Table ofContents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

**FORM 10-Q**

 

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

 

**For the quarterly period ended June 30, 2009**

 

**or**

 

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

 

**For the transition periodfrom           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”,“accelerated filer” and “smaller reporting company” in Rule 12b-2 of theExchange Act. (Check one):

 

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

 

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

 

As of June 30, 2009, 24,069,291 shares of theissuer’s common stock, par value $0.01 per share, and 843,333 shares of theissuer’s Series A preferred stock were outstanding.

 

 

 

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**EXPLANATORY NOTE**

 

On February 8, 2007,Tripath Technology Inc., a Delaware corporation (“Tripath”) filed a voluntarypetition for relief under Chapter 11 of the Bankruptcy Code. On February 1,2008, the bankruptcy court issued an order confirming approval of the Plan ofReorganization, including the merger and the transfer of all of Tripath’sexisting assets into a separate bankruptcy estate and the discharge of all ofTripath’s liabilities.  The Plan ofReorganization also contemplated the merger of Etelos, Incorporated, aWashington corporation (“Etelos-WA”) with Tripath.   The overall impact of the confirmed Plan ofReorganization was for Tripath to emerge from the bankruptcy proceeding with noassets and no liabilities as a shell corporation and for all issued andoutstanding securities of and interests in Tripath, including debentures, stockoptions (including, but not limited to, all stock options granted toemployees), warrants, and other shares of common stock to be canceled andextinguished.

 

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

 

Also, on April 23,2008, Etelos, Inc., formerly Tripath, amended its certificate ofincorporation with the state of Delaware to change its total authorized sharesof stock to 300,000,000 shares, of which 250,000,000 shares are designated“common stock” with a par value of $0.01 per share and 50,000,000 shares aredesignated “preferred stock” with a par value of $0.01 per share.  The preferred stock may be issued from timeto time in one or more series, each of such series to consist of such number ofshares and to have such terms, rights, powers and preferences, and thequalifications and limitations with respect thereto, as stated in theresolutions providing for the issue of such series adopted by the board ofdirectors.

 

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

 

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**Etelos, Inc.**

** **

**QuarterlyReport on Form 10-Q**

** **

**For theQuarterly Period Ended June 30, 2009**

 

TABLEOF CONTENTS

 
| ** **                              | ** **                                                                             | ** ** | **Page** |
|-----------------------------------------|----------------------------------------------------------------------------------------|------------|----------|
|                                    |                                                                                   |       |     |
| **FORWARD  LOOKING STATEMENTS**         |                                                                                   | 1          |
| ** **                              |                                                                                   |       |
| **PART  I —FINANCIAL INFORMATION** |                                                                                   | 2          |
| ** **                              |                                                                                   |       |
| Item  1.                                | FINANCIAL  STATEMENTS (UNAUDITED)                                                      |       | 2        |
|                                    |                                                                                   |       |     |
| Item  2.                                | MANAGEMENT'S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |       | 24       |
|                                    |                                                                                   |       |     |
| Item  3.                                | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |       | 34       |
|                                    |                                                                                   |       |     |
| Item 4.                                 | CONTROLS AND  PROCEDURES                                                               |       | 34       |
|                                    |                                                                                   |       |     |
| **PART  II —OTHER INFORMATION**    |                                                                                   | 35         |
| ** **                              |                                                                                   |       |
| Item 1.                                 | LEGAL PROCEEDINGS                                                                      |       | 35       |
|                                    |                                                                                   |       |     |
| Item 1A.                                | RISK FACTORS                                                                           |       | 36       |
|                                    |                                                                                   |       |     |
| Item 6.                                 | EXHIBITS                                                                               |       | 50       |
|                                    |                                                                                   |       |     |
| SIGNATURES                              |                                                                                   | 51         |
|                                    |                                                                                   |       |
| EXHIBIT  INDEX                          |                                                                                   | 52         |

 

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**FORWARDLOOKING STATEMENTS**

 

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

 

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

 

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

 

You should be aware thatour actual results could differ materially from those contained in theforward-looking statements due to a number of factors, including:

 

·                                          ourability to obtain future financing or funds when needed;

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

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

·                                          ourability to successfully obtain a diverse customer base;

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

·                                          ourability to attract and retain a qualified employee base;

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

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

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

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

 

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

 

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**PART I—FINANCIALINFORMATION**

 

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

 

**ETELOS, INC.**

**CONDENSED BALANCE SHEETS**

(in thousands, except share data)

(Unaudited)

 
| ** **                                                                                                                                                                       | ** ** | **June 30,  2009** | ** ** | **December 31,   2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------------|------------|
|                                                                                                                                                                             |       |                    |       |                              |       |
| ASSETS                                                                                                                                                                           |       |                    |       |                              |       |
| Current assets:                                                                                                                                                                  |       |                    |       |                              |       |
| Cash and cash  equivalents                                                                                                                                                       |       | $                       | 1          |                              | $          | 7 |   |
| Accounts receivable,  net                                                                                                                                                        |       | 4                       |       | 60                                |       |
| Prepaid expenses and  other current assets                                                                                                                                       |       | 14                      |       | 46                                |       |
| Current portion  accreting interest on convertible notes payable                                                                                                                 |       | 328                     |       | —                            |       |
| Total current assets                                                                                                                                                             |       | 347                     |       | 113                               |       |
|                                                                                                                                                                             |       |                    |       |                              |       |
| Property and equipment,  net                                                                                                                                                     |       | 62                      |       | 82                                |       |
| Accreting interest on  convertible notes payable, less current portion                                                                                                           |       | 85                      |       | —                            |       |
| Debt issuance costs                                                                                                                                                              |       | 9                       |       | —                            |       |
| Other assets                                                                                                                                                                     |       | 2                       |       | 10                                |       |
|                                                                                                                                                                             |       |                    |       |                              |       |
| **Total  assets**                                                                                                                                                                | ** ** | **$**                   | **505**    | ** **                        | **$**      | **205** | ** ** |
|                                                                                                                                                                             |       |                    |       |                              |       |
| LIABILITIES AND  STOCKHOLDERS’ DEFICIT                                                                                                                                      |       |                    |       |                              |       |
| Current liabilities:                                                                                                                                                             |       |                    |       |                              |       |
| Accounts payable                                                                                                                                                                 |       | $                       | 1,178      |                              | $          | 983 |   |
| Accounts payable  related parties                                                                                                                                                |       | 18                      |       | 42                                |       |
| Accrued payroll and  related expenses                                                                                                                                            |       | 924                     |       | 399                               |       |
| Other accrued expenses                                                                                                                                                           |       | 1,273                   |       | 1,381                             |       |
| Deferred revenue                                                                                                                                                                 |       | 5                       |       | 64                                |       |
| Current portion  convertible notes payable, net of discounts                                                                                                                     |       | 1,764                   |       | 7,264                             |       |
| Current portion other  notes payable                                                                                                                                             |       | 644                     |       | 89                                |       |
| Current portion notes  payable to related parties, net of discounts                                                                                                              |       | 184                     |       | 132                               |       |
| Current portion capital  leases                                                                                                                                                  |       | 10                      |       | 9                                 |       |
| Warrant and derivative  liability                                                                                                                                                |       | 264                     |       | 108                               |       |
| Total current  liabilities                                                                                                                                                       |       | 6,264                   |       | 10,471                            |       |
|                                                                                                                                                                             |       |                    |       |                              |       |
| Long-term convertible  notes payable, net of premiums and discounts, less current portion                                                                                        |       | 6,502                   |       | —                            |       |
| Long-term notes payable  to related parties, less current portion                                                                                                                |       | 552                     |       | 552                               |       |
| Long-term capital  leases, less current portion                                                                                                                                  |       | 18                      |       | 24                                |       |
|                                                                                                                                                                             |       |                    |       |                              |       |
| Total liabilities                                                                                                                                                                |       | 13,336                  |       | 11,047                            |       |
|                                                                                                                                                                             |       |                    |       |                              |       |
| Commitments and  contingencies                                                                                                                                                   |       |                    |       |                              |       |
|                                                                                                                                                                             |       |                    |       |                              |       |
| Stockholders’ deficit:                                                                                                                                                      |       |                    |       |                              |       |
| Preferred stock, $0.01  par value: 50,000,000 shares authorized with liquidation preferences:                                                                                    |       |                    |       |                              |       |
| New Series A:  3,333,333 shares authorized; issued and outstanding: 843,333 shares at June 30,  2009 and 833,333 shares at December 31, 2008                      |       | 8                       |       | 8                                 |       |
| Common stock, $0.01 par  value: 250,000,000 shares authorized; issued and outstanding - 24,069,291  shares at June 30, 2009 and 23,027,624 shares at December 31, 2008 |       | 241                     |       | 231                               |       |
| Additional paid-in  capital                                                                                                                                                      |       | 20,248                  |       | 18,722                            |       |
| Accumulated deficit                                                                                                                                                              |       | (33,328                 | )          | (29,803                           | )          |
| Total stockholders’  deficit                                                                                                                                                |       | (12,831                 | )          | (10,842                           | )          |
|                                                                                                                                                                             |       |                    |       |                              |       |
| **Total  liabilities and stockholders’ deficit**                                                                                                                            | ** ** | **$**                   | **505**    | ** **                        | **$**      | **205** | ** ** |

 

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

 

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**ETELOS, INC.**

**CONDENSED STATEMENTS OF OPERATIONS**

(in thousands, except per share data)

(Unaudited)

 
| ** **                                                                                                 | ** ** | **Three**         | ** ** | **Three**         | ** ** | **Six**           | ** ** | **Six**           | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                                                 | ** ** | **Months**        | ** ** | **Months**        | ** ** | **Months**        | ** ** | **Months**        | ** ** |
| ** **                                                                                                 | ** ** | **Ended**         | ** ** | **Ended**         | ** ** | **Ended**         | ** ** | **Ended**         | ** ** |
| ** **                                                                                                 | ** ** | **June 30,** | ** ** | **June 30,** | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                                                                 | ** ** | **2009**          | ** ** | **2008**          | ** ** | **2009**          | ** ** | **2008**          | ** ** |
| ** **                                                                                                 | ** ** | ** **        | ** ** | ** **        | ** ** | ** **        | ** ** | ** **        | ** ** |
| Revenue                                                                                                    |       | $                 | 69         |              | $          | 22                |       | $                 | 126        |   | $ | 45 |   |
| Cost of revenue                                                                                            |       | 80                |       | 148               |       | 172               |       | 249               |       |
| Gross (loss)                                                                                               |       | (11               | )          | (126              | )          | (46               | )          | (204              | )          |
|                                                                                                       |       |              |       |              |       |              |       |              |       |
| Operating expenses:                                                                                        |       |              |       |              |       |              |       |              |       |
| Research and  development                                                                                  |       | 281               |       | 1,283             |       | 1,187             |       | 2,476             |       |
| Sales and marketing                                                                                        |       | 177               |       | 508               |       | 746               |       | 801               |       |
| General and  administrative                                                                                |       | 390               |       | 630               |       | 1,065             |       | 1,100             |       |
| Change in valuation of  liability related to warrants from settlement, financing, and consulting  services |       | (2,455            | )          | —            |       | (299              | )          | —            |       |
| Total operating expenses  (income)                                                                         |       | (1,607            | )          | 2,421             |       | 2,699             |       | 4,377             |       |
|                                                                                                       |       |              |       |              |       |              |       |              |       |
| Income (Loss) from  Operations                                                                             |       | 1,596             |       | (2,547            | )          | (2,745            | )          | (4,581            | )          |
|                                                                                                       |       |              |       |              |       |              |       |              |       |
| Other (expense)                                                                                            |       |              |       |              |       |              |       |              |       |
| Merger costs                                                                                               |       | —            |       | (13,444           | )          | —            |       | (13,444           | )          |
| Other expense                                                                                              |       | —            |       | (15               | )          | —            |       | (15               | )          |
| Loss on extinguishment  of debt                                                                            |       | (300              | )          | —            |       | (300              | )          | —            |       |
| Total other (expense)                                                                                      |       | (300              | )          | (13,459           | )          | (300              | )          | (13,459           | )          |
|                                                                                                       |       |              |       |              |       |              |       |              |       |
| Interest expense, net                                                                                      |       | (147              | )          | (117              | )          | (273              | )          | (315              | )          |
| Amortization of notes  discount                                                                            |       | (58               | )          | (427              | )          | (72               | )          | (427              | )          |
| Change in valuation of  liability relating to embedded derivatives and warrants                            |       | 1,819             |       | (4,032            | )          | (135              | )          | (4,032            | )          |
| Beneficial conversion  of interest conversion                                                              |       | —            |       | (991              | )          | —            |       | (991              | )          |
| Total interest income  (expense)                                                                           |       | 1,614             |       | (5,567            | )          | (480              | )          | (5,765            | )          |
|                                                                                                       |       |              |       |              |       |              |       |              |       |
| Income (Loss) before  taxes                                                                                |       | 2,910             |       | (21,573           | )          | (3,525            | )          | (23,805           | )          |
|                                                                                                       |       |              |       |              |       |              |       |              |       |
| Provision for income  taxes                                                                                |       | —            |       | —            |       | —            |       | —            |       |
|                                                                                                       |       |              |       |              |       |              |       |              |       |
| **Net  income (loss)**                                                                                     | ** ** | **$**             | **2,910**  | ** **        | **$**      | **(21,573**       | **)**      | **$**             | **(3,525** | **)** | **$** | **(23,805** | **)** |
|                                                                                                       |       |              |       |              |       |              |       |              |       |
| Basic net income (loss)  per share                                                                         |       | $                 | 0.12       |              | $          | (1.13             | )          | $                 | (0.15      | ) | $ | (1.80 | ) |
| Diluted net income (loss)  per share                                                                       |       | $                 | 0.08       |              | $          | (1.13             | )          | $                 | (0.15      | ) | $ | (1.80 | ) |
|                                                                                                       |       |              |       |              |       |              |       |              |       |
| Weighted average number  of common shares used in computing basic net income (loss) per share              |       | 24,069            |       | 19,046            |       | 23,896            |       | 13,198            |       |
| Weighted average number  of common shares used in computing diluted net income (loss) per share            |       | 38,466            |       | 19,046            |       | 23,896            |       | 13,198            |       |

 

The accompanying notesare 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, 2008**             |       | 833,333               |       | $                | 8          |                | 23,027,624     |            | $          | 231                    |       | $           | 18,722     |   | $ | (29,803 | ) | $ | (10,842 | ) |
| Issuance of Preferred  New Series A Stock     |       | 10,000                |       | —           |       | —              |           | —          |       | 6                      |       | —      |       | 6 |   |
| Issuance of common stock  upon exercise of options |       | —                |       | —           |       | 41,667              |           | —          |       | 2                      |       | —      |       | 2 |   |
| Issuance of common stock  to consultant            |       | —                |       | —           |       | 1,000,000           |           | 10              |       | 500                    |       | —      |       | 510 |   |
| Stock based compensation                           |       | —                |       | —           |       | —              |           | —          |       | 87                     |       | —      |       | 87 |   |
| Reclass warrant and  derivative liability          |       | —                |       | —           |       | —              |           | —          |       | 931                    |       | —      |       | 931 |   |
| Net loss                                           |       | —                |       | —           |       | —              |           | —          |       | —                 |       | (3,525      | )          | (3,525 | ) |
| **Balance  at June 30, 2009**                 | ** ** | **843,333**           | ** ** | **$**            | **8**      | ** **          | **24,069,291** | ** **      | **$**      | **241**                | ** ** | **$**       | **20,248** | ** ** | **$** | **(33,328** | **)** | **$** | **(12,831** | **)** |

 

