimated fair value of the Series I warrants issued in January 2010,using the Black-Scholes Merton valuation model and the 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%.

 

As of March 31,2010, all of the warrants remain outstanding and exercisable, and the Companycontinues to conclude that such warrants meet the criteria in ASC 815-10 to beaccounted for as an equity instrument.

 

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

 

In connection with theissuance of promissory notes in February, March, and July 2009, theCompany issued warrants to purchase 26,667, 133,333, and 500,000 shares,respectively, of the Company’s common stock at an exercise price of $0.75 pershare, which warrants have a term of three, three, and five years,respectively.

 

As of March 31,2010, these warrants remain outstanding and exercisable, and the Companycontinues to conclude that these warrants meet the criteria in ASC 815-10 to beaccounted for as an equity instrument.

 

*Warrantsissued with New Series A Preferred Stock*

 

In connection with theissuance of shares of New Series A Preferred Stock in December 2008and January 2009, the Company issued warrants to purchase 833,333 and10,000 shares of common stock of the Company, respectively, at an exerciseprice of $0.75 per share, and a three year term. The lead investor in thisfinancing was Daniel J.A. Kolke, the Company’s founder, chairman, chiefexecutive officer, acting chief financial officer, and chief technologyofficer, with participation from two of the Company’s directors and other priorinvestors.

 

As of March 31,2010, these warrants remain outstanding and exercisable, and the Companycontinues to conclude that these warrants meet the criteria in ASC 815-10 to beaccounted for as an equity instrument.

 

*WarrantIssued in Connection with Litigation Settlement*

 

In December 2008,the Company entered into a settlement agreement with Kaufman Bros., pursuant towhich the Company issued to Kaufman Bros. a warrant to purchase 500,000 sharesof the Company’s common stock at an exercise price of $0.75 per share, whichwarrant has a term of five years.

 

As of March 31,2010, this warrant remains outstanding and exercisable, and the Companycontinues to conclude that this warrant meets the criteria in ASC 815-10 to beaccounted for as an equity instrument.

 

*WarrantIssued in Connection with Consulting Agreement*

 

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

 

As of March 31,2010, this warrant remains outstanding and exercisable, and the Company continuesto conclude that this warrant meets the criteria in ASC 815-10 to be accountedfor as an equity instrument.

 

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The following is asummary of the movement related to embedded derivatives liabilities during thequarter ended March 31, 2010 (in thousands):

 
| ** **                                                                    | ** ** | **Embedded  derivatives** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------------------------|------------|---------------------------|------------|-----------|------------|
|                                                                          |       |                      |       |      |       |
| Balance as of  December 31, 2009                                         |       | $                         | 315        |      | $          | 315 |   |
|                                                                          |       |                      |       |      |       |
| Fair value of embedded derivatives issued with 10%  Senior Secured Debentures |       | 7                         |       | 7         |       |
| Change in marked-to-market value of  January 2008 Debentures             |       | (3                        | )          | (3        | )          |
| Change in marked-to-market value of April 2008  Debentures               |       | (6                        | )          | (6        | )          |
| Change in marked-to-market value of 10% Senior  Secured Debentures            |       | (7                        | )          | (7        | )          |
|                                                                          |       |                      |       |      |       |
| Balance as of March 31, 2010                                             |       | $                         | 306        |      | $          | 306 |   |

 

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

 

TheCompany previously entered into a series of loan transactions with the parentsand two brothers of Mr. Daniel J.A. Kolke, the Company’s founder,chairman, chief executive officer, acting chief financial officer, and chieftechnology officer.  In connection with settlement of these loans, theCompany issued three unsecured promissory notes in the aggregate principalamount of $815.8 thousand which will become secured by certain of the Company’spresently unidentified assets if and when Mr. Kolke is no longer neitheran employee nor a member of the Company’s****boardof directors. The unsecured promissory notes bear interest at 7.5 percent.  On December 22, 2009, the board ofdirectors, with Daniel J.A. Kolke abstaining, approved the issuance of 434,754shares of common stock of the Company to Daniel and Selma Kolke, as payment of45% of principal and 100% of accrued interest due on their note as of December 31,2009, at a value of $0.75 per share, or approximately $326 thousand.  The aggregate amount outstanding as of March 31,2010, 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 an unsecured note of $200 thousand in partial settlement oflitigation related to real property the Company leased in San Mateo,California.  The note bears interest of6% and is due on June 30, 2011. Accrued interest is due on March 31,2010 and June 30, 2010, and monthly payments of principal of $16,667 alongwith accrued interest begin on July 31, 2010.

 

***9. Equity***

 

*Common Stock*

 

TheCompany has 24,116,477 shares of common stock outstanding as of March 31,2010, from a total of 250,000,000 authorized shares.

 

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*PreferredStock*

 

The Company had 743,333 shares of New Series A Preferred Stock parvalue of $0.01 per share outstanding at December 31, 2009, from a total of3,333,333 authorized shares. During the quarter ended March 31, 2010,76,667 shares of New Series A Preferred Stock were converted into commonstock.

 

The rights,preferences, and privileges of the New Series A Preferred stock are asfollows:

 

*Voting Rights. *The New Series A Preferred Stock and common stockvote as a single class upon any matter submitted to the stockholders for a voteand the holder of each share of Series A Preferred Stock has the right toone vote for each share of common stock into which such share of Series APreferred Stock could then be converted.

 

*Liquidation. *The New Series A Preferred Stock is entitled to aliquidation preference before any distribution or payment is made in respect tothe common stock of 120% of the stated value. All remaining assets of the Company, if any, shall be distributed to theholders of common stock.

 

*Conversion. *Each share of New Series A Preferred Stock isconvertible, at the option of the holder, into the number of fully paid andnonassessable shares of common stock determined by dividing the stated value of$0.75 per share by the then applicable conversion price, which is currently$0.75 per share.

 

*Warrants*

 

As of March 31,2010, warrants to purchase up to 10,239,444 shares of our common stock wereexercisable 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     |                                                             | 833,333    |                    | $          | 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 |   |
| Total               |       | 10,239,444                                                       |       |                    |       |                     |       |

 

The Companydetermined the estimated fair value of its warrants issued by using theBlack-Scholes Merton model. See discussion, *supra*, Note 6.  The average exercise price of outstandingwarrants to purchase the Company’s common stock is $0.46 and $0.55,respectively, at March 31, 2010 and 2009.

 

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*Sharesreserved*

 

As of March 31,2010, the Company has the following shares of Common Stock reserved:

 
| Options Issued                |   | 9,547,998  |   |
|-------------------------------|--------|------------|--------|
| Option Plan Available         |   | 4,239,542  |   |
| Debenture Conversion(s)       |   | 13,692,695 |   |
| Debenture Interest Conversion |   | 229,107    |   |
| Warrants Issued               |   | 10,239,444 |   |
| Total                         |   | 37,948,786 |   |

 

***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                                |       | —     |       | $                                                      | —     |                                                |       |                            |       |   |
| Exercised                              |       | —     |       | $                                                      | —     |                                                |       |                            |       |   |
| Canceled                               |       | —     |       | $                                                      | —     |                                                |       |                            |       |   |
| Outstanding at  March 31, 2010    |       | 9,547,998  |       | $                                                      | 0.32       |                                                | 8.60       |                            | $          | 9,824 |   |
| Exercisable at  March 31, 2010    |       | 4,494,865  |       | $                                                      | 0.20       |                                                | 8.00       |                            | $          | 5,164 |   |
| Unvested at March 31,  2010       |       | 5,053,133  |       | $                                                      | 0.43       |                                                | 9.14       |                            | $          | 4,659 |   |

 

Aggregateintrinsic value was determined based upon the closing price of the Company’scommon stock price on March 31, 2010, of $1.35 per share. The averageexercise price of outstanding employee stock options to purchase the Company’scommon stock is $0.32 and $0.24, respectively, at March 31, 2010 and 2009.

 

Nooptions were exercised during the three months ended March 31, 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 relocated itsheadquarters from San Mateo, California to Renton, Washington and terminatedeight employees based in California.  On October 31,2008, the Company closed its offices in San Mateo, California and abandoned theleased premises of its former offices there. Effective on October 31, 2008, David S.G. MacKenzie resigned hisposition as vice president and chief financial officer and the Company has notyet appointed any person to serve separately as its chief financialofficer.  On October 31, 2008, theCompany relocated its headquarters and abandoned the subleased premises of itsformer offices in Renton, Washington.  InOctober 2008, the Company terminated eight more employees employed in bothits California and Washington offices. In connection with this restructuring plan, the Company has accrued orincurred one-time restructuring costs in the amount of $632 thousand during thequarter and year ended December 31, 2008. In 2009, the Company revised these restructuring costs based on updatedinformation from settlements entered into with the landlord of the San Mateoleased premises and the Company’s former chief executive officer.

 

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As part of its reduction of monthly cash operatingexpenses during the quarter ended September 30, 2008, and continuingthrough the date of this report, the Company placed all employees on partialdeferrals of salary, ranging from 10% to 100% of base salary and accrued thesedeferrals.  At March 31, 2010, andas of the date of this report, this deferral amount remains unpaid, includingamounts due to former employees who were employed in the Company’s Californiaoffice.

 

The following summarizes the Company’s restructuringcharges:

 
| ** **                      | ** ** | **Office &  Equipment  Leases** | ** ** | **Employee  Termination  Costs** | ** ** | **Other** | ** ** | **Total** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|----------------------------------|------------|-----------|------------|-----------|------------|
|                            |       |                                     |       |                             |       |      |       |      |       |
| Balance: December 31, 2009 |       | $                                        | 633        |                             | $          | —    |       | $         | 73         |   | $ | 706 |   |
|                            |       |                                     |       |                             |       |      |       |      |       |
| Less: Payments                  |       | (325                                     | )          | —                           |       | —    |       | (325      | )          |
|                            |       |                                     |       |                             |       |      |       |      |       |
| Balance: March 31, 2010    |       | $                                        | 308        |                             | $          | —    |       | $         | 73         |   | $ | 381 |   |

 

Theabove restructuring cost liabilities as of March 31, 2010 are included inOther Accrued Expenses in the Company’s balance sheet.

