##### Table of Contents

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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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|x | QUARTERLY REPORT PURSUANT TO THE SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
|- | -----------------------------------------------------------------------------------------------

For the quarterly period ended March 31, 2006

OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

Commission file number: 001-31265



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Avatech Solutions, Inc.

(Exact Name
of Registrant as Specified in its Charter)



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|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|Delaware                                                       |  | 84-1035353                       
|(State or Other Jurisdiction of Incorporation or Organization) |  | (IRS Employer Identification No.)



|                                                 |  |           
|------------------------------------------------ |  | ----------
|10715 Red Run Blvd., Suite 101, Owings Mills, MD |  | 21117     
|(Address of Principal Executive Offices)         |  | (Zip Code)

(410) 581 - 8080

(Registrants telephone number, including area code)



---

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the
Act).    Yes ̈No  x

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

Indicate the number of shares outstanding of each of the issuers classes of common equity, as of the latest practicable date.



|                        |  |                           
|----------------------- |  | --------------------------
|Class                   |  | Outstanding at May 3, 2006
|Common Stock, par value |  | 11,736,441                
|$.01 per share          |  |                           



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##### Table of Contents

AVATECH SOLUTIONS, INC. AND SUBSIDIARIES

INDEX



|           |  |                                                                                                         |  |     
|---------- |  | ------------------------------------------------------------------------------------------------------- |  | ----
|           |  |                                                                                                         |  | Page
|PART I     |  | FINANCIAL INFORMATION                                                                                   |  |     
|           |  |                                                                                                        
|ITEM 1.    |  | Consolidated Financial Statements                                                                       |  |     
|           |  |                                                                                                        
|           |  | Consolidated Balance Sheets  March 31, 2006 (Unaudited) and June 30, 2005                              |  | 3   
|           |  |                                                                                                        
|           |  | Consolidated Statements of Operations  Three months ended March 31, 2006 and 2005 (Unaudited)          |  | 5   
|           |  |                                                                                                        
|           |  | Consolidated Statements of Operations  Nine months ended March 31, 2006 and 2005 (Unaudited)           |  | 6   
|           |  |                                                                                                        
|           |  | Consolidated Statement of Stockholders Equity (Deficit)  Nine months ended March 31, 2006 (Unaudited) |  | 7   
|           |  |                                                                                                        
|           |  | Consolidated Statements of Cash Flows  Nine months ended March 31, 2006 and 2005 (Unaudited)           |  | 8   
|           |  |                                                                                                        
|           |  | Notes to Consolidated Financial Statements (Unaudited)                                                  |  | 9   
|           |  |                                                                                                        
|ITEM 2.    |  | Managements Discussion and Analysis of Results of Operations and Financial Condition                   |  | 15  
|           |  |                                                                                                        
|ITEM 3.    |  | Quantitative and Qualitative Disclosures About Market Risk                                              |  | 24  
|           |  |                                                                                                        
|ITEM 4.    |  | Controls and Procedures                                                                                 |  | 24  
|           |  |                                                                                                        
|PART II    |  | OTHER INFORMATION                                                                                       |  |     
|           |  |                                                                                                        
|ITEM 6.    |  | Exhibits                                                                                                |  | 25  
|           | 
|SIGNATURES |  | 26                                                                                                     



2



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##### Table of Contents

PART I. FINANCIAL INFORMATION

Avatech Solutions, Inc. and Subsidiaries

Consolidated Balance Sheets



|                                                                                                               |  |                |           |               |   |          
|-------------------------------------------------------------------------------------------------------------- |  | -------------- | --------- | ------------- | - | ---------
|                                                                                                               |  | March 31, 2006 |           | June 30, 2005
|                                                                                                               | 
|                                                                                                               |  | (unaudited)    |           | (audited)    
|Assets                                                                                                         |  |                |           |               |   |          
|Current assets:                                                                                                |  |                |           |               |   |          
|Cash and cash equivalents                                                                                      |  | $              | 172,000   |               | $ | 295,000  
|Accounts receivable, less allowance of $150,000 and $149,000 at March 31, 2006 and June 30, 2005, respectively |  |                | 5,916,000 |               |   | 5,808,000
|Other receivables                                                                                              |  |                | 108,000   |               |   | 189,000  
|Inventory                                                                                                      |  |                | 1,195,000 |               |   | 531,000  
|Prepaid expenses and other                                                                                     |  |                | 175,000   |               |   | 227,000  
|                                                                                                               |  |                |           |               |   |          
|Total current assets                                                                                           |  |                | 7,566,000 |               |   | 7,050,000
|                                                                                                               |  |               
|Property and equipment:                                                                                        |  |                |           |               |   |          
|Computer software and equipment                                                                                |  |                | 2,495,000 |               |   | 2,720,000
|Office furniture and equipment                                                                                 |  |                | 861,000   |               |   | 910,000  
|Leasehold improvements                                                                                         |  |                | 129,000   |               |   | 278,000  
|                                                                                                               |  |                |           |               |   |          
|                                                                                                               |  |                | 3,485,000 |               |   | 3,908,000
|                                                                                                               |  |               
|Less accumulated depreciation and amortization                                                                 |  |                | 2,871,000 |               |   | 3,215,000
|                                                                                                               |  |                |           |               |   |          
|                                                                                                               |  |                | 614,000   |               |   | 693,000  
|                                                                                                               |  |               
|Customer list, net of accumulated amortization of $69,000 at March 31, 2006 and $17,000 at June 30, 2005       |  |                | 210,000   |               |   | 262,000  
|Goodwill                                                                                                       |  |                | 52,000    |               |   | 52,000   
|Other assets                                                                                                   |  |                | 114,000   |               |   | 162,000  
|                                                                                                               |  |                |           |               |   |          
|Total assets                                                                                                   |  | $              | 8,556,000 |               | $ | 8,219,000
|                                                                                                               |  |                |           |               |   |          

See accompanying notes.



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##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Balance Sheets (continued)



|                                                                                                                                                                                            |  |                |            |   |               |   |            |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ---------- | - | ------------- | - | ---------- | -
|                                                                                                                                                                                            |  | March 31, 2006 |            |   | June 30, 2005 |  
|                                                                                                                                                                                            | 
|                                                                                                                                                                                            |  | (unaudited)    |            |   | (audited)     |  
|Liabilities and stockholders equity (deficit)                                                                                                                                              |  |                |            |   |               |   |            |  
|Current liabilities:                                                                                                                                                                        |  |                |            |   |               |   |            |  
|Accounts payable and accrued expenses                                                                                                                                                       |  | $              | 3,179,000  |   |               | $ | 3,379,000  |  
|Accrued compensation and related benefits                                                                                                                                                   |  |                | 750,000    |   |               |   | 401,000    |  
|Borrowings under lines-of-credit                                                                                                                                                            |  |                | 1,260,000  |   |               |   | 3,198,000  |  
|Current portion of long-term debt                                                                                                                                                           |  |                | 48,000     |   |               |   | 605,000    |  
|Note payable to related party                                                                                                                                                               |  |                | 902,000    |   |               |   |           |  
|Deferred revenue                                                                                                                                                                            |  |                | 827,000    |   |               |   | 572,000    |  
|Other current liabilities                                                                                                                                                                   |  |                | 295,000    |   |               |   | 441,000    |  
|                                                                                                                                                                                            |  |                |            |   |               |   |            |  
|Total current liabilities                                                                                                                                                                   |  |                | 7,261,000  |   |               |   | 8,596,000  |  
|                                                                                                                                                                                            |  |               
|Long-term debt                                                                                                                                                                              |  |                | 40,000     |   |               |   | 1,163,000  |  
|Note payable to related party  long-term                                                                                                                                                   |  |                |           |   |               |   | 902,000    |  
|Other long-term liabilities                                                                                                                                                                 |  |                | 119,000    |   |               |   | 260,000    |  
|Commitments and contingencies                                                                                                                                                               |  |                |           |   |               |   |           |  
|                                                                                                                                                                                            |  |               
|Stockholders equity (deficit):                                                                                                                                                             |  |                |            |   |               |   |            |  
|Series D Convertible Preferred Stock, $0.01 par value; 1,297,537 shares authorized and issued; 1,189,140 and 1,297,537 shares outstanding at
March 31, 2006 and June 30, 2005, respectively |  |                | 12,000     |   |               |   | 13,000     |  
|Series E Convertible Preferred Stock, $0.01 par value; 3,000 shares authorized; 1,191 shares issued and outstanding at March 31, 2006 and
no shares issued and outstanding at June 30, 2005 |  |                |           |   |               |   |           |  
|Common stock, $0.01 par value; 80,000,000 shares authorized; 11,733,077 and 10,868,330 shares issued and outstanding at March 31, 2006
and June 30, 2005, respectively                      |  |                | 117,000    |   |               |   | 109,000    |  
|Additional paid-in capital                                                                                                                                                                  |  |                | 7,020,000  |   |               |   | 5,476,000  |  
|Accumulated deficit                                                                                                                                                                         |  |                | (6,013,000 | ) |               |   | (8,300,000 | )
|                                                                                                                                                                                            |  |                |            |   |               |   |            |  
|Total stockholders equity (deficit)                                                                                                                                                        |  |                | 1,136,000  |   |               |   | (2,702,000 | )
|                                                                                                                                                                                            |  |                |            |   |               |   |            |  
|Total liabilities and stockholders equity (deficit)                                                                                                                                        |  | $              | 8,556,000  |   |               | $ | 8,219,000  |  
|                                                                                                                                                                                            |  |                |            |   |               |   |            |  

See accompanying notes.



