##### Table of Contents

---



SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



FORM 10-Q



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



For the quarterly period ended December 31, 2005



OR



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



Commission file number: 001-31265



Avatech Solutions, Inc.

(Exact Name
of Registrant as Specified in its Charter)



|                                                               |  |  |  |                                  
|-------------------------------------------------------------- |  |  |  | ---------------------------------
|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 January 30, 2006
|Common Stock, par value $.01 per share |  | 11,474,405                     



---



1



---

##### Table of Contents

AVATECH SOLUTIONS, INC. AND SUBSIDIARIES



INDEX



|           |  |                                                                                                   |  |     
|---------- |  | ------------------------------------------------------------------------------------------------- |  | ----
|           |  |                                                                                                   |  | Page
|           |  |                                                                                                  
|PART I     |  | FINANCIAL INFORMATION                                                                             |  |     
|           |  |                                                                                                  
|ITEM 1.    |  | Consolidated Financial Statements                                                                 |  |     
|           |  |                                                                                                  
|           |  | Consolidated Balance Sheets  December 31, 2005 (Unaudited) and June 30, 2005                     |  | 3   
|           |  |                                                                                                  
|           |  | Consolidated Statements of Operations  Three months ended December 31, 2005 and 2004 (Unaudited) |  | 5   
|           |  |                                                                                                  
|           |  | Consolidated Statements of Operations  Six Months Ended December 31, 2005 and 2004 (Unaudited)   |  | 6   
|           |  |                                                                                                  
|           |  | Consolidated Statement of Stockholders Deficit  Six months ended December 31, 2005 (Unaudited)  |  | 7   
|           |  |                                                                                                  
|           |  | Consolidated Statements of Cash Flows  Six months ended December 31, 2005 and 2004 (Unaudited)   |  | 8   
|           |  |                                                                                                  
|           |  | Notes to Consolidated Financial Statements (Unaudited)                                            |  | 9   
|           |  |                                                                                                  
|ITEM 2.    |  | Managements Discussion and Analysis of Results of Operations and Financial Condition             |  | 14  
|           |  |                                                                                                  
|ITEM 3.    |  | Quantitative and Qualitative Disclosures About Market Risk                                        |  | 22  
|           |  |                                                                                                  
|ITEM 4.    |  | Controls and Procedures                                                                           |  | 22  
|           |  |                                                                                                  
|PART II    |  | OTHER INFORMATION                                                                                 |  |     
|           |  |                                                                                                  
|ITEM 4.    |  | Submission of Matters to a Vote of Security Holders                                               |  | 23  
|           |  |                                                                                                  
|ITEM 6.    |  | Exhibits                                                                                          |  | 23  
|           | 
|SIGNATURES |  | 24                                                                                               



2



---

##### Table of Contents

PART I. FINANCIAL INFORMATION



Avatech Solutions, Inc. and Subsidiaries

Consolidated Balance Sheets



|                                                                                                                  |  |                  |           |              |   |          
|----------------------------------------------------------------------------------------------------------------- |  | ---------------- | --------- | ------------ | - | ---------
|                                                                                                                  |  | December 31,2005 |           | June 30,2005
|                                                                                                                  |  | (unaudited)      |           | (audited)   
|Assets                                                                                                            |  |                  |           |              |   |          
|Current assets:                                                                                                   |  |                  |           |              |   |          
|Cash and cash equivalents                                                                                         |  | $                | 301,000   |              | $ | 295,000  
|Accounts receivable, less allowance of $143,000 and $149,000 at December 31, 2005 and June 30, 2005, respectively |  |                  | 5,589,000 |              |   | 5,808,000
|Other receivables                                                                                                 |  |                  | 154,000   |              |   | 189,000  
|Inventory                                                                                                         |  |                  | 923,000   |              |   | 531,000  
|Prepaid expenses and other                                                                                        |  |                  | 185,000   |              |   | 227,000  
|                                                                                                                  |  |                  |           |              |   |          
|Total current assets                                                                                              |  |                  | 7,152,000 |              |   | 7,050,000
|Property and equipment:                                                                                           |  |                  |           |              |   |          
|Computer software and equipment                                                                                   |  |                  | 2,741,000 |              |   | 2,720,000
|Office furniture and equipment                                                                                    |  |                  | 941,000   |              |   | 910,000  
|Leasehold improvements                                                                                            |  |                  | 275,000   |              |   | 278,000  
|                                                                                                                  |  |                  |           |              |   |          
|                                                                                                                  |  |                  | 3,957,000 |              |   | 3,908,000
|Less accumulated depreciation and amortization                                                                    |  |                  | 3,294,000 |              |   | 3,215,000
|                                                                                                                  |  |                  |           |              |   |          
|                                                                                                                  |  |                  | 663,000   |              |   | 693,000  
|Customer list, net of accumulated amortization of $52,000 at December 31, 2005 and $17,000 at June 30, 2005       |  |                  | 227,000   |              |   | 262,000  
|Goodwill                                                                                                          |  |                  | 52,000    |              |   | 52,000   
|Other assets                                                                                                      |  |                  | 210,000   |              |   | 162,000  
|                                                                                                                  |  |                  |           |              |   |          
|Total assets                                                                                                      |  | $                | 8,304,000 |              | $ | 8,219,000
|                                                                                                                  |  |                  |           |              |   |          