 

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”) inthe Superior Court of San Mateo County, California (Case No. CIV479535).  A default judgment was setaside because the landlord failed to properly serve either the Company orEtelos-WA. The Company was subsequently served properly and trial was set for February 8,2010.  The parties went to mediation in January 2010and subsequently entered into a settlement agreement, including a release ofclaims, in which the Company agreed: (a) to pay $66,000 in cash within 30days, (b) to issue 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.

 

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***12. Commitments and Contingencies***

 

**Financing Obligations**

 

The following is a summary of the maturity scheduleof our convertible notes and debentures obligations as of March 31, 2010:

 
| ** **          | ** ** | **Convertible  Notes and  Debentures** | ** ** | **Notes  Payable** | ** ** | **Total** | ** ** |
|---------------------|------------|----------------------------------------|------------|--------------------|------------|-----------|------------|
| 2010                |       | $                                      | 1,689      |               | $          | 258       |       | $ | 1,947 |   |
| 2011                |       | 3,375                                  |       | 100                |       | 3,475     |       |
| 2012                |       | 6,332                                  |       | —             |       | 6,332     |       |
| 2013                |       | —                                 |       | —             |       | —    |       |
| 2014 and thereafter |       | —                                 |       | 286                |       | 286       |       |
| Total               |       | $                                      | 11,396     |               | $          | 644       |       | $ | 12,040 |   |

 

**Operating and Capital Leases**

 

All capital leases were paid off in full during theyear ended December 31, 2009.

 

See Note 13, Subsequent Events, for a discussionregarding the Company’s subleased premises in Renton, Washington.

 

**Other Commitments**

 

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.

 

See Note 13, Subsequent Events, for a discussionregarding unpaid salaries due to current employees.

 

***13. Subsequent Events***

 

On October 31, 2008, the Company relocated itWashington offices and abandoned the sub-leased premises of its former officesin Renton, Washington. The sublease for these premises runs through June 2010.  On March 5, 2010, the prime landlordfiled a complaint for breach of contract and successor liability. (King County(WA) Superior Court No. 10-2-09385-1 KNT). On March 26, 2010, theCompany filed an answer and counterclaim and asserted affirmative defenses againstthe prime landlord, including that the prime landlord is not a party to thesublease for the premises.  Subsequently,on April 8, 2010, the sub-landlord served a third party complaint againstthe Company relating to the same subleased premises, in a proceeding filedagainst the sub-landlord by the prime landlord (King County (WA) Superior CourtNo. 10-2- 09840-2 KNT), in which the sub-landlord asserted affirmativedefenses and counterclaims against the prime landlord, including that,beginning in December 2008, the premises were unusable due to water damageand lack of maintenance or repairs by the prime landlord.  The Company has accrued the rent expenseaccording to the terms of the sublease as restructuring charges since 2008 andthe liability balance remains unpaid and accrued as of March 31,2010.  These matters are being evaluated.

 

On April 5, 2010, the Company was served with asummons and complaint for breach of contract and unjust enrichment by LakebayTechnologies LLC  (King County (WA) SuperiorCourt No. 10-2-10054-7). This matter is currently being evaluated by the Company.

 

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In partial settlement ofapproximately $273 thousand of an aggregate $574 thousand in unpaid salariesdue and owing to current employees of the Company as of December 31, 2009,the board of directors authorized the registration of 500,000 shares of commonstock previously reserved under the Company’s 2009 Equity Incentive Plan aspartial payment of up to 50% of the amount of unpaid salary due and owing toeach current employee. Of those 500,000 shares, 346,123 are to be issued at aneffective price of $0.79 per share, under the registration statement filed on April 9,2010.

 

On March 31, 2010,the board of directors authorized a warrant replacement financing, wherebyholders of existing warrants that paid cash to exercise their warrants prior toApril 30, 2010, would receive a new warrant in substantially identicalform as the exercised warrant, with an exercise price equal to the closingprice of the Company’s common stock on the date of exercise.  Since March 31, 2010, the Company hasreceived $125 thousand from the exercise of warrants to purchase 166,667 sharesof common stock with an average exercise price of $0.75 per share.

 

The Company failed tomake the required interest payments on the 10% Senior Secured Debentures duringthe quarter ended March 31, 2010, and through the date of thisreport.  In exchange for the holders ofthe 10% Senior Secured Debentures agreeing to waive their remedies in the eventof this default, the Company’s board of directors, in April, authorized theCompany to issue 50,484 shares of common stock to the holders of the 10% SeniorSecured Debentures in consideration of their agreement to waive the default,for the quarter ending March 31, 2010.  Under the terms of thatagreement, covering all periods through July 1, 2010, the Companycontinues to accrue interest at the stated interest rate, which interest willbe payable at maturity, and to classify the 10% Senior Secured Debentures aslong-term liabilities in the Company’s financial statements.

 

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

 

**Overview**

** **

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

 

***Business***

 

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

 

We have developedproducts for Web Applications, which include open standards-based tools for Webdevelopers, businesses and individual users such as the Etelos ApplicationServerTM (EASTM)and the Etelos Development EnvironmentTM (EDETM).  EAS and EDE support many common programminglanguages and also support our English Application Scripting Engine (EASETM), an open standards-based scripting language 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.

 

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Our business model focuses on the sales and operationof private-label Web application marketplaces, including provision of theprofessional services required to develop, deploy and operate suchmarketplaces, and the launch of offerings of the Etelos Platform SuiteTM.  The Etelos Platform Suite is designed toallow Independent Software Vendors (ISVs) to implement a SaaS delivery versionof their existing applications, whether or not those applications are alreadyWeb Applications, and to syndicate the offering of those applications throughmultiple private label marketplaces. In these difficult economic times, webelieve that a variety of ISVs will have applications that they need to move tothe Web for lower cost implementation, easier, simpler scalability, and broaderdistribution. The Etelos Platform Suite also enables Marketplace Partners,including non-technology businesses, to have their own private labelmarketplaces and tools to offer SaaS Web Applications to better serve theircustomers in multiple distribution channels.

 

Although we have long enabled applications to bedistributed via the Web, we believe that our shift away from a direct marketingfocus to providing professional services and tools to ISVs will have four majorbenefits for our business.  These benefitsare as follows:

 

·      This strategy will expose the core Etelosplatform to more ISVs for greater benefit to their end users and the creationof a larger pool of applications for syndication.

·      The development and operation of thirdparty-branded marketplaces shifts the financial expense and operational burdensof sales and marketing to end users to Marketplace Partners that better knowtheir customers and are better capitalized to support necessary sales andmarketing activities.

·      This two-pronged go-to-market strategy isoffered on a revenue-sharing basis, which reduces barriers to acceptance byeliminating up front costs for Syndication Partners to offer their productsthrough multiple Marketplace Partners, and by paying Marketplace Partners onlyfor sales success.

·      This shift allows us to focus on our corecompetency in development and operation of online marketplaces, while bettermanaging limited financial and other resources.

 

In addition to revenuesfrom consulting services, we receive a transaction fee or subscription fee fortransactions that occur within these private-label Web applicationmarketplaces.  Most customers in thesemarketplaces pay a subscription fee, which we share with Syndication Partnersand Marketplace Partners; this revenue share is calculated as a percentage ofgross revenues from the sale of subscriptions to Syndication Partner offeringsin private-label Web application marketplaces operating on the Etelos PlatformSuite.

 

***History***

 

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

 

On February 8, 2007, Tripath Technology Inc., aDelaware corporation filed a voluntary petition for relief under Chapter 11 ofthe Bankruptcy Code. On February 1, 2008, the bankruptcy court issued anorder confirming approval of Tripath’s plan of reorganization, including themerger and the transfer of all of Tripath’s existing assets into a separatebankruptcy estate and the discharge of all of Tripath’s liabilities.  The plan of reorganization also contemplatedthe merger of Etelos, Incorporated with and into Tripath.

 

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

 

 

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***Recent Developments***

 

***Financings***

 

On June 30, 2009, we restructured the convertible6% secured debentures we issued in January 2008 and April 2008 in theprincipal amount of $5.5 million. Under the terms of the restructuring, theterms of the debentures were extended to December 31, 2012, interestaccrues at 0% from the date of the restructuring until October 1, 2010,and at 6% thereafter. All accrued but unpaid interest as of June 30, 2009,and interest due to be earned to September 30, 2010 under the originalterms of the debentures was added to the principal amount and is payable on thedate of maturity.  Our obligation to makemonthly amortizing redemption payments was terminated; we will make semi-annualinterest payments only. We also agreed to terminate the registration rightsagreement entered into with the debentures and to to exchange for no cashconsideration, all or a portion of the warrants issued in connection with thesedebentures for shares of our Common Stock, at a ratio of one share of commonstock for each share of common stock underlying such 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.

 

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 certainconditions, to require the investor to purchase an additional debenture in theprincipal amount of $125 thousand between March 15 and 31, 2010. Weexercised that right on March 15, 2010, and issued an additional debenturein the principal amount of $125 thousand to an entity affiliated with Mr. Morissette.  See “MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS — Liquidity and Capital Resources”below for a description of the terms of all of our outstanding debentures.

 

The Company failed to make the requiredinterest payments on the 10% Senior Secured Debentures during the quarter endedMarch 31, 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, authorized the Company toissue 50,484 shares of common stock to the holders of the 10% Senior SecuredDebentures in consideration of their agreement to waive the default, for thequarter ending March 31, 2010.  Under the terms of that agreement,covering all periods through July 1, 2010, 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.

 

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***Business***

 

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

 

Although we have longenabled applications to be distributed via the Web, we believe this shift awayfrom a core direct marketing focus of offering multiple products through asingle portal in the Etelos Marketplace will have four major benefits for our business.First, this offering will expose the core platform to more ISVs for greaterbenefit to their end users and the creation of a larger pool of applicationsfor syndication. Second, the development and operation of third party-brandedmarketplaces shifts the financial expense and operational burdens of sales andmarketing to end users to Marketplace Partners that better know their customersand are better capitalized to support necessary sales and marketing activities. Third, because this two-pronged go-to-market strategy is offered on arevenue-sharing basis, it fundamentally reduces barriers to acceptance byeliminating up front costs for Syndication Partners to offer their productsthrough multiple Marketplace Partners, and by charging Marketplace Partnersonly for sales success.  Finally, thisshift allows us to focus on our core competency in development and operation ofonline marketplaces, while better managing limited financial and otherresources.