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)

 
| ** **                                                                                 | ** ** | **Six**           | ** ** | **Six**           | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                                 | ** ** | **Months**        | ** ** | **Months**        | ** ** |
| ** **                                                                                 | ** ** | **Ended**         | ** ** | **Ended**         | ** ** |
| ** **                                                                                 | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                                                 | ** ** | **2009**          | ** ** | **2008**          | ** ** |
|                                                                                       |       |              |       |              |       |
| **Cash  flows from operating activities:**                                                 | ** ** | ** **        | ** ** | ** **        | ** ** |
| Net income (loss)                                                                          | ** ** | $                 | (3,525     | )                 | $          | (23,805 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: | ** ** |              |       |              |       |
| Depreciation and  amortization                                                             | ** ** | 19                |       | 13                |       |
| Amortization of notes  discount                                                            | ** ** | 72                |       | 165               |       |
| Amortization of  financing fees                                                            | ** ** | —            |       | 32                |       |
| Stock based  compensation                                                                  | ** ** | 87                |       | 69                |       |
| Interest expense paid  in common stock                                                     | ** ** | —            |       | 77                |       |
| Consulting expenses  paid through issuance of common stock and warrants                    | ** ** | 1,511             |       | —            |       |
| BCF on interest  payments                                                                  | ** ** | —            |       | 991               |       |
| Change in valuation of  embedded derivatives and warrant liability                         | ** ** | (164              | )          | 4,377             |       |
| Loss on extinguishment  of restructured debentures                                         | ** ** | 300               |       | —            |       |
| Merger costs paid in  common stock                                                         | ** ** | —            |       | 13,177            |       |
| Changes in operating  assets and liabilities:                                              | ** ** |              |       |              |       |
| Accounts receivable,  net                                                                  | ** ** | 56                |       | (5                | )          |
| Prepaid expenses and  other current assets                                                 | ** ** | 32                |       | (41               | )          |
| Other assets                                                                               | ** ** | (1                | )          | (65               | )          |
| Accounts payable                                                                           | ** ** | 195               |       | 153               |       |
| Accounts payables  related parties                                                         | ** ** | (24               | )          | (54               | )          |
| Accrued payroll and  related expenses                                                      | ** ** | 525               |       | 73                |       |
| Other accrued expenses                                                                     | ** ** | 311               |       | 137               |       |
| Deferred revenues                                                                          | ** ** | (59               | )          | —            |       |
| Deferred rent                                                                              | ** ** | —            |       | 5                 |       |
| **Net  cash provided by (used in) operating activities**                                   | ** ** | (665              | )          | (4,701            | )          |
| **Cash  flows from investing activities:**                                                 | ** ** |              |       |              |       |
| Purchases of property  and equipment                                                       | ** ** | —            |       | (44               | )          |
| **Net  cash provided by (used in) investing activities**                                   | ** ** | —            |       | (44               | )          |
| **Cash  flows from financing activities:**                                                 | ** ** |              |       |              |       |
| Proceeds from notes  payable                                                               | ** ** | 555               |       | 5,500             |       |
| Proceeds from issuance  of common stock                                                    | ** ** | 2                 |       | 460               |       |
| Proceeds from issuance  of preferred stock                                                 | ** ** | 7                 |       | —            |       |
| Payment of fees for  financing transactions                                                | ** ** | —            |       | (234              | )          |
| Proceeds from notes  payable to related parties                                            | ** ** | 100               |       | —            |       |
| Payments of notes  payable to related parties                                              | ** ** | —            |       | (105              | )          |
| Payment on capital  lease                                                                  | ** ** | (5                | )          | (8                | )          |
| **Net  cash provided by financing activities**                                             | ** ** | 659               |       | 5,613             |       |
| ** **                                                                                 | ** ** |              |       |              |       |
| **Net  increase (decrease) in cash and cash equivalents**                                  | ** ** | (6                | )          | 868               |       |
| ** **                                                                                 | ** ** |              |       |              |       |
| **Cash  and cash equivalents at beginning of year**                                        | ** ** | 7                 |       | 928               |       |
| ** **                                                                                 | ** ** | ** **        | ** ** | ** **        | ** ** |
| **Cash  and cash equivalents at end of period**                                            | ** ** | **$**             | **1**      | ** **        | **$**      | **1,796** | ** ** |
| ** **                                                                                 | ** ** | ** **        | ** ** | ** **        | ** ** |
| **Supplemental  disclosures of cash flow information:**                                    | ** ** | ** **        | ** ** | ** **        | ** ** |
| Cash paid for income taxes                                                                 | ** ** | —            |       | —            |       |
| Cash paid for interest                                                                     | ** ** | —            |       | 126               |       |
| ** **                                                                                 | ** ** |              |       |              |       |
| **Supplemental  disclosures of non-cash financing activities:**                            | ** ** |              |       |              |       |
| Reclass of warrants  from liability to equity                                              | ** ** | 799               |       | —            |       |
| Increase in convertible  notes principal                                                   | ** ** | 413               |       | —            |       |
| Reclass of derivatives  from liability to equity                                           | ** ** | 132               |       | —            |       |
| Record warrants and  embedded derivatives as liabilites                                    | ** ** | —            |       | 6,489             |       |
| Issuance of common  stock for convertible debt                                             | ** ** | —            |       | 2,463             |       |
| Issuance of common  stock for interest conversion                                          | ** ** | —            |       | 199               |       |
| Issuance of detachable  warrants                                                           | ** ** | —            |       | 73                |       |
| Discount on convertible  notes                                                             | ** ** | —            |       | 68                |       |
| Issuance of common  stock for anti-dilution                                                | ** ** | —            |       | 55                |       |
| Repurchase of common  stock                                                                | ** ** |              |       | 36                |       |
| Conversion of preferred  stock to common stock                                             | ** ** | —            |       | 15                |       |

 

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

 

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NOTES TO FINANCIAL STATEMENTS

***1. Organization***

 

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

 

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

 

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

 

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

 

Informationconcerning number of shares outstanding for Etelos, Inc. including theconversion prices and number of shares issuable upon conversion of convertiblesecurities and exercise prices of warrants and stock options and the number ofshares issuable upon exercise of the options and warrants, has been adjusted toreflect this stock split for all periods presented.  Also, thestockholders’ deficit section of the accompanying balance sheet has beenadjusted to reflect the legal capital structure of Tripath adjusted for thechange in authorized shares of common and preferred stock.

 

***2.  The Company***

 

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

 

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Eteloshas a Web Application distribution platform delivering Web Applications forbusinesses.  Etelos provides aSoftware-as-a-Service (SaaS) ecosystem for building, distributing, and usingWeb Applications, including a marketplace to deploy and support them.  Unlike other cloud computing andPlatform-as-a-Service (PaaS) solutions, Etelos enables software manufacturersto migrate existing applications or create new applications, then package,distribute, host, bill, market and support their SaaS enabled applicationsthrough multiple private label applications marketplaces.

 

Eteloshas developed products for Web Applications, which include open standards-basedtools for Web developers, businesses and individual users such as the EtelosApplication ServerTM (EASTM) and the Etelos Development EnvironmentTM (EDETM).  EAS andEDE support many common programming languages and also support the EnglishApplication Scripting Engine (EASETM), a simple-to-use open standards-based scriptinglanguage developed by the Company.  Inorder to support broader adoption of its products, EASE and other components ofthe EDE are made available to developers at market appropriate pricing.  This is done to support the development ofnew Web Applications and the migration of existing Web Applications into theEtelos ecosystem where there are tools and other support mechanisms for themarketing, distribution, and support of these applications.  Etelos generally receives a transaction feeor subscription fee for transactions that occur within the Etelos ecosystemeither via the Etelos MarketplaceTM pursuant to Storefront Operating Agreements,or in third-party branded Marketplaces operated by Etelos pursuant toMarketplace Partner Agreements (sometimes referred to as “an EtelosMarketplace” or, collectively, as “the Etelos Marketplaces”).  Most customers in Etelos Marketplaces pay asubscription fee, which revenue Etelos shares with Syndication Partners andMarketplace Partners; this revenue share is calculated as a percentage of grossrevenues from the sale of subscriptions to customers of Syndication Partnerproducts and service in the Etelos Marketplaces.

 

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

 

*Basis of Presentation*

 

The accompanyingcondensed financial statements include our accounts as of June 30, 2009,and December 31, 2008, and for the six months ended June 30, 2009 and2008. The accompanying condensed balance sheet as of December 31, 2008,has been derived from the audited balance sheet in the Company’s annual reporton Form 10-K for the fiscal year ended December 31, 2008. These condensedfinancial statements have been prepared by management, without audit, pursuantto the rules and regulations of the Securities and Exchange Commission, orSEC. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America have been condensed oromitted pursuant to such rules and regulations.

 

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 June 30,2009, and the six months ended June 30, 2009, are not necessarilyindicative of the results to be expected for the full year or for any futureperiods.

 

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

 

*Concentration of Credit Risk*

 

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

 

TheCompany’s accounts receivables are derived primarily from customers.  For the six months ended June 30, 2009,three customers accounted for 91% of the Company’s revenue in the period. Onecustomer accounted for 86% of the Company’s accounts receivable in the sixmonths ended June 30, 2009.

 

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*Allowance for Doubtful Accounts*

 

TheCompany provides, when appropriate, an allowance for doubtful accounts toensure trade receivables are not overstated due to un-collectability. The collectabilityof the Company’s receivables is evaluated based on a variety of factors,including the length of time receivables are past due, indication of thecustomer’s willingness to pay, significant one-time events, and historicalexperience. As of June 30, 2009, and December 31, 2008, the Companydetermined that an allowance for doubtful accounts was not necessary orwarranted.

 

*Deferred Revenue*

 

Deferredrevenue represents money received or promised but not recognized as revenuebecause the work has not been completed or the software subscription has beenfully delivered, and therefore is deferred until the work is completed or thesoftware subscription is fully delivered when it is then transferred to theappropriate revenue account.

 

*Property and Equipment*

 

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

 

*Fair Value of Financial Instruments*

 

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

 

*Research and Development and Software Development Costs*

 

Researchand development expenses consist primarily of salaries, payroll taxes,benefits, and related expenditures for technology, software development,project management, and support personnel. Costs related to the research anddevelopment of new products, services and enhancements to existing products areexpensed as provided for by Statement of Financial Accounting Standard (SFAS) No. 86,“Accounting for Costs of Computer Software to be Sold, Leased or OtherwiseMarketed” (FAS 86).  Under FAS 86, 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.

 

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

 

*Revenue Recognition*

 

Etelosdistributes Web Applications and it Marketplace Platform as a subscriptionservice using the SaaS or software-on-demand business model and allow thirdparties to offer their products or services through storefronts in an EtelosMarketplace, and to advertise on its web site or in its magazine for afee.  It also license certain of its software products under perpetual andterm licenses.  Revenues are recognized on these service and licensingtransactions using the criteria in SEC Staff Accounting Bulletin 104, “RevenueRecognition in Financial Statements”, and SOP 97-2, “Software RevenueRecognition”, respectively, which both provide that revenue may be recognizedwhen all of the following are met:

 

·                                          persuasive evidence of anarrangement exists,

·                                          the product or service hasbeen delivered,

·                                          the fee is fixed ordeterminable, and

·                                          collection of the resultingreceivable is reasonably assured or probable.

 

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

 

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

 

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

 

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

 

*Stock Based Compensation*

 

TheCompany, under SFAS No. 123 (revised 2004), “Share-Based Payment” (FAS123(R)), is applying the “modified prospective method” and used theBlack-Scholes Merton model to value all new stock based compensation awardsgranted starting January 1, 2007, and for any modification, cancellation,or repurchase of awards granted prior to January 1, 2007.  As aresult, the Company has recorded compensation cost in the statement ofoperations based on the fair value of the award for the requisite serviceperiod. FAS 123(R) also requires the Company to estimate forfeitures incalculating the expense relating to share-based compensation as opposed to onlyrecognizing these forfeitures and the corresponding reduction in expense asthey occur. This resulted in $87 thousand and $69 thousand of expense for thesix months ended June 30, 2009 and 2008, respectively.

 

FAS123(R) requires the cash flows resulting from the tax benefits resultingfrom tax deductions in excess of the compensation cost recognized for thoseoptions to be classified as financing cash flows. Due to its loss position,there were no such tax benefits during the six months ended June 30, 2009and 2008. Prior to the adoption of FAS 123(R), those benefits would have beenreported as operating cash flows had we received any tax benefits related tostock option exercises.

 

*Income Taxes*

 

TheCompany accounts for income taxes in accordance with SFAS No. 109,“Accounting for Income Taxes” which utilizes the liability method of accountingfor income taxes. Deferred tax assets and liabilities are recognized for thefuture tax consequences attributable to differences between the financialstatement carrying amount of existing assets and liabilities and theirrespective tax bases. Deferred tax assets and liabilities are measured usingenacted tax rates expected to apply to taxable income in the years in whichthose temporary differences are expected to be recovered or settled. Valuationallowances are established when necessary to reduce deferred tax assets to theamounts expected to be realized.

 

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

 

TheCompany files income tax returns in the United States of America federaljurisdiction and various state jurisdictions in the United States 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 FIN 48.  In addition, the Company did not record acumulative effect adjustment related to the adoption of FIN 48.

 

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TheCompany’s policy is to recognize interest and penalties accrued on anyunrecognized tax benefits as a component of income tax expense.  As of the date of the adoption of FIN 48, theCompany did not have any accrued interest or penalties associated with anyunrecognized tax benefits, nor was any such interest expense recognized duringthe six months ended June 30, 2009 and 2008, or the year ended December 31,2008.  The Company’s effective tax ratediffers from the federal statutory rate primarily due to increases in itsdeferred income tax valuation allowance.

 

*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 (loss) per share iscomputed using the weighted average number of common shares and, if dilutive,potential common shares outstanding during the period. Potential common sharesconsist of unvested restricted stock (using the treasury stock method), theincremental common shares issuable upon the exercise of stock options andwarrants (using the treasury stock method) and the conversion of the Company’sconvertible notes and debentures (using the if-converted method).  Astheir effect is antidilutive, 82,287 and 4,580,893 shares of common stockexercisable under outstanding employee stock options, 611,111 and 611,111shares of common stock exercisable under outstanding warrants, 7,171,708 and6,426,074 shares of common stock issuable upon conversion of the outstandingconvertible notes payable and debentures, as of June 30, 2009 and 2008,respectively, have been excluded from this calculation.  The averageexercise price of outstanding employee stock options to purchase the Company’scommon stock is $0.24 and $0.23, respectively, at June 30, 2009 and 2008.The average exercise price of outstanding warrants to purchase the Company’scommon stock is $0.55 and $1.80, respectively, at June 30, 2009 and 2008.

 

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

 
| ** **                              | ** ** | **For the Three Months** | ** ** | **For the SixMonths** | ** ** |
|-----------------------------------------|------------|-----------------------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | **Ended June 30,**            | ** ** | **Ended June 30,**    | ** ** |
| ** **                              | ** ** | **2009**                                | ** ** | **2008**                        | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Numerator:                              |       |                                    |       |                            |       |   |   |   |   |
| Net income (loss)                       |       | $                                       | 2,910      |                            | $          | (21,573 | ) | $ | (3,525 | ) | $ | (23,805 | ) |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Interest on convertible notes payable   |       | 109                                     |       |                            |       |   |   |   |   |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Net income (loss) - diluted             |       | $                                       | 3,019      |                            | $          | (21,573 | ) | $ | (3,525 | ) | $ | (23,805 | ) |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Denominator:                            |       |                                    |       |                            |       |   |   |   |   |
| Weighted average common stock           |       | 24,069                                  |       | 19,046                          |       | 23,896 |   | 13,198 |   |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Convertible notes payable               |       | 7,172                                   |       |                            |       |   |   |   |   |
| Preferred stock New Series A       |       | 843                                     |       |                            |       |   |   |   |   |
| Warrants                                |       | 2,199                                   |       |                            |       |   |   |   |   |
| Options                                 |       | 4,183                                   |       |                            |       |   |   |   |   |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Weighted average common stock - diluted |       | 38,466                                  |       | 19,046                          |       | 23,896 |   | 13,198 |   |
|                                    |       |                                    |       |                            |       |   |   |   |   |
| Net income (loss) per share:            |       |                                    |       |                            |       |   |   |   |   |
| Basic                                   |       | $                                       | 0.12       |                            | $          | (1.13 | ) | $ | (0.15 | ) | $ | (1.80 | ) |
| Diluted                                 |       | $                                       | 0.08       |                            | $          | (1.13 | ) | $ | (0.15 | ) | $ | (1.80 | ) |

 

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*Use of Estimates*

 

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

 

*Segment Reporting*

 

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

 

***4. Going Concern***

 

Thefinancial statements have been prepared with the assumption that the Companywill continue as a going concern.  The Company has experienced net lossesof $3.5 million and $23.8 million for the six months ended June 30, 2009and 2008, respectively, and has a total stockholders’ deficit of $12.8 millionand $10.8 million, as of June 30, 2009, and December 31, 2008,respectively, all of which raise substantial doubt about its ability tocontinue as a going concern. The financial statements do not include anyadjustments relating to the recoverability and classification of asset carryingamounts or the amount and classification of liabilities that might arise shouldit be unable to continue as a going concern.