See accompanying
notes.



3



---

##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Balance Sheets (continued)



|                                                                                                                                                                                               |  |                  |            |   |               |   |            |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | ---------- | - | ------------- | - | ---------- | -
|                                                                                                                                                                                               |  | December 31,2005 |            |   | June 30, 2005 |  
|                                                                                                                                                                                               |  | (unaudited)      |            |   | (audited)     |  
|Liabilities and stockholders deficit                                                                                                                                                          |  |                  |            |   |               |   |            |  
|Current liabilities:                                                                                                                                                                           |  |                  |            |   |               |   |            |  
|Accounts payable and accrued expenses                                                                                                                                                          |  | $                | 2,768,000  |   |               | $ | 3,379,000  |  
|Accrued compensation and related benefits                                                                                                                                                      |  |                  | 678,000    |   |               |   | 401,000    |  
|Borrowings under lines-of-credit                                                                                                                                                               |  |                  | 1,295,000  |   |               |   | 3,198,000  |  
|Current portion of long-term debt                                                                                                                                                              |  |                  | 416,000    |   |               |   | 605,000    |  
|Note payable to related party                                                                                                                                                                  |  |                  | 902,000    |   |               |   |           |  
|Deferred revenue                                                                                                                                                                               |  |                  | 890,000    |   |               |   | 572,000    |  
|Other current liabilities                                                                                                                                                                      |  |                  | 532,000    |   |               |   | 441,000    |  
|                                                                                                                                                                                               |  |                  |            |   |               |   |            |  
|Total current liabilities                                                                                                                                                                      |  |                  | 7,481,000  |   |               |   | 8,596,000  |  
|Long-term debt                                                                                                                                                                                 |  |                  | 959,000    |   |               |   | 1,163,000  |  
|Note payable to related party                                                                                                                                                                  |  |                  |           |   |               |   | 902,000    |  
|Other long-term liabilities                                                                                                                                                                    |  |                  | 167,000    |   |               |   | 260,000    |  
|Commitments and contingencies                                                                                                                                                                  |  |                  |           |   |               |   |           |  
|Stockholders deficit:                                                                                                                                                                         |  |                  |            |   |               |   |            |  
|Series D Convertible Preferred Stock, $0.01 par value; 1,297,537 shares authorized and issued; 1,214,140 and 1,297,537 shares outstanding at
December 31, 2005 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 December 31, 2005
and no shares issued and outstanding at June 30, 2005 |  |                  |           |   |               |   |           |  
|Common stock, $0.01 par value; 80,000,000 shares authorized; 11,369,184 and 10,868,330 shares issued and outstanding at December 31, 2005
and June 30, 2005, respectively                      |  |                  | 114,000    |   |               |   | 109,000    |  
|Additional paid-in capital                                                                                                                                                                     |  |                  | 6,861,000  |   |               |   | 5,476,000  |  
|Accumulated deficit                                                                                                                                                                            |  |                  | (7,290,000 | ) |               |   | (8,300,000 | )
|                                                                                                                                                                                               |  |                  |            |   |               |   |            |  
|Total stockholders deficit                                                                                                                                                                    |  |                  | (303,000   | ) |               |   | (2,702,000 | )
|                                                                                                                                                                                               |  |                  |            |   |               |   |            |  
|Total liabilities and stockholders deficit                                                                                                                                                    |  | $                | 8,304,000  |   |               | $ | 8,219,000  |  
|                                                                                                                                                                                               |  |                  |            |   |               |   |            |  



See accompanying
notes.