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##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Operations



|                                            |      |                              |            |      |             |   |            |  
|------------------------------------------- | ---- | ---------------------------- | ---------- | ---- | ----------- | - | ---------- | -
|                                            |      | Three Months Ended March 31, |           
|                                            | 2006 |                              |            | 2005 |            
|                                            |      | (unaudited)                  |            |      | (unaudited) |  
|Revenues:                                   |      |                              |            |      |             |   |            |  
|Product sales                               |      | $                            | 6,926,000  |      |             | $ | 5,396,000  |  
|Service revenue                             |      |                              | 1,836,000  |      |             |   | 1,537,000  |  
|Commission revenue                          |      |                              | 2,251,000  |      |             |   | 1,605,000  |  
|Sale of developed software                  |      |                              |           |      |             |   | 1,900,000  |  
|                                            |      |                              |            |      |             |   |            |  
|                                            |      |                              | 11,013,000 |      |             |   | 10,438,000 |  
|                                            |      |                              |            |      |             |   |            |  
|Cost of revenue:                            |      |                              |            |      |             |   |            |  
|Cost of product sales                       |      |                              | 3,827,000  |      |             |   | 3,173,000  |  
|Cost of service revenue                     |      |                              | 1,308,000  |      |             |   | 1,157,000  |  
|Cost of developed software                  |      |                              |           |      |             |   | 59,000     |  
|                                            |      |                              |            |      |             |   |            |  
|                                            |      |                              | 5,135,000  |      |             |   | 4,389,000  |  
|                                            |      |                              |            |      |             |   |            |  
|Gross margin                                |      |                              | 5,878,000  |      |             |   | 6,049,000  |  
|                                            |      |                              |            |      |             |   |            |  
|Other operating expenses:                   |      |                              |            |      |             |   |            |  
|Selling, general and administrative         |      |                              | 4,631,000  |      |             |   | 3,792,000  |  
|Depreciation and amortization               |      |                              | 98,000     |      |             |   | 94,000     |  
|                                            |      |                              |            |      |             |   |            |  
|                                            |      |                              | 4,729,000  |      |             |   | 3,886,000  |  
|                                            |      |                              |            |      |             |   |            |  
|Operating income                            |      |                              | 1,149,000  |      |             |   | 2,163,000  |  
|                                            |      |                              |            |      |             |   |            |  
|                                            |      |                             
|Other income (expense):                     |      |                              |            |      |             |   |            |  
|Gain on early extinguishment of debt        |      |                              | 233,000    |      |             |   |           |  
|Interest and other income                   |      |                              | 8,000      |      |             |   | 15,000     |  
|Interest expense                            |      |                              | (93,000    | )    |             |   | (149,000   | )
|                                            |      |                              |            |      |             |   |            |  
|                                            |      |                              | 148,000    |      |             |   | (134,000   | )
|                                            |      |                              |            |      |             |   |            |  
|Income before income taxes                  |      |                              | 1,297,000  |      |             |   | 2,029,000  |  
|Income tax expense                          |      |                              | 20,000     |      |             |   | 4,000      |  
|                                            |      |                              |            |      |             |   |            |  
|Net income                                  |      |                              | 1,277,000  |      |             |   | 2,025,000  |  
|Preferred stock dividends                   |      |                              | (48,000    | )    |             |   | (20,000    | )
|                                            |      |                              |            |      |             |   |            |  
|Net income available to common stockholders |      | $                            | 1,229,000  |      |             | $ | 2,005,000  |  
|                                            |      |                              |            |      |             |   |            |  
|Earnings per common share, basic            |      | $                            | 0.11       |      |             | $ | 0.18       |  
|                                            |      |                              |            |      |             |   |            |  
|Earnings per common share, diluted          |      | $                            | 0.07       |      |             | $ | 0.14       |  
|                                            |      |                              |            |      |             |   |            |  
|Shares used in computation - basic          |      |                              | 11,585,455 |      |             |   | 10,865,042 |  
|                                            |      |                              |            |      |             |   |            |  
|Shares used in computation - diluted        |      |                              | 17,338,249 |      |             |   | 14,092,635 |  
|                                            |      |                              |            |      |             |   |            |  

See accompanying notes.



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##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Operations



|                                            |      |                             |            |      |             |   |            |  
|------------------------------------------- | ---- | --------------------------- | ---------- | ---- | ----------- | - | ---------- | -
|                                            |      | Nine Months Ended March 31, |           
|                                            | 2006 |                             |            | 2005 |            
|                                            |      | (unaudited)                 |            |      | (unaudited) |  
|Revenues:                                   |      |                             |            |      |             |   |            |  
|Product sales                               |      | $                           | 18,871,000 |      |             | $ | 15,028,000 |  
|Service revenue                             |      |                             | 5,563,000  |      |             |   | 4,275,000  |  
|Commission revenue                          |      |                             | 5,258,000  |      |             |   | 4,174,000  |  
|Sale of developed software                  |      |                             |           |      |             |   | 1,900,000  |  
|                                            |      |                             |            |      |             |   |            |  
|                                            |      |                             | 29,692,000 |      |             |   | 25,377,000 |  
|                                            |      |                             |            |      |             |   |            |  
|Cost of revenue:                            |      |                             |            |      |             |   |            |  
|Cost of product sales                       |      |                             | 11,029,000 |      |             |   | 9,778,000  |  
|Cost of service revenue                     |      |                             | 3,706,000  |      |             |   | 3,288,000  |  
|Cost of developed software                  |      |                             |           |      |             |   | 59,000     |  
|                                            |      |                             |            |      |             |   |            |  
|                                            |      |                             | 14,735,000 |      |             |   | 13,125,000 |  
|                                            |      |                             |            |      |             |   |            |  
|Gross margin                                |      |                             | 14,957,000 |      |             |   | 12,252,000 |  
|                                            |      |                             |            |      |             |   |            |  
|Other operating expenses:                   |      |                             |            |      |             |   |            |  
|Selling, general and administrative         |      |                             | 12,219,000 |      |             |   | 10,374,000 |  
|Depreciation and amortization               |      |                             | 291,000    |      |             |   | 228,000    |  
|                                            |      |                             |            |      |             |   |            |  
|                                            |      |                             | 12,510,000 |      |             |   | 10,602,000 |  
|                                            |      |                             |            |      |             |   |            |  
|Operating income                            |      |                             | 2,447,000  |      |             |   | 1,650,000  |  
|                                            |      |                             |            |      |             |   |            |  
|Other income (expense):                     |      |                             |            |      |             |   |            |  
|Gain on early extinguishment of debt        |      |                             | 233,000    |      |             |   |           |  
|Interest and other income                   |      |                             | 15,000     |      |             |   | 18,000     |  
|Interest expense                            |      |                             | (356,000   | )    |             |   | (367,000   | )
|Minority interest                           |      |                             |           |      |             |   | (59,000    | )
|                                            |      |                             |            |      |             |   |            |  
|                                            |      |                             | (108,000   | )    |             |   | (408,000   | )
|                                            |      |                             |            |      |             |   |            |  
|Income before income taxes                  |      |                             | 2,339,000  |      |             |   | 1,242,000  |  
|Income tax expense                          |      |                             | 52,000     |      |             |   | 21,000     |  
|                                            |      |                             |            |      |             |   |            |  
|Net income                                  |      |                             | 2,287,000  |      |             |   | 1,221,000  |  
|Preferred stock dividends                   |      |                             | (137,000   | )    |             |   | (59,000    | )
|                                            |      |                             |            |      |             |   |            |  
|Net income available to common stockholders |      | $                           | 2,150,000  |      |             | $ | 1,162,000  |  
|                                            |      |                             |            |      |             |   |            |  
|Earnings per common share, basic            |      | $                           | 0.19       |      |             | $ | 0.11       |  
|                                            |      |                             |            |      |             |   |            |  
|Earnings per common share, diluted          |      | $                           | 0.14       |      |             | $ | 0.09       |  
|                                            |      |                             |            |      |             |   |            |  
|Shares used in computation - basic          |      |                             | 11,231,776 |      |             |   | 10,188,717 |  
|                                            |      |                             |            |      |             |   |            |  
|Shares used in computation - diluted        |      |                             | 16,610,646 |      |             |   | 13,531,524 |  
|                                            |      |                             |            |      |             |   |            |  

See accompanying notes.



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##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statement of Stockholders Equity (Deficit) (Unaudited)



|                                                                                    |  |                          |   |  |                          |        |              |                 |                          |           |   |                    |  |            |       |   |         |  |   |           |   |  |   |            |   |  |   |            |  
|----------------------------------------------------------------------------------- |  | ------------------------ | - |  | ------------------------ | ------ | ------------ | --------------- | ------------------------ | --------- | - | ------------------ |  | ---------- | ----- | - | ------- |  | - | --------- | - |  | - | ---------- | - |  | - | ---------- | -
|                                                                                    |  | Series D Preferred Stock |   |  | Series E Preferred Stock |        | Common Stock |                 | AdditionalPaid-InCapital |           |   | AccumulatedDeficit |  |            | Total |  
|                                                                                    |  | Number ofShares          |   |  | Par Value                |        |              | Number ofShares |                          | Par Value |   | Number of Shares   |  | Par Value  |       |   |        
|Balance at July 1, 2005                                                             |  | 1,297,537                |   |  | $                        | 13,000 |              |                 |                         |           | $ |                   |  | 10,868,330 |       | $ | 109,000 |  | $ | 5,476,000 |   |  | $ | (8,300,000 | ) |  | $ | (2,702,000 | )
|Issuance of common stock as compensation                                            |  |                          |   |  |                          |        |              |                 |                          |           |   |                    |  | 55,019     |       |   |         |  |   | 38,000    |   |  |   |            |   |  |   | 38,000     |  
|Vesting of stock options issued to employees                                        |  |                          |   |  |                          |        |              |                 |                          |           |   |                    |  |            |       |   |         |  |   | 115,000   |   |  |   |            |   |  |   | 115,000    |  
|Issuance of common stock purchased through Employee Stock Purchase Plan             |  |                          |   |  |                          |        |              |                 |                          |           |   |                    |  | 210,132    |       |   | 2,000   |  |   | 82,000    |   |  |   |            |   |  |   | 84,000     |  
|Issuance of common stock upon the exercise of stock options                         |  |                          |   |  |                          |        |              |                 |                          |           |   |                    |  | 348,214    |       |   | 4,000   |  |   | 164,000   |   |  |   |            |   |  |   | 168,000    |  
|Warrants exercised to purchase common stock                                         |  |                          |   |  |                          |        |              |                 |                          |           |   |                    |  | 34,616     |       |   |         |  |   | 14,000    |   |  |   |            |   |  |   | 14,000     |  
|Issuance of common stock warrants                                                   |  |                          |   |  |                          |        |              |                 |                          |           |   |                    |  |            |       |   |         |  |   | 78,000    |   |  |   |            |   |  |   | 78,000     |  
|Issuance of Series E Convertible Preferred Stock and common stock purchase warrants |  |                          |   |  |                          |        |              |                 | 1,191                    |           |   |                    |  |            |       |   |         |  |   | 1,191,000 |   |  |   |            |   |  |   | 1,191,000  |  
|Preferred stock dividends                                                           |  |                          |   |  |                          |        |              |                 |                          |           |   |                    |  |            |       |   |         |  |   | (137,000  | ) |  |   |            |   |  |   | (137,000   | )
|Conversion of Series D Preferred Convertible Stock into common stock                |  | (108,397                 | ) |  |                          | (1,000 | )            |                 |                          |           |   |                    |  | 216,766    |       |   | 2,000   |  |   | (1,000    | ) |  |   |            |   |  |   |           |  
|Net income for the nine months ended March 31, 2006                                 |  |                          |   |  |                          |        |              |                 |                          |           |   |                    |  |            |       |   |         |  |   |           |   |  |   | 2,287,000  |   |  |   | 2,287,000  |  
|                                                                                    |  |                          |   |  |                          |        |              |                 |                          |           |   |                    |  |            |       |   |         |  |   |           |   |  |   |            |   |  |   |            |  
|Balance at March 31, 2006                                                           |  | 1,189,140                |   |  | $                        | 12,000 |              |                 | 1,191                    |           | $ |                   |  | 11,733,077 |       | $ | 117,000 |  | $ | 7,020,000 |   |  | $ | (6,013,000 | ) |  | $ | 1,136,000  |  
|                                                                                    |  |                          |   |  |                          |        |              |                 |                          |           |   |                    |  |            |       |   |         |  |   |           |   |  |   |            |   |  |   |            |  