 

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

 

TheCompany’s cash balance including proceeds from its recent debt financings andpreferred stock financing may not be sufficient to fund operations beyond August 2009. If cash reserves are not sufficient to sustain operations, then managementplans to further reduce operating expenses and/or raise additional capital by sellingshares of capital stock or other securities that could result in substantialdilution to existing shareholders.  However, there are no commitments orarrangements for future financings in place at this time and the Company cangive no assurance that such capital will be available on favorable terms, or atall.  The Company may need additional financing thereafter until it canachieve profitability.  If it cannot, then it will be forced to furthercurtail operations or possibly be forced to evaluate a sale or liquidation ofassets.  Even if it is successful in raising additional funds, there is noassurance regarding the terms of any additional investment.

 

Inthe quarter ended June 30, 2009, the Company entered into a bridge loanwith the holder of its January 2008 and April 2008 Debentures, in theprincipal amount of $385 thousand.  Theamount of this bridge loan, together with two subsequent bridge loans from theholder of its January 2008 and April 2008 Debentures in theadditional aggregate amount of $400 thousand after the end of the quarter, isestimated to cover its operating expenses through August 2009.  These notes bear interest at ten percent perannum, and mature between October 17, 2009, and February 10, 2010,and are subject to the security interest granted to the holder of the January 2008and April 2008 Debentures in connection with those debentures.

 

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

 

In April 2009, the FASBissued SFAS No. 165, *Subsequent Events* (FAS 165).  FAS 165 establishes general standards ofaccounting for and disclosure of events that occur after the balance sheet datebut before financial statements are issued or available to be issued. TheCompany adopted FAS 165 for the quarter ending June 30, 2009. Adoption didnot have a material impact on the financial statements.

 

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In April 2009, the FASBissued SFAS No. 167, *Amendments to FASBInterpretation No. 46(R) *(FAS 167). FAS 167 requires a qualitative approach toidentifying a controlling financial interest in a variable interest entity(VIE), and requires ongoing assessment of whether an entity is a VIE andwhether an interest in a VIE makes the holder the primary beneficiary of theVIE. FAS 167 is effective for annual reporting periods beginning after November 15,2009. The Company is currently evaluating the impact of the pending adoption ofFAS 167 on the financial statements.

 

In June 2009, the FASBissued SFAS No. 168, *The FASBAccounting Standards Codification and the Hierarchy of Generally AcceptedAccounting Principles* (FAS168).  FAS 168 identifies the FASBAccounting Standards Codification as the authoritative source of generallyaccepted accounting principles in the United States. Rules andinterpretive releases of the Securities and Exchange Commission (SEC) underfederal securities laws are also sources of authoritative GAAP for SECregistrants.  FAS 168 is effective forfinancial statements issued for interim and annual periods ending after September 15,2009. The Company does not expect adoption to have a material impact on thefinancial statements, other than to update the GAAP references throughout the footnotedisclosures.

 

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

 

***6.Convertible Notes and Debentures and Embedded Derivative and Warrant Liability***

 

Convertible notes anddebentures comprise (in thousands):

 
| ** **                                                                | ** ** | **June 30,********2009** | ** ** | **December 31,  2008** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------------|------------|-----------------------------|------------|
|                                                                      |       |                          |       |                        |       |
| 6% Convertible Notes                                                      |       | $                             | 1,764      |                        | $          | 1,764 |   |
| January 2008 Debentures                                              |       | 2,320                         |       | 2,000                       |       |
| April 2008 Debentures                                                |       | 4,012                         |       | 3,500                       |       |
|                                                                      |       | 8,096                         |       | 7,264                       |       |
| Plus (less) premium (discount) on notes payable                           |       | 170                           |       | (—                     | )          |
|                                                                      |       | 8,266                         |       | 7,264                       |       |
| Less current portion of notes payable                                     |       | (1,764                        | )          | (7,264                      | )          |
|                                                                      |       |                          |       |                        |       |
| Long term notes payable, net of premium (discount),  less current portion |       | $                             | 6,502      |                        | $          | — |   |

 

*6%Convertible Notes*

 

During the period August 2007to October 2007, the Company issued 6% convertible notes (the “6%Convertible Notes”) with a face value of $3,326 thousand at an original issuediscount of 10 percent with detachable warrants to purchase shares of itscommon stock in exchange for $3,024 thousand.  These notes matured on March 31,2009, with interest due and payable on February 1, 2008, and on the lastday of each calendar quarter thereafter. The Company was required to makepayments on the outstanding principal balance beginning September 1, 2008,and on the 1st day of each calendar quarter thereafter. The default interestrate was 8 percent. The notes and unpaid interest are convertible into sharesof the Company’s common stock at the option of the holder or involuntarily uponthe occurrence of certain financing events. As of December 31, 2008, and June 30,2009, $1,562 thousand of the face value of the 6% Convertible Notes had beenconverted to 2,083 thousand shares of the Company’s common stock and $1,764thousand remain outstanding. The Company failed to make required interest andprincipal payments as of December 31, 2008, and through June 30,2009. Accordingly, the Company was and remains in default under the terms ofthe notes, which resulted in all principal and interest related to the notesbecoming due and payable to the holders. As a result, the Company classifiedall amounts due related to the 6% Convertible Notes as current liabilities asat December 31, 2008, and June 30, 2009.

 

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

 

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

 

On January 31, 2008,the Company issued convertible debentures (the “January 2008 Debentures”)with a principal amount of $2 million and detachable warrants to purchase222,222 shares of its common stock in exchange for $1.9 million.  The January 2008Debentures are all held by Enable Capital Management LLC or its affiliates(“Enable Capital”).  Enable Capital beneficiallyowns more than 10% of the Company’s common stock.  The January 2008 Debentures are due on January 31,2010, and bear interest at 6 percent per annum payable semiannually on January 1and July 1, commencing July 1, 2008.  Monthly principal paymentsequal to 1/18th of the principal amount were to begin on September 1,2008.  The Company had the right to pay interest and monthly principalpayments in cash, or upon notice to the holders and compliance with certainequity conditions, it can pay all or a portion of any such payment in commonstock valued at a price equal to the lesser of the then effective conversionprice or 85 percent of the average of the volume weighted average price pershare for its common stock for the 10 consecutive trading days immediatelyprior to the applicable payment date.  The equity conditions that it mustmeet include having a currently effective registration statement covering theshares of common stock issuable upon conversion of the debenture, and havingthe daily dollar trading volume for its common stock exceed $250,000 for eachof the 20 consecutive trading days before the date in question.  The January 2008Debentures and any accrued interest are convertible at anytime at thediscretion of the holder at a conversion price per share of $1.35, subject to acap on the beneficial ownership of its shares of common stock by the holder andits affiliates following such conversion. The conversion price is adjusted upona stock split, reverse stock split, or upon issuance of stock dividends,whereby the conversion price would be adjusted to ensure that the holder wouldbe receiving the same number of shares, as though the conversion right had beenexercised prior to the triggering event.  Further, the conversion price isadjusted if common stock or equivalents are subsequently sold or re-priced at aprice below the conversion price or rights, options or warrants are issued toholders of its common stock entitling them to purchase common stock at priceslower than the volume weighted average price on the date issued.

 

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

 

The January 2008Debentures impose certain covenants on the Company, including restrictionsagainst incurring additional indebtedness, creating any liens on its property,amending its certificate of incorporation or bylaws, redeeming or payingdividends on shares of our outstanding common stock, and entering into certainrelated party transactions.  The January 2008 Debentures also definecertain events of default, including, without limitation, failure to make apayment obligation, failure to observe other covenants of the debenture orrelated agreements (subject to applicable cure periods), breach ofrepresentation or warranty, bankruptcy, default under another significantcontract or credit obligation, delisting of its common stock, a change incontrol, failure to secure and maintain an effective registration statementcovering the resale of the common stock underlying the debentures and thewarrants, or failure to deliver share certificates in a timely manner.  Inthe event of default, the holders of the January 2008 Debentures have theright to accelerate all amounts outstanding under the debentures and demandpayment of a mandatory default amount equal to 130 percent of the amountoutstanding plus accrued interest and expenses. The Company failed to makerequired interest and principal payments on the January 2008 Debenturesbeginning with the payment due on September 30, 2008 and through June 30,2009. Accordingly, the Company is in default under the terms of the January 2008Debentures, and the holders have the right to demand that the default amountequal to 130% of the amount outstanding plus accrued interest be paid to theholders. As of December 31, 2008 and June 30, 2009, the Companyclassified all amounts due related to the January 2008 Debentures ascurrent liabilities, and the holders had not elected to exercise their rightsarising from the Company’s default.

 

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

 

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*Restructuringof January 2008 Debentures*

 

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

 

The Company evaluated therestructuring of the January 2008 Debentures, under the guidance inEITF 96-19 “Debtor’s Accounting for a Modification or Exchange of DebtInstruments” (EITF 96-19) and in EITF 06-06 “Debtor’s Accounting for a Modification(or Exchange) of Convertible Debt Instruments” (EITF 06-06) as of June 30,2009. The Company concluded that the restructuring of the January 2008Debentures met the definition of an extinguishment of debt as the terms of themodified debentures were substantially different from the original terms.Accordingly, the Company recorded the difference between the fair value andcarrying value of the January 2008 Debentures as a loss on extinguishmentof debt of $300 thousand in earnings for the six months ended June 30,2009.

 

Additionally, as part ofthe restructuring of the January 2008 Debentures, the outstanding accruedinterest of $170 thousand as of June 30, 2009, was reclassified tooutstanding principal, and the interest that was to have been earned under theoriginal terms of the debentures from July 1, 2009, through September 30,2010, of $150 thousand was recorded as an increase to outstanding principalwith the corresponding debit amount being recorded in the line entitled“Accreting interest on convertible notes payable” in the accompanying balancesheet. This interest amount will be accreted to earnings over the revisedmaturity date of the January 2008 Debentures using the effective interestmethod.

 

The Company recorded adebt premium of $300 thousand related to the difference between the fair valueand the revised principal amount of the January 2008 Debentures, alongwith the increase in the fair value of the embedded conversion option of $50thousand as a debt discount, and debt issuance costs related to fees incurredby the Company from service providers related to the restructuring of the January 2008Debentures of $9 thousand were capitalized as an “Other Asset” in theaccompanying balance sheet. These items will be accreted or amortized to earningsover the revised maturity date of the January 2008 Debentures using theeffective interest method.

 

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

 

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

 

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

 

In connection with the January 2008Debentures and the April 2008 Debentures, the Company also entered into aregistration rights agreement with the investors, pursuant to which it agreedto file a registration statement covering the resale of the shares of commonstock that may be issued to such investors upon the conversion of thedebentures, payment

 

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in kind, and the exerciseof the related warrants.  The Company agreed to maintain the effectivenessof the registration statement (subject to certain limitations) for a period oftime until the holders can sell the underlying common stock without volumerestrictions under Rule 144 of the Securities Act of 1933, or theSecurities Act. If the registration statement is not declared effective by anagreed to date, or if the Company fail to maintain the effectiveness of theregistration statement, then the Company is required to pay to each investor,as partial liquidated damages, cash equal to 1.0 percent of the aggregatepurchase price paid by such investor for the securities purchased in thefinancing and then held by such investor, and must pay to such investor 1percent for each subsequent 30-day period that the default remains uncured, upto a maximum aggregate liquidated damages amount of 10 percent of the aggregatepurchase price paid by the holders of the debentures.

 

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

 

*Restructuringof April 2008 Debentures*

 

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

 

The Company evaluated therestructuring of the April 2008 Debentures, under the guidance inEITF 96-19 and in EITF 06-06 as of June 30, 2009. The Company concludedthat the restructuring of the April 2008 Debentures did not meet thedefinition of an extinguishment of debt as the terms of the modified debentureswere not substantially different from the original terms. However, as the April 2008Debentures included an embedded conversion feature, the Company is required toaccount for any increase in the fair value of the embedded conversion optionimmediately prior to and immediately after the transaction as a debt discountwith the credit being recorded as additional paid in capital. Accordingly, theCompany recorded the increase in the fair value of the embedded conversionoption of $80 thousand as a debt discount that will be amortized over therevised maturity date of the April 2008 Debentures using the effectiveinterest method.

 

Additionally, as part ofthe restructuring of the April 2008 Debentures, the outstanding accruedinterest of $250 thousand as of June 30, 2009, was reclassified tooutstanding principal, and the interest that was to have been earned under theoriginal terms of the debentures from July 1, 2009, through September 30,2010, of $263 thousand was recorded as an increase to outstanding principalwith the corresponding debit amount being recorded in the line entitled“Accreting interest on convertible notes payable” in the accompanying balancesheet. This interest amount will be accreted to earnings over the revisedmaturity date of the April 2008 Debentures using the effective interestmethod.

 

*EmbeddedDerivatives*

 

The Company has evaluatedthe embedded derivatives included in the 6% Convertible Notes and the January 2008and April 2008 Debentures, consisting of the conversion features andcertain put and call features described above, under the guidance in SFAS No. 133“Accounting for Derivative Instruments and Hedging Activities and its relatedguidance and interpretations” (FAS 133) on the issuance date of the ConvertibleNotes and January 2008 and April 2008 Debentures 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.  FAS 133generally indicates that if the conversion features are (i) indexed to theCompany’s capital stock under the guidance in EITF 07-05, “DeterminingWhether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own

 

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Stock”(EITF 07-05), and (ii) wouldbe classified as equity if a freestanding derivative under the guidance in EITF00-19, “Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock” (EITF 00-19), the embeddedderivatives need not be bifurcated from the debt host.  EITF 00-19generally requires, among other factors, that (i) the Company can settlethe derivative in cash or its own stock, at its option, (ii) settlementcan be made in unregistered shares, and (iii) the Company has sufficientauthorized shares to issue shares of its common stock for all equityinstruments convertible to or which can be exercised for its capitalstock.  FAS 133 also provides guidance on when put and call featuresincluded in a debt host agreement are not clearly and closely related to thedebt host must be bifurcated and recorded as a liability.  Only the January 2008and April 2008 Debentures include put and call features.

 

*EmbeddedDerivatives — 6% Convertible Notes*

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the conversion features embedded in the 6%Convertible Notes met the criteria in FAS 133 at issuance and through April 21,2008, the day prior to the merger with Tripath, because the conversion to theCompany’s common stock could only be settled in its capital stock, the capitalstock could be unregistered and the sufficiency of the authorized shares was underthe Company’s control as it could control the outcome of a shareholder vote toincrease the authorized shares.  However, on the date of the merger withTripath, April 22, 2008, the Company concluded it no longer had control toensure the sufficiency of its authorized shares of common stock and recordedthe conversion features embedded in the 6% Convertible Notes with an estimatedfair value of $3,674 thousand and recorded the amount in the line entitled“Warrant and derivative liability” in the accompanying balance sheets. At December 31,2008, and June 30, 2009, the estimated fair value of the conversionfeatures was subsequently revalued to $2 thousand and $0 thousand, with therelated credit of $3,672 and $2 thousand included in the Company’s statement ofoperations in interest expense for the year ended December 31, 2008, andthe six months ended June 30, 2009, respectively. The Company determinedthe estimated fair value of the conversion features on April 22 and December 31,2008, and June 30, 2009, by using the Black-Scholes Merton valuation modeland the following assumptions: fair value of the Company’s common stock of$2.91, $0.33, and $0.36, respectively, per share; terms of 0.95, 0.25, and 0years, respectively; risk free interest rates of 1.82%, 0.11% and 0.0%,respectively; and volatility of 47.16%, 73.59%, and 0.0%, respectively.Probabilities were then applied to the outputs using the Matlab Monte CarloSimulation of the Company’s stock prices to arrive at a value for theconversion options.