 

During the period ended December 31,2008, we began to implement this shift and, during the periods up to the dateof this report, we have entered into new Syndication Partner agreements withISVs to deliver SaaS-enabled versions of their products and to syndicate thoseapps for distribution through a number of third party-branded SaaSmarketplaces. In the interim periods, we have launched third party privatelabeled marketplaces and we have announced agreements to market and launchadditional third party private label marketplaces, including to third partiesnot traditionally regarded as technology providers.  We expect to makefurther such announcements reflecting this shift during the coming months butwe do not have an estimate or projection of how, or when, or if, the benefits,if any, of this shift will be reflected in our operating results.

 

In the quarter ended December 31, 2009, andsubsequently, we resolved a number of significant litigation items in a mannerthat 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.

 

In addition, payment schedules for approximately $300thousand in long overdue accounts payable have been negotiated for payment overthe next 6-12 months.

 

In partial settlement ofapproximately $273 thousand of an aggregate $574 thousand in unpaid salariesdue and owing to current employees of the Company as of December 31, 2009,the board of directors authorized the registration of 500,000 shares of commonstock previously reserved under the Company’s 2009 Equity Incentive Plan as partialpayment of up to 50% of the amount of unpaid salary due and owing to eachcurrent employee.  Of those 500,000shares, 346,123 shares are to be issued at an effective price of $0.79 pershare, under the registration statement filed on April 9, 2010.

 

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On March 31, 2010,the board of directors authorized a warrant replacement financing, wherebyholders of warrants that paid cash to exercise their warrants prior to April 30,2010, would receive an replacement warrant in substantially identical form asthe exercised warrant, with an execicse price equal to the closing price of theCompany’s common stock on the date of exercise. See Subsequent Events.

 

***Industry Background***

 

The 1990s saw thewidespread adoption among large enterprises of packaged business managementapplications that automated a variety of departmental functions, such asaccounting, 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-Medium sizedBusinesses (SMBs), which we define as businesses with up to 1,000 employees,have application software requirements that are similar, in many respects, tolarge enterprises because their core business processes are substantially thesame. These requirements include the integration of back-office activities,such as managing payroll and tracking inventory; front-office activities,including order management and customer support; and, increasingly, sophisticatede-commerce capabilities. According to a 2006 forecast for the CRM market and2007 forecasts for the ERP and supply chain management, or SCM, markets fromGartner, Inc., companies in North America spent approximately $13.7billion on ERP, CRM, and SCM software applications in 2006, of which SMBsaccounted for $4.4 billion, or 32 percent. Gartner projects that SMB spendingon these applications will grow 8.7 percent annually from 2006 to 2010,compared to 5.7 percent for large businesses.

 

SMBs are generally lesscapable than large enterprises of performing the costly, complex, andtime-consuming integration of multiple point products from one or more vendors.As a result, a comprehensive business suite may provide comparatively greaterbenefits and value for the SMB customer. Suites designed for, and broadlyadopted by, large enterprises to provide a comprehensive, integrated platformfor managing these core business processes generally are not well suited toSMBs due to the complexity and cost of such applications.

 

Recently, SMBs have begunto benefit from the development of the on-demand SaaS model. SaaS uses theInternet to provide users with access to software applications from a centrallyhosted computing facility through a web browser. SaaS eliminates the costsassociated with installing and maintaining applications within the customer’sinformation technology infrastructure. On-demand applications are generallylicensed for a monthly, quarterly or annual subscription fee, as opposed toon-premise enterprise applications that typically require the payment of a muchlarger, upfront license fee. As a result, on-demand applications requiresubstantially less initial and ongoing investment in software, hardware andimplementation services and lower ongoing support and maintenance, making themmore affordable for SMBs.

 

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To date, the on-demandsoftware model has been applied to a variety of types of business softwareapplications, including CRM, security, accounting, human resources management,messaging, and others, and it has been broadly adopted by a wide variety ofbusinesses. IDC estimates worldwide on-demand enterprise software vendorrevenues were approximately $3.7 billion in 2006 and that they will grow 32percent annually through 2011 to $14.8 billion.

 

While SaaS applicationshave enabled SMBs to benefit from enterprise-class capabilities, most are stillproducts that require extensive, costly, and time-consuming integration to workwith other applications. SMBs generally have been unable to implement acomprehensive set of business management products at an affordable level ofcost that will enable them to run their businesses using a single system ofrecords, provide real-time views of their operations, and be readilycustomizable and rapidly deployed and implemented, especially in ageographically dispersed organization.

 

***EtelosTM Products and Services***

 

We have developed andoffer a range of products and services for developers and for consumers of WebApplications.  Our product offerings aregrouped into two basic programs: the Etelos EcosystemTM and the Etelos Platform SuiteTM.

 

The Etelos Ecosystem. The Etelos Ecosystem is a dynamicdevelopment, distribution, and consumption environment for scaling applicationsand providing business solutions to common business problems.  Ourecosystem is constantly being improved and expanded to contain the tools andsupport programs that help foster continued development of a network of addedvalue development and distribution partners.

 

Our products for WebApplications include open standards-based tools for Web developers, businessand individual users such as the Etelos Application ServerTM (EASTM) and theEtelos Development EnvironmentTM (EDETM).  EAS and EDE support manycommon application languages and also support the English Application ScriptingEngine (EASETM),our simple-to-use open standards scripting language.  In order to supportbroader adoption of our products, EASE and other components of our platform areprovided to developers and users at 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, sales and support ofthese applications.  We generally receive a transaction fee, arevenue-share based subscription fee or a license fee for transactions thatoccur within the Etelos ecosystem via an Etelos Marketplace.

 

Web Applications builtwith or brought to the Etelos ecosystem are made available for distribution inan Etelos Marketplace as a subscription service using the Software-as-a-Service(SaaS) or software-on-demand business model. The Etelos ecosystem givesdevelopers of Web Applications, including us, an easy place to distribute andsupport Web Applications.  Web Applications delivered through the EtelosMarketplace or through third-party branded Marketplaces operated by us can beeasily and conveniently billed, distributed and configured to provide updatesand support to users exactly in accordance with the developer’s desires,without requiring the developer to perform development unrelated to theunderlying Web Application or to operate a robust licensing and deliveryinfrastructure.  An Etelos Marketplace relieves the burdens to developersof delivery and support to the users of their Web Applications.  We alsoprovide additional paid professional services and support on behalf of ourSyndication and Marketplace Partners.

 

An Etelos Marketplaceenables rapid adoption of Web Applications by giving customers freedom ofchoice to select from a wide array of fully customizable, on-demand businessapplications.  These applications may be deployed in the hostingenvironment of the customer’s choice, including hosting services providedthrough us. 

 

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Web Applications built onour platform may be integrated with other Web Applications through the use ofEtelos App SyncTM,hosted anywhere, and customized to create highly flexible business solutions. Not only can businesses easily choose from a range of Web Applications, butthey can instantly “try or buy” them. The flexibility of the Etelos ecosystemenables businesses to assemble a Web Applications suite.  TheBuild-a-SuiteTMconcept is ideally tailored for particular business needs and building scalablesolutions.

 

Etelos Platform Suite

 

The Etelos Platform Suite allows third parties touse our software platforms and our services to develop and operate privatelabel applications and marketplaces.  Webegan working with third parties on private label solutions in November 2008and our first customers launched their private label marketplaces in mid-fiscal2009.

 

There are four components to the Etelos PlatformSuite:

 

·                                          The SaaS Application Platform enablestechnology providers to move their non-Web Application or service to web-basedSaaS distribution;

·                                          The SaaS Marketplace Platform enablesthird parties to offer a variety of syndicated Web Applications and services ina third party-branded SaaS marketplace;

·                                          The SaaS Distribution Platform allowstechnology companies and service providers to distribute additional WebApplications and services to customers on a SaaS platform; and

·                                          The SaaS Syndication Platform lets SaaSproviders distribute their Web Applications and services through a network ofthird party-branded marketplaces.

 

The Etelos Platform Suite allowsour customers to take advantage of our tools and experience in the SaaS marketto move their existing applications to the Web for lower costimplementation, easier, simpler scalability, and broader distribution. Our Etelos Platform Suite enables Marketplace Partners, includingnon-technology businesses, to have their own private label marketplaces andtools to offer SaaS Web Applications to better serve their customers inmultiple distribution channels.

 

Etelos Web ApplicationHosting. By usingalmost any programming language a developer chooses, including our own EASElanguage, and by hosting Web Applications wherever users want, utilizing ourEtelos Application Server, the Etelos Development Environment allows ourpartners to extend solutions using our platform.  Our customers rely on our products and theproducts of our Syndication Partners to run their businesses, and, as a result,it is our responsibility to ensure the availability of our service. We continueto improve our infrastructure with the goal of maximizing the availability ofour Web Applications and those of our developers, distributors and users. We host on a highly-scalable network located in secure third-partyfacilities.  We have facility space, power, and Internet connectivityprovided by Network OS, a third party co-location and hosting provider, locatedin the Seattle, WA area. In anticipation of future growth, we may engageadditional providers and/or expand the number of data centers utilized withexisting vendors. Our hosting operations incorporate industry-standard hardwareand our EAS operating system and databases and application servers provide aflexible, scalable architecture. Elements of our products’ infrastructure canbe replaced or added with no interruption in service, helping to ensure thatthe failure of any single device will not cause a broad service outage.

 

 

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Professional Services.

 

We are developingrepeatable, cost-effective consulting and implementation services to assist ourcustomers with integrating Web Applications, using them on and off-line andimporting data from other systems. We provide support services to aid inchanging their business processes to take advantage of the enhanced flexibilityenabled by our Build-a-Suite concept. Build-a-Suite enables ourcustomers to implement cost reducing, scalable business processes within theirorganization and identifying, configuring, and customizing our products andthose of our partners for each unique business process and requirement, with agoal of entering data once and using it across the organization and across theapplications used by the business.