See accompanying notes.



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##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Cash Flows



|                                                                                            |      |                             |             |      |  |   |             |  
|------------------------------------------------------------------------------------------- | ---- | --------------------------- | ----------- | ---- |  | - | ----------- | -
|                                                                                            |      | Nine Months Ended March 31, |            
|                                                                                            | 2006 |                             |             | 2005 | 
|                                                                                            |      | (unaudited)                 |            
|Cash flows from operating activities                                                        |      |                             |             |      |  |   |             |  
|Net income                                                                                  |      | $                           | 2,287,000   |      |  | $ | 1,221,000   |  
|Adjustments to reconcile net income to net cash provided by (used in) operating activities: |      |                             |             |      |  |   |             |  
|Provision for (recovery) of bad debts                                                       |      |                             | (2,000      | )    |  |   | 25,000      |  
|Depreciation and amortization                                                               |      |                             | 291,000     |      |  |   | 228,000     |  
|Non-cash stock compensation expense                                                         |      |                             | 153,000     |      |  |   | 34,000      |  
|Amortization of financing costs charged to interest expense                                 |      |                             |            |      |  |   | 19,000      |  
|Gain on early extinguishment of debt                                                        |      |                             | (233,000    | )    |  |   |            |  
|Loss on disposal of assets                                                                  |      |                             | 9,000       |      |  |   |            |  
|Changes in operating assets and liabilities:                                                |      |                             |             |      |  |   |             |  
|Accounts and other receivables                                                              |      |                             | (25,000     | )    |  |   | (926,000    | )
|Inventory                                                                                   |      |                             | (664,000    | )    |  |   | (226,000    | )
|Prepaid expenses and other current assets                                                   |      |                             | 52,000      |      |  |   | 149,000     |  
|Other assets                                                                                |      |                             | 23,000      |      |  |   | 70,000      |  
|Accounts payable and accrued expenses                                                       |      |                             | (200,000    | )    |  |   | (1,491,000  | )
|Accrued compensation and related benefits                                                   |      |                             | 349,000     |      |  |   | (44,000     | )
|Deferred revenue                                                                            |      |                             | 255,000     |      |  |   | 107,000     |  
|Other current liabilities                                                                   |      |                             | (146,000    | )    |  |   | 39,000      |  
|                                                                                            |      |                             |             |      |  |   |             |  
|Net cash provided by (used in) operating activities                                         |      |                             | 2,149,000   |      |  |   | (795,000    | )
|                                                                                            |      |                             |             |      |  |   |             |  
|Cash flows from investing activities                                                        |      |                             |             |      |  |   |             |  
|Purchase of property and equipment, net                                                     |      |                             | (144,000    | )    |  |   | (348,000    | )
|                                                                                            |      |                             |             |      |  |   |             |  
|Net cash used in investing activities                                                       |      |                             | (144,000    | )    |  |   | (348,000    | )
|                                                                                            |      |                             |             |      |  |   |             |  
|Cash flows from financing activities                                                        |      |                             |             |      |  |   |             |  
|Proceeds from borrowings under line-of-credit                                               |      |                             | 41,154,000  |      |  |   | 31,972,000  |  
|Repayments of borrowings under line-of-credit                                               |      |                             | (43,092,000 | )    |  |   | (30,924,000 | )
|Repayments of long-term debt                                                                |      |                             | (1,447,000  | )    |  |   | (59,000     | )
|Proceeds from sale of preferred stock                                                       |      |                             | 1,191,000   |      |  |   |            |  
|Proceeds from sale of common stock to employees and exercise of stock options and warrants  |      |                             | 266,000     |      |  |   | 237,000     |  
|Payment of preferred stock dividends                                                        |      |                             | (137,000    | )    |  |   | (59,000     | )
|Change in other assets related to financing costs                                           |      |                             | 78,000      |      |  |   | (50,000     | )
|Change in other long-term liabilities                                                       |      |                             | (141,000    | )    |  |   | (28,000     | )
|                                                                                            |      |                             |             |      |  |   |             |  
|Net cash provided by (used in) financing activities                                         |      |                             | (2,128,000  | )    |  |   | 1,089,000   |  
|                                                                                            |      |                             |             |      |  |   |             |  
|Net change in cash and cash equivalents                                                     |      |                             | (123,000    | )    |  |   | (54,000     | )
|Cash and cash equivalents - beginning of period                                             |      |                             | 295,000     |      |  |   | 690,000     |  
|                                                                                            |      |                             |             |      |  |   |             |  
|Cash and cash equivalents - end of period                                                   |      | $                           | 172,000     |      |  | $ | 636,000     |  
|                                                                                            |      |                             |             |      |  |   |             |  

See accompanying notes.



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##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2006

1. Basis of
Presentation

Avatech Solutions, Inc. (the Company) provides design automation and facilities and data management software, hardware,
training, technical support and professional services to corporations, government agencies and educational institutions throughout the United States.

The
accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and in accordance with the instructions to Article 10 of Regulation S-X.
Accordingly, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules or regulations.
The interim financial statements are unaudited, but reflect all adjustments (consisting of normal recurring accruals), which are, in managements opinion, necessary to present a fair statement of results of the interim periods presented. These
financial statements should be read in conjunction with the financial statements and the notes thereto in the Companys Annual Report on Form 10-K for the fiscal year ended June 30, 2005. Operating results for the three and nine months
ended March 31, 2006 are not necessarily indicative of results for any future period.

The consolidated financial statements include the accounts of
Avatech Solutions, Inc. and its majority owned subsidiaries. All intercompany accounts and transactions between the Company and its consolidated affiliated companies have been eliminated in consolidation.

2. Employee Stock Compensation Plans

During the first quarter ended
September 30, 2005 the Company adopted Financial Accounting Standards Board Statement No. 123R, Share-Based Payment (Statement 123R), which requires an entity to measure the cost of employee services received in exchange for an
award of equity instruments based on the grant-date fair value of the award. Previously, the Company accounted for stock-based compensation plans and the employee stock purchase plan in accordance with Accounting Principles Board (APB) Opinion
No. 25, Accounting for Stock Issued to Employees and related Interpretations and provided the required pro forma disclosures of Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based
Compensation. On July 1, 2005, the Company elected to adopt the modified prospective-transition method as provided by Statement 123R. Under this transition method, compensation cost recognized during fiscal year 2006 includes
(a) compensation cost for all share-based payments granted prior to, but not yet vested as of July 1, 2005, based on the grant-date fair value estimated in accordance with the original provisions of Statement 123, and (b) compensation
cost for all share-based payments granted subsequent to July 1, 2005, based on the grant-date fair value estimated in accordance with the provisions of Statement 123R. The effect of applying Statement 123R was a decrease to net income of
$40,000 for the quarter ended March 31, 2006, or less than $0.01 per basic and diluted share. For the nine months ended March 31, 2006, the effect of applying this Statement was $115,000, or less than $0.01 per basic and diluted share.
Results for prior periods have not been restated.

The Board of Directors may grant options under four stock option plans to purchase shares of the
Companys common stock at a price not less than the fair market value of the common stock at the grant date. The Avatech Solutions, Inc. 2000 Stock Option Plan and the Avatech Solutions, Inc. 2002 Stock Option Plan are the only plans with
significant stock option awards available for grant. All plans provide for the granting of either qualified or non-qualified stock options to purchase an aggregate of up to 4,955,000 shares of common stock to eligible employees, officers, and
directors of the Company. The exercise price of each stock option equals 100% of the market price of the Companys stock on the date of grant and generally has a maximum term of 10 years. Options generally vest ratably over three or four years,
depending on the specific grant award. For the three and nine months ended March 31, 2006, the Company also issued 4,616 and 55,019 shares, respectively, of fully vested common stock to members of



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##### Table of Contents

the Board of Directors with an aggregate market value of $6,000 and $38,000, respectively. For the three and nine months
ended March 31, 2006, total stock compensation expense charged against income for these plans was $46,000 and $153,000, respectively.