 

Upon the restructuring ofthe Company’s January and April Debentures on June 30, 2009, theCompany concluded that the conversion features embedded in the 6% ConvertibleNotes met the criteria in SFAS 133 to be accounted for as an equity instrumentbecause the Company had control to ensure the sufficiency of its authorizedshares of common stock, as the modified anti-dilution provisions relating tothe January 2008 and April 2008 Debentures include a floor on theconversion price adjustment as a result of any subsequent equity sales. Due tothe change in classification from liability to equity, the Company recorded areclassification of the fair value as of June 30, 2009 to additional paidin capital of $0 thousand.

 

*EmbeddedDerivatives — January 2008 and April 2008 Debentures*

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the conversion features embedded in the January 2008Debentures met the criteria in FAS 133 at issuance and through April 21,2008, the day prior to the merger with Tripath, and therefore, were notbifurcated from the debt host because the conversion to the Company’s commonstock could only be settled in its common stock, the common stock could beunregistered and the sufficiency of the authorized shares was under theCompany’s control as it could control the outcome of a shareholder vote toincrease the authorized shares.  However, on the date of the merger withTripath, April 22, 2008, the Company concluded it no longer had control toensure the sufficiency of its authorized shares of common stock nor could itsettle the conversion feature in unregistered shares. Therefore, the Companyrecorded the conversion features embedded in the January 2008 Debentureswith an estimated fair value of $896 thousand and recorded the amount in theline entitled “Warrant and derivative liability” in the accompanying balancesheet.  At December 31, 2008, and June 30, 2009, the estimatedfair value of the conversion feature was subsequently revalued to $5 thousandand $2 thousand, respectively, with the related credit of $891 thousand and $3thousand included in the Company’s statement of operations in interest expensefor the year ended December 31, 2008, and the six months ended June 30,2009. The Company determined the estimated fair value of the conversion optionson April 22 and December 31, 2008, and June 30, 2009, using theBlack-Scholes Merton valuation model and the following assumptions: fair valueof the Company’s common stock of $2.91, $0.33, and $0.36, respectively, pershare; terms of 1.75 years, 1.08 years, and 0.58 years, respectively; risk freeinterest rates of 1.84%, 0.40%, and 0.39%, respectively; and volatility of47.16% 65.48%, and 48.84%, respectively.  Probabilities were then appliedto the outputs using the Matlab Monte Carlo Simulation of the Company’s stockprices to arrive at a value for the conversion options.

 

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Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the conversion features embedded in the April 2008Debentures should be bifurcated from the debt host and recorded as liabilitiesbecause the conversion features must be settled in registered shares and thatdue to the Merger with Tripath the Company no longer had control over ashareholder vote to ensure the sufficiency of its authorized shares of commonstock. The estimated fair value of the embedded conversion features was $1,507thousand at April 22, 2008, and recorded in the line entitled “Warrant andderivative liability” in the accompanying Balance Sheet. At December 31,2008, and June 30, 2009, the estimated fair value of the embeddedconversion features was subsequently revalued to $10 thousand and $2 thousand,respectively, with the related credit of $1,497 thousand and $8 thousandincluded in the Company’s statement of operations in interest expense for theyear ended December 31, 2008, and the six months ended June 30, 2009,respectively. The Company determined the estimated fair value of the conversionoptions on April 22 and December 31, 2008, and June 30, 2009,using the Black-Scholes Merton valuation model and the following assumptions:fair value of the Company’s common stock of $2.91, $0.33, and $0.36,respectively, per share; terms of 2, 1.33, and 0.83 years, respectively; riskfree interest rates of 1.87%, 2.24%, and 0.49%, respectively; and volatility of49.00%, 61.48%, and 58.72%, respectively.  Probabilities were then appliedto the outputs using the Matlab Monte Carlo Simulation of the Company’s stockprices to arrive at a value for the conversion options.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the conversion features embedded in the January 2008and April 2008 Debentures met the criteria in FAS 133 to be accounted foras an equity instrument because the Company had control to ensure thesufficiency of its authorized shares of common stock, as the modifiedanti-dilution provisions relating to the January 2008 and April 2008Debentures include a floor on the conversion price adjustment as a result ofany subsequent equity sales, and because the conversion features no longer arerequired to be settled in registered shares. Due to the change inclassification from liability to equity, the Company recorded areclassification of the fair value of the conversion features embedded in the January 2008and April 2008 Debentures as of June 30, 2009, to additional paid incapital of $0 thousand and $2 thousand, respectively.

 

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

 

Upon the restructuring ofthe January and April Debentures on June 30, 2009, the Companyconcluded that the put and call features embedded in the January 2008 and April 2008Debentures continue to be not clearly and closely related to the debt host andtherefore should be bifurcated from the debt host and recorded as a liabilityat their estimated fair value. The Company determined the net fair value of theput and call to be $97 thousand and $168 thousand for the January 2008 andApril 2008 Debentures, respectively, with the related debit of $97thousand and $168 thousand, respectively, included in the Company’s statementof operations in interest expense for the six months ended June 30, 2009.The Company determined the estimated fair value of the put on June 30,2009, using the Black-Scholes Merton valuation model and the followingassumptions: fair value and exercise price of the put embedded in the January 2008and April 2008 Debentures equivalent to 130% of the outstanding principaland accrued interest of $3,015,858 and $5,216,312, respectively; term of 3.5years to the maturity date of December 31, 2012; risk free interest rateof 1.81%; and volatility of 14.69% which was determined using the volatility ofthe Bank Prime Lending Rate. The Company determined the estimated fair value ofthe call on June 30, 2009, using the Black-Scholes Merton valuation modeland the following assumptions: fair value and exercise price of the callembedded in the January 2008 and April 2008 Debentures equivalent to100% of the outstanding principal and accrued interest of $2,319,890 and$4,012,548, respectively; term of 3.5 years to the maturity date of December 31,2012; risk free interest rate of 1.81%; and volatility of 14.69% which wasdetermined using the volatility of the Bank Prime Lending Rate.

 

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

 

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

 

The Company evaluated theterms and conditions of the detachable warrants issued with the January 2008and April 2008 Debentures under the guidance in EITF 00-19 and EITF 07-05to determine whether the detachable warrants should be accounted for as equityor a liability and thereafter adjusted to their respective estimated fair valueat each reporting date.

 

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Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the detachable warrants issued with the January 2008Debentures met the criteria in EITF 00-19 and EITF 07-05 at issuance andthrough April 22, 2008, and therefore, were accounted for as equitybecause the warrants could only be settled by issuance of the Company’s commonstock, the common stock could be unregistered, and the sufficiency of the authorizedshares was under the Company’s control as it could control the outcome of ashareholder vote to increase the authorized shares.  However, on the dateof the merger with Tripath, April 22, 2008, the Company concluded it nolonger had control to ensure the sufficiency of its authorized shares of commonstock nor could it settle the warrants in unregistered shares and therefore,recorded the estimated value fair value of the warrants of $320 thousand in theline entitled “Warrant and embedded derivative liability” in the accompanyingBalance Sheets.  At December 31, 2008, and June 30, 2009, theestimated fair value of the warrants was revalued to $1 thousand and $1thousand, respectively, with the related credit of $319 thousand and $0thousand included in the Company’s statement of operations in interest expensefor the year ended December 31, 2008, and the six months ended June 30,2009, respectively. The Company determined the estimated fair value of thewarrants on April 22 and December 31, 2008, and June 30, 2009,by using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $2.91, $0.33, and$0.36, respectively, per share; terms of 2.5, 2.08 and 1.58 years,respectively; risk free interest rates of 2.54%, 0.78%, and 0.88%,respectively; and volatility of 47.81%, 56.98%, and 59.34%, respectively.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the detachable warrants issued with the April 2008Debentures did not meet the criteria in EITF 00-19 and EITF 07-05 at issuancebecause it no longer had control to ensure the sufficiency of its authorizedshares of common stock nor could it settle the warrants in unregistered sharesand therefore, recorded the estimated value fair value of the warrants of $590thousand in the line entitled “Warrant and embedded derivative liability” inthe accompanying Balance Sheet.  At December 31, 2008, and June 30,2009, the estimated fair value of the warrants was revalued to $4 thousand and$2 thousand with the related credit of $586 thousand and $2 thousand includedin the Company’s statement of operations in interest expense for the year endedDecember 31, 2008, and the six months ended June 30, 2009,respectively. The Company determined the estimated fair value of the warrantson April 22 and December 31, 2008, and June 30, 2009, by usingthe Black-Scholes Merton valuation model and the following assumptions: fairvalue of the Company’s common stock of $2.91, $0.33, and $0.36, respectively,per share; terms of 3, 2.33, and 1.83 years, respectively; risk free interestrates of 2.43%, 0.84%, and 1.02%, respectively; and volatility of 49.17%,62.44%, and 57.08%, respectively.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued with the January 2008 and April 2008Debentures met the criteria in EITF 00-19 and EITF 07-05 to be accounted for asan equity instrument because the Company had control to ensure the sufficiencyof its authorized shares of common stock, as the modified anti-dilutionprovisions relating to the January 2008 and April 2008 Debenturesinclude a floor on the conversion price adjustment as a result of anysubsequent equity sales. Due to the change in classification from liability toequity, the Company recorded a reclassification of the fair value as of June 30,2009, to additional paid in capital of $1 thousand and $2 thousand,respectively.

 

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

 

Effective on February 23and March 31, 2009, the Company issued promissory notes, pursuant to whichthe Company issued warrants to purchase 26,667 and 133,333 shares, respectively,of the Company’s common stock at an exercise price of $0.75 per share, whichwarrants have a term of three years.

 

The Company evaluated theterms and conditions of the warrants issued with the promissory notes under theguidance in EITF 00-19 and EITF 07-05 to determine whether the warrants shouldbe accounted for as equity or a liability and thereafter adjusted to theirrespective estimated fair value at each reporting date.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrant issued with the promissory note inFebruary 2009, did not meet the criteria in FAS 133 at issuance becausethe Company did not have control to ensure the sufficiency of its authorizedshares of common stock and therefore, recorded the estimated value fair valueof the warrant of $36 thousand in the line entitled “Warrant and embeddedderivative liability” in the accompanying Balance Sheet.  At June 30,2009, the estimated fair value of the warrant was revalued to $1 thousand withthe related credit of $35 thousand included in the Company’s statement ofoperations in interest expense for the six months ended June 30, 2009. TheCompany determined the estimated fair value of the warrant on February 23and June 30, 2009, by using the Black-Scholes Merton valuation model andthe following assumptions: fair value of the Company’s common stock of $2.01and $0.36, respectively, per share; terms of 3 and 2.67 years, respectively;risk free interest rates of 1.34% and 1.46%, respectively; and volatility of53.63% and 52.58%, respectively.

 

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The fair value of the warrant recorded uponissuance was treated as a discount on other notes payable, and was amortizedover the life of the promissory note, which matured on May 31, 2009, usingthe interest method. During the six months ended June 30, 2009, $36thousand of the discount was amortized to interest expense.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued with the promissory note in February 2009met the criteria in EITF 00-19 and EITF 07-05 to be accounted for as an equityinstrument because the Company had control to ensure the sufficiency of itsauthorized shares of common stock, as the modified anti-dilution provisionsrelating to the January 2008 and April 2008 Debentures include afloor on the conversion price adjustment as a result of any subsequent equitysales. Due to the change in classification from liability to equity, theCompany recorded a reclassification of the fair value as of June 30, 2009to additional paid in capital of $1 thousand.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrant issued with the promissory note inMarch 2009, did not meet the criteria in FAS 133 at issuance because the Companydid not have control to ensure the sufficiency of its authorized shares ofcommon stock and therefore, recorded the estimated value fair value of thewarrant of $83 thousand in the line entitled “Warrant and embedded derivativeliability” in the accompanying Balance Sheet.  At June 30, 2009, theestimated fair value of the warrant was revalued to $7 thousand with therelated credit of $76 thousand included in the Company’s statement ofoperations in interest expense for the six months ended June 30, 2009. The Company determined the estimated fair value of the warrant on March 31and June 30, 2009, by using the Black-Scholes Merton valuation model andthe following assumptions: fair value of the Company’s common stock of $1.20and $0.36 per share, respectively; term of 3 and 2.75 years, respectively; riskfree interest rate of 1.15% and 1.51%, respectively; and volatility of 53.28%and 51.87%, respectively.

 

The fair value of thewarrant recorded upon issuance was treated as a discount on notes payable torelated parties, and will be amortized over the life of the promissory note,which is due to mature on October 31, 2009, using the interest method.During the six months ended June 30, 2009, $35 thousand of the discountwas amortized to interest expense.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued with the promissory note in March 2009met the criteria in EITF 00-19 and EITF 07-05 to be accounted for as an equity instrumentbecause the Company had control to ensure the sufficiency of its authorizedshares of common stock, as the modified anti-dilution provisions relating tothe January 2008 and April 2008 Debentures include a floor on theconversion price adjustment as a result of any subsequent equity sales. Due tothe change in classification from liability to equity, the Company recorded areclassification of the fair value as of June 30, 2009 to additional paidin capital of $7 thousand.

 

*Warrantsissued with New Series A Preferred Stock*

 

In October 2008 andas amended in December 2008, the Board of Directors authorized thedesignation and issuance of up to 3,333,333 shares of a New Series AConvertible Preferred Stock (the “New Series A Preferred Stock”), and theoffering of a December 2008 Preferred Stock Financing of up to $2,500,000of New Series A Preferred Stock and a number of warrants with an exerciseprice of $0.75 equal to 100% of the number of shares purchased by eachpurchaser. Through the six months ended June 30, 2009, and the periodending December 31, 2008, respectively, the Company closed a round offinancing for the sale of 10,000 and 833,333 shares, respectively, of its New Series APreferred Stock at $0.75 per share, for an aggregate purchase price of $7.5thousand and $625 thousand, respectively, and warrants to purchase 10,000 and833,333 shares of common stock of the Company, respectively, at an exerciseprice of $0.75 per share, and a three year term. This financing was led byDaniel J.A. Kolke, the Company’s founder, chairman, chief executive officer,acting chief financial officer, and chief technology officer, withparticipation from two of its directors and other prior investors. The holdersof the January 2008 Debentures and the April 2008 Debenturesconsented to this financing, but did not participate.

 

The Company concluded atthe date of issuance and through the reporting date that the embeddedconversion features in the New Series A Preferred Stock should not bebifurcated from the equity host as they were clearly and closely related to theequity host. Also during the year ended December 31, 2008, the Companyrecorded a beneficial conversion feature related to the New Series APreferred Stock, which could have been converted to the Company’s common stock,through the date the conversion feature was recorded, as a dividend expense of$22 thousand.

 

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The Company evaluated theterms and conditions of the detachable warrants issued with the New Series APreferred Stock under the guidance in EITF 00-19 and EITF 07-05 to determinewhether the detachable warrants should be accounted for as equity or a liabilityand thereafter adjusted to their respective estimated fair value at eachreporting date.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the detachable warrants issued with the New Series APreferred Stock did not meet the criteria in EITF 00-19 and EITF 07-05 atissuance because the Company did not have control to ensure the sufficiency ofits authorized shares of common stock. Therefore, the Company recorded theestimated value fair value of the warrants of $148 thousand in the lineentitled “Warrant and embedded derivative liability” in the accompanyingBalance Sheet.  At December 31, 2008, and June 30, 2009,respectively, the estimated fair value of the warrants was revalued to $40thousand and $40 thousand, respectively, with the related credit of $108thousand and $0 thousand included in the Company’s statement of operations infinancing expense for the year ended December 31, 2008, and the six monthsended June 30, 2009, respectively. The Company determined the estimatedfair value of the warrants on December 3 and 31, 2008 and June 30,2009, and February 27 and June 30, 2009, by using the Black-ScholesMerton valuation model and the following assumptions: fair value of the Company’scommon stock of $0.60, $0.33 and $0.36, and $0.51 and $0.36, respectively, pershare; terms of 3, 2.92 and 2.42, and 3.0 and 2.67 years, respectively; riskfree interest rates of 1.07%, 0.98% and 1.33%, and 1.4% and 1.46%,respectively; and volatility of 53.07%, 54.96% and 54.25%, and 53.63% and52.58%, respectively.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued in relation to the New Series APreferred Stock met the criteria in EITF 00-19 and EITF 07-05 to be accountedfor as an equity instrument because the Company had control to ensure thesufficiency of its authorized shares of common stock, as the modifiedanti-dilution provisions relating to the January 2008 and April 2008Debentures include a floor on the conversion price adjustment as a result ofany subsequent equity sales. Due to the change in classification from liabilityto equity, the Company recorded a reclassification of the fair value as of June 30,2009 to additional paid in capital of $40 thousand.