 

Our consulting andimplementation methodology leverages the nature of our on-demand WebApplication software architecture, the industry-specific expertise of ourprofessional services employees, and the design of the Etelos ecosystem andPrivate-label Web application marketplaces operating on the Etelos PlatformSuite. They are used to simplify, reduce costs and expedite the implementationof scalable Web Applications to aid in better business operations. We generallyemploy a joint staffing model for implementation projects in which we involvethe customer more actively in the implementation process than traditionalsoftware companies. We believe this better prepares our customers to supporttheir own application set.  In addition, because our Web Applications areon-demand, our Professional Services employees can remotely configure manyapplications for most situations. Our consulting and implementation servicesare generally offered on a fixed price basis. Our network of partners alsoprovides professional services to our customers.

 

Customer Support andManagement.

 

Our technical supportorganization, with personnel in the United States, offers support via the Web24 hours a day, seven days a week. Our system allows for skills-based and timezone-based routing to address general and technical inquiries across allaspects of our services. For our direct customers and development partners, weoffer tiered customer support programs depending upon the service needs of bothour and their customers’ Web Applications. Support contracts typically have aone-year term. For customers who purchase Web Applications through distributionpartners, we attempt to assure a quality customer experience by providingprimary product support, instead of permitting the distribution partner toprovide that support.

 

***Etelos Benefits***

 

The advantages of our products and services are:

 

Open Standards.  Products distributed in an EtelosMarketplace are developed on open standards.  This foundation makes theproducts 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 an Etelos Marketplace 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-Demand Delivery Model. We deliver our products over theInternet as a license-based or subscription based service using a SaaS model,making adoption easy and scalability simple.  The SaaS delivery model alsoeliminates the need for customers to buy and maintain on-premise hardware andsoftware. Our products are designed to be reliable, scalable and secure. Ourarchitecture enables businesses to maintain very high levels of availability,scale easily as their business and customers grow while providing a safe andsecure environment for business-critical data and applications.

 

Low Total Cost ofOwnership. OurSaaS delivery model and each different Web Application’s ease of use andconfigurability aids in helping to significantly reduce implementation andmaintenance costs of hardware, software and services. The Etelos ecosystemvirtually eliminates the need for dedicated software development 

 

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or information technologysupport personnel. Customers subscribe to products through an EtelosMarketplace for a monthly fee based on the number of users and the productsthey select.  Subscription fees paid to us periodically, typicallymonthly, tend to be significantly less than typical upfront costs paid bybusinesses to purchase product licenses from other providers. Our on-demanddelivery model virtually eliminates ongoing maintenance and upgrade costsassociated with a typical distributed infrastructure. Because Web Applicationsdistributed in an Etelos Marketplace are developed on open standards anddelivered over the Internet, any desired customization can be highly targeted,and therefore usually performed at lower cost to the business customer.

 

Rapid Implementation. The Internet-based on-demand deliverymodel implemented by an Etelos Marketplace enables remote deployment andeliminates many of the steps and costs typically associated with on-premiseinstallations. Syndication Partners and their customers can implement ourofferings themselves, or work with our development partners or our professionalservices organization to meet their specific needs.

 

Security, Control andChoice.  Thecombination of open standards and Internet-based on-demand delivery and supportenabled using an Etelos Marketplace provides customers with security for theirimportant business data, control over the use and portability of that data, andflexibility and freedom of choice in Web Applications that provide built-inquality and scalability as solutions to specific business needs.

 

***Sales and Marketing***

 

We generate sales throughboth indirect and direct approaches. Most selling of subscriptions for WebApplications and Hosting is done over the Internet.  Sales of customproducts and Professional Services tend to be direct. Our direct sales teamconsists of professionals in various locations in the United States, includingresellers, with additional development, distribution, and businessrelationships being developed in North America, South America, Europe, and theAsia-Pacific region.

 

Our Web Applications andHosting sales activities generally are the result of word of mouth, marketingprograms, or user referrals.  Our sales and support personnel provide webbased seminars, forums, and direct support services to ensure continuedsubscription sales.  The sales cycle typically ranges from days to months,and can vary based on the Web Application, the scope of any customizationdesired, and the scope of any professional services required to meet specificcustomer requirements.

 

Our sales process forCustom Products and Professional Services typically begins with the generationof a sales lead from a marketing program or customer referral. After the leadis qualified, our sales personnel conduct focused web-based demonstrationsalong with initial price discussions. Members of our professional services teamare engaged, as needed, to offer insight around aspects of the implementation.Our sales cycle typically ranges from days to months, but can vary based on thespecific application, the size and complexity of the potential customer’sinformation technology environment, and many other factors.

 

We tailor our marketingefforts around relevant application categories, customer sizes, and customerindustries. As part of our marketing strategy, we have established a number ofkey programs and initiatives, including online and search engine advertising,email campaigns, web based seminars, product launch events, trade show andindustry event sponsorship and participation, and marketing support fordevelopment and distribution partners.

 

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***Critical Accounting Policies Involving ManagementEstimates and Assumptions***

 

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

 

***Allowance for Doubtful Accounts***

 

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

 

***Revenue Recognition***

 

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

 

·                  Persuasive evidence of anarrangement exists,

·                  The product or service hasbeen delivered,

·                  The fee is fixed ordeterminable, and

·                  Collection of the resultingreceivable is reasonably assured or probable.

 

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

 

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

 

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.

 

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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 of operations.  To date, because we plan to license all oursoftware products, we have determined that the provisions of ASC 985-20 shouldbe 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.

 

***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 subjective assumptions,including the expected term of the stock-based awards, stock price volatility,and the pre-vesting option forfeiture rate. We estimate the expected life ofoptions granted based on historical exercise patterns, which we believe arerepresentative of future behavior. We estimate the volatility of our commonstock on the date of grant based on the historical volatility of other publiclytraded companies in our industry. The assumptions used in calculating the fairvalue of stock-based awards represent our best estimates, but these estimatesinvolve inherent uncertainties and the application of management judgment. As aresult, if factors change and we use different assumptions, our stock-basedcompensation expense could be materially different in the future. In addition,we are required to estimate the expected forfeiture rate, as well as theprobability that performance conditions that affect the vesting of certainawards will be achieved, and only recognize expense for those shares expectedto vest. We estimate the forfeiture rate based on historical

 

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experienceof our stock-based awards that are granted, exercised, and cancelled. If ouractual forfeiture rate is materially different from our estimate, the stock-basedcompensation expense could be significantly different from what we haverecorded in the current period. Beginning in the quarter ended December 31,2008, and continuing in the quarter ended March 31, 2010, the globaleconomy has been highly volatile and, during this period, the Company found itnecessary to take drastic measures to reduce operating expenses, but thelikelihood of success of these efforts cannot be predicted.  Therefore the forfeiture rate in the quarterended December 31, 2008, was very high. The forfeiture rate declined substantially during the three months endedMarch 31, 2010, but it is not known whether this forfeiture rate will bemaintained in the future; management will continue to monitor its estimates.

 

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

 

Weevaluate the embedded derivatives included in the debt instruments we issueunder the guidance in ASC 815-10 “Derivatives and Hedging” (ASC 815-10) on theissuance date of the debt and on each subsequent reporting date to determinewhether such embedded derivatives are clearly and closely related to the debthost.  The purpose of the evaluation isto determine whether the embedded derivatives, which are not clearly andclosely related 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) theCompany can settle the derivative in cash or its own stock, at its option, (ii) settlementcan be made in unregistered shares, and (iii) the Company has sufficientauthorized shares to issue shares of its common stock for all equityinstruments convertible to or which can be exercised for its capital stock. ASC815-10 also provides guidance on when put and call features included in a debthost agreement are not clearly and closely related to the debt host and must bebifurcated and recorded as liability. The guidance in ASC 815-10 is complex and it has many interpretations.  Accordingly, we must use judgment to applyand interpret this guidance as well as ensure we have applied the correctguidance.

 

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 judgmentmay vary from quarter to quarter and changes in estimates may result insignificant increases or decreases in expenses. Moreover, because of the relative size of our operations and the numberof stock options and derivative instruments we have issued, income and expensesassociated with changes in the value of outstanding derivative securitieshistorically have had an 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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**Results of Operations**

 

***Three Months Ended March 31, 2010, Compared with ThreeMonths Ended March 31, 2009***

 

***Revenues***

 

Revenues were $2 thousandand $58 thousand for the quarters ended March 31, 2010 and 2009,respectively. Revenues decreased by $56 thousand, or 97 percent, in the threemonths ended March 31, 2010, compared to the same period in 2009.  This decrease was due to our focus on theimplementation of longer-term projects without immediate cash flow.  In the year ended December 31, 2009, andthrough the date of this report, we also experienced a significant decline insales of our customer resource management product, which had been introduced inmid-2007.

 

***Cost of Revenue***

 

Cost of revenue includes our costs of hardware, software and otherresources used in delivery of our products and services. Cost of revenue was $9thousand and $93 thousand for the quarters ended March 31, 2010 and 2009,respectively. Cost of revenue for the three months ended March 31, 2010,decreased by $84 thousand, or by 90 percent.  The decrease in cost ofrevenue was primarily attributable to the decreased costs of hosting andInternet bandwidth associated with the deployment of our products and services.Stated as a percentage of revenues, cost of revenue for the three months ended March 31,2010, was 450 percent and for the corresponding period of 2009 was 160 percent.

 

***Operating Expenses***

 

*Researchand Development*. Research and development expenses include primarily employee and employeerelated expenses. Research and development expenses were $264 thousand and $255thousand for the quarters ended March 31, 2010 and 2009, respectively.Stated as a percentage of revenues, research and development expenses for thecorresponding periods were 13,200 percent and 440 percent, respectively.Research and development expenses increased by $9 thousand or by 4 percent, in thethree months ended March 31, 2010, compared to the same period in 2009. This increase was primarily due to increased salary and benefits expensesfor engineers engaged in research and development.