4



---

##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Operations



|                                                   |  |                                 |            |   |             |   |            |  
|-------------------------------------------------- |  | ------------------------------- | ---------- | - | ----------- | - | ---------- | -
|                                                   |  | Three Months Ended December 31, |           
|                                                   |  | 2005                            |            |   | 2004        |  
|                                                   |  | (unaudited)                     |            |   | (unaudited) |  
|Revenues:                                          |  |                                 |            |   |             |   |            |  
|Product sales                                      |  | $                               | 5,734,000  |   |             | $ | 5,152,000  |  
|Service revenue                                    |  |                                 | 1,864,000  |   |             |   | 1,434,000  |  
|Commission revenue                                 |  |                                 | 1,853,000  |   |             |   | 1,600,000  |  
|                                                   |  |                                 |            |   |             |   |            |  
|                                                   |  |                                 | 9,451,000  |   |             |   | 8,186,000  |  
|                                                   |  |                                 |            |   |             |   |            |  
|Cost of revenue:                                   |  |                                 |            |   |             |   |            |  
|Cost of product sales                              |  |                                 | 3,382,000  |   |             |   | 3,485,000  |  
|Cost of service revenue                            |  |                                 | 1,171,000  |   |             |   | 1,161,000  |  
|                                                   |  |                                 |            |   |             |   |            |  
|                                                   |  |                                 | 4,553,000  |   |             |   | 4,646,000  |  
|                                                   |  |                                 |            |   |             |   |            |  
|Gross margin                                       |  |                                 | 4,898,000  |   |             |   | 3,540,000  |  
|                                                   |  |                                 |            |   |             |   |            |  
|Other operating expenses:                          |  |                                 |            |   |             |   |            |  
|Selling, general and administrative                |  |                                 | 3,860,000  |   |             |   | 3,307,000  |  
|Depreciation and amortization                      |  |                                 | 99,000     |   |             |   | 73,000     |  
|                                                   |  |                                 |            |   |             |   |            |  
|                                                   |  |                                 | 3,959,000  |   |             |   | 3,380,000  |  
|                                                   |  |                                 |            |   |             |   |            |  
|Operating income                                   |  |                                 | 939,000    |   |             |   | 160,000    |  
|                                                   |  |                                 |            |   |             |   |            |  
|Other income (expense):                            |  |                                 |            |   |             |   |            |  
|Minority interest                                  |  |                                 |           |   |             |   | (21,000    | )
|Interest and other income                          |  |                                 | 2,000      |   |             |   | (9,000     | )
|Interest expense                                   |  |                                 | (124,000   | ) |             |   | (114,000   | )
|                                                   |  |                                 |            |   |             |   |            |  
|                                                   |  |                                 | (122,000   | ) |             |   | (144,000   | )
|                                                   |  |                                 |            |   |             |   |            |  
|Income before income taxes                         |  |                                 | 817,000    |   |             |   | 16,000     |  
|Income tax expense                                 |  |                                 | 12,000     |   |             |   | 7,000      |  
|                                                   |  |                                 |            |   |             |   |            |  
|Net income                                         |  |                                 | 805,000    |   |             |   | 9,000      |  
|Preferred stock dividends                          |  |                                 | (50,000    | ) |             |   | (19,000    | )
|                                                   |  |                                 |            |   |             |   |            |  
|Net income (loss) available to common stockholders |  | $                               | 755,000    |   |             | $ | (10,000    | )
|                                                   |  |                                 |            |   |             |   |            |  
|Earnings (loss) per common share, basic            |  | $                               | 0.07       |   |             | $ | (0.00      | )
|                                                   |  |                                 |            |   |             |   |            |  
|Earnings (loss) per common share, diluted          |  | $                               | 0.05       |   |             | $ | (0.00      | )
|                                                   |  |                                 |            |   |             |   |            |  
|Shares used in computation - basic                 |  |                                 | 11,231,627 |   |             |   | 10,124,694 |  
|                                                   |  |                                 |            |   |             |   |            |  
|Shares used in computation - diluted               |  |                                 | 17,051,497 |   |             |   | 10,124,694 |  
|                                                   |  |                                 |            |   |             |   |            |  



See accompanying
notes.