 

*WarrantsIssued in Connection with Litigation Settlement*

 

Effective December 5,2008, the Company entered into a settlement agreement with Kaufman Bros.,pursuant to which the Company issued to Kaufman Bros. warrants to purchase500,000 shares of the Company’s common stock at an exercise price of $0.75 pershare, which warrants have a term of five years. See discussion *infra* Note 11.

 

The Company evaluated theterms and conditions of the warrants issued in the settlement under theguidance in EITF 00-19 and EITF 07-05 to determine whether the warrants shouldbe accounted for as equity or a liability and thereafter adjusted to theirrespective estimated fair value at each reporting date.

 

Prior to the restructuringof the January 2008 and April 2008 Debentures on June 30, 2009,the Company concluded that the warrants issued in the settlement did not meetthe criteria in EITF 00-19 and EITF 07-05 at issuance because the Company didnot have control to ensure the sufficiency of its authorized shares of commonstock and therefore, recorded the estimated value fair value of the warrants of$130 thousand in the line entitled “Warrant and embedded derivative liability”in the accompanying Balance Sheet.  At December 31, 2008, and June 30,2009, respectively, the estimated fair value of the warrants was revalued to$46 thousand and $47 thousand with the related (credit) debit of ($84) thousandand $1 thousand included in the Company’s statement of operations in settlementexpense for the year ended December 31, 2008, and the six months ended June 30,2009, respectively. The Company determined the estimated fair value of thewarrants on December 5 and December 31, 2008, and June 30, 2009,by using the Black-Scholes Merton valuation model and the followingassumptions: fair value of the Company’s common stock of $0.60, $0.33, and$0.36, respectively, per share; terms of 5 years, 4.92, and 4.42 years,respectively; risk free interest rates of 1.67%, 1.53%, and 2.28%, respectively;and volatility of 56.16%, 56.74%, and 54.68%, respectively.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued in relation to the litigationsettlement met the criteria in EITF 00-19 and EITF 07-05 to be accounted for asan equity instrument because the Company had control to ensure the sufficiencyof its authorized shares of common stock, as the modified anti-dilutionprovisions relating to the January 2008 and April 2008 Debenturesinclude a floor on the conversion price adjustment as a result of anysubsequent equity sales. Due to the change in classification from liability toequity, the Company recorded a reclassification of the fair value as of June 30,2009, to additional paid in capital of $47 thousand.

 

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*WarrantsIssued in Connection with Consulting Agreement*

 

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

 

The Company evaluated theterms and conditions of the warrants issued in relation to the consultingagreement under the guidance in EITF 00-19 and EITF 07-05 to determine whetherthe warrants should be accounted for as equity or a liability and thereafteradjusted to their respective estimated fair value at each reporting date.

 

Prior to therestructuring of the January 2008 and April 2008 Debentures on June 30,2009, the Company concluded that the warrants issued in relation to theconsulting agreement did not meet the criteria in EITF 00-19 and EITF 07-05 atissuance because the Company did not have control to ensure the sufficiency ofits authorized shares of common stock and therefore, recorded the estimatedvalue fair value of the warrants of $1,001 thousand in the line entitled“Warrant and embedded derivative liability” in the accompanying BalanceSheet.  At June 30, 2009, the estimated fair value of the warrantswas revalued to $702 thousand with the related credit of $299 thousand includedin the Company’s statement of operations in investor relations expense for thesix months ended June 30, 2009. The Company determined the estimated fairvalue of the warrants on March 2 and June 30, 2009, by using theBlack-Scholes Merton valuation model and the following assumptions: fair valueof the Company’s common stock of $0.51 and $0.36, respectively, per share;terms of 5 years and 4.67 years, respectively; risk free interest rates of1.86% and 2.39%, respectively; and volatility of 56.68% and 54.64%,respectively.

 

Upon the restructuring ofthe January 2008 and April 2008 Debentures on June 30, 2009, theCompany concluded that the warrants issued in relation to the consultingagreement met the criteria in EITF 00-19 and EITF 07-05 to be accounted for asan equity instrument because the Company had control to ensure the sufficiencyof its authorized shares of common stock, as the modified anti-dilutionprovisions relating to the January 2008 and April 2008 Debenturesinclude a floor on the conversion price adjustment as a result of anysubsequent equity sales. Due to the change in classification from liability toequity, the Company recorded a reclassification of the fair value as of June 30,2009 to additional paid in capital of $702 thousand.

 

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

 
| ** **                                                                                                   | ** ** | **Embedded  derivatives** | ** ** | **Warrant  liabilities** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|--------------------------|------------|-----------|------------|
|                                                                                                         |       |                      |       |                     |       |      |       |
| Balance as of  December 31, 2008                                                                        |       | $                         | 16         |                     | $          | 92        |       | $ | 108 |   |
|                                                                                                         |       |                      |       |                     |       |      |       |
| Fair value of  warrant liabilities issued with Other Notes Payable and Notes Payable to  Related Parties     |       |                      |       | 120                      |       | 120       |       |
| Fair value of  warrant liabilities issued with New Series A Preferred warrants                          |       |                      |       | 1                        |       | 1         |       |
| Fair value of  warrant liabilities issued with consulting agreement                                          |       |                      |       | 1,001                    |       | 1,001     |       |
| Change in marked-to-market value of 6% convertible  notes payable                                            |       | (2                        | )          |                     |       | (2        | )          |
| Change in marked-to-market value of  January 2008 Debentures                                            |       | 92                        |       |                     |       | 92        |       |
| Change in marked-to-market value of April 2008  Debentures                                              |       | 160                       |       |                     |       | 160       |       |
| Change in marked-to-market value of January 2008  warrants                                              |       |                      |       | (—                  | )          | (—   | )          |
| Change in marked-to-market value of April 2008  warrants                                                |       |                      |       | (3                       | )          | (3        | )          |
| Change in marked-to-market value of Other  Notes Payable and Notes Payable to Related Parties warrants       |       |                      |       | (112                     | )          | (112      | )          |
| Change in marked-to-market value of New  Series A Preferred warrants                                    |       |                      |       | (2                       | )          | (2        | )          |
| Change in marked-to-market value of litigation  settlement warrants                                          |       |                      |       | 1                        |       | 1         |       |
| Change in marked-to-market value of consulting  agreement warrants                                           |       |                      |       | (299                     | )          | (299      | )          |
| Reclassification to additional paid in capital upon  restructuring of January and April Debentures |       | (2                        | )          | (799                     | )          | (801      | )          |
|                                                                                                         |       |                      |       |                     |       |      |       |
| Balance as of June 30, 2009                                                                             |       | $                         | 264        |                     | $          | —    |       | $ | 264 |   |

 

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

 

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

 

During the quarter ended March 31,2009, the Company entered into an unsecured promissory note with a director, inthe principal amount of $100,000, with a maturity date of October 31,2009, and an interest rate of ten percent per annum.  In connection with this promissory note, theCompany also issued to the director 133,333 detachable warrants to purchasecommon stock of the Company with an exercise price of $0.75 per share and aterm of three years.

 

***8. Equity***

 

*Preferred Stock*

 

Duringthe six months ended June 30, 2009, the Company closed the sale of 10,000shares of its New Series A Preferred Stock at $0.75 per share, for anaggregate purchase price of $7.5 thousand, and warrants to purchase 10,000shares of common stock of the Company, at an exercise price of $0.75 per share,and a three year term.

 

*Common Stock*

 

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

 

OnMarch 2, 2009, the Company entered into a consulting agreement withSalzwedel Financial Communications, Inc. to provide services to theCompany for a period of one year. Compensation payable under that agreement included 1,000,000 shares ofthe Company’s common stock and a warrant to purchase 2,000,000 shares of theCompany’s common stock at a price of $0.01 per share, until March 14,2014.

 

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

 

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

 
| **Options**                            | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price Per  Share** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|----------------------------------------|------------|------------|------------|----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding at  December 31, 2008 |       | 4,086,497  |       | $                                                              | 0.24       |                                                        | 8.6        |                                | $          | 3,971 |   |
| Granted                                |       | 750,000    |       | $                                                              | 0.10       |                                                        |       |                                |       |   |
| Exercised                              |       | (41,667    | )          | $                                                              | 0.05       |                                                        |       |                                |       |   |
| Canceled                               |       | —     |       | —                                                         |       |                                                        |       |                                |       |
| Outstanding at  June 30, 2009     |       | 4,794,830  |       | $                                                              | 0.24       |                                                        | 8.37       |                                | $          | 1,349 |   |
| Exercisable at  June 30, 2009     |       | 1,090,644  |       | $                                                              | 0.20       |                                                        | 8.06       |                                | $          | 311 |   |
| Unvested at June 30,  2009        |       | 3,704,186  |       | $                                                              | 0.25       |                                                        | 8.46       |                                | $          | 1,037 |   |

 

AggregateIntrinsic Value was determined based upon the closing price of the Company’spublicly listed common stock price on June 30, 2009.

 

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Theamount of cash received as a result of options exercised during the six monthsended June 30, 2009, was $2 thousand. There were no equity instrumentsgranted under share-based payment arrangements and therefore there was no cashused to settle any equity instrument. The Company does not plan to repurchaseany shares during the upcoming annual period.

 

***10. Restructuring***

 

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

 

***11. Litigation and Claims***

 

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

 

OnOctober 31, 2008, the Company closed its offices in San Mateo,California.  The landlord for thesepremises has filed a complaint claiming damages of $659 thousand and otheramounts against the Company’s predecessor Etelos, Incorporated, a Washingtoncorporation (“Etelos —WA”) in the Superior Court of San Mateo County,California (Case No. CIV 479535).  Adefault judgment was entered for the landlord because neither the Company norEtelos-WA appeared due to not being properly served. The Company filed a motionto set aside the default because the landlord failed to properly serve eitherthe Company or Etelos-WA.  That motionwas brought on behalf of the Company as the surviving corporation after theMerger but was denied for lack of standing. A new motion to set aside the default has been filed and this matter ispending.   The Company is continuing todefend its position.

 

OnSeptember 18, 2008, the employment of Jeffrey L. Garon as president andchief executive officer of the Company was terminated.  On October 19, 2008, Mr. Garon resignedfrom the Board of Directors.  Mr. Garonand the Company entered into an Employment Agreement dated August 11,2007, which provided certain benefits to Mr. Garon in the event oftermination of his employment, and granted to the Company certain rights torepurchase shares issued on behalf of Mr. Garon pursuant to his employmentagreement, in accordance with a Stock Purchase Agreement dated February

 

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

 

Aspart of the reduction of monthly cash operating expenses beginning in thequarter ending September 30, 2008, and continuing after the end of the quarter,the Company placed all employees on partial deferrals of salary, ranging from10% to 100% of base salary. As of June 30, 2009, and until the filing date ofthis report, a substantial part of this deferral amount remains unpaid,including amounts due to employees who subsequently were terminated. The $924thousand of these unpaid salary were accrued under accrued payroll and relatedexpenses payable as of June 30, 2009. Two former employees have asserted claimswith the California Labor Commission for payment of these unpaid amounts andthe assertion of other such claims or demands by such employees, or bygovernmental authorities, is foreseeable.

 

***12. Subsequent Events***

 

InJuly 2009, we entered into an additional secured bridge loan with EnableGrowth Partners, LP, in the principal amount of $250 thousand, with interest at10% per annum, due January 9, 2010, and in connection with that noteissued to Enable Growth Partners, LP a five year warrant to purchase 500,000shares of the Company’s common stock at an exercise price of $0.75 per share.

 

InAugust 2009, we entered into an additional secured bridge loan with EnableGrowth Partners, LP, in the principal amount of $150 thousand, with interest at10% per annum, due February 10, 2010.

 

EnableGrowth Partners, LP is an affiliate of Enable Capital Management, LLC, whichentity and its affiliates beneficially owns more than 10% of the Company’scommon stock.

 

**Item 2.    MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Overview**

** **

The following discussionof our financial condition and results of operations should be read inconjunction with our condensed consolidated financial statements and therelated notes and other financial information appearing elsewhere in thisreport. Readers are also urged to carefully review and consider the variousdisclosures made by us which attempt to advise interested parties of thefactors which affect our business, including without limitation, thedisclosures made under “Item 1A. Risk Factors” included in Part II of thisreport.

 

***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 the English Application Scripting Engine (EASETM), a simple-to-use openstandards-based scripting language developed by us.  In order to support broader adoption of ourproducts, EASE and other components of the EDE are made available to developersat market appropriate pricing.  This isdone to support the development of new Web Applications and the migration ofexisting Web Applications into the Etelos ecosystem where there are tools andother support mechanisms for the marketing, distribution, and support of theseapplications.

 

We generally receive atransaction fee or subscription fee for transactions that occur within theEtelos ecosystem either via the Etelos MarketplaceTM pursuant to StorefrontOperating Agreements, or in third-party branded Marketplaces operated by uspursuant to Marketplace Partner Agreements (sometimes referred to as “an EtelosMarketplace” or, collectively, as “the Etelos Marketplaces”).  Most customers in Etelos Marketplaces pay asubscription fee, which we share with Syndication Partners and MarketplacePartners; this revenue share is calculated as a percentage of gross revenues fromthe sale of subscriptions to Syndication Partner offerings in the EtelosMarketplaces.

 

Etelos Marketplacessupport and encourage communities of developers, distributors, and consumers toexpand their offerings, collaborate on new ideas and improvements, and providescalable solutions using Web Applications available to others.

 

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***History***

 

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

 

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

 

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

 

***RecentDevelopments***

 

On November 6, 2008,we announced changes to our business model to focus on the sales 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 ourbusiness.  First, this offering will expose the core platform to more ISVsfor greater benefit to their end users and the creation of a larger pool ofapplications for syndication. Second, the development and operation of thirdparty-branded marketplaces shifts the financial expense and operational burdensof sales and marketing to end users to Marketplace Partners that better knowtheir customers and are better capitalized to support necessary sales andmarketing activities.  Third, because this two-pronged go-to-marketstrategy is offered on a revenue-sharing basis, it fundamentally reducesbarriers to acceptance by eliminating up front costs for Syndication Partnersto offer their products through multiple Marketplace Partners, and by chargingMarketplace Partners only for sales success.  Finally, this shift allows us to focus on our core competency in developmentand operation of online marketplaces, while better managing limited financialand other resources.

 

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

 

Inthe quarter ended June 30, 2009, the Company entered into a bridge loanwith the holder of its January 2008 and April 2008 Debentures, in theprincipal amount of $385 thousand.  Theamount of this bridge loan, together with two subsequent bridge loans from theholder of its January 2008 and April 2008 Debentures in theadditional aggregate amount of $400 thousand after the end of the quarter, isestimated to cover its operating expenses through August 2009.  These notes bear interest at ten percent perannum, and have mature between October 17, 2009, and February 10,2010, and are subject to the security interest granted to the holder of the January 2008and April 2008 Debentures in connection with those debentures.

 

***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 principlesgenerally accepted in the United States, we must make a variety of estimatesand assumptions that affect the reported amounts of assets and liabilities, thedisclosure of contingent assets and liabilities, and the reported amounts ofrevenues and expenses.  We haveidentified the following accounting policies that we believe requireapplication of management’s most subjective judgments, often requiring the needto make estimates about the effect of matters that are inherently uncertain andmay change in subsequent periods.