The following
table illustrates the effect on net income and income per share as if the Company had applied the fair value recognition provisions of Statement 123R to stock-based employee compensation for period ended March 31, 2005:



|                                                                                                                     |  |                           |           |   |                          |   |           |  
|-------------------------------------------------------------------------------------------------------------------- |  | ------------------------- | --------- | - | ------------------------ | - | --------- | -
|                                                                                                                     |  | Three monthsended 3/31/05 |           |   | Nine monthsended 3/31/05 |  
|Net income, as reported                                                                                              |  | $                         | 2,025,000 |   |                          | $ | 1,221,000 |  
|Add: Stock-based compensation cost included in net income, net of taxes                                              |  |                           | 9,000     |   |                          |   | 34,000    |  
|Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of taxes |  |                           | (63,000   | ) |                          |   | (207,000  | )
|                                                                                                                     |  |                           |           |   |                          |   |           |  
|Pro forma net income                                                                                                 |  |                           | 1,971,000 |   |                          |   | 1,048,000 |  
|Preferred stock dividends                                                                                            |  |                           | (20,000   | ) |                          |   | (59,000   | )
|                                                                                                                     |  |                           |           |   |                          |   |           |  
|Pro forma net income attributable to common stockholders                                                             |  | $                         | 1,951,000 |   |                          | $ | 989,000   |  
|                                                                                                                     |  |                           |           |   |                          |   |           |  
|Net income attributable to common stockholders:                                                                      |  |                           |           |   |                          |   |           |  
|Basic  as reported                                                                                                  |  | $                         | 0.18      |   |                          | $ | 0.11      |  
|                                                                                                                     |  |                           |           |   |                          |   |           |  
|Diluted  as reported                                                                                                |  | $                         | 0.14      |   |                          | $ | 0.09      |  
|                                                                                                                     |  |                           |           |   |                          |   |           |  
|Basic  pro forma                                                                                                    |  | $                         | 0.18      |   |                          | $ | 0.10      |  
|                                                                                                                     |  |                           |           |   |                          |   |           |  
|Diluted  pro forma                                                                                                  |  | $                         | 0.14      |   |                          | $ | 0.07      |  
|                                                                                                                     |  |                           |           |   |                          |   |           |  

For the purpose of estimating the grant-date fair value of stock options as required by Statement 123R, the
Company used a Black-Scholes-Merton option-pricing formula and is amortizing the value of the options to expense over the options vesting periods ratably.

To determine the pro forma data as required by Statement 123, the Company used stock option pricing models to measure the fair value of stock options as of the date of grant. For all stock options granted prior to November 19, 2002,
the date the Companys common stock became publicly traded and had a readily determinable market value, the Company used the minimum value method to calculate pro forma stock compensation expense. The minimum value method calculates the fair
value of options as the excess of the estimated fair value of the underlying stock at the date of grant over the present value of both the exercise price and the expected dividend payments, each discounted at the risk-free rate, over the expected
life of the option. For all stock options granted after this date, the Company used the Black-Scholes-Merton option pricing model.

The following are the assumptions made in computing the fair value of stock-based awards:



|                                               |  |                              |           |   |                             |   |           |      |  |   |           |   |  |   |           |  
|---------------------------------------------- |  | ---------------------------- | --------- | - | --------------------------- | - | --------- | ---- |  | - | --------- | - |  | - | --------- | -
|                                               |  | Three months ended March 31, |           |   | Nine months ended March 31, |  
|                                               |  | 2006                         |           |   | 2005                        |   |           | 2006 |  |   | 2005      |  
|Average risk-free interest rate                |  |                              | 4.31      | % |                             |   | 3.35      | %    |  |   | 4.37      | % |  |   | 3.35      | %
|Dividend yield                                 |  |                              | 0         | % |                             |   | 0         | %    |  |   | 0         | % |  |   | 0         | %
|Expected term                                  |  |                              | 6.1 years |   |                             |   | 8.8 years |      |  |   | 6.1 years |   |  |   | 8.8 years |  
|Average expected volatility                    |  |                              | 1.27      |   |                             |   | 2.58      |      |  |   | 1.28      |   |  |   | 2.58      |  
|Weighted average fair value of granted options |  | $                            | 1.42      |   |                             | $ | 0.50      |      |  | $ | 1.31      |   |  | $ | 0.44      |  

Expected volatilities are based on historical volatility of the Companys stock. The expected term of options
granted represents the period of time that options granted are expected to be outstanding. The Company uses historical data to estimate option exercise and employee termination within the valuation model. The risk-free rate for periods within the
contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.



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##### Table of Contents

A summary of stock option activity during the nine months ended March 31, 2006 and related information is included
in the table below:



|                                            |  |           |   |  |                                |      |                           |   |          
|------------------------------------------- |  | --------- | - |  | ------------------------------ | ---- | ------------------------- | - | ---------
|                                            |  | Options   |   |  | Weighted-AverageExercise Price |      | Aggregate Intrinsic Value
|Outstanding at July 1, 2005                 |  | 1,738,941 |   |  | $                              | 0.69 |                           |   |          
|Granted                                     |  | 733,250   |   |  |                                | 1.58 |                           |   |          
|Exercised                                   |  | (348,215  | ) |  |                                | 0.55 |                           |   |          
|Forfeited                                   |  | (108,537  | ) |  |                                | 0.34 |                           |   |          
|                                            |  |           |   |  |                                |      |                           |   |          
|Outstanding at March 31, 2006               |  | 2,015,439 |   |  | $                              | 0.87 |                           | $ | 2,580,000
|                                            |  |           |   |  |                                |      |                           |   |          
|Exercisable at March 31, 2006               |  | 966,466   |   |  | $                              | 0.78 |                           | $ | 1,324,000
|                                            |  |           |   |  |                                |      |                           |   |          
|Weighted-average remaining contractual life |  | 7.2 Years |   |  |                                |      |                           |   |          
|                                            |  |           |   |  |                                |      |                           |   |          

The weighted average grant date fair value of options granted during the quarter ended March 31, 2006 was
$1.42 per share. All options granted have an exercise price equal to the fair value of the Companys common stock on the date of grant. Exercise prices for options outstanding as of March 31, 2006 ranged from $0.17 to $63.33 as follows:



|                        |  |                    |  |                                                    |      |                                                               |           |                    |         |                                                    |   |                                                               |  |          
|----------------------- |  | ------------------ |  | -------------------------------------------------- | ---- | ------------------------------------------------------------- | --------- | ------------------ | ------- | -------------------------------------------------- | - | ------------------------------------------------------------- |  | ---------
|Range of ExercisePrices |  | OptionsOutstanding |  | WeightedAverageExercisePrices ofOptionsOutstanding |      | WeightedAverageRemainingContractual Lifeof OptionsOutstanding |           | OptionsExercisable |         | WeightedAverageExercisePrices ofOptionsExercisable |   | WeightedAverageRemainingContractual Lifeof OptionsExercisable
|$ 0.12 -    0.34        |  | 613,650            |  | $                                                  | 0.20 |                                                               | 6.1 years |                    | 481,150 |                                                    | $ | 0.20                                                          |  | 5.6 years
|0.35    0.91           |  | 867,000            |  |                                                    | 0.63 |                                                               | 8.6 years |                    | 450,829 |                                                    |   | 0.65                                                          |  | 8.3 years
|1.05  63.33            |  | 534,789            |  |                                                    | 2.02 |                                                               | 9.5 years |                    | 34,467  |                                                    |   | 10.63                                                         |  | 4.9 years
|                        |  |                    |  |                                                    |      |                                                               |           |                    |         |                                                    |   |                                                               |  |          
|                        |  | 2,015,439          |  |                                                    |      |                                                               |           |                    | 966,466 |                                                    |   |                                                               |  |          
|                        |  |                    |  |                                                    |      |                                                               |           |                    |         |                                                    |   |                                                               |  |          

Assuming that no additional share-based payments are granted after March 31, 2006, unamortized stock
compensation expense of $724,000 will be recognized in the statement of operations over a weighted average period of 3.0 years.

3. Borrowings Under
Lines-of-Credit

The Company maintained a $3.0 million line of credit with a bank payable within 60 days of demand and expiring in September 2006.
Outstanding borrowings were limited to 85% of the Companys aggregate outstanding eligible accounts receivable, bore interest at the greater of 7.5% or the prime rate plus 2.0% (9.25% at March 31, 2006) and were secured by the assets of
the Company. In addition, the bank had the right to restrict any prepayment of other indebtedness by the Company.

On January 27, 2006 the Company
replaced its existing line of credit with a new credit facility with another bank. The new line of credit provides for up to $5 million of borrowings limited to 80% of the Companys aggregate eligible accounts receivable. The loan bears
interest at a rate tied to the banks prime rate and will decrease as the Companys aggregate net worth increases. The interest rate ranges from the banks prime rate plus two percent to a low of the prime rate prime rate plus 0.25%
when the Companys net worth exceeds $4,000,000 at the end of a fiscal quarter. Based on the Companys current net worth, the interest rate for the third fiscal quarter will be the banks prime rate plus two percent. The loan will
expire on December 31, 2006 and is secured by all of the Companys assets, except inventory. The Company fully expects to renew the line of credit prior to its expiration.



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##### Table of Contents

On October 28, 2004, a wholly-owned subsidiary entered into a loan agreement with the bank to provide for a $700,000
revolving credit facility expiring on October 28, 2005. Borrowings under this credit facility bore interest at the greater of 7.5% or the prime rate plus 2.0% (9.25% at March 31, 2006) and were secured by the assets of the Company and the
guarantee of the Chairman of the Board of Directors. This credit facility was renewed through December 31, 2005 and on that date the Company determined that it no longer needed this facility and elected to let it expire.

The aggregate outstanding borrowings from the bank under its credit line were $1,260,000 and $3,198,000 at March 31, 2006 and June 30, 2005, respectively.

4. Long-Term Debt

Loans From Software Vendor

On July 22, 2003, the Company entered into a marketing and channel distribution agreement with a software vendor. Under this agreement, the
Company provided marketing, distribution and related services for the vendors products. In connection with this agreement, the software vendor agreed to fund certain marketing costs incurred by the Company. Additionally, the arrangement
provided for a loan by the software vendor to fund working capital needs related to the distribution of these products.

The terms of the loan agreement
provided for a loan of $1,500,000 with repayment of principal plus interest at 6% per annum in thirty-five equal quarterly installments commencing in January 2005. In July 2005 the Company made the decision to discontinue its relationship with
the vendor and restructured the loan. The new terms of the loan provided for quarterly principal payments of approximately $91,000 plus interest at an annual rate of 6%. These quarterly payments began in July 2005 and continued until January 2006
when the Company replaced its existing line of credit and repaid this loan. The early extinguishment of this debt resulted in a gain to the Company of $233,000. The balance of this loan was $1,456,000 at June 30, 2005.

Note Payable To Related Party

On July 1, 2005, the Company
extended the maturity date of a $902,000 subordinated note to a director and shareholder to July 1, 2006. The note accrues interest at 12% per annum, with quarterly interest payments due commencing October 1, 2005. In consideration
for the extension of the loans maturity, the Company issued warrants to purchase 38,878 shares of common stock for $0.60 per share expiring on June 1, 2010. Using the Black-Scholes option pricing model, these warrants were valued at
$23,000.