5



---

##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Operations



|                                                   |  |                               |            |   |             |   |            |  
|-------------------------------------------------- |  | ----------------------------- | ---------- | - | ----------- | - | ---------- | -
|                                                   |  | Six Months Ended December 31, |           
|                                                   |  | 2005                          |            |   | 2004        |  
|                                                   |  | (unaudited)                   |            |   | (unaudited) |  
|Revenues:                                          |  |                               |            |   |             |   |            |  
|Product sales                                      |  | $                             | 11,945,000 |   |             | $ | 9,632,000  |  
|Service revenue                                    |  |                               | 3,727,000  |   |             |   | 2,739,000  |  
|Commission revenue                                 |  |                               | 3,007,000  |   |             |   | 2,568,000  |  
|                                                   |  |                               |            |   |             |   |            |  
|                                                   |  |                               | 18,679,000 |   |             |   | 14,939,000 |  
|                                                   |  |                               |            |   |             |   |            |  
|Cost of revenue:                                   |  |                               |            |   |             |   |            |  
|Cost of product sales                              |  |                               | 7,202,000  |   |             |   | 6,605,000  |  
|Cost of service revenue                            |  |                               | 2,398,000  |   |             |   | 2,131,000  |  
|                                                   |  |                               |            |   |             |   |            |  
|                                                   |  |                               | 9,600,000  |   |             |   | 8,736,000  |  
|                                                   |  |                               |            |   |             |   |            |  
|Gross margin                                       |  |                               | 9,079,000  |   |             |   | 6,203,000  |  
|                                                   |  |                               |            |   |             |   |            |  
|Other operating expenses:                          |  |                               |            |   |             |   |            |  
|Selling, general and administrative                |  |                               | 7,588,000  |   |             |   | 6,584,000  |  
|Depreciation and amortization                      |  |                               | 193,000    |   |             |   | 134,000    |  
|                                                   |  |                               |            |   |             |   |            |  
|                                                   |  |                               | 7,781,000  |   |             |   | 6,718,000  |  
|                                                   |  |                               |            |   |             |   |            |  
|Operating income (loss)                            |  |                               | 1,298,000  |   |             |   | (515,000   | )
|                                                   |  |                               |            |   |             |   |            |  
|Other income (expense):                            |  |                               |            |   |             |   |            |  
|Minority interest                                  |  |                               |           |   |             |   | (59,000    | )
|Interest and other income                          |  |                               | 7,000      |   |             |   | 4,000      |  
|Interest expense                                   |  |                               | (263,000   | ) |             |   | (218,000   | )
|                                                   |  |                               |            |   |             |   |            |  
|                                                   |  |                               | (256,000   | ) |             |   | (273,000   | )
|                                                   |  |                               |            |   |             |   |            |  
|Income (loss) before income taxes                  |  |                               | 1,042,000  |   |             |   | (789,000   | )
|Income tax expense                                 |  |                               | 32,000     |   |             |   | 15,000     |  
|                                                   |  |                               |            |   |             |   |            |  
|Net income (loss)                                  |  |                               | 1,010,000  |   |             |   | (804,000   | )
|Preferred stock dividends                          |  |                               | (89,000    | ) |             |   | (39,000    | )
|                                                   |  |                               |            |   |             |   |            |  
|Net income (loss) available to common stockholders |  | $                             | 921,000    |   |             | $ | (843,000   | )
|                                                   |  |                               |            |   |             |   |            |  
|Earnings (loss) per common share, basic            |  | $                             | 0.08       |   |             | $ | (0.09      | )
|                                                   |  |                               |            |   |             |   |            |  
|Earnings (loss) per common share, diluted          |  | $                             | 0.06       |   |             | $ | (0.09      | )
|                                                   |  |                               |            |   |             |   |            |  
|Shares used in computation - basic                 |  |                               | 11,058,411 |   |             |   | 9,862,176  |  
|                                                   |  |                               |            |   |             |   |            |  
|Shares used in computation - diluted               |  |                               | 16,539,757 |   |             |   | 9,862,176  |  
|                                                   |  |                               |            |   |             |   |            |  



See accompanying
notes.