 

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***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 Securities and Exchange Commission Staff AccountingBulletin 104, “Revenue Recognition in Financial Statements” (SAB 104) and SOP97-2, “Software Revenue Recognition”, (SOP 97-2) 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 SAB 104 or SOP 97-2 applies to our revenuetransactions.  We than determine if thecriteria above have been met by assessing the SAB 104 and SOP 97-2 and theirvarious interpretations in view of the agreements and other documentationrelated to the revenue transactions.  Theinterpretation of the agreements often requires considerable judgment as wellas determining what accounting literature is appropriate and how thatliterature should be applied.  If ourstandard agreements are used to establish evidence of the arrangement, then ourrevenue is generally recognized as follows:

 

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

 

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

 

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

 

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***Internal Use Software***

 

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

 

***Stock-Based Compensation Expense***

 

EffectiveJanuary 1, 2006, we adopted FAS 123(R) using the modified prospectivemethod and therefore have not restated prior periods’ results. Under the fairvalue recognition provisions of FAS 123(R), we recognize stock-basedcompensation expense net of an estimated forfeiture rate and therefore onlyrecognize compensation cost for those shares expected to vest over the serviceperiod of the award.  Calculatingstock-based compensation expense requires the input of highly subjectiveassumptions, including the expected term of the stock-based awards, stock pricevolatility, and the pre-vesting option forfeiture rate. We estimate theexpected life of options granted based on historical exercise patterns, whichwe believe are representative of future behavior. We estimate the volatility ofour common stock on the date of grant based on the historical volatility ofother publicly traded companies in our industry. The assumptions used incalculating the fair value of stock-based awards represent our best estimates,but these estimates involve inherent uncertainties and the application ofmanagement judgment. As a result, if factors change and we use differentassumptions, our stock-based compensation expense could be materially differentin the future. In addition, we are required to estimate the expected forfeiturerate, as well as the probability that performance conditions that affect thevesting of certain awards will be achieved, and only recognize expense forthose shares expected to vest. We estimate the forfeiture rate based onhistorical experience of our stock-based awards that are granted, exercised,and cancelled. If our actual forfeiture rate is materially different from ourestimate, the stock-based compensation expense could be significantly differentfrom what we have recorded in the current period. Beginning in the quarterended December 31, 2008, and continuing in the quarter ended June 30,2009, the global economy has been highly volatile and, during this period, theCompany found it necessary to take drastic measures to reduce operatingexpenses, but the likelihood of success of these efforts cannot bepredicted.  Therefore the forfeiture ratein the quarter ended December 31, 2008, was very high.  The forfeiture rate declined substantiallyduring the six months ended June 30, 2009, but it is not known whetherthis forfeiture rate will be maintained in the future; management will continueto monitor its estimates.

 

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

 

TheCompany evaluates the embedded derivatives included in the debt instruments itissues under the guidance in Statement of Financial Accounting Standard No. 133“Accounting for Derivative Instruments and Hedging Activities” and its relatedguidance and interpretations (FAS 133) on the issuance date of the debt and oneach subsequent reporting date to determine whether such embedded derivativesare clearly and closely related to the debt host.  The purpose of the evaluation is to determinewhether the embedded derivatives, which are not clearly and closely related tothe debt host, need to be bifurcated from the debt host and accounted for as aderivative at their estimated fair value as a liability or asset at the date ofissuance and thereafter, adjusted to estimated fair value with a charge or creditto the Company’s statement of operations. FAS 133 generally indicates that if the conversion features are (i) indexedto the Company’s capital stock under the guidance in EITF 07-05, “DeterminingWhether an Instrument (or Embedded Feature) is Indexed to an Entity’s OwnStock” (EITF 07-05), and (ii) would be classified as equity if afreestanding derivative under the guidance in EITF 00-19, “Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock” (EITF 00-19), then the embedded derivatives need not bebifurcated from the debt host.  We alsoevaluate the warrants issued with the debt under EITF 00-19 to determinewhether the proceeds allocated to the warrants or the fair value of thewarrants should be recorded as equity or a liability, respectively, and if aliability adjusted to fair value with a charge or credit to the Company’sstatement of operations.  EITF 00-19generally requires, among other factors, that (i) the Company can settle

 

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thederivative in cash or its own stock, at its option, (ii) settlement can bemade in unregistered shares, and (iii) the Company has sufficientauthorized shares to issue shares of its common stock for all equityinstruments convertible to or which can be exercised for its capitalstock.  FAS 133 also provides guidance onwhen put and call features included in a debt host agreement are not clearlyand closely related to the debt host and must be bifurcated and recorded asliability.  The guidance in FAS 133 iscomplex and it has many interpretations. Accordingly, we must use judgment to apply and interpret this guidance aswell as ensure we have applied the correct guidance.

 

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

 

Our analysis and judgmentmay vary from quarter to quarter and, in some cases such as the current quarterending June 30, 2009, may present results in the Company’s financialstatements for that particular quarter that do not reflect the Company’sperformance for that quarter.  Forexample, as was the case in the quarter ending June 30, 2009, despite thefacts that, in that quarter, the Company had minimal revenues, did not pay itsemployees on a current basis and, like many other companies, experienced theeffects of the unusual volatility of the global business climate in this periodand the application of the “mark to market” accounting rules result in theCompany’s statements of operations for the quarter ending June 30, 2009,showing net income of $2.9 million.  TheCompany’s financial statements for any particular period may not be indicativeof the Company’s performance for that period as a result of the application ofsuch accounting rules, and therefore should not be relied upon by any person asan accurate depiction of the true financial condition of the Company.

 

**Results of Operations**

 

***Three Months Ended June 30, 2009, Compared with ThreeMonths Ended June 30, 2008***

 

***Revenues***

 

Revenues were $69thousand and $22 thousand for the quarters ended June 30, 2009 and 2008,respectively. Revenues increased by $47 thousand, or 213 percent, in the threemonths ended June 30, 2009, compared to the same period in 2008.  This increase was due to our temporary focuson short term consulting projects with immediate cash flow.  In the year ended December 31, 2008, andto the date of this report, we also experienced a significant decline in salesof our customer resource management product, which had been introduced inmid-2007.

 

***Cost of Revenue***

 

Cost of revenue includesour costs of hardware, software and other resources used in delivery of ourproducts and services. Cost of revenue was $80 thousand and $148 thousand forthe quarters ended June 30, 2009 and 2008, respectively. Cost of revenuefor the three months ended June 30, 2009, decreased by $68 thousand, or by46 percent.  The decrease in cost of revenue from 2008 to 2009 wasprimarily attributable to the decreased costs of hosting and Internet bandwidthassociated with the deployment of our products and services. Stated as apercentage of revenues, cost of revenue for the three months ended June 30,2009, was 116 percent and for the corresponding period of 2008 was 672 percent.

*** ***

***Operating Expenses***

 

*Researchand Development*. Research and development expenses include primarily employee and employeerelated expenses. Research and development expenses were $281 thousand and $1.3million for the quarters ended June 30, 2009 and 2008, respectively.Stated as a percentage of revenues, research and development expense for thecorresponding periods was 407 percent and 5,909 percent, respectively. Researchand development expenses decreased by $1,002 thousand or by 78 percent, in thethree months ended June 30, 2009, compared to the same period in 2008. This decrease was primarily due to decreased salary and benefits expensesfor fewer 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 $177 thousand and $508 thousand forthe quarters ended June 30, 2009

 

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and 2008, respectively.The $331 thousand, or 65 percent decrease in sales and marketing expense wasdue to decreased activities of sales and marketing following the restructuringbegun in the quarter ended December 31, 2008. Stated as a percentage ofrevenues, sales and marketing expense for the corresponding periods was 257percent and 2,309 percent, respectively.

* *

*Generaland Administrative.* General and administrative expenses include payroll and related employeebenefits, and other headcount-related costs associated with finance,facilities, legal and other administrative expenses. General and administrativeexpenses were $390 thousand and $630 thousand for the quarters ended June 30,2009 and 2008, respectively. The $240 thousand, or 38 percent, decreases ingeneral and administrative expense was primarily attributable to decreasedhiring of accounting, administrative, legal, and compliance personnel and muchless use of consultants and temporary personnel.  Stated as a percentageof revenues, general and administrative expense for the corresponding periodswas 565 percent and 2,864 percent, respectively.

 

***Interest Income (Expense)***

 

Interest income was$1,614 thousand for the three months ended June 30, 2009, compared toexpense of $(5,567) thousand for the comparable period of 2008, and consistsprimarily of interest expense on convertible notes and debentures, amortizationof discounts on convertible notes and debentures, and changes in the mark tomarket valuation of derivative and warrant liabilities. The increase of $7.2million in interest income (expense) from 2008 to 2009 related to the $5.9million change in the mark to market valuation of derivative and warrantliabilities primarily due to the decrease in the Company’s stock price at June 30,2009 when compared to June 30, 2008, and to a non recurring expense in2008 of $1.0 million related to the beneficial conversion of interestconversion.

 

***Net Income (Loss)***

 

Our net income was $2.9million for the quarter ending June 30, 2009, and net loss was $21.6million for the quarter ending June 30, 2008, respectively, an increase of$24.5 million.  The increase in net income from 2008 to 2009 was primarilydue to non recurring merger related costs of $13.4 million that occurred in thequarter ended June 30, 2008, and to the change in the mark to marketvaluation of derivative and warrant liabilities primarily due to the decreasein the Company’s stock price at June 30, 2009 when compared to June 30,2008 of $8.3 million.

 

***Six Months Ended June 30, 2009, Compared with SixMonths Ended June 30, 2008***

 

***Revenues***

 

Revenues were $126thousand and $45 thousand for the periods ended June 30, 2009 and 2008,respectively. Revenues increased by $81 thousand, or 180 percent, in the sixmonths ended June 30, 2009, compared to the same period in 2008. Thisincrease was due to our temporary focus on short term consulting projects withimmediate cash flow.  In the year ended December 31,2008, and to the date of this report, we also experienced a significant declinein sales of our customer resource management product, which had been introducedin mid-2007.

 

***Cost of Revenue***

 

Cost of revenue includesour costs of hardware, software and other resources used in delivery of ourproducts and services. Cost of revenue was $172 thousand and $249 thousand forthe periods ended June 30, 2009 and 2008, respectively. Cost of revenuefor the six months ended June 30, 2009, decreased by $77 thousand, or by31 percent.  The decrease in cost of revenue from 2008 to 2009 wasprimarily attributable to the decreased costs of hosting and Internet bandwidthassociated with the deployment of our products and services. Stated as apercentage of revenues, cost of revenue for the six months ended June 30,2009, was 137 percent and for the corresponding period of 2008 was 553 percent.

 

***Operating Expenses***

 

*Researchand Development*. Research and development expenses include primarily employee and employeerelated expenses. Research and development expenses were $1.2 million and $2.5million for the six months periods ended June 30, 2009 and 2008,respectively. Stated as a percentage of revenues, research and developmentexpense for the corresponding periods was 942 percent and 5,502 percent,respectively. Research and development expenses decreased by $1.3 million or by52 percent, in the six months ended June 30, 2009, compared to the sameperiod in 2008.  This decrease was primarily due to decreased salary and benefitsexpenses for fewer engineers engaged in research and development.

 

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*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 $746 thousand and $801 thousand forthe six months periods ended June 30, 2009 and 2008, respectively. The $55thousand, or 7 percent, decrease in sales and marketing expense was due todecreased activities of sales and marketing following the restructuring begunin the quarter ended December 31, 2008. Stated as a percentage ofrevenues, sales and marketing expense for the corresponding periods was 592percent and 1780 percent, respectively.

 

*Generaland Administrative.* General and administrative expenses include payroll and related employeebenefits, and other headcount-related costs associated with finance,facilities, legal and other administrative expenses. General and administrativeexpenses were $1,065 thousand and $1,100 thousand for the periods ended June 30,2009 and 2008, respectively. The $35 thousand, or 3 percent, decrease ingeneral and administrative expense was primarily attributable to decreasedhiring of accounting, administrative, legal, and compliance personnel and muchless use of consultants and temporary personnel.  Stated as a percentageof revenues, general and administrative expense for the corresponding periodswas 845 percent and 2,444 percent, respectively.

 

***Interest Income (Expense)***

 

Interest (expense) was$(480) thousand for the six months ended June 30, 2009, compared to$(5,765) thousand for the comparable period of 2008, and consists primarily ofinterest expense on convertible notes and debentures, amortization of discountson convertible notes and debentures, and changes in the mark to marketvaluation of derivative and warrant liabilities. The decrease of $5.3 millionin interest income (expense) from 2008 to 2009 related to the $3.9 millionchange in mark to market valuation of the derivative and warrant liabilitiesprimarily due to the decrease in the Company’s stock price at June 30,2009 when compared to June 30, 2008, and to a non recurring expense in2008 of $1.0 million related to the beneficial conversion of interestconversion.

 

***Net Loss***

 

Our net loss was $3.5million and $23.8 million for the six months periods ended June 30, 2009and 2008, respectively, a decrease of $20.3 million, or 85 percent.  Thedecrease in net loss from 2008 to 2009 was primarily due to non recurringmerger related costs of $13.4 million that occurred in the quarter ended June 30,2008, the $3.6 million change in the mark to market valuation of derivative andwarrant liabilities primarily due to the decrease in the Company’s stock priceat June 30, 2009 when compared to June 30, 2008, decreased salary andbenefits expenses for fewer engineers engaged in research and development of$1.3 million, and to a non recurring expense in 2008 of $1.0 million related tothe beneficial conversion of interest conversion.

 

**Liquidity and Capital Resources**

 

OnJune 30, 2009, we had $1 thousand in cash and cash equivalents, netaccounts receivable of $4 thousand, and prepaid expenses and other currentassets of $14 thousand.  The currentportion of accreting interest on our long-term convertible notes payable was $328thousand.  Our working capital deficit atJune 30, 2009, was $5.9 million, compared to a deficit of $10.3 million atDecember 31, 2008. The decrease in working capital deficit was due to thereclassification of the January 2008 and April 2008 Debentures from short termto long term debt due to the restructuring of the debentures on June 30, 2009,and further discussed in “Note 6 Convertible Notes and Debentures and EmbeddedDerivative and Warrant Liability” in our financial statements included in this report.

 

Netcash used by operating activities during the six months ended June 30,2009, was $(665) thousand, compared to $(4.7) million during the six monthsended June 30, 2008. The primary use of cash from operating activitiesduring the six months ended June 30, 2009, was related to payment ofexpenses relating to accounting and compliance.

 

Netcash provided by financing activities during the six months ended June 30,2009, was $659 thousand, primarily from the issuance of bridge loan notes. Inthe quarter ended June 30, 2009, the Company entered into a bridge loanwith the holder of its January 2008 and April 2008 Debentures, in theprincipal amount of $385 thousand.  Theamount of this bridge loan, together with two subsequent bridge loans from theholder of its January 2008 and April 2008 Debentures in theadditional aggregate amount of $400 thousand after the end of the quarter, isestimated to cover its operating expenses through August 2009.  These notes bear interest at ten percent perannum, and have mature between October 17, 2009, and February 10,2010, and are subject to the security interest granted to the holder of the January 2008and April 2008 Debentures in connection with those debentures.

 

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

 

Weneed immediate and substantial cash to continue our operations. Management hasprojected that the combination of cash on hand will be sufficient to allow usto continue our operations only through August 2009. If cash reserves arenot sufficient to sustain operations, then we plan to raise additional capitalby selling shares of our capital stock or other securities.  However, there are no commitments orarrangements for future financings in place at this time and we can give noassurance that such capital will be available on favorable terms, or at all.  We may need additional financing thereafteruntil we can achieve profitability. We are considering alternatives to addressour cash flow situation that include: (1) raising capital throughadditional sale of our common stock and/or debentures and (2) reducingcash operating expenses to levels that are in line with current revenues.  If we cannot obtain additional financing,then we may be forced to curtail our operations, cease voluntarily filingreports with the SEC, or possibly be forced to evaluate a sale or liquidationof our assets or consider other strategic alternatives such as bankruptcy.  Even if we are successful in raisingadditional funds, there is no assurance regarding the terms of any additionalinvestment and any such investment or other strategic alternative would likelysubstantially dilute or eliminate the interests of our stockholders.

 

***September 2007 Notes***

 

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

 

Underthe terms of the remaining $1.8 million of the notes that were not converted, periodicprincipal payments were payable beginning on September 1, 2008.  On June 15, 2008, the holders of thesenotes agreed to either convert the then-accrued interest to shares of commonstock at a rate of one share for each $1.35 of interest owed or to add thethen-accrued interest to the principal, and to waive any default arising out ofour failure to pay the accrued and unpaid interest through June 15, 2008.