 

*Salesand Marketing Expenses*.  Sales and marketing expenses include payroll, employeebenefits, and other headcount-related costs associated with sales and marketingpersonnel and travel, advertising, promotions, trade shows, seminars, and otherprograms. Sales and marketing expenses were $166 thousand and $160 thousand forthe quarters ended March 31, 2010 and 2009, respectively. The $6 thousand,or 4 percent, increase in sales and marketing expenses was due to increasedactivities of sales and marketing during this period.  Stated as a percentage of revenues, sales andmarketing expenses for the corresponding periods was 8,300 percent and 276percent, respectively.

 

*Generaland Administrative.* General and administrative expenses include payroll and related employeebenefits, and other headcount-related costs associated with finance,facilities, legal and other administrative expenses. General and administrativeexpenses were $366 thousand and $1,736 thousand for the quarters ended March 31,2010 and 2009, respectively. The $1,370 thousand, or 79 percent, decrease wasprimarily attributable to a one time expense in the quarter ended March 31,2009 regarding a consulting agreement paid by the issuance of shares andwarrants valued at approximately $1.5 million, offset by an increase ofapproximately 

 

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$100 thousand due to theuse of consultants and temporary personnel for accounting, administrative andlegal purposes.  Stated as a percentageof revenues, general and administrative expense for the corresponding periodswas 18,300 percent and 2,993 percent, respectively.

 

***Interest Expense***

 

Interest expense was $416 thousand for the threemonths ended March 31, 2010, compared to $2,094 thousand for thecomparable period of 2009, and consists primarily of interest expense onconvertible notes and debentures, amortization of discounts on convertiblenotes and debentures, and the change in mark-to-market valuation of derivativeand warrant liabilities. The decrease of $1,678 thousand in interest expensefrom 2009 to 2010 primarily related to the reduction in the mark-to-marketvaluation of warrant liabilities due to their reclassification from liabilitiesto equity upon the restructuring of the January 2008 and April 2008Debentures in June 2009.

 

***Net Loss***

 

Our net loss was $1.2million for the quarter ending March 31, 2010, compared to net loss of$6.4 million for the quarter ending March 31, 2009, a decrease of $5.2million.  The decrease from 2009 to 2010 was primarily due to the $4.2million change in the mark-to-market valuation of derivative and warrantliabilities primarily due to the decrease in the Company’s stock price at March 31,2009, from December 31, 2008, and a decrease in operating expenses of $1.4million as noted above.

 

**Liquidity and Capital Resources**

 

OnMarch 31, 2010, we had $12 thousand in cash and cash equivalents, netaccounts receivable of $46 thousand, and prepaid expenses and other currentassets and other receivables of $182 thousand. Our working capital deficit at March 31, 2010, was $5.3 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.

 

Netcash used by operating activities during the three months ended March 31,2010, was $749 thousand, compared to $218 thousand during the three monthsended March 31, 2009. The primary use of cash from operating activitiesduring the three months ended March 31, 2010, was related to payment ofexpenses relating to accounting and compliance.

 

Investingactivities did not provide any cash during the three months ended March 31,2010.  At that date we did not have anysignificant commitments for capital expenditures.

 

Netcash provided by financing activities during the three months ended March 31,2010, was $316 thousand, primarily from the issuance of various promissorynotes and the 10% Senior Secured Debentures, in the aggregate amount of $375thousand, net of loan payment of $59 thousand. See “ — Recent Developments” 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 mid 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 

 

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cashflow situation that include: (1) raising capital through additional saleof our common stock and/or debentures and (2) reducing cash operatingexpenses to levels that are in line with current revenues.  If we cannot obtain additional financing,then we may be forced to curtail our operations, cease voluntarily filing reportswith the SEC, or possibly be forced to evaluate a sale or liquidation of ourassets or consider other strategic alternatives such as bankruptcy.  Even if we are successful in raisingadditional funds, there is no assurance regarding the terms of any additionalinvestment and any such investment or other strategic alternative would likelysubstantially dilute or eliminate the interests of our stockholders.

 

***September 2007 Notes***

 

OurSeptember 2007 notes were issued as part of a private placement that wascompleted during August and September 2007.  In that private placement we issued a totalof approximately $3.3 million of 6% convertible notes at an original issuediscount of 10% with 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 Partners LP purchased the January 2008 Debentures then heldby Hudson Bay Fund LTD and 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 our January 2008Debentures; 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.

 

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On March 2, 2009,Enable Growth Partners LP purchased the April 2008 Debentures then held byHudson Bay Overseas Fund LTD; price terms were not disclosed.  As a result of this transaction, EnableGrowth Partners LP owns all of the April 2008 Debentures.

 

OnJune 30, 2009, we executed an agreement to restructure our January 2008and April 2008 Debentures, which have an aggregate principal amount of$5.5 million.  Under the terms of theagreement, the terms of the debentures were extended to December 31, 2012,interest accrual will be at 0% from the date of the agreement until October 1,2010, and all accrued interest as of October 1, 2010, has been added toprincipal to be paid at maturity. Our obligations to make monthly amortizingredemption payments has been terminated; we are required to make semi-annualinterest payments only, beginning January 1, 2011. The registration rightsagreement entered into in connection with the debentures was terminated and weagreed 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..

 

***10%Senior Secured Debentures***

 

See “ — RecentDevelopments” above.

 

***Operating and Capital Leases***

 

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

 

**Off Balance Sheet Arrangements**

 

Wedid not have any off-balance sheet arrangements as of the period ended March 31,2010.

 

**Going Concern 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 March 31, 2010, we have been unable to generate cashflows sufficient to support our operations and have been dependent on debtraised from qualified investors.

 

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

 

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

 

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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 October 2009, the FinancialAccounting Standards Board (“FASB”) issued new standards forrevenue recognition with multiple deliverables. These new standards impact thedetermination of when the individual deliverables included in amultiple-element arrangement may be treated as separate units of accounting.Additionally, these new standards modify the manner in which the transactionconsideration is allocated across the separately identified deliverables by nolonger permitting the residual method of allocating arrangement consideration.These new standards are required to be adopted in the first quarter of 2011;however, early adoption is permitted. The Company does not expect these newstandards to significantly impact the financial statements.

 

InOctober 2009, the FASB issued new standards for the accounting for certainrevenue arrangements that include software elements. These new standards amendthe scope of pre-existing software revenue guidance by removing from theguidance non-software components of tangible products and certain softwarecomponents of tangible products. These new standards are required to be adoptedin the first quarter of 2011; however, early adoption is permitted. The Companydoes not expect these new standards to significantly impact the financialstatements.

 

InJanuary 2010, the Financial Accounting Standards Board (“FASB”) issuedamended standards that require additional fair value disclosures. These amendedstandards require disclosures about inputs and valuation techniques used tomeasure fair value as well as disclosures about significant transfers,beginning in the first quarter of 2010. The Company adopted these amendedstandards on January 1, 2010, and there was no impact to the financialstatements upon adoption. Additionally, these amended standards requirepresentation of disaggregated activity within the reconciliation for fair valuemeasurements using significant unobservable inputs (Level 3), beginning in thefirst quarter of 2011. The Company does not expect these new standards tosignificantly impact the financial statements.

 

In February 2010, theFASB issued amended guidance on subsequent events to alleviate potentialconflicts between FASB guidance and SEC requirements. Under this amendedguidance, SEC filers are no longer required to disclose the date through whichsubsequent events have been evaluated in originally issued and revisedfinancial statements. This guidance was effective immediately and we adoptedthese new requirements for the period ended March 31, 2010. The adoptionof this guidance did not have a material impact on our financial statements.

 

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

** **

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

 

**Item4.**      CONTROLSAND PROCEDURES

** **

Disclosure controls and procedures are controls andother procedures that are designed to ensure that the information required tobe 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 the rules andforms of the SEC. Disclosure controls and procedures include, withoutlimitation, 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 the supervisionand with the participation of our management, including our chief executiveofficer and chief financial officer, of the effectiveness of the design andoperation of our disclosure controls and procedures as of March 31, 2010,the end of the period covered by this report. Based on that evaluation, ourchief executive officer and chief financial officer concluded that ourdisclosure controls and procedures were not effective at the reasonableassurance level as of March 31, 2010, because of certain materialweaknesses in our internal control over financial reporting.

 

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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 our Form 10-Kthat we filed with the SEC on April 29, 2009 for more informationregarding the weaknesses in our internal control over financial reporting.

 

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 Over FinancialReporting.**

 

During 2009, we engaged outside consultants with technicalaccounting knowledge and expertise to advise and ensure the preparation of ourfinancial statements in accordance with GAAP, with particular emphasis oncertain complex or non-routine transactions. Nevertheless, our ability to remediate all weaknesses is substantiallyimpaired by our limited financial resources.

 

During the quarter, in the process of reviewing ourinternal controls over financial accounting, we reassigned certain duties ofpersonnel, in order to more appropriately segregate certain financialaccounting functions.

 

**Limitations On Disclosure Controls And Procedures.**

 

Because of the inherent limitations in all controlsystems, no evaluation of controls can provide absolute assurance that allcontrol 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**

 

**Item 1.   LEGAL PROCEEDINGS**.

 

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

 

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”) inthe Superior Court of San Mateo County, California (Case No. CIV479535).  A default judgment was setaside because the landlord failed to properly serve either the Company orEtelos-WA. The Company was subsequently served properly and trial was set for February 8,2010.  The parties went to mediation in January 2010and subsequently entered into a settlement agreement, including a release ofclaims, in which the Company agreed: (a) to pay $66,000 in cash within 30days, (b) to issue 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.