6



---

##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statement of Stockholders Deficit (Unaudited)



|                                                                                    |  |                          |   |  |                          |        |              |                 |       |           |   |                  |  |            |  |                          |         |  |                    |           |   |       |   |            |   |  |   |            |  
|----------------------------------------------------------------------------------- |  | ------------------------ | - |  | ------------------------ | ------ | ------------ | --------------- | ----- | --------- | - | ---------------- |  | ---------- |  | ------------------------ | ------- |  | ------------------ | --------- | - | ----- | - | ---------- | - |  | - | ---------- | -
|                                                                                    |  | Series D Preferred Stock |   |  | Series E Preferred Stock |        | Common Stock |                 |       |           |   |                  |  |            |  |                         
|                                                                                    |  | Number ofShares          |   |  | Par Value                |        |              | Numberof Shares |       | Par Value |   | Number of Shares |  | Par Value  |  | AdditionalPaid-InCapital |         |  | AccumulatedDeficit |           |   | Total |  
|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                                            |  |                          |   |  |                          |        |              |                 |       |           |   |                  |  | 50,403     |  |                          |         |  |                    | 32,000    |   |       |   |            |   |  |   | 32,000     |  
|Vesting of stock options issued to employees                                        |  |                          |   |  |                          |        |              |                 |       |           |   |                  |  |            |  |                          |         |  |                    | 75,000    |   |       |   |            |   |  |   | 75,000     |  
|Issuance of common stock purchased through Employee Stock Purchase Plan             |  |                          |   |  |                          |        |              |                 |       |           |   |                  |  | 120,394    |  |                          | 1,000   |  |                    | 40,000    |   |       |   |            |   |  |   | 41,000     |  
|Issuance of common stock upon the exercise of stock options                         |  |                          |   |  |                          |        |              |                 |       |           |   |                  |  | 133,716    |  |                          | 2,000   |  |                    | 48,000    |   |       |   |            |   |  |   | 50,000     |  
|Warrants exercised to purchase common stock                                         |  |                          |   |  |                          |        |              |                 |       |           |   |                  |  | 29,616     |  |                          |         |  |                    | 11,000    |   |       |   |            |   |  |   | 11,000     |  
|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                                                           |  |                          |   |  |                          |        |              |                 |       |           |   |                  |  |            |  |                          |         |  |                    | (89,000   | ) |       |   |            |   |  |   | (89,000    | )
|Conversion of Series D Preferred Convertible Stock into common stock                |  | (83,397                  | ) |  |                          | (1,000 | )            |                 |       |           |   |                  |  | 166,725    |  |                          | 2,000   |  |                    | (1,000    | ) |       |   |            |   |  |   |           |  
|Net income for the six months ended December 31, 2005                               |  |                          |   |  |                          |        |              |                 |       |           |   |                  |  |            |  |                          |         |  |                    |           |   |       |   | 1,010,000  |   |  |   | 1,010,000  |  
|                                                                                    |  |                          |   |  |                          |        |              |                 |       |           |   |                  |  |            |  |                          |         |  |                    |           |   |       |   |            |   |  |   |            |  
|Balance at December 31, 2005                                                        |  | 1,214,140                |   |  | $                        | 12,000 |              |                 | 1,191 |           | $ |                 |  | 11,369,184 |  | $                        | 114,000 |  | $                  | 6,861,000 |   |       | $ | (7,290,000 | ) |  | $ | (303,000   | )
|                                                                                    |  |                          |   |  |                          |        |              |                 |       |           |   |                  |  |            |  |                          |         |  |                    |           |   |       |   |            |   |  |   |            |  



See accompanying
notes.