 

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

 

***January 2008 Debentures***

 

InJanuary 2008, we issued our January 2008 Debentures with an aggregateprincipal amount of $2.0 million. Under the terms of these debentures, we wereto begin making monthly redemption payments on September 1, 2008, throughthe maturity date of January 31, 2010. We did not make any of the monthly payments and we were in default

 

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

 

OnJune 30, 2009, we executed an agreement to restructure our January 2008and April 2008 Convertible 6% Secured Debentures with a principal amountof $5.5 Million.  Under the terms of theagreement, the term of the debentures is extended to December 31, 2012,interest accrual will be at 0% from the date of the agreement until October 1,2010, and all accrued interest as of October 1, 2010, has been added toprincipal to be paid at maturity. Our obligation to make monthly

 

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amortizingredemption payments has been terminated; we are required to make semi-annualinterest payments only, beginning January 1, 2011. The registration rightsagreement entered into in conjunction with the debentures has been terminatedand the warrants issued in conjunction with the debentures will be exchangedfor Etelos common stock on 1:1 basis.

 

***April 2008 Debentures***

 

InApril 2008, we issued our April 2008 Debentures with an aggregate principalamount of $3.5 million. Under the terms of these debentures, we are to beginmaking monthly redemption payments on November 1, 2008, through thematurity date of April 30, 2010.  We did not make any of the monthly payments and we were in default.

 

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

 

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

 

***BridgeLoans***

 

Inthe quarter ended June 30, 2009, the Company entered into a bridge loanwith the holder of its January 2008 and April 2008 Debentures, in theprincipal amount of $385 thousand.  Theamount of this bridge loan, together with two subsequent bridge loans from theholder of its January 2008 and April 2008 Debentures in the additionalaggregate amount of $400 thousand after the end of the quarter, is estimated tocover its operating expenses through August 2009.  These notes bear interest at ten percent perannum, and have mature between October 17, 2009, and February 10,2010, and are subject to the security interest granted to the holder of the January 2008and April 2008 Debentures in connection with those debentures.

 

***Operating and Capital Leases***

 

Wehave non-cancelable leases for corporate facilities and equipment.  Rent expense under the leases totaled $12.4thousand and $126 thousand for the six months ended June 30, 2009 and2008, respectively.  Future minimumrental payments required under non-cancelable leases are as follows for thetwelve months ended December 31:

 
| ** **                                         | ** ** | **Operating  Leases** | ** ** | **Capital  Leases** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|---------------------|------------|
|                                               |       |                  |       |                |       |
| 2010                                               |       | —                |       | 8                   |       |
| 2011                                               |       | —                |       | 13                  |       |
| 2012                                               |       | —                |       | 11                  |       |
| 2013                                               |       | —                |       | —              |       |
| Total minimum lease payments                       |       | $                     | —     |                | $          | 32 |   |
| Less: amount representing interest                 |       |                  |       | (4                  | )          |
| Present value of minimum lease payments            |       |                  |       | 28                  |       |
| Less: current portion of capital lease obligations |       |                  |       | (10                 | )          |
| Long-term capital lease obligations                |       |                  |       | $                   | 18         |   |
|                                                    |            |                       |            |                     |            |  |  |

 

OnOctober 31, 2008, the Company closed its offices in San Mateo,California.  The landlord for thesepremises has filed a complaint claiming damages of $659 thousand and otheramounts against the Company’s predecessor Etelos, Incorporated, a Washingtoncorporation [“Etelos —WA”] in the Superior Court of San Mateo County,California (Case No. CIV 479535). The landlord failed to properly serve either the Company or Etelos-WA andhas taken a default.  The Company filed amotion to set aside the default because the landlord failed to serve either theCompany or Etelos-WA.  That motion wasbrought on behalf of the Company as the surviving corporation after the Mergerbut was denied for lack of standing.  Anew motion to set aside the default has been filed and this matter ispending.   The Company is continuing todefend its position.

 

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

 

**OffBalance Sheet Arrangements**

 

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

 

**GoingConcern Issue**

 

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

 

Duringthe quarter ended June 30, 2009, we have been unable to generate cashflows sufficient to support our operations and have been dependent on debtraised from qualified investors.

 

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

 

Wehave supported current operations by raising additional operating cash throughbridge loans and the private sale of our convertible debentures and preferredstock.  This has provided us with thecash inflows to continue our business plan, but has not resulted in significantimprovement in our financial position. We are considering alternatives toaddress our cash flow situation that include: (1) raising capital throughadditional sale of our common stock and/or debentures and (2) reducingcash operating expenses to levels that are in line with current revenues.

 

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

 

**RecentAccounting Pronouncements**

 

In April 2009, the FASBissued SFAS No. 165, *Subsequent Events* (FAS 165). FAS 165 establishesgeneral standards of accounting for and disclosure of events that occur afterthe balance sheet date but before financial statements are issued or availableto be issued. The Company adopted FAS 165 for the quarter ending June 30,2009. Adoption did not have a material impact on the financial statements.

 

In April 2009, the FASBissued SFAS No. 167, *Amendments to FASBInterpretation No. 46(R) *(FAS 167). FAS 167 requires a qualitative approach toidentifying a controlling financial interest in a variable interest entity(VIE), and requires ongoing assessment of whether an entity is a VIE andwhether an interest in a VIE makes the holder the primary beneficiary of theVIE. FAS 167 is effective for annual reporting periods beginning after November 15,2009. The Company is currently evaluating the impact of the pending adoption ofFAS 167 on the financial statements.

 

In June 2009, the FASB issued SFAS No. 168, *The FASB Accounting Standards Codification and theHierarchy of Generally Accepted Accounting Principles* (FAS 168). FAS 168 identifies theFASB Accounting Standards Codification as the authoritative source of generallyaccepted accounting principles in the United States. Rules andinterpretive releases of the Securities and Exchange Commission (SEC) underfederal securities laws are also sources of authoritative GAAP for SECregistrants. FAS 168 is effective for financial statements issued for interimand annual periods ending after September 15, 2009. The Company does notexpect adoption to have a material impact on the financial statements, other than toupdate the GAAP references throughout the footnote disclosures.

 

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

 

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

** **

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

 

**Item 4.**    CONTROLS ANDPROCEDURES

** **

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

 

As required by ExchangeAct Rule 13a-15(b), 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 June 30, 2009,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 June 30, 2009, because of certain materialweaknesses in our internal controls over financial reporting.

 

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

 

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

 

**Changes In Internal Controls OverFinancial Reporting.**

 

No changes were made inour internal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) of the Exchange Act) during our most recent fiscal quarter thathas materially affected, or is likely to materially affect, our internalcontrol over financial reporting.

 

**Limitations On DisclosureControls And Procedures.**

 

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

 

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**PART II**—**OTHER INFORMATION**

 

**Item 1.    LEGAL PROCEEDINGS**.

 

From time to time,we become subject to various legal proceedings and claims, both asserted andunasserted, that arise in the ordinary course of business. Litigation ingeneral, and securities litigation in particular, can be expensive anddisruptive to normal business operations. Moreover, the results of legalproceedings are difficult to predict. An unfavorable resolution of one or moreof these lawsuits would materially adversely affect our business, results ofoperations, or financial condition. We accrue legal costs when incurred.  The need to defend any such claims couldrequire payments of legal fees and our limited financial resources couldseverely impact our ability to defend any such claims.

 

In June 2008,Kaufman Bros. L.P. filed suit against us in the United States District Courtfor the Southern District of New York (Case No. 80 CV 5716) and sought atemporary restraining order and other extraordinary relief.  The complaintarises out of an advisory services agreement, pursuant to which Kaufman Bros.was to provide us with advisory services in connection with financings and strategictransactions. We notified Kaufman Bros. that we believed it had failed toprovide the required services under the agreement, and that we were thereforeentitled to terminate the agreement for cause. In the suit, Kaufman Bros. wasseeking (i) monetary damages of $400,000 for anticipatory breach of theagreement; (ii) $73,800 in fees allegedly owed in connection with apreviously closed financing transaction; (iii) and injunction prohibitingus from cancelling any shares issued to Kaufman Bros. as compensation, (iv) adeclaration from the court that we are not entitled to a refund of any feespreviously paid to Kaufman Bros., and (v) a declaration that we areobligated to pay Kaufman Bros. a commission on any financing or transactionthat we enter into within 18 months following the termination of theagreement.  On July 15, 2008, Kaufman Bros. voluntarily filed anotice of dismissal without prejudice.  Settlement discussions wereunsuccessful and, on July 31, 2008, Kaufman Bros. re-filed substantiallythe same claims in the Supreme Court of New York - County of New York (Index No. 08-602239).Effective on December 5, 2008, the Company entered into a settlementagreement with Kaufman Bros., pursuant to which (i) the Company agreed topay to Kaufman Bros. $210,000, in twelve monthly installments of $17,500; (ii) theCompany issued to Kaufman Bros. warrants to purchase 500,000 shares of theCompany’s common stock at an exercise price of $0.75 per share, which warrantshave a term of five years; (iii) the Company and Kaufman Bros. agreedimmediately to terminate all provisions, terms and conditions of the advisoryservices agreement and exchanged mutual releases; and (iv) Kaufman Bros.agreed to dismiss the pending lawsuit in the Supreme Court of New York, withoutprejudice. Subsequent to entering into the settlement agreement, we have notfully complied with our payment obligations under the settlement agreement but,through the date of filing of this report, Kaufman Bros. has not exercised anyof its remedies for default under the settlement agreement.

 

On October 31,2008, the Company closed its offices in San Mateo, California.  Thelandlord for these premises has filed a complaint claiming damages of $659thousand and other amounts against the Company’s predecessor Etelos,Incorporated, a Washington corporation [“Etelos —WA”] in the Superior Court ofSan Mateo County, California (Case No. CIV 479535).  The landlordfailed to properly serve either the Company or Etelos-WA and has taken adefault.  The Company filed a motion to set aside the default because thelandlord failed to serve either the Company or Etelos-WA.  That motion wasbrought on behalf of the Company as the surviving corporation after the Mergerbut that motion was denied for lack of standing.  A new motion to setaside the default has been filed and this matter is pending.   TheCompany is continuing to defend its position.

 

OnSeptember 18, 2008, the employment of Jeffrey L. Garon as president andchief executive officer of the Company was terminated.  On October 19, 2008, Mr. Garonresigned from the Board of Directors.  Mr. Garonand the Company entered into an Employment Agreement dated August 11,2007, which provided certain benefits to Mr. Garon in the event oftermination of his employment, and granted to the Company certain rights torepurchase shares issued on behalf of Mr. Garon pursuant to his employmentagreement, in accordance with a Stock Purchase Agreement dated February 29,2008.On June 22, 2009, we filed ademand for Arbitration with the American Arbitration Association [Case No. 74166 00535 09 LMT] seeking injunctive and other relief, includingrescission of the Employment Agreement and the Stock PurchaseAgreement that we entered into with Mr. Garon.  The demand includesassertions that Mr. Garon misrepresented his employment qualificationsand, *inter alia*, seeks to recoverfrom Mr. Garon 2,383,333 shares of our common stock that were issuedin connection with his employment.  Mr. Garon has filed acounter-demand against the Company, certain employees of the Company, andmembers of our Board of Directors seeking declaratory relief, apreliminary injunction, and damages in an amount to be proved at thearbitration.

 

As part of ourreduction of monthly cash operating expenses during the quarter ending September 30,2008, and continuing after the end of the quarter, we placed all employees onpartial deferrals of salary, ranging from 10% to 100% of base salary.  At the end of the quarter, until the date ofthis filing, a substantial part of this deferral amount remains unpaid,including amounts due to employees who subsequently were terminated; the amountof accrued payroll and related expenses payable is $924 thousand, as of the sixmonths ended June 30, 2009.  Twoformer employees have asserted claims with the California Labor Commission forpayment of these unpaid amounts and the assertion of other such claims ordemands by such employees, or by governmental authorities, is foreseeable.

 

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In connection withour reverse merger, multiple financings, and protection of our intellectualproperty, we have incurred substantial accounts payable to law firms thatremain unpaid and overdue.  We have beenin communication with these vendors and expect to enter into negotiated paymentplans with these vendors, and others, but there is no assurance that we will besuccessful in these negotiations, or that we will be able to make 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 commonstock involves a high degree of risk. You should carefully consider the risksdescribed below together with all of the other information included in thisreport before making an investment decision. If any of the following risksactually occur, our business, financial condition or results of operationscould suffer. In that case, the market price of our common stock could decline,and you may lose all or part of your investment.

 

***Ourcurrent cash will fund our business as currently planned only through August 2009.We need additional funding or we will be forced to curtail or cease operations.***

 

We need immediate andsubstantial cash to continue our operations. We currently have no fundingcommitments.  Based upon the $400thousand subsequently received in the period after the six months ended June 30,2009, Management has projected that cash on hand will be sufficient to allow usto continue our operations only through August 2009.  Since August 2008, all remainingemployees have been on deferred salary, ranging from 10% to 100% of basesalary; although some payments have been made to these employees from time totime during this period, these employees are owed $924 thousand in accruedsalary and related expenses as of the six months ended June 30, 2009, andthere is no assurance that any of these employees will be able to continue towork for us on this arrangement.  We alsoneed to negotiate payment plans for certain trade payables and there is a riskthat trade creditors will not accept deferred payment and exercise otherremedies to collect balances due and owing. We therefore will need additionalfunding, either through equity or debt financings, or we will be forced tocurtail or cease operations or consider other strategic alternatives such asbankruptcy.

 

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

 

We began our operationsin 1999 but we did not adopt the SaaS on-demand Web Applications delivery modeluntil 2005, and further changed our business model beginning in the quarterended December 31, 2008. As such, we have a limited operating history inthe SaaS industry in general, and even more limited experience with our newbusiness model, from which to evaluate our business and prospects.  We incurred a net loss of $3.5 million forthe six months ended June 30, 2009, and $23.8 million for the six monthsended June 30, 2008, and have an accumulated deficit of $33.3 million at June 30,2009.  We cannot assure you that ourfuture planned operations will be implemented successfully or that we will everhave profits.  Furthermore, we areexperiencing the initial costs and uncertainties of a young operating company,including start-up expenditures, unforeseen costs and difficulties,complications, and delays, all of which must be resolved and/or paid withoutthe benefit of a predictable revenue stream. We cannot be sure that we will be successful in meeting these challengesand addressing these risks and uncertainties. If we are unable to do so, then we may be required to scale back ourbusiness, sell or license some or all of our technology or assets, or curtailor cease operations.

 

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

 

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

 

·                  maintain andimprove our technology;

 

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·                  expand ourproduct and service offerings and maintain the high quality of products andservices offered;

 

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

 

·                  manage ourexpanding operations, including the integration of any future acquisitions;

 

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

 

·                  maintainadequate control of our expenses;

 

·                  implement ourproduct development, marketing, sales, and acquisition strategies and adapt andmodify them as needed; and/or

 

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

 

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

 

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

 

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

 

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

 

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

 

Although we haveperiodically shown profits due to mark-to-market accounting anomalies relatedto warrant liability and embedded derivatives, we have never been profitablefrom operations on a quarterly or annual basis since our formation. Ouroperations resulted in a net loss of $3.5 million for the six months ended June 30,2009, and $23.8 million for the six months ended June 30, 2008. As of June 30,2009, our accumulated deficit was $33.3 million.  We expect to make significant futureexpenditures related to the development and expansion of our business. Inaddition, as a public company, we incur significant legal, accounting, andother expenses that we did not incur as a private company. As a result of theseincreased expenditures, we will have to generate and sustain increased revenueto achieve and maintain future profitability. While our revenue has grown somewhat in recent periods, that growth hasnot been significant and future revenue growth may not be sustainable and wemay not achieve sufficient revenue to achieve or maintain profitability. Wehave incurred and may continue to incur significant losses in the future for a numberof reasons, including due to the other risks described in this report, and wemay encounter unforeseen expenses, difficulties, complications, delays, andother unknown factors. Accordingly, we may not be able to achieve or maintainprofitability and we may continue to incur significant losses for theforeseeable future.

 

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

 

Our success will depend,to a large extent, on the willingness of individuals and SMBs to accept on-demandservices for Web Applications that they view as critical to the success oftheir business. Many businesses have invested substantial effort and financialresources to integrate traditional enterprise software into their businessesand may be reluctant or unwilling to switch to a different application or tomigrate these applications to on-demand Web Applications.