Other Long-Term Debt

The Company entered
into two loans in connection with its April 2005 acquisition of Comtrex Corporation which totaled $88,000 as of March 31, 2006.

5. Income Taxes

Income tax expense relates to the recordation of state income taxes and a federal alternative minimum tax provision as a result of the Companys
profitable results. The Company, however, has significant net operating loss carry forwards and does not expect to pay significant federal income taxes for the foreseeable future.

6. Earnings Per Share

Basic earnings per common share is computed as net earnings available to common stockholders
divided by the weighted-average number of common shares outstanding for the period. Diluted earnings per common share include the potential dilution that would occur from common shares issuable upon the exercise of outstanding stock options and
warrants and the conversion of preferred stocks.



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##### Table of Contents

As of March 31, 2006, 6,755,111 shares of common stock were issuable upon the conversion or exercise of options,
warrants and preferred stock. For the three and nine months ended March 31, 2006, there were 21,113 and 364,363 of common stock equivalents, respectively, excluded from the computation of diluted earnings per share because their effect would
have been antidilutive.

The following summarizes the computations of basic and diluted earnings per common share for the three and nine months ended
March 31, 2006:



|                                            |  |                              |            |   |      |   |            |  
|------------------------------------------- |  | ---------------------------- | ---------- | - | ---- | - | ---------- | -
|                                            |  | Three Months Ended March 31, |           
|                                            |  | 2006                         |            |   | 2005 |  
|Numerator:                                  |  |                              |            |   |      |   |            |  
|Net income                                  |  | $                            | 1,277,000  |   |      | $ | 2,025,000  |  
|Less: preferred stock dividends             |  |                              | (48,000    | ) |      |   | (20,000    | )
|                                            |  |                              |            |   |      |   |            |  
|Net income available to common stockholders |  | $                            | 1,229,000  |   |      | $ | 2,005,000  |  
|                                            |  |                              |            |   |      |   |            |  
|Denominator:                                |  |                              |            |   |      |   |            |  
|Weighted average shares outstanding - basic |  |                              | 11,585,455 |   |      |   | 10,865,042 |  
|                                            |  |                             
|Assumed conversion of preferred stock       |  |                              | 4,212,709  |   |      |   | 2,597,236  |  
|Effect of outstanding stock options         |  |                              | 1,130,553  |   |      |   | 519,725    |  
|Effect of outstanding stock warrants        |  |                              | 409,532    |   |      |   | 110,632    |  
|                                            |  |                              |            |   |      |   |            |  
|                                            |  |                              | 17,338,249 |   |      |   | 14,092,635 |  
|                                            |  |                              |            |   |      |   |            |  
|Earnings per common share, basic            |  | $                            | 0.11       |   |      | $ | 0.18       |  
|                                            |  |                              |            |   |      |   |            |  
|Earnings per common share, diluted          |  | $                            | 0.07       |   |      | $ | 0.14       |  
|                                            |  |                              |            |   |      |   |            |  



|                                            |  |                             |            |   |      |   |            |  
|------------------------------------------- |  | --------------------------- | ---------- | - | ---- | - | ---------- | -
|                                            |  | Nine Months Ended March 31, |           
|                                            |  | 2006                        |            |   | 2005 |  
|Numerator:                                  |  |                             |            |   |      |   |            |  
|Net income                                  |  | $                           | 2,287,000  |   |      | $ | 1,221,000  |  
|Less: preferred stock dividends             |  |                             | (137,000   | ) |      |   | (59,000    | )
|                                            |  |                             |            |   |      |   |            |  
|Net income available to common stockholders |  | $                           | 2,150,000  |   |      | $ | 1,162,000  |  
|                                            |  |                             |            |   |      |   |            |  
|Denominator:                                |  |                             |            |   |      |   |            |  
|Weighted average shares outstanding - basic |  |                             | 11,231,776 |   |      |   | 10,188,717 |  
|                                            |  |                            
|Assumed conversion of preferred stock       |  |                             | 4,297,776  |   |      |   | 2,597,236  |  
|Effect of outstanding stock options         |  |                             | 815,020    |   |      |   | 486,960    |  
|Effect of outstanding stock warrants        |  |                             | 266,074    |   |      |   | 258,611    |  
|                                            |  |                             |            |   |      |   |            |  
|                                            |  |                             | 16,610,646 |   |      |   | 13,531,524 |  
|                                            |  |                             |            |   |      |   |            |  
|Earnings per common share, basic            |  | $                           | 0.19       |   |      | $ | 0.11       |  
|                                            |  |                             |            |   |      |   |            |  
|Earnings per common share, diluted          |  | $                           | 0.14       |   |      | $ | 0.09       |  
|                                            |  |                             |            |   |      |   |            |  

7. Pending Acquisition

On March 22, 2006, the Company signed a non-binding letter of intent to acquire the stock of Sterling Systems and Consulting, Inc. (a Michigan corporation) and its affiliates. The letter of intent reflects the agreement in principle of
the parties to proceed to negotiate a definitive agreement. Closing is contingent upon numerous conditions, including approval by both companies Boards of Directors and Sterlings owners, execution of definitive merger documents,
financing arrangements, satisfactory due diligence, and other conditions.



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##### Table of Contents

8. Subsequent Event

On April 28, 2006, the Company signed a non-binding term sheet with a Philadelphia-based private equity firm to sell to the firm $20 million of convertible preferred stock with annual dividends of 11% that will
accrue but not be paid until conversion. The proceeds of the sale will be used to fund the acquisition of Sterling Systems and Consulting, Inc. as described in Note 7 and to provide additional acquisition capital. The preferred stock would be
convertible into common stock at a $1.85 conversion price and would include warrants to purchase 5% of the Companys common stock at $2.50 per share for up to three years after the date the transaction closes. The transaction is subject to
numerous conditions, including receipt by Avatech of an opinion concerning the fairness of the transaction to the Company and its common stockholders, and satisfactory due diligence on the part of both parties. The Company expects to close the
transaction by June 30, 2006.

9. Liquidity and Capital Resources

The Companys operations have significantly improved over the last year and it has generated sufficient capital to erase its stockholders deficit and now has stockholders equity of $1,136,000. Also,
in July 2005, the Company raised cash of $1,191,000 through an offering of 1,191 shares of Series E Convertible Preferred Stock with the proceeds utilized for working capital purposes and as described in Note 3, the Company replaced its existing
credit facilities with a new $5 million line of credit.

Based on the cash generated from the sale of the Series E Convertible Preferred Stock in July
2005, the availability from the Companys new line of credit (See Note 3) and an evaluation of likely cash to be generated from operations in the near term and other available capital resources, management believes that it has sufficient
sources of working capital to fund its operations in the normal course of business.



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##### Table of Contents

ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

THE FOLLOWING
DISCUSSION AND ANALYSIS OF THE FINANCIAL CONDITION AND RESULTS OF OPERATIONS SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND THE RELATED NOTES THERETO INCLUDED ELSEWHERE IN THIS REPORT.

Certain statements set forth below constitute forward-looking statements. Such forward-looking statements involve known and unknown risk,
uncertainties and other factors including, but not limited to, those discussed in our annual and quarterly reports, that may cause our actual results, performance or achievements to be materially different from any future results, performance or
achievements implied by such forward-looking statements. These forward-looking statements may generally be identified by the use of the words may, will, believe, should, expects,
anticipates, estimates, and similar expressions. Given these uncertainties, investors and prospective investors are cautioned not to place undue reliance on such forward-looking statements. The Company disclaims any
obligation to update information contained in any forward-looking statement.

Overview

Avatech Solutions is a leader in design and engineering technology solutions with expertise in CAD software, data management, facilities management and
process optimization for the manufacturing, engineering, building design and facilities management industries. Avatech specializes in software resale, integration, standards development and deployment, education and technical support, aimed at
improving design and documentation efficiencies and the seamless integration of workflow processes. The Companys sales are to corporations, government agencies, and educational institutions throughout the United States.

The Companys product sales may be somewhat cyclic, and increase when the developer of a specific software product offers a new version, promotions
or discontinues support of an older product. As is common among software resellers, the Company purchases products from its suppliers with a combination of cash and credit. Avatech does not usually carry significant inventory, and generally places
an order with the supplier only after receiving a firm commitment from its customer and, except in unusual situations, does not allow its customers to return merchandise. As of March 31, 2006, the Company increased its level of inventory in
order to maximize the incentives that it received from its principal supplier.

Product Sales. Product sales consist of the sale of
prepackaged software to customers in the United States. Sales are focused on three major product categories and associated value-added services- design automation, facilities management and data management.

Service Revenue. Avatech offers training courses in over thirty different subjects related to various software solutions offered at nineteen
training facilities and through mobile labs that it can send to a customer site or other off-site facilities. Training is led by employees who serve as class instructors and have formal training or successful industry experience in the topics they
teach. The Company also provides training services that are highly tailored to meet the needs of a particular customer, including company-specific operational topics, customized product usage, and other general technology or process training. As
part of the training offering, the Company has developed and deployed an Internet based assessment tool that allows its clients to test their employees knowledge and ability to use the software tools.

Commission Revenue. The Company generates commission revenue from the resale of Autodesk software to customers which Autodesk considers
major accounts. Autodesk designates these customers as major accounts based on specific criteria, primarily sales volume, and typically gives these customers volume discounts. The Company is responsible for managing and reselling
Autodesk products to a number of these major account customers; however, software products are shipped directly from Autodesk to the customers. Avatech receives commissions upon shipment of the products from Autodesk to the customer based on the
product sales price.

Also included in commission revenue are the commissions that the Company earns from selling subscriptions to current
Autodesk customers. An Autodesk subscription provides the customer with access



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to Autodesk upgrades released during the subscription term, online support from Autodesk technicians and several other
benefits. Since the Company functions as a sales agent on behalf of Autodesk and does not have any responsibility for the delivery of the services, it records a sale of a subscription as commission revenue.

Cost of Product Sales. The cost of product sales consists of the cost of purchasing products from software suppliers or hardware manufacturers as
well as the associated shipping and handling costs.