 

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On October 31, 2008, the Company relocated itsWashington offices and abandoned the sub-leased premises of its former officesin Renton, Washington. The sublease for these premises runs through June 2010.  On March 5, 2010, the prime landlordfiled a complaint for breach of contract and successor liability. (King County(WA) Superior Court No. 10-2-09385-1 KNT). On March 26, 2010, theCompany filed an answer and counterclaim and asserted affirmative defensesagainst the prime landlord, including that the prime landlord is not a party tothe sublease for the premises. Subsequently, on April 8, 2010, the sub-landlord served a thirdparty complaint against the Company relating to the same subleased premises, ina proceeding filed against the sub-landlord by the prime landlord (King County(WA) Superior Court No. 10-2- 09840-2 KNT), in which the sub-landlordasserted affirmative defenses and counterclaims against the prime landlord,including that, beginning in December 2008, the premises were unusable dueto water damage and lack of maintenance or repairs by the prime landlord.  These matters are being evaluated.

 

On April 5, 2010, the Company was served with asummons and complaint for breach of contract and unjust enrichment by LakebayTechnologies LLC  (King County (WA)Superior Court No. 10-2-10054-7). This matter  is currently being evaluated by the Company.

 

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 amount andall related taxes remains unpaid, but accrued, including amounts due toemployees who subsequently were terminated.

 

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

 

**Item 1A.  RISK FACTORS**.

 

Investment in our common stock involves a high degreeof risk. You should carefully consider the risks described below together withall of the other information included in this report before making aninvestment decision. If any of the following risks actually occur, ourbusiness, financial condition or results of operations could suffer. In thatcase, the market price of our common stock could decline, and you may lose allor part of your investment.

 

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

 

We need immediate and substantial cash to continue ouroperations. Management has projected that cash on hand will be sufficient onlyto allow us to continue our operations through mid 2010.  We are presently engaged in active discussionsfor additional investments by existing and prospective investors but wecurrently 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 

 

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payments and negotiate payment plans for certain notespayable and other payables and there is a risk that trade creditors will notaccept deferred payment and may exercise other remedies to collect balances dueand owing. We therefore will need additional funding, either through equity ordebt financings, or we will be forced to curtail or cease operations orconsider other strategic alternatives such as bankruptcy.

 

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

 

We have decreased our number of full-time employeesfrom 46 at June 30, 2008, to 13 as of March 31, 2010.  All except the three 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 or quarterlybasis since our formation.  We incurrednet losses of $1.2 million and $6.4 million for the quarters ended March 31,2010 and 2009, respectively, and have an accumulated deficit of $36.6 millionat December 31, 2009 and $37.8 million at March 31, 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 operating history maynot serve as an adequate basis to judge our future prospects and results ofoperations.***

 

We began our operations in 1999 but we did not adoptthe 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 ourbusiness. Since our inception our revenues have not always grown from year toyear.  We cannot assure you that we willachieve our growth targets, or that we will achieve positive cash-flow orprofitability, or that we will not incur negative cash flow or net losses inthe future. We expect that our operating expenses will increase as we expand.Any significant failure to realize anticipated revenue growth could result insignificant operating losses beyond our forecasts. We will continue toencounter risks and difficulties frequently experienced by companies at asimilar stage of development, including our potential failure to:

 

·                  maintain and improve our technology;

 

·                  expand our product and service offerings and maintain the high qualityof products and services offered;

 

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·                  sell subscriptions to our products and offerings by our SyndicationPartners to sufficient, quality customers to produce revenues adequate to meetour operating needs;

 

·                  manage our expanding operations, including the integration of anyfuture acquisitions;

 

·                  obtain sufficient working capital to support our expansion and to fillcustomers’ orders in time;

 

·                  maintain adequate control of our expenses;

 

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

 

·                  anticipate and adapt to changing conditions in the markets in which weoperate as well as the impact of any changes in government regulation, mergersand acquisitions involving our competitors, technological developments, andother significant competitive and market dynamics.

 

If we are not successful in addressing any or all ofthese risks, then our business may be materially and adversely affected.

 

***We may encounter substantialcompetition in our business and our failure to compete effectively mayadversely affect our ability to generate revenue.***

 

We believe that existing and new competitors willcontinue 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 than us tosuccessfully endure downturns in our markets. In periods of reduced demand forour products, we can either choose to maintain market share by reducing oursubscription prices to meet competition or maintain subscription prices, whichlikely would result in sacrifice of our market share. Sales and overallprofitability would be reduced and sustained losses may continue in eithercase. In addition, we cannot be assured that additional competitors will notenter our existing markets, or that we will be able to compete successfullyagainst existing or new competition.

 

***The market for on-demand WebApplications may develop more slowly than we expect.***

 

Our success will depend, to a large extent, on thewillingness of individuals and SMBs to accept on-demand services for WebApplications that they view as critical to the success of their business. Manybusinesses have invested substantial effort and financial resources tointegrate traditional enterprise software into their businesses and may bereluctant or unwilling to switch to a different application or to migrate theseapplications to on-demand Web Applications.

 

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Other factors that may affect market acceptance of ourWeb Applications include our ability to:

 

·                  minimize the time and resources required to implement productsdistributed through an Etelos Marketplace;

 

·                  maintain high levels of customer satisfaction;

 

·                  implement upgrades and other changes to our products without disruptingour service; and/or

 

·                  provide rapid response time during periods of intense activity oncustomer websites.

 

In addition, market acceptance of our Web Applicationsmay be affected by:

 

·                  the security capabilities, reliability, and availability of on-demandservices;

 

·                  customer concerns with entrusting a third party to store and managetheir data, especially confidential or sensitive data;

 

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

 

·                  the price, performance, and availability of competing products andservices.

 

***Our inability to fund our capitalto meet our expenditure requirements may adversely affect our growth andprofitability.***

 

Our continued growth is dependent upon our ability toraise capital from outside sources. Our ability to obtain financing will dependupon a number of factors, including our financial condition and results ofoperations, the condition of the economy, and conditions in relevant financialmarkets.  If we are unable to obtainfinancing, as needed, on a timely basis and on acceptable terms, our financialposition, competitive position, growth, and profitability may be adverselyaffected.  The current state of the USand global economy raises substantial doubts, especially about our ability toraise the additional capital that we will need to sustain our businessoperations.

 

***Our customers are individuals,small and medium-sized businesses, and divisions of large companies, which mayincrease our costs to reach, acquire and retain customers.***

 

We market and distribute our products and services andother offerings in Etelos Marketplaces to individuals, SMBs, and divisions oflarge companies. To grow our revenue quickly, we must add new customers, selladditional services to existing customers, and encourage existing customers torenew their subscriptions. However, selling to and retaining individuals andSMBs can be more difficult than selling to and retaining large enterprisesbecause SMB customers tend to be more price sensitive and more difficult toreach with broad marketing campaigns.  Inaddition, individuals and SMBs have high churn rates in part because of thenature of their businesses and often lack the staffing to benefit fully fromour products.  Further, individuals andSMBs often require higher sales, marketing, and support expenditures by vendorsthat sell to them per revenue dollar generated for those vendors.

 

***Many of our customers are pricesensitive, and if the prices that we or our Syndication Partners charge forsubscriptions 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, and we havelimited experience with respect to determining the appropriate prices for ourproducts or services. In addition, we have no control over prices charged byour 

 

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Syndication Partners for their products or servicesoffered in an Etelos Marketplace. As the market for our products or servicesmatures, or as new competitors introduce new products or services that competewith ours, we may be unable to renew agreements with existing customers orattract new customers at the same price or based on the same pricing model aspreviously used. As a result, it is possible that competitive dynamics in ourmarket may require us to change pricing models or reduce prices, which couldharm our revenue, gross margin, and operating results.

 

***We may not be able to preventothers from unauthorized use of our patents and other intellectual property,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 foreign patentapplications covering our technology and we expect to file more U.S. andforeign patent applications in the future. We have filed to protect most ofthose patents in many foreign countries. But the process of seeking 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 we seek,if at all, or that any future patents issued to us will not be challenged,invalidated, or circumvented. Since the filing of some of these patentapplications may have been, or will be, made after the date of first sale ordisclosure of the subject inventions, patent protection may not be availablefor these inventions outside the United States. Any patents that may issue in the future may not provide sufficientlybroad protection or they may not prove to be enforceable in actions againstalleged infringers. Also, we cannot assure you that any future service mark ortrademark registrations will be issued for pending or future applications orthat any registered service marks or trademarks will be enforceable or provideadequate protection of our domestic and foreign proprietary rights.

 

We do not analyze the software that we distribute fromour ISV Syndication Partners to determine the adequacy of their intellectualproperty rights.  We have not maintainedoperating controls or logs, or initiated or conducted any forensic, codehistory, ‘genealogy’ or other forms of audit, analysis, processes, training, orcode review of software code incorporated into any Etelos product or in otherproducts offered by our ISV Syndication Partners in any Etelos Marketplace.These products may include code subject to various forms of ‘open source’, ‘copyleft’,or similar licenses that require as a condition of modification or distributionof software subject to such license(s) that (i) such software orother software combined or distributed with such software be disclosed ordistributed in source code form, or (ii) such software or other softwarecombined or distributed with such software, and any related intellectualproperty, be licensed on a royalty-free basis, including for the purposes ofmaking additional copies or derivative works of such software.  This may adversely affect our ability topatent certain inventions or to license or distribute certain products -whether by open source license or other form of license or right - and mayresult in liability to unknown parties for infringement of their patents orother intellectual property rights.

 

***We require our 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 developtechnologies that are competitive to ours or infringe our intellectualproperty.

 

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Enforcement of our intellectual property rights alsodepends on our successful legal actions against these infringers, but theseactions may not be successful, even when our rights have been infringed.  In addition, the legal standards relating tothe validity, enforceability, and scope of protection of intellectual propertyrights in Internet-related industries are uncertain and still evolving.

 

***Assertions by third parties thatwe infringe their intellectual property, whether successful or not, couldsubject us to costly and time-consuming litigation or expensive licenses.***

 

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 against ourcustomers, or us, with or without merit, could be time-consuming, expensive tolitigate 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 claim against usor against our Marketplace Partners or customers, we may have substantialdirect and indirect costs.  Direct costscan include a requirement to pay damages or stop using technology found to bein violation of a third party’s rights. We may have to purchase a license forthe technology, which may not be available on reasonable terms, if at all, maysignificantly increase our operating expenses, or may require us to restrictour business activities in one or more respects. As a result, we may also berequired to develop alternative non-infringing technology, which could requiresignificant effort and expense.  Substantialindirect costs also may be expected in the form of diversion of development andmanagement resources in strategic planning for legal, technology, and businessdefenses to such claims.