7



---

##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Cash Flows



|                                                                                                   |  |                               |             |   |      |   |              |  
|-------------------------------------------------------------------------------------------------- |  | ----------------------------- | ----------- | - | ---- | - | ------------ | -
|                                                                                                   |  | Six Months Ended December 31, |            
|                                                                                                   |  | 2005                          |             |   | 2004 |  
|                                                                                                   |  | (unaudited)                   |            
|Cash flows from operating activities                                                               |  |                               |             |   |      |   |              |  
|Net income (loss)                                                                                  |  | $                             | 1,010,000   |   |      | $ | (804,000     | )
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |  |                               |             |   |      |   |              |  
|Recovery of bad debts                                                                              |  |                               | (3,000      | ) |      |   |             |  
|Depreciation and amortization                                                                      |  |                               | 193,000     |   |      |   | 134,0004,146 |  
|Non-cash stock compensation expense                                                                |  |                               | 107,000     |   |      |   | 25,000       |  
|Amortization of financing costs charged to interest expense                                        |  |                               | 1,000       |   |      |   | 31,000       |  
|Loss on disposal of assets                                                                         |  |                               | 2,000       |   |      |   |             |  
|Changes in operating assets and liabilities:                                                       |  |                               |             |   |      |   |              |  
|Accounts and other receivables                                                                     |  |                               | 254,000     |   |      |   | (464,000     | )
|Inventory                                                                                          |  |                               | (392,000    | ) |      |   | (116,000     | )
|Prepaid expenses and other current assets                                                          |  |                               | 42,000      |   |      |   | 75,000       |  
|Other assets                                                                                       |  |                               | 30,000      |   |      |   | (91,000      | )
|Accounts payable and accrued expenses                                                              |  |                               | (641,000    | ) |      |   | (724,000     | )
|Accrued compensation and related benefits                                                          |  |                               | 277,000     |   |      |   | (45,000      | )
|Deferred revenue                                                                                   |  |                               | 318,000     |   |      |   | 26,000       |  
|Other current liabilities                                                                          |  |                               | 91,000      |   |      |   | 10,000       |  
|                                                                                                   |  |                               |             |   |      |   |              |  
|Net cash provided by (used in) operating activities                                                |  |                               | 1,289,000   |   |      |   | (1,943,000   | )
|                                                                                                   |  |                               |             |   |      |   |              |  
|Cash flows from investing activities                                                               |  |                               |             |   |      |   |              |  
|Purchase of property and equipment                                                                 |  |                               | (112,000    | ) |      |   | (261,000     | )
|                                                                                                   |  |                               |             |   |      |   |              |  
|Net cash used in investing activities                                                              |  |                               | (112,000    | ) |      |   | (261,000     | )
|                                                                                                   |  |                               |             |   |      |   |              |  
|Cash flows from financing activities                                                               |  |                               |             |   |      |   |              |  
|Proceeds from borrowings under line-of-credit                                                      |  |                               | 24,070,000  |   |      |   | 20,698,000   |  
|Repayments of borrowings under line-of-credit                                                      |  |                               | (25,973,000 | ) |      |   | (19,243,000  | )
|Repayments of long-term debt                                                                       |  |                               | (379,000    | ) |      |   | (27,000      | )
|Proceeds from sale of preferred stock                                                              |  |                               | 1,191,000   |   |      |   |             |  
|Proceeds from sale of common stock to employees and exercise of stock options and warrants         |  |                               | 102,000     |   |      |   | 237,000      |  
|Payment of preferred stock dividends                                                               |  |                               | (89,000     | ) |      |   | (39,000      | )
|Change in other assets related to financing costs                                                  |  |                               |            |   |      |   | (50,000      | )
|Change in other long-term liabilities                                                              |  |                               | (93,000     | ) |      |   | 17,000       |  
|                                                                                                   |  |                               |             |   |      |   |              |  
|Net cash provided by (used in) financing activities                                                |  |                               | (1,171,000  | ) |      |   | 1,593,000    |  
|                                                                                                   |  |                               |             |   |      |   |              |  
|Net change in cash and cash equivalents                                                            |  |                               | 6,000       |   |      |   | (611,000     | )
|Cash and cash equivalents - beginning of period                                                    |  |                               | 295,000     |   |      |   | 690,000      |  
|                                                                                                   |  |                               |             |   |      |   |              |  
|Cash and cash equivalents - end of period                                                          |  | $                             | 301,000     |   |      | $ | 79,000       |  
|                                                                                                   |  |                               |             |   |      |   |              |  



See accompanying
notes.



8



---

##### Table of Contents

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

December 31, 2005



|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 six months ended December 31, 2005 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 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 $52,000 for the quarter ended December 31, 2005, or less than $0.01 per basic and diluted share. For the six months ended December 31,
2005, the effect of applying this Statement was $75,000, 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 six months ended
December 31, 2005, the Company also issued 9,818 and 50,402 shares, respectively, of fully vested common stock to members of the Board of Directors with an aggregate market value of $10,800 and $30,800, respectively. For the three and six months
ended December 31, 2005, total stock compensation expense charged against income for these plans was $63,000 and $108,000, respectively.