Cost of Service Revenue. Cost of service revenue includes the direct costs
associated with the implementation of software and hardware solutions as well as training, support services, and professional services. These costs consist primarily of compensation, benefits, travel, and the costs of third-party contractors engaged
by the Company. The cost of service revenue does not include an allocation of overhead costs.

Selling, General and Administrative
Expenses. Selling, general and administrative expenses consist primarily of compensation and other expenses associated with the Companys sales force, management, finance, human resources, and information systems. Advertising and public
relations expenses and expenses for facilities, such as rent and utilities, are also included in selling, general and administrative expenses.

Depreciation and Amortization Expenses. Depreciation and amortization expenses represent the period costs associated with our investment in property and equipment, consisting principally of computer equipment, software, furniture and
fixtures, and leasehold improvements. The Company computes depreciation and amortization expenses using the straight-line method. Avatech leases all of its facilities and depreciates leasehold improvements over the lesser of the lease term or the
estimated useful life of the asset.

Interest Expense. Interest expense consists primarily of interest on a revolving
line-of-credit, a note payable to a member of the Board of Directors and a loan from a vendor.

Three Months Ended March 31, 2006 Compared to the
Three Months Ended March 31, 2005

The following tables set forth a comparison of the three month period ended March 31, 2006
to the three month period ended March 31, 2005. The amounts are derived from selected items reflected in our unaudited Consolidated Statements of Operations included elsewhere in this report. The three months financial results are not
necessarily indicative of future results.

Revenues



|                           |  |                              |            |      |   |            |  |        |   
|-------------------------- |  | ---------------------------- | ---------- | ---- | - | ---------- |  | ------ | --
|                           |  | Three Months Ended March 31, |           
|                           |  | 2006                         |            | 2005 |   | % increase | 
|Revenues:                  |  |                              |            |      |   |            |  |        |   
|Product sales              |  | $                            | 6,926,000  |      | $ | 5,396,000  |  | 28.4   | % 
|Service revenue            |  |                              | 1,836,000  |      |   | 1,537,000  |  | 19.4   | % 
|Commission revenue         |  |                              | 2,251,000  |      |   | 1,605,000  |  | 40.2   | % 
|Sale of developed software |  |                              |           |      |   | 1,900,000  |  | (100.0 | )%
|                           |  |                              |            |      |   |            |  |        |   
|Total revenues             |  | $                            | 11,013,000 |      | $ | 10,438,000 |  | 5.5    | % 
|                           |  |                              |            |      |   |            |  |        |   

Revenues. Total revenues increased $575,000, or 5.5%, between periods and $2,475,000, or
29.0%, excluding the $1.9 million revenue recorded in the 2005 period from the one-time sale of developed software. All categories of ongoing revenues showed significant increases.

Product sales increased to $6,926,000 for the quarter, an increase of $1,530,000 from the quarter ended March 31, 2005, or 28.4%. The Companys
growth in this category is attributed to a number of factors including a larger, more focused sales force, the retirement of certain products by the Companys main supplier, Autodesk, resulting in its customers purchasing the newer version of
the retiring software, and a concentrated focus by the Company to maximize the sales incentives awarded by Autodesk.



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Service revenues increased $299,000, or 19.4%, for the three months ended March 31, 2006 as compared
to the same period in the prior fiscal year. The Company continued its strategy of investing in its services business by adding personnel and expanding its training, support and consulting capabilities. This strategy resulted in the continued growth
in its services revenues for the period and as the Company continues to invest in this area it expects continued growth in its services revenues.

Commission revenues increased $646,000 or 40.2% for the three months ended March 31, 2006, compared to the same period in the prior fiscal year. The increase in commission revenues was a result of a significant increase in the sales
volume due to a continued focus by the Company to increase this category of business.

Cost of Revenues and Gross Margin



|                           |  |                              |           |      |   |            |  |        |   
|-------------------------- |  | ---------------------------- | --------- | ---- | - | ---------- |  | ------ | --
|                           |  | Three Months Ended March 31, |          
|                           |  | 2006                         |           | 2005 |   | % increase | 
|Cost of revenue:           |  |                              |           |      |   |            |  |        |   
|Cost of product sales      |  | $                            | 3,827,000 |      | $ | 3,173,000  |  | 20.6   | % 
|Cost of service revenue    |  |                              | 1,308,000 |      |   | 1,157,000  |  | 13.1   | % 
|Cost of developed software |  |                              |          |      |   | 59,000     |  | (100.0 | )%
|                           |  |                              |           |      |   |            |  |        |   
|Total cost of revenue      |  | $                            | 5,135,000 |      | $ | 4,389,000  |  | 17.0   | % 
|                           |  |                              |           |      |   |            |  |        |   
|Gross margin               |  | $                            | 5,878,000 |      | $ | 6,049,000  |  |        |   
|                           |  |                              |           |      |   |            |  |        |   

Cost of revenue. Excluding the cost of developed software from the one-time sale of a
software product to Autodesk in the prior fiscal quarter, the total cost of revenue increased $805,000, or 18.6%, for the three months ended March 31, 2006 as compared to the same period in the prior fiscal year. The percentage increase in
ongoing cost was significantly lower than the 29.0% increase in ongoing revenues due to the successful efforts of the Company to sell a mix of products with a higher profit margin coupled with a significant increase in the sales incentives that the
Company earned from Autodesk for the period.

The Company has earned sales incentives in each of its past quarters and fully expects to
continue to earn them in the future as these incentives are an integral part of the financial arrangement between the Company and Autodesk. The incentives are calculated based upon the Companys achievement of regional sales targets and
increase significantly when sales exceed 115% of the targeted amounts. As a result of the efforts of a larger, more focused sales force, the retirement of certain products by Autodesk resulting in its customers purchasing the newer version of the
retiring software, and a concentrated focus by the Company to maximize the sales incentives, the Companys sales incentives were approximately $700,000 higher for the quarter ended March 31, 2006 than in the first two quarters of fiscal
2006.

Cost of product sales increased $654,000, or only 20.6%, despite the fact that product sales increased by 28.4% between periods. The
cost of product sales as a percentage of related revenue for the three months ended March 31, 2006 was 55.3%, compared to 58.8% in the same period in 2005. The main reasons for the lower cost of product sales were that the Company realized
greater incentives from Autodesk as a result of its higher sales during the period and those incentives are accounted for as a reduction in cost of product sales and that the Company realigned its compensation structure to reward sales of higher
margin products.

Cost of service revenue increased only $151,000, or 13.1%, for the three months ended March 31, 2006 compared to the
same period in the prior fiscal year while service revenues increased 19.4%. Cost of service revenue as a percentage of related revenue for the three months ended March 31, 2006 decreased to 71.2% from 75.3% in the same period in the prior
fiscal year. This decrease was due to a more effective utilization of the Companys services personnel resulting in a significant increase in billable time without a proportional increase in personnel costs.

Gross margin. Overall, the gross margin percentage, excluding the effects of the one-time sale of developed software, increased from 49.3% for the
three months ended March 31, 2005 to 53.4% for the



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same period in the current fiscal year. The increase in the gross margin percentage was due to improvements in the
product mix in the core Autodesk business, higher sales incentives, service utilization improvements and higher commission revenue as a percentage of total revenue.

Other Operating Expenses



|                                    |  |                              |           |      |   |            |  |      |  
|----------------------------------- |  | ---------------------------- | --------- | ---- | - | ---------- |  | ---- | -
|                                    |  | Three Months Ended March 31, |          
|                                    |  | 2006                         |           | 2005 |   | % increase | 
|Other operating expenses:           |  |                              |           |      |   |            |  |      |  
|Selling, general and administrative |  | $                            | 4,631,000 |      | $ | 3,792,000  |  | 22.1 | %
|Depreciation and amortization       |  |                              | 98,000    |      |   | 94,000     |  | 4.3  | %
|                                    |  |                              |           |      |   |            |  |      |  
|Total other operating expenses      |  | $                            | 4,729,000 |      | $ | 3,886,000  |  | 21.7 | %
|                                    |  |                              |           |      |   |            |  |      |  

Selling, General and Administrative Expense. Selling, general and administrative expenses
increased $839,000, or 22.1%, for the three months ended March 31, 2006 compared to the same period in the prior fiscal year due to higher salary expense and sales commissions due to new sales personnel hired in the past twelve months and
larger incentive payments to sales personnel and management. Selling, general and administrative expense as a percent of total revenues was 42.1% for the three months ended March 31, 2006 down from 44.4% for the same period in the prior fiscal
year, excluding the effects of the one-time sale of developed software.

Depreciation and Amortization. Depreciation and
amortization expenses increased $4,000, or 4.3%, for the three months ended March 31, 2006 compared to the same period in the prior fiscal year.

Other income (expense)



|                                     |  |                              |         |   |      |   |          |            |  |       |   
|------------------------------------ |  | ---------------------------- | ------- | - | ---- | - | -------- | ---------- |  | ----- | --
|                                     |  | Three Months Ended March 31, |        
|                                     |  | 2006                         |         |   | 2005 |   |          | % increase | 
|Other income (expense):              |  |                              |         |   |      |   |          |            |  |       |   
|Gain on early extinguishment of debt |  | $                            | 233,000 |   |      | $ |         |            |  | 100.0 | % 
|Interest and other income            |  |                              | 8,000   |   |      |   | 15,000   |            |  | (46.7 | )%
|Interest expense                     |  |                              | (93,000 | ) |      |   | (149,000 | )          |  | (37.6 | )%
|                                     |  |                              |         |   |      |   |          |            |  |       |   
|Total other income (expense)         |  | $                            | 148,000 |   |      | $ | (134,000 | )          |  | 210.4 | % 
|                                     |  |                              |         |   |      |   |          |            |  |       |   

Other Income (Expense). Other income (expense) increased $282,000 for the three months
ended March 31, 2006 compared to the same period in the prior fiscal year. The most significant cause of the increase was the gain on early extinguishment of debt of $233,000 that the Company realized as a result of a prepayment of a debt
obligation to a vendor as described in Note 4. Interest expense decreased due to significantly lower borrowings on the Companys line of credit as well as the prepayment of the vendor note.