 

***We rely on our management teamand need additional personnel to grow our business, and the loss of one or morekey employees or our inability to attract and retain qualified personnel couldharm our business.***

 

Our success and future growth depends to a significantdegree on the skills and continued services of our management team, especiallyDaniel J.A. Kolke, our interim Chief Executive Officer, Acting Chief FinancialOfficer, and Chairman of the Board. The loss of the services of any member ofour management team for any reason may have a material adverse effect on ourbusiness and prospects.  We do notmaintain key man insurance on any members of our management team, including Mr. Kolke.

 

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Subsequent to the termination of our former ChiefExecutive Officer, we significantly and materially reduced our management teamand have not hired replacements for the management team in the positions ofVice President 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 March 31, 2010, and we have notfilled any of these positions to the date of this report.

 

Our future success also depends on our ability toattract, 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.

 

***If we do not effectively expandand train our sales force and our services and support teams, then we may beunable to add new customers and retain existing customers.***

 

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

 

***We do not have a dedicated sales team and our revenues andoperating results are substantially dependent on third-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 addadditional resellers or replace our current reseller with other resellers or anin-house sales team in the event we lose our reseller or the reseller devotesinadequate time and resources to selling our products.  To the extent we distribute or license ourproducts or services directly to end-user customers, we may be in competitionwith our resellers. In response to future direct sales strategies or for otherbusiness reasons, our resellers may from time to time choose to resell ourcompetitors’ products in addition to, or in place of, our products. Ourrevenues and financial condition may be adversely affected if our resellerstops marketing and selling our products or if the reseller is not able togenerate end-user customers to purchase our products.

 

***Ouroperating results may be subject to fluctuations that could increase thevolatility of the price of our Common Stock.***

 

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

 

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

 

***We use third-party data centersto support our services. Any disruption of service at these facilities couldinterrupt or delay our ability to deliver our service to our customers.***

 

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

 

We owe substantial amounts to our data center facilityproviders and they have no obligation to continue their services or renew theiragreements with us on commercially reasonable terms, or at all. If we areunable to renew our agreements with any facility provider on commerciallyreasonable terms, then we may experience increased costs or downtime inconnection with the transfer to a new data center facility.

 

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

 

***Any significant fluctuation inprice of servers or related support may have a material adverse effect on thecost of our products and services.***

 

The prices of servers and related support are subjectto market conditions and generally we do not, and do not expect to, havelong-term contracts with our suppliers for those items. While these items aregenerally available and we have not experienced any shortage in the past, wecannot 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 product prices,especially in the short-term, to recover cost increases in these items. Ourfuture profitability may be adversely affected to the extent we are unable topass on higher server and support related costs to our customers.

 

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***We may become liable to ourcustomers and lose customers if we have defects or disruptions in our productsand services or if we provide poor service.***

 

Because we deliver products as a service through anEtelos Marketplace, errors or defects in the Web Applications underlying theservice, or a failure of our hosting infrastructure may make the serviceunavailable to our customers. Because our customers use the products to managecritical 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.

 

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

 

The Web Applicationsoffered in an Etelos Marketplace are inherently complex and may containmaterial defects or errors, particularly when first introduced or when newversions or enhancements are released. We have, from time to time, founddefects in our products and services, and new errors in our existing softwareand services may be detected in the future. We have no actual knowledge, but wereasonably expect that the products and services offered by our SyndicationPartners may have similar errors and/or defects. Any errors or defects thatcause interruptions to the availability of our services and the services forour Marketplace Partners could result in:

 

·                  a reduction in sales or delay in marketacceptance of services from us or our Marketplace Partners;

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

·                  loss of existing customers and difficultyin attracting new customers;

·                  diversion of development resources;

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

·                  increased warranty and insurance costs.

 

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

 

***If our security measures arebreached and unauthorized access is obtained to a customer’s data, then we mayincur 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 to develop newproducts or services, distribute our products or services into new markets, oradd Syndication Partners to offer their products or services for distributionin an Etelos Marketplace, then our revenue growth will be harmed and we may notbe able to achieve profitability.***

 

Our ability to attract new customers and to increaserevenue from existing customers will depend in large part on our ability toenhance and improve our existing products and to add new Marketplace Partnersand 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 maintain proper andeffective internal controls or are unable to remediate the material weakness inour internal controls, then our ability to produce accurate and timelyfinancial statements could be impaired and investors’ views of us could beharmed.***

 

Ensuring that we have adequate internal financial andaccounting controls and procedures in place so that we can produce accuratefinancial statements on a timely basis is a costly and time-consuming effortthat needs to be re-evaluated frequently. Our internal control over financialreporting is a process designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsin accordance with generally accepted accounting principles.

 

During our audit for the years ended December 31,2008 and 2009, we identified material weaknesses in our internal controls. Thematerial weaknesses relate to the absence of specific policies and proceduresfor some accounting functions and the need for accounting personnel who possessthe skill sets necessary to operate and report as a public company, andspecifically the skills necessary to ensure that adequate review of criticalaccount reconciliations is performed and that supporting documentation iscomplete, accurate, and in accordance with generally accepted accountingprinciples. Our financial position and limited resources make it difficult forus to address these weaknesses.  If wefail to address these material weaknesses or if additional material weaknessesin our internal controls are discovered in the future, then we may fail to meetour future reporting obligations, our financial statements may contain materialmisstatements and the price of our common stock may decline.

 

Implementing any appropriate changes to our internalcontrols may distract our officers and employees, entail substantial costs tomodify our existing processes, and add personnel and take significant time tocomplete. These changes may not, however, be effective in maintaining theadequacy of our internal controls, and any failure to maintain that adequacy,or consequent inability to produce accurate financial statements on a timelybasis, could increase our operating costs and harm our business. In addition,investors’ perceptions that our internal controls are inadequate or that we areunable to produce accurate financial statements on a timely basis may harm ourstock price and make it more difficult for us to effectively market anddistribute our products and services to new and existing customers.

 

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***Government regulation of theInternet and e-commerce is evolving, and unfavorable changes or our failure tocomply with regulations could harm our operating results.***

 

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

 

***Privacy concerns and laws orother regulations may reduce the effectiveness of our products and services andharm 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.

 

In addition to government activity, privacy advocacygroups and the technology and other industries are considering various new,additional, or different self-regulatory standards that may place additionalburdens on us and our Marketplace and Syndication Partners. If the gathering ofpersonal information were to be curtailed, then Web-based applications would beless effective, which may reduce demand for the products and services offeredin an Etelos Marketplace and harm our business.

 

***Our operating results may beharmed 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 taxes fromour customers or remitted any such taxes to any taxing jurisdiction where wemay be required to do so. We have begun an analysis of this issue but to datehave 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 quarters ended March 31, 2010 or 2009, in respectof sales or other tax liabilities in any jurisdiction. A successful assertionthat we should be collecting sales or other taxes on our service could resultin substantial tax liabilities for past sales, discourage customers frompurchasing our products, or otherwise harm our business and operating results.

 

***Changes in financial accountingstandards or practices may cause adverse, unexpected financial reportingfluctuations, and harm our operating results.***

 

A change in accounting standards or practices couldharm our operating results and may even affect our reporting of transactionscompleted before the change is effective. New accounting pronouncements and varyinginterpretations of accounting pronouncements have occurred and may occur in thefuture. Changes to existing rules or the questioning of current practicesmay harm our operating results or the way we conduct our business.

 

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***We may expand by acquiring orinvesting in other companies, which may divert management’s attention, resultin additional dilution to our stockholders, and consume resources that arenecessary to operate and sustain our business.***

 

Although we have no ongoing negotiations or currentagreements or commitments for any acquisitions, our business strategy mayinclude 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 business relationshipmay result in unforeseen operating difficulties and expenditures. In particular,we may encounter difficulties assimilating or integrating the businesses,technologies, products, services offerings, personnel, or operations of theacquired companies, particularly if the key personnel of the acquired companychoose not to work for us, the target’s software is not easily adapted to workwith ours, or we are unable to retain the customers of any acquired businessdue to changes in management or otherwise. Acquisitions may also disrupt ourbusiness, divert our resources, and require significant management attentionthat would otherwise be available for operation and development of ourbusiness. Moreover, the anticipated benefits of any acquisition, investment, orbusiness relationship may not be realized or we may be exposed to unknown liabilities.For one or more of those transactions, we may:

 

·                  issue additional equity securities that would dilute our stockholders;

 

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

 

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

 

·                  incur large charges or substantial liabilities;

 

·                  encounter difficulties retaining key employees of the acquired companyor integrating diverse software codes or business cultures; and/or

 

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

 

Any of these risks could harm our business andoperating results.

 

***We may be subject to other legalclaims.***

 

Wehave entered into litigation settlement agreements that include promissorynotes payable over several months in 2010. 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.

 

As part of our reduction of monthly cash operatingexpenses during the quarter ended September 30, 2008, and continuing afterthe end of the quarter ended March 31, 2010, and to the filing date ofthis report, we placed all employees on partial deferrals of salary, rangingfrom 10% to 100% of base salary.  At theend of the quarter, until the filing date of this report, this deferral amountremains unpaid, including amounts due to employees who subsequently wereterminated. Two former employees have asserted claims with the California LaborCommission for payment of these unpaid amounts and the assertion of such claimsor demands by other terminated or current employees, or by other governmentalauthorities, is foreseeable.

 

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On October 31, 2008,the Company relocated it Washington offices and abandoned the sub-leasedpremises of its former offices in Renton, Washington. The sublease for thesepremises runs through June 2010.  OnMarch 5, 2010, the prime landlord filed a complaint for breach of contractand successor liability. (King County (WA) Superior Court No. 10-2-09385-1KNT). On March 26, 2010, the Company filed an answer and counterclaim andasserted affirmative defenses against the prime landlord, including the factthat the prime landlord 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 the fact that, beginning in December 2008,the premises were unusable due to water damage and lack of maintenance orrepairs by the prime landlord.  Thesematters are being evaluated and the Company will vigorously defend itself.