 

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

 

·                  minimize thetime and resources required to implement products distributed through an EtelosMarketplace;

 

·                  maintain highlevels of customer satisfaction;

 

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

 

·                  provide rapidresponse time during periods of intense activity on customer websites.

 

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

 

·                  the securitycapabilities, reliability, and availability of on-demand services;

 

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

 

·                  the level ofcustomization or configuration we offer; and/or

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

We have decreased ournumber of full-time employees from 46 at June 30, 2008, to 13 as of June 30,2009.  All of these remaining employeesare on deferred salary, ranging from 10% to 100% of base salary, and there isno assurance that any of these personnel will be able to continue to work onthis payment arrangement. As of the six months ended June 30, 2009,accrued salary and related expenses owed to employees was $924 thousand.  Our operating plan has placed, and ouranticipated growth plan is expected to continue to place, a significant strainon our very limited managerial, administrative, operational, financial, andother resources, compounded by these recent reductions in headcount. Althoughwe will be required to continue to improve our operational, financial, andmanagement controls and our reporting procedures it is clear that we may not beable to do so effectively and may not be able to recruit or retain adequate,qualified personnel to meet our operating demands. As such, we may be unable tomanage our expenses effectively in the future, which may negatively impact ourgross margins or operating expenses in any particular quarter.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

We rely on a combinationof patent, copyright, service mark, trademark, and trade secret laws, as wellas confidentiality procedures and contractual restrictions, to establish andprotect our proprietary rights on a global basis, all of which provide onlylimited protection. We cannot assure you that any patent will issue from ourcurrently pending patent applications in a manner that gives us the protectionthat we seek, if at all, or that any future patents issued to us will not bechallenged, invalidated, or circumvented. Since the filing of some of thesepatent applications may have been, or will be, made after the date of firstsale or disclosure of the subject inventions, patent protection may not beavailable for these inventions outside the United States.  Any patents that may issue in the future maynot provide sufficiently broad protection or they may not prove to beenforceable in actions against alleged infringers. Also, we cannot assure youthat any future service mark or trademark registrations will be issued forpending or future applications or that any registered service marks ortrademarks will be enforceable or provide adequate protection of our domesticand foreign proprietary rights.

 

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We have not maintainedoperating controls or logs, or initiated or conducted any forensic, codehistory, ‘genealogy’ or other forms of audit, analysis, processes, training, orcode review of software code incorporated into any Etelos product or in otherproducts offered by Syndication Partners in an Etelos Marketplace. We do notreview the intellectual property rights related to products or services offeredby Syndication Partners in an Etelos Marketplace. These products may include codesubject to various forms of ‘open source’, ‘copyleft’, or similar licenses thatrequire as a condition of modification or distribution of software subject tosuch license(s) that (i) such software or other software combined ordistributed with such software be disclosed or distributed in source code form,or (ii) such software or other software combined or distributed with suchsoftware, and any related intellectual property, be licensed on a royalty-freebasis, including for the purposes of making additional copies or derivativeworks of such software.  This mayadversely affect our ability to patent certain inventions or to license ordistribute certain products - whether by open source license or other form oflicense or right - and may result in liability to unknown parties forinfringement of their patents or other intellectual property rights.

 

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

 

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

 

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

 

The software and technologyindustries are characterized by the existence of a large number of patents,copyrights, trademarks, and trade secrets and by frequent litigation based onallegations of infringement or other violations of intellectual propertyrights. As we face increasing competition, the possibility of intellectualproperty rights claims against us may grow; the costs of defending against suchclaims can be very large. Our technologies may not be able to withstand anythird-party claims or rights against their use. Additionally, many of ourpartner and product agreements require us to indemnify our customers forcertain third-party intellectual property infringement claims, which couldincrease our costs as a result of defending such claims and may require that wepay damages or purchase expensive licenses, if there were an adverse rulingrelated to any such claims. These types of claims could harm our relationshipswith our customers, may deter future customers from subscribing to ourservices, or could expose us to litigation for these claims. Even if we are nota party to any litigation between a customer and a third party, an adverseoutcome in any such litigation could make it more difficult for us to defendour intellectual property in any subsequent litigation in which we are a namedparty.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Our ability to attractnew customers and to increase revenue from existing customers will depend inlarge part on our ability to enhance and improve our existing products and toadd new Marketplace Partners and new Syndication Partners to offer theirproducts and services and distribute into new markets. The success of anyenhancement or new Syndication Partner

 

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offering depends onseveral factors, including the timely completion, introduction, and marketacceptance of the enhancement, product or service. Any new product or serviceoffered by a Syndication Partner or that we develop or acquire may not beintroduced in a timely or cost-effective manner and may not achieve the broadmarket acceptance necessary to generate significant revenue. Any new marketsinto which we attempt to distribute our products or services may not bereceptive. If we are unable to successfully develop or acquire new products orservices, enhance our existing products and services to meet customerrequirements, or distribute our products and services into new markets, thenour revenue will not grow as expected and we may not be able to achieveprofitability.

 

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

 

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

 

During our audit for theyear ended December 31, 2008, we identified material weaknesses in ourinternal controls. The material weaknesses relate to the absence of specificpolicies and procedures for some accounting functions and the need foraccounting personnel who possess the skill sets necessary to operate and reportas a public company, and specifically the skills necessary to ensure thatadequate review of critical account reconciliations is performed and thatsupporting documentation is complete, accurate, and in accordance withgenerally accepted accounting principles. Our financial position and limitedresources make it difficult for us to address these weaknesses.  If we fail to address these materialweaknesses or if additional material weaknesses in our internal controls arediscovered in the future, then we may fail to meet our future reportingobligations, our financial statements may contain material misstatements andthe price of our common stock may decline.

 

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

 

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

 

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

 

·                  a reduction insales or delay in market acceptance of services from us or our MarketplacePartners;

 

·                  sales credits orrefunds to our customers and customers of our Marketplace Partners;

 

·                  loss of existingcustomers and difficulty in attracting new customers;

 

·                  diversion ofdevelopment resources;

 

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

 

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·                  increasedwarranty 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.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Although we have noongoing negotiations or current agreements or commitments for any acquisitions,our business strategy may include acquiring complementary products, services,technologies, or businesses. We also may enter into relationships with otherbusinesses to expand our product or service offerings or our ability to provideservice in foreign jurisdictions, which could involve preferred or exclusivelicenses, additional channels of distribution, discount pricing, investments inother companies, or other 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 relationship may result in unforeseen operatingdifficulties and expenditures. In particular, we may encounter difficultiesassimilating or integrating the businesses, technologies, products, servicesofferings, personnel, or operations of the acquired companies, particularly ifthe key personnel of the acquired company choose not to work for us, thetarget’s software is not easily adapted to work with ours, or we are unable toretain the customers of any acquired business due to changes in management orotherwise. Acquisitions may also disrupt our business, divert our resources,and require significant management attention that would otherwise be availablefor operation and development of our business. Moreover, the anticipatedbenefits of any acquisition, investment, or business relationship may not berealized or we may be exposed to unknown liabilities. For one or more of thosetransactions, we may:

 

·                  issue additionalequity securities that would dilute our stockholders;

 

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

 

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

 

·                  incur largecharges or substantial liabilities;

 

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

 

·                  become subjectto adverse tax consequences, substantial depreciation, or deferred compensationcharges.

 

Any of these risks couldharm our business and operating results.

 

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

 

In June 2008,Kaufman Bros. L.P. filed suit against us in the United States District Courtfor the Southern District of New York (Case No. 80 CV 5716) and sought atemporary restraining order and other extraordinary relief.  The complaintarose out of an advisory services agreement, pursuant to which Kaufman Bros.was to provide us with advisory services in connection with financings andstrategic transactions. We notified Kaufman Bros. that we believed it hadfailed to provide the required services under the agreement, and that we weretherefore entitled to terminate the agreement for cause. In the suit, KaufmanBros. was seeking (i) monetary damages of $400,000 for anticipatory breachof the agreement; (ii) $73,800 in fees allegedly owed in connection with apreviously closed financing transaction; (iii) and injunction prohibitingus from cancelling any shares issued to Kaufman Bros. as compensation, (iv) adeclaration from the court that we are not entitled to a refund of any feespreviously paid to Kaufman Bros., and (v) a declaration that we areobligated to pay Kaufman Bros. a commission on any financing or transactionthat we enter into within 18 months following the termination of theagreement.  On July 15, 2008, Kaufman Bros. voluntarily filed anotice of dismissal without prejudice.  Settlement discussions wereunsuccessful and, on July 31, 2008, Kaufman Bros. re-filed substantiallythe same claims in the Supreme Court of New York - County of New York (Index No. 08-602239).Effective on December 5, 2008, the Company entered into a settlementagreement with Kaufman Bros., pursuant to which (i) the Company agreed topay to Kaufman Bros. $210,000, in twelve monthly installments of $17,500; (ii) theCompany issued to Kaufman Bros. warrants to purchase 500,000 shares of the Company’scommon stock at an exercise price of $0.75 per share, which warrants have aterm of five years; (iii) the Company and Kaufman Bros. agreed immediatelyto terminate all provisions, terms and conditions of the advisory servicesagreement and exchanged mutual releases; and (iv) Kaufman Bros. agreed todismiss the pending lawsuit in the Supreme Court of New York, withoutprejudice. Subsequent to entering into the settlement agreement, we have notfully complied with our payment obligations under the settlement agreement but,through the date of filing of this report, Kaufman Bros. has not exercised anyof its remedies for default under the settlement agreement.

 

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On October 31, 2008,the Company closed its offices in San Mateo, California.  The landlord forthese premises has filed a complaint claiming damages of $659 thousand andother amounts against the Company’s predecessor Etelos, Incorporated, aWashington corporation [“Etelos —WA”] in the Superior Court of San MateoCounty, California (Case No. CIV 479535).  The landlord failed toproperly serve either the Company or Etelos-WA and has taken a default. The Company filed a motion to set aside the default because the landlordfailed to serve either the Company or Etelos-WA.  That motion was broughton behalf of the Company as the surviving corporation after the Merger but thatmotion was denied for lack of standing.  A new motion to set aside thedefault has been filed and this matter is pending.  The Company iscontinuing to defend its position.

 

OnSeptember 18, 2008, the employment of Jeffrey L. Garon as president andchief executive officer of the Company was terminated.  On October 19, 2008, Mr. Garonresigned from the Board of Directors.  Mr. Garonand the Company entered into an Employment Agreement dated August 11,2007, which provided certain benefits to Mr. Garon in the event oftermination of his employment, and granted to the Company certain rights torepurchase shares issued on behalf of Mr. Garon pursuant to his employmentagreement, in accordance with a Stock Purchase Agreement dated February 29,2008.On June 22, 2009, we filed ademand for Arbitration with the American Arbitration Association [Case No. 74166 00535 09 LMT] seeking injunctive and other relief, includingrescission of the Employment Agreement and the Stock PurchaseAgreement that we entered into with Mr. Garon.  The demand includesassertions that Mr. Garon misrepresented his employment qualificationsand, *inter alia*, seeks to recoverfrom Mr. Garon 2,383,333 shares of our common stock that were issuedin connection with his employment.  Mr. Garon has filed acounter-demand against the Company, certain employees of the Company, andmembers of our Board of Directors seeking declaratory relief, apreliminary injunction, and damages in an amount to be proved at thearbitration.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Actual sales or theprospect of future sales of shares of our common stock pursuant to a prospectusor under Rule 144 may have a depressive effect upon the price of, andmarket for, our common stock.  As of June 30,2009, 24,069,291 shares of our common stock were issued and outstanding, ofwhich 18,017,624 are “restricted securities” and under some circumstances may,in the future, be under a registration under the Securities Act or incompliance with Rule 144 adopted under the Securities Act.  In general, under Rule 144, subject tothe satisfaction of other conditions, a person who has beneficially owned restrictedshares of common stock for at least one year is entitled to sell, within anythree month period, a number of shares that does not exceed the greater of 1percent of the total number of outstanding shares of the same class; or if thecommon stock is quoted on NASDAQ or a stock exchange, the average weeklytrading volume during the four calendar weeks immediately preceding thesale.  We cannot predict what effect, ifany, that sales of shares of common stock, or the availability of these sharesfor sale, will have on the market prices prevailing from time to time.  Nevertheless, the possibility thatsubstantial amounts of common stock may be sold in the public market mayadversely effect prevailing prices for our common stock and could impair our abilityto raise capital in the future through the sale of equity securities.

 

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

 

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

 

In addition, inconnection with our January 2008 and April 2008 Debentures, in theaggregate, we owe a total of $6.3 million principal amount of these convertibledebentures, convertible into 4,690,695 shares of our common stock, and warrantsto purchase an additional 611,111 shares of our common stock. The conversion orexercise into our common stock could result in a substantial increase in thenumber of shares in our public float. Depending upon market liquidity at the time a resale of our common stockis made by the investors in such private placements, such sale could cause thetrading price of our common stock to decline. In addition, the sale of a substantial number of shares of our commonstock, or anticipation of such sales, could make it more difficult for us tosell equity or equity-related securities in the future at a time and at a pricethat we might otherwise wish to effect sales.

 

***Wehave significant indebtedness and agreed to certain restrictions as a result ofour recent private placements of convertible debentures.***

 

We have incurred $8.1million of long term convertible debt, including $6.3 million in principalamount of indebtedness as a result of the issuance of our January 2008 andApril 2008 Debentures.  The January 2008and April 2008 Debentures carry substantial covenants that imposesignificant restrictions on us, including restrictions against incurringadditional indebtedness, creating any liens on our property, amending ourcertificate of incorporation or bylaws, redeeming or paying dividends on sharesof our outstanding common stock, and entering into certain related partytransactions.  The debentures also carrysubstantial covenants that impose significant requirements on us, including, amongothers, requirements that we pay interest and other charges on the debentures;

 

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

 

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

 

Our January 2008 andApril 2008 Debentures impose significant covenants on us, some of whichmay impair our ability to issue additional debt or equity, if necessary.

 

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

 

Our January 2008 andApril 2008 Debentures and 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 January 2008 or April 2008Debentures or the exercise price of the warrants.  If this were to occur, current investors,other than the investors in our recent private placements, would sustainmaterial dilution in their ownership interest.

 

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

 

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

 

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

 

·                  limiting theliability of, and providing indemnification to, our directors and officers;

 

·                  limiting theability of our stockholders to call and bring business before special meetings;

 

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

 

·                  controlling theprocedures for the conduct and scheduling of board and stockholder meetings;and

 

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

 

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

 

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

 

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

 

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

 

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

 

·                  significantlyreduce the equity interest of our current stockholders;

 

·                  cause a changein control if a substantial number of our shares of common stock or votingpreferred stock are issued, which may affect, among other things, our abilityto use our net operating loss carry-forwards, if any, and could also result ina change in management; and/or

 

·                  adversely affectprevailing market prices for our common stock.

 

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

 

·                  develop orenhance our products and services;

 

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·                  continue toexpand our development, sales and marketing organizations;

 

·                  acquirecomplementary technologies, products or businesses;

 

·                  expandoperations;

 

·                  hire, train andretain employees; and/or

 

·                  respond tocompetitive pressures or unanticipated working capital requirements.

 

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

 

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

 

·                  will likelycause a change in control if a substantial number of our shares of common stockor voting preferred stock are issued and could also result in a change inmanagement; and/or may adversely affect prevailing market prices for our commonstock.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

**Item 6.   EXHIBITS**

 

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

 

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** **

**SIGNATURES**

** **

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

 

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

 

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** **

**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                          |
|----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1 (1)             |       | Promissory  Note dated April 17, 2009, issued to Enable Growth Partners LP                                                                                                                                          |
| 10.2 (2)             |       | Amendment  Agreement dated June 30, 2009                                                                                                                                                                            |
| 10.3 *               |       | Promissory  Note dated July 9, 2009, issued to Enable Growth Partners LP                                                                                                                                            |
| 10.4 *               |       | Promissory  Note dated August 10, 2009, issued to Enable Growth Partners LP                                                                                                                                         |
| 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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*                            Filedwith this report

**                     Furnishedwith this Report

(1)                     Incorporatedby reference to the Registrant’s Form 8-K filed on April 21, 2009.

(2)                     Incorporatedby reference to the Registrant’s Form 8-K filed on July 1, 2009

 

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