Income tax expense



|                   |  |                              |        |      |   |            |  |       |  
|------------------ |  | ---------------------------- | ------ | ---- | - | ---------- |  | ----- | -
|                   |  | Three Months Ended March 31, |       
|                   |  | 2006                         |        | 2005 |   | % increase | 
|Income tax expense |  | $                            | 20,000 |      | $ | 4,000      |  | 400.0 | %
|                   |  |                              |        |      |   |            |  |       |  

Income Tax Expense. Income tax expense increased $16,000 for the three months ended
March 31, 2006 compared to the same period in the prior fiscal year. The increase in tax expense relates to the recordation of state income taxes and a federal alternative minimum tax provision as a result of the Companys profitable
results. The Company, however, has significant net operating loss carry forwards and does not expect to pay significant federal income taxes for the foreseeable future. As the Company continues to demonstrate its ability to consistently earn net
income, some portion of the deferred tax asset



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valuation allowance may need to be reversed in future periods. The Company will continue to evaluate the likelihood of
this asset being realized and will adjust the valuation allowance when circumstances warrant its recordation. Any future reversal of the valuation allowance would have a material, non-cash effect on reported earnings.

Nine Months Ended March 31, 2006 Compared to the Nine Months Ended March 31, 2005

The following tables set forth a comparison of the nine month period ended March 31, 2006 to the nine month period ended March 31, 2005. The
amounts are derived from selected items reflected in our unaudited Consolidated Statements of Operations included elsewhere in this report. The nine months financial results are not necessarily indicative of future results.

Revenues



|                           |  |                             |            |      |   |            |  |        |   
|-------------------------- |  | --------------------------- | ---------- | ---- | - | ---------- |  | ------ | --
|                           |  | Nine Months Ended March 31, |           
|                           |  | 2006                        |            | 2005 |   | %          | 
|Revenues:                  |  |                             |            |      |   |            |  |        |   
|Product sales              |  | $                           | 18,871,000 |      | $ | 15,028,000 |  | 25.6   | % 
|Service revenue            |  |                             | 5,563,000  |      |   | 4,275,000  |  | 30.1   | % 
|Commission revenue         |  |                             | 5,258,000  |      |   | 4,174,000  |  | 26.0   | % 
|Sale of developed software |  |                             |           |      |   | 1,900,000  |  | (100.0 | )%
|                           |  |                             |            |      |   |            |  |        |   
|Total revenues             |  | $                           | 29,692,000 |      | $ | 25,377,000 |  | 17.0   | % 
|                           |  |                             |            |      |   |            |  |        |   

Revenues. Total revenues increased $4,315,000, or 17.0%, between periods and $6,215,000, or
26.5% excluding the revenue from the one-time sale of developed software of $1.9 million. All categories of ongoing revenues showed significant increases.

Product sales increased to $18,871,000 for the nine months ended March 31, 2006, an increase of $3,843,000 from the same period in 2005, or 25.6%. The Companys growth in this category is attributed to a
number of factors including a larger, more focused sales force, the retirement of certain products by the Companys main supplier, Autodesk, resulting in its customers purchasing the newer version of the retiring software, and a concentrated
focus by the Company to maximize the sales incentives awarded by Autodesk.

Service revenues increased $1,288,000, or 30.1%, for the nine
months ended March 31, 2006 as compared to the same period in the prior fiscal year. The Company continued its strategy of investing in its services business by adding personnel and expanding its training, support and consulting capabilities.
This strategy resulted in the large growth in its services revenues for the period and as the Company continues to invest in this area it expects continued growth in its services revenues.

Commission revenues increased $1,084,000 or 26.0% for the nine months ended March 31, 2006, compared to the same period in the prior fiscal year.
The increase in commission revenues was a result of a significant increase in the sales volume due to a continued focus by the Company to increase this category of business.

Cost of Revenues and Gross Margin



|                           |  |                             |            |      |   |            |  |        |   
|-------------------------- |  | --------------------------- | ---------- | ---- | - | ---------- |  | ------ | --
|                           |  | Nine Months Ended March 31, |           
|                           |  | 2006                        |            | 2005 |   | %          | 
|Cost of revenue:           |  |                             |            |      |   |            |  |        |   
|Cost of product sales      |  | $                           | 11,029,000 |      | $ | 9,778,000  |  | 12.8   | % 
|Cost of service revenue    |  |                             | 3,706,000  |      |   | 3,288,000  |  | 12.7   | % 
|Cost of developed software |  |                             |           |      |   | 59,000     |  | (100.0 | )%
|                           |  |                             |            |      |   |            |  |        |   
|Total cost of revenue      |  | $                           | 14,735,000 |      | $ | 13,125,000 |  | 12.3   | % 
|                           |  |                             |            |      |   |            |  |        |   
|Gross margin               |  | $                           | 14,957,000 |      | $ | 12,252,000 |  |        |   
|                           |  |                             |            |      |   |            |  |        |   



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Costs of revenue. Excluding the cost of developed software from the one-time sale of a software
product to Autodesk in the prior fiscal quarter, the total cost of revenue increased $1,669,000, or 12.8%, for the nine months ended March 31, 2006 as compared to the same period in the prior fiscal year. The percentage increase in ongoing cost
was significantly lower than the 26.5% increase in ongoing revenues due to the successful efforts of the Company to sell a mix of products with a higher profit margin coupled with a significant increase in the sales incentives that the Company
earned from Autodesk for the period.

Cost of product sales increased $1,251,000, or 12.8%, despite a 25.6% increase in product revenues.
The cost of product sales as a percentage of related revenue for the nine months ended March 31, 2006 was 58.4%, compared to 65.1% in the same period in 2005. The main reasons for the lower cost of product sales was that the Company realized
greater incentives from Autodesk as a result of its higher sales during the period and those incentives are accounted for as a reduction in cost of product sales; the Company realigned its compensation structure to reward sales of higher margin
products; and, in December 2004 Avatech eliminated a poor performing product line that produced lower than expected margins and increased the Companys cost of sales for the nine months ended March 31, 2005.

Cost of service revenue increased $418,000, or 12.7%, for the nine months ended March 31, 2006 compared to the same period in the prior fiscal year,
but service revenues increased by 30.1%. As a result, cost of service revenue as a percentage of related revenue for the nine months ended March 31, 2006 decreased to 66.6% from 76.9% in the same period in the prior fiscal year. This decrease
was due to a more effective utilization of the Companys services personnel resulting in a significant increase in billable time without a proportional increase in personnel costs.

Gross margin. Overall, the gross margin percentage, excluding the effects of the one-time sale of developed software, increased significantly from
44.3% for the nine months ended March 31, 2005 to 50.4% for the same period in the current fiscal year. The increase in the gross margin percentage was due to improvements in the product mix in the core Autodesk business, higher sales
incentives, service utilization improvements and higher commission revenue as a percentage of total revenue.

Other Operating Expenses



|                                    |  |                             |            |      |   |            |  |      |  
|----------------------------------- |  | --------------------------- | ---------- | ---- | - | ---------- |  | ---- | -
|                                    |  | Nine Months Ended March 31, |           
|                                    |  | 2006                        |            | 2005 |   | %          | 
|Other operating expenses:           |  |                             |            |      |   |            |  |      |  
|Selling, general and administrative |  | $                           | 12,219,000 |      | $ | 10,374,000 |  | 17.8 | %
|Depreciation and amortization       |  |                             | 291,000    |      |   | 228,000    |  | 27.6 | %
|                                    |  |                             |            |      |   |            |  |      |  
|Total other operating expenses      |  | $                           | 12,510,000 |      | $ | 10,602,000 |  | 18.0 | %
|                                    |  |                             |            |      |   |            |  |      |  

Selling, General and Administrative Expense. Selling, general and administrative expenses
increased $1,845,000, or 17.8%, for the nine months ended March 31, 2006 compared to the same period in the prior fiscal year due to higher salary expense and sales commissions due to new sales personnel hired in the past twelve months.
Selling, general and administrative expense as a percent of total revenues was 41.2% for the nine months ended March 31, 2006, down from 44.2% for the same period in the prior fiscal year, excluding the effects of the one-time sale of developed
software. The percentage decrease is due to the Companys continued cost containment efforts coupled with the growth in revenues.

Depreciation and Amortization. Depreciation and amortization expenses increased $63,000, or 27.6%, for the nine months ended March 31, 2006 compared to the same period in the prior fiscal year. These expenses increased due to
the Companys investment in upgrading its information technology infrastructure, purchases of new, upgraded computers for several of the Companys training centers as well as for new personnel that were hired during the last twelve months
and the amortization of a customer list, recorded as a result of the Companys purchase of Comtrex Corporation in April 2005.

Other income
(expense)



|                                     |  |                             |          |   |      |   |          |   |  |        |   
|------------------------------------ |  | --------------------------- | -------- | - | ---- | - | -------- | - |  | ------ | --
|                                     |  | Nine Months Ended March 31, |         
|                                     |  | 2006                        |          |   | 2005 |   |          | % | 
|Other income (expense):              |  |                             |          |   |      |   |          |   |  |        |   
|Gain on early extinguishment of debt |  | $                           | 233,000  |   |      | $ |         |   |  | 100.0  | % 
|Interest and other income            |  |                             | 15,000   |   |      |   | 18,000   |   |  | (16.7  | )%
|Interest expense                     |  |                             | (356,000 | ) |      |   | (367,000 | ) |  | (3.0   | )%
|Minority interest                    |  |                             |         |   |      |   | (59,000  | ) |  | (100.0 | )%
|                                     |  |                             |          |   |      |   |          |   |  |        |   
|Total other income (expense)         |  | $                           | (108,000 | ) |      | $ | (408,000 | ) |  | (73.5  | )%
|                                     |  |                             |          |   |      |   |          |   |  |        |   



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Other Income (Expense). Other expense decreased $300,000 for the nine months ended March 31,
2006 compared to the same period in the prior fiscal year. The most significant cause of the increase was the gain on early extinguishment of debt of $233,000 that the Company realized as a result of a prepayment of a debt obligation to a vendor as
described in Note 4. Interest expense decreased slightly due to lower borrowings on the Companys line of credit as well as the prepayment of the vendor note, offset by higher interest rates. The minority interest expense in the prior period
represents dividends paid on shares of preferred stock issued by a subsidiary and those shares were converted into common stock last fiscal year.