 

On April 5, 2010,the Company was served with a summons and complaint for breach of contract andunjust enrichment by Lakebay Technologies LLC. (King County (WA) Superior Court No. 10-2-10054-7). This matter wasjust served and is being evaluated by the Company.

 

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, andaffiliates control us through their positions and stock ownership and theirinterests may differ from other stockholders.***

 

As of March 31, 2010, our officers, directors,and affiliates beneficially own approximately 72 percent of our common stockand 60 percent of our preferred stock. As a result, if they act together, theyare able to influence the outcome of stockholder votes on various matters,including the election of directors and extraordinary corporate transactions,including business combinations. This concentration could also have the effectof delaying or preventing a change in control that could otherwise bebeneficial to our stockholders. The interests of our officers, directors, andaffiliates may differ from other stockholders. Furthermore, the current ratiosof ownership of our common stock reduce the public float and liquidity of ourcommon stock, which can in turn affect the market price of our common stock.

 

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

 

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

 

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

 

The purchasers of our January 2008 and April 2008Debentures and related warrants, as well as the holders of our otheroutstanding convertible notes, may, subject to compliance with Rule 144,rely on the provisions of 

 

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Rule 144 to resell the shares of our common stockacquired upon the conversion and exercise of such securities.  We have no way of knowing whether or whensuch shares may be sold.  Depending uponmarket liquidity at the time, a sale of shares by such investors at any giventime could cause the trading price of our common stock to decline.  The sale of substantial number of shares ofour common stock, or anticipation of such sales, could make it more difficultfor us to sell equity or equity-related securities in the future at a time andat a price that we might otherwise wish to effect sales.

 

In addition, in connection with our January 2008and April 2008 Debentures and 10% Senior Secured Debentures, in theaggregate, we owe a total of $9.7 million principal amount of these convertibledebentures, convertible into 11,440,695 shares of our common stock, andwarrants to purchase an additional 6,236,111 shares of our common stock. Theconversion 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.

 

***Wehave significant indebtedness.***

 

We have incurred $9.7million in principal amount of indebtedness as a result of the issuance of our10% Senior Secured Debentures, January 2008 and April 2008Debentures.  The debentures imposesignificant requirements on us, including, among others, requirements that wepay interest and other charges on the debentures.  Our ability to comply with these provisionsmay be affected by changes in our business condition or results of our operations,or other events beyond our control.

 

***Certaincovenants we agreed to in connection with the debentures may impair our abilityto issue additional debt or equity.***

 

Our September 2009, January 2008 and April 2008Debentures impose significant covenants on us, including restrictions againstincurring additional indebtedness, creating any liens on our property, amendingour certificate of incorporation or bylaws, redeeming or paying dividends onshares of our outstanding common stock, and entering into certain related partytransactions. These covenants and restrictions may impair our ability to issueadditional debt or equity, if necessary.

 

***If we need additional financingin the future and are required to issue securities which are priced at lessthan the conversion price of our debentures or the exercise price of warrantssold in our recent private placements, it will result in additional dilution.***

 

Our September 2009, January 2008and April 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.

 

 

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***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 of incorporation,amended and restated bylaws and Delaware law contain provisions that could havethe effect of rendering more difficult or discouraging an acquisition deemedundesirable by our board of directors. Our corporate governance documentsinclude provisions:

 

·                  authorizing blank check preferred stock, which could be issued withvoting, liquidation, dividend, and other rights superior to our common stock;

 

·                  limiting the liability of, and providing indemnification to, ourdirectors and officers;

 

·                  limiting the ability of our stockholders to call and bring businessbefore special meetings;

 

·                  requiring advance notice of stockholder proposals for business to beconducted at meetings of our stockholders and for nominations of candidates forelection to our board of directors;

 

·                  controlling the procedures for the conduct and scheduling of board andstockholder meetings; and

 

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

 

These provisions, alone or together, could delayhostile takeovers and changes in control or changes in our management.

 

Any provision of our amended and restated certificateof incorporation or bylaws or Delaware law that has the effect of delaying ordeterring a change in control could limit the opportunity for our stockholdersto receive a premium for their shares of our common stock, and could alsoaffect the price that some investors are willing to pay for our common stock.

 

***We may issue additional shares ofour capital stock, including through convertible debt securities, to financefuture operations or complete a business combination, which would reduce theequity interest of our stockholders and could cause a change in control of ourownership.***

 

Although we have no commitments as of the date of thisreport 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.  We may not be able to obtainadditional debt or equity financing on favorable terms, if at all.  If we engage in debt financing, then we maybe required to accept terms that restrict our ability to incur additionalindebtedness and force us to maintain specified liquidity or other ratios.

 

Further, the issuance of additional shares of ourcommon stock or any number of shares of preferred stock, including uponconversion of any debt securities, may:

 

·                  significantly reduce the equity interest of our current stockholders;

 

·                  cause a change in control if a substantial number of our shares ofcommon stock or voting preferred stock are issued, which may affect, amongother things, our ability to use our net operating loss carry-forwards, if any,and could also result in a change in management; and/or

 

·                  adversely affect prevailing market prices for our common stock.

 

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If weneed additional capital and cannot raise it on acceptable terms, we may not beable to, among other things:

 

·                  develop or enhance our products and services;

 

·                  continue to expand our development, sales and marketing organizations;

 

·                  acquire complementary technologies, products or businesses;

 

·                  expand operations;

 

·                  hire, train and retain employees; and/or

 

·                  respond to competitive pressures or unanticipated working capitalrequirements.

 

Although we have no commitments as of the date hereofto 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:

 

·                  may significantly reduce the equity interest of our currentstockholders; and

 

·                  will likely cause a change in control if a substantial number of ourshares of common stock or voting preferred stock are issued and could alsoresult in a change in management; and/or may adversely affect prevailing marketprices for our common stock.

 

The 2007 Stock Incentive Plan and all options issuedunder the 2007 Stock Incentive Plan contain provisions for acceleration of allunvested 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 IncentivePlan and the 2007 Stock Incentive Plan and all options currently issuedthereunder and options granted outside such plan provides for acceleratedvesting of all unvested options in the event of a change of control.  This may be regarded as both a disincentiveto acquisition of the Company as a liquidation strategy and a barrier toretention of key employees following a change-of-control acquisition andtherefore make such an acquisition more costly or difficult, and therefore anunattractive strategic option, for a prospective acquirer.

 

***We have never paid dividends onour capital stock and we do not anticipate paying any cash dividends in theforeseeable future.***

 

We have paid no cash dividends on any of our classesof capital stock to date and we currently intend to retain our future earnings,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 thinly tradedon the Over-the-Counter Bulletin Board, which may not provide liquidity for ourinvestors.***

 

Our common stock is quoted on the Over-the-CounterBulletin Board. The Over-the-Counter Bulletin Board is an inter-dealer,over-the-counter market that provides significantly less liquidity than theNASDAQ Stock Market or other national or regional exchanges. Securities tradedon the Over-the-Counter Bulletin Board are usually thinly traded, highlyvolatile, have fewer market makers, and are not followed by analysts.

 

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 be volatileand you may not be able to sell your shares for more than what you paid.***

 

Our stock price is likely to be subject to significantvolatility and you may not be able to sell shares of common stock at or abovethe price you paid for them. The market price of the common stock couldcontinue to fluctuate in the future in response to various factors including,but not limited to: quarterly variations in operating results; our ability tocontrol costs and improve cash flow; announcements of technological innovationsor new products by us or our competitors; changes in investor perceptions; andnew products or produce enhancements by us or our competitors. The stock marketin general has continued to experience volatility, which may further affect ourstock price. As such, you may not be able to resell your shares of common stockat or above the price you paid for them.

 

***Our common stock is likely to besubject to penny stock rules***

 

Our common stock is subject to Rule 15g-1 through15g-9 under the Exchange Act, which imposes certain sales practice requirementson broker-dealers which sell our common stock to persons other than establishedcustomers and “accredited investors” (generally, individuals with net worths inexcess of $1 million or annual incomes exceeding $200 thousand (or $300thousand together with their spouses)). For transactions covered by this rule, a broker-dealer must make aspecial suitability determination for the purchaser and have received thepurchaser’s written consent to the transaction prior to the sale.  This rule adversely affects the abilityof broker-dealers to sell our common stock and purchasers of our common stockto sell their shares of such common stock. Additionally, our common stock is likely to be subject to the SECregulations for “penny stock.”  Pennystock includes any equity security that is not listed on a national exchangeand has a market price of less than $5.00 per share, subject to certainexceptions.  The regulations require thatprior to any non-exempt buy/sell transaction in a penny stock, a disclosureschedule set forth by the SEC relating to the penny stock market must bedelivered to the purchaser of such penny stock. This disclosure must include the amount of commissions payable to boththe broker-dealer and the registered representative and current pricequotations for the common 

 

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stock.  Theregulations also require that monthly statements be sent to holders of pennystock which disclose recent price information for the penny stock and informationof the limited market for penny stocks. These requirements adversely affect the market liquidity of our commonstock.

 

**Item 6.  EXHIBITS**

 

See the exhibit indeximmediately following the signature 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: April 26, 2010 | Daniel J.A. Kolke, Chief Executive Officer                 |
|                      | (Duly Authorized Officer and Principal Executive  Officer) |

 

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**EXHIBIT INDEX**

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                                          |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.1 (1)          |       | Form of 10% Senior Secured Debenture issued in connection with  January 2010 financing                                                                                                                         |
| 4.2 (1)          |       | Form of Warrant issued in connection with January 2010  financing, with an exercise price of $0.60 per share                                                                                                   |
| 10.1(1)          |       | Form of Securities Purchase Agreement dated January 25,  2010                                                                                                                                                  |
| 10.2(1)          |       | Form of Amendment to Security Agreement dated January 25, 2010                                                                                                                                                 |
| 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                                                                        |
| (1) | Incorporated by reference to the Registrant’s Form 8-K filed on  January 26, 2010. |

 

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