Income tax expense



|                   |  |                             |        |      |   |        |  |       |  
|------------------ |  | --------------------------- | ------ | ---- | - | ------ |  | ----- | -
|                   |  | Nine Months Ended March 31, |       
|                   |  | 2006                        |        | 2005 |   | %      | 
|Income tax expense |  | $                           | 52,000 |      | $ | 21,000 |  | 147.6 | %
|                   |  |                             |        |      |   |        |  |       |  

Income Tax Expense. Income tax expense increased $31,000 for the nine months ended
March 31, 2006 compared to the same period in the prior fiscal year. The increase in tax expense relates to the recordation of state income taxes and a federal alternative minimum tax provision as a result of the Companys profitable
results. The Company, however, has significant net operating loss carry forwards and does not expect to pay significant federal income taxes for the foreseeable future. As the Company continues to demonstrate its ability to consistently earn net
income, some portion of the deferred tax asset valuation allowance may need to be reversed in future periods. The Company will continue to evaluate the likelihood of this asset being realized and will adjust the valuation allowance when
circumstances warrant its recordation. Any future reversal of the valuation allowance would have a material, non-cash effect on reported earnings.

Liquidity and Capital Resources

Historically, the Company has financed its operations and met its capital expenditure
requirements primarily through cash flows provided by operations, borrowings under short-term and long-term debt arrangements, and sales of preferred stock.

The Companys operating assets and liabilities consist primarily of accounts receivable, inventory and accounts payable. Changes in these balances are affected principally by the timing of sales and investments
in inventory based on expected customer demand. The Company minimizes inventory levels through arrangements with suppliers to ship products with an average delivery period of two days and centralized inventory management. The Company purchases
approximately 90% of its product from one principal supplier which provides $3.0 million of available credit to finance those purchases.

The Companys investing activities consist principally of investments in computer and office equipment. Capital expenditures for the nine months ended March 31, 2006 were approximately $144,000, compared to $348,000 for the same
period in 2005.

For the nine months ended March 31, 2006 net cash provided by operating activities was $2,149,000, a betterment of
$2,944,000 over the same period in 2005. The major difference between the periods was that the Company earned $2,287,000 net income in 2006 as compared to net income of $1,221,000 in 2005, a difference of $1,066,000. In addition, accounts and other
receivables increased by only $25,000 for the nine months ended March 31, 2006 but increased by $926,000 during the same period in 2005, a difference of $901,000 and accounts payable and accrued expenses decreased by $200,000 in 2006 as
compared with $1,491,000 in 2005.

For the nine months ended March 31, 2006 the Company used $2,128,000 of its cash in financing
activities compared with providing cash of $1,089,000 for the same period in 2005. The main reason for this difference is that during 2005, as described in Note 4 to the financial statements, the Company paid down its long-term debt from the cash
provided by its operating activities.



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The Company maintained a $3.0 million line of credit with a bank payable within 60 days of demand and
expiring in September 2006. Outstanding borrowings were limited to 85% of the Companys aggregate outstanding eligible accounts receivable, bore interest at the greater of 7.5%, or the prime rate plus 2.0% (9.25% at March 31, 2006) and
were secured by the assets of the Company. In addition, the bank had the right to restrict any prepayment of other indebtedness by the Company.

As discussed in Note 3 to the financial statements, on January 27, 2006 the Company replaced its existing line of credit with a new credit facility with another bank. The new line of credit provides for up to $5 million of borrowings
limited to 80% of the Companys aggregate eligible accounts receivable. The loan bears interest at a rate tied to the banks prime rate and will decrease as the Companys aggregate net worth increases. The interest rate ranges from
the banks prime rate plus two percent to a low of the prime rate prime rate plus 0.25% when the Companys net worth exceeds $4,000,000 at the end of a fiscal quarter. Based on the Companys current net worth, the interest rate for
the third fiscal quarter will be the banks prime rate plus two percent. The loan will expire on December 31, 2006 and is secured by all of the Companys assets, except inventory. The Company fully expects to renew the line of credit
prior to its expiration.

On October 28, 2004, a wholly-owned subsidiary entered into a loan agreement with the bank to provide for a $700,000
revolving credit facility expiring on October 28, 2005. Borrowings under this credit facility bore interest at the greater of 7.5% or the prime rate plus 2.0% (9.25% at March 31, 2006) and were secured by the assets of the Company and the
guarantee of the Chairman of the Board of Directors. This credit facility was renewed through December 31, 2005 and on that date the Company determined that it no longer needed this facility and elected to let it expire.

The total borrowings from the bank under its lines of credit were approximately $1.3 million and $3.2 million as of March 31, 2006 and June 30,
2005, respectively.

On July 1, 2005, the Company extended the maturity date of a $902,000 subordinated note to a director and
shareholder to July 1, 2006 and is shown in current liabilities in the accompanying consolidated balance sheet. The note accrues interest at 12% per annum, with quarterly interest payments due commencing October 1, 2005.

In July 2005, the Company raised cash of $1,191,000 through an offering of 1,191 shares of Series E Convertible Preferred Stock.

Outstanding debt totaled approximately $2.2 million at March 31, 2006, and the Company had working capital of approximately $305,000. As previously
described, on January 27, 2006 the Companys existing line of credit was replaced with a $5 million line of credit with a new bank and the company prepaid a long-term obligation to a previous vendor resulting in a gain on early
extinguishment of debt of approximately $233,000. The new line of credit expires on December 31, 2006 but the Company fully expects to renew the facility prior to its expiration.

As a result of its recent string of profitable quarterly results, the Companys working capital needs have stabilized and management believes the
Companys near-term needs can be met from its available cash resources, cash flows from operations and its lines of credit.

Since
Avatech is one of the largest resellers of Autodesk software and since Autodesk has continued to state its intention to continue to strengthen its relationships with its resellers, the Company fully expects to continue to be a leading seller of
Autodesk software at margins sufficient to grow its business and improve its financial results. On January 30, 2006, Avatech signed the new Channel Partner Agreement with Autodesk which designates the Company as an authorized reseller of
Autodesk products through the expiration of the Agreement, January 31, 2007. In addition, the Company continues to diversify its revenues by increasing its service revenues and the sale of non-Autodesk software.



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Below is a summary of the Companys contractual obligations and commitments at March 31, 2006:



|                                                            |  |       |           |                 |   |             |  |             |           |                  |   |         |  |   |        
|----------------------------------------------------------- |  | ----- | --------- | --------------- | - | ----------- |  | ----------- | --------- | ---------------- | - | ------- |  | - | -------
|                                                            |  | Total |           | Less than 1year |   | 1  3 years |  | 3  5 years |           | More than 5years
|Contractual Obligations                                     |  |       |           |                 |   |             |  |             |           |                  |   |         |  |   |        
|Lines of credit *                                           |  | $     | 1,260,000 |                 | $ | 1,260,000   |  | $           |          |                  | $ |        |  | $ |       
|Long-term obligations                                       |  |       | 88,000    |                 |   | 48,000      |  |             | 40,000    |                  |   |        |  |   |       
|Interest on fixed rate obligations                          |  |       | 111,000   |                 |   | 110,000     |  |             | 1,000     |                  |   |        |  |   |       
|Operating leases                                            |  |       | 4,269,000 |                 |   | 1,264,000   |  |             | 1,910,000 |                  |   | 950,000 |  |   | 145,000
|Note payable to related party and capital lease obligations |  |       | 1,041,000 |                 |   | 995,000     |  |             | 46,000    |                  |   |        |  |   |       
|                                                            |  |       |           |                 |   |             |  |             |           |                  |   |         |  |   |        
|Total obligations                                           |  | $     | 6,769,000 |                 | $ | 3,677,000   |  | $           | 1,997,000 |                  | $ | 950,000 |  | $ | 145,000
|                                                            |  |       |           |                 |   |             |  |             |           |                  |   |         |  |   |        

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|* | The Companys line of credit is scheduled to expire on December 31, 2006 but the Company fully expects to renew the line prior to its expiration.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------



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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is exposed to market risk from changes in
interest rates associated with its variable rate lines-of-credit. At March 31, 2006, 35% of the outstanding debt bears interest at variable rates. Accordingly, the Companys earnings and cash flow are affected by changes in interest rates.
Assuming the current level of borrowings at variable rates and assuming a 100 basis point change in the average interest rate under these borrowings, the Company estimates that its interest expense and net income would have changed by less than
$10,000 for the nine months ended March 31, 2006. In the event of an adverse change in interest rates, management would likely take actions to further mitigate this exposure. However, due to the uncertainty of the actions that would be taken
and their possible effects, the analysis assumes no such actions. Further, the analysis does not consider the effects of the change in the level of overall economic activity that could exist in such an environment.

ITEM 4. CONTROLS AND PROCEDURES

The Company maintains a system of disclosure controls and procedures that is designed to
provide reasonable assurance that information, which is required to be disclosed by the Company in the reports that it files or submits under the Securities and Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within
the time periods specified in the rules and forms of the Securities and Exchange Commission, and is accumulated and communicated to management in a timely manner. The Companys Chief Executive Officer and Chief Financial Officer have
evaluated this system of disclosure controls and procedures as of the end of the period covered by this quarterly report, and believe that the system is effective. There have been no changes in our internal control over financial reporting during
the most recent quarter that have materially affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.



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PART II. OTHER INFORMATION

ITEM 6. EXHIBITS



|            |  |                                                          
|----------- |  | ---------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                   
|           
|31.1        |  | Rule 15d-14(a) Certification of Chief Executive Officer *
|            | 
|31.2        |  | Rule 15d-14(a) Certification of Chief Financial Officer *
|            | 
|32.1        |  | Section 1350 Certifications *                            

---

|* | Filed herewith
|- | --------------



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SIGNATURES

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



|                   |  |                                          |  |                                             
|------------------ |  | ---------------------------------------- |  | --------------------------------------------
|                   |  | AVATECH SOLUTIONS, INC. AND SUBSIDIARIES
|                   |  |                                         
|Date: May 15, 2006 |  | By                                       |  | /s/ Donald R. Walsh                         
|                   |  |                                          |  | Donald R. Walsh                             
|                   |  |                                          |  | Chief Executive Officer                     
|                   |  |                                         
|Date: May 15, 2006 |  | By                                       |  | /s/ Lawrence Rychlak                        
|                   |  |                                          |  | Lawrence Rychlak                            
|                   |  |                                          |  | Vice President and Chief Financial Officer  
|                   |  |                                          |  | (Principal financial and accounting officer)



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