9



---

##### Table of Contents

The following table illustrates the effect on net loss and loss per share as if the Company had applied the fair value
recognition provisions of Statement 123R to stock-based employee compensation for period ended December 31, 2004:



|                                                                                                                     |  |                            |         |   |                          |   |          |  
|-------------------------------------------------------------------------------------------------------------------- |  | -------------------------- | ------- | - | ------------------------ | - | -------- | -
|                                                                                                                     |  | Three monthsended 12/31/04 |         |   | Six monthsended 12/31/04 |  
|Net income (loss), as reported                                                                                       |  | $                          | 9,000   |   |                          | $ | (804,000 | )
|Add: Stock-based compensation cost included in net loss, net of taxes                                                |  |                            | 10,000  |   |                          |   | 25,000   |  
|Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of taxes |  |                            | (74,000 | ) |                          |   | (144,000 | )
|                                                                                                                     |  |                            |         |   |                          |   |          |  
|Pro forma net loss                                                                                                   |  |                            | (55,000 | ) |                          |   | (923,000 | )
|Preferred stock dividends                                                                                            |  |                            | (19,000 | ) |                          |   | (39,000  | )
|                                                                                                                     |  |                            |         |   |                          |   |          |  
|Pro forma net loss attributable to common stockholders                                                               |  | $                          | (74,000 | ) |                          | $ | (962,000 | )
|                                                                                                                     |  |                            |         |   |                          |   |          |  
|Net loss attributable to common stockholders:                                                                        |  |                            |         |   |                          |   |          |  
|Basic  as reported                                                                                                  |  | $                          | (0.00   | ) |                          | $ | (0.09    | )
|                                                                                                                     |  |                            |         |   |                          |   |          |  
|Diluted  as reported                                                                                                |  | $                          | (0.00   | ) |                          | $ | (0.09    | )
|                                                                                                                     |  |                            |         |   |                          |   |          |  
|Basic  pro forma                                                                                                    |  | $                          | (0.01   | ) |                          | $ | (0.10    | )
|                                                                                                                     |  |                            |         |   |                          |   |          |  
|Diluted  pro forma                                                                                                  |  | $                          | (0.01   | ) |                          | $ | (0.10    | )
|                                                                                                                     |  |                            |         |   |                          |   |          |  



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 endedDecember 31, |           |   | Six months endedDecember 31, |  
|                                               |  | 2005                           |           |   | 2004                         |   |           | 2005 |  |   | 2004      |  
|Average risk-free interest rate                |  |                                | 4.47      | % |                              |   | 3.35      | %    |  |   | 4.13      | % |  |   | 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                    |  |                                | 1.29      |   |                              |   | 2.58      |      |  |   | 1.38      |   |  |   | 2.58      |  
|Weighted average fair value of granted options |  | $                              | 1.08      |   |                              | $ | 0.50      |      |  | $ | 0.77      |   |  | $ | 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.



10



---

##### Table of Contents

A summary of stock option activity during the six months ended December 31, 2005 and related information is included
in the table below:



|                                            |  |           |   |  |                                |      |                           |   |          
|------------------------------------------- |  | --------- | - |  | ------------------------------ | ---- | ------------------------- | - | ---------
|                                            |  | Options   |   |  | Weighted-AverageExercise Price |      | Aggregate Intrinsic Value
|Outstanding at July 1, 2005                 |  | 1,738,941 |   |  | $                              | 0.60 |                           |   |          
|Granted                                     |  | 400,000   |   |  |                                | 0.81 |                           |   |          
|Exercised                                   |  | (133,717  | ) |  |                                | 0.36 |                           |   |          
|Forfeited                                   |  | (85,356   | ) |  |                                | 0.52 |                           |   |          
|                                            |  |           |   |  |                                |      |                           |   |          
|Outstanding at December 31, 2005            |  | 1,919,868 |   |  | $                              | 0.69 |                           | $ | 1,162,000
|                                            |  |           |   |  |                                |      |                           |   |          
|Exercisable at December 31, 2005            |  | 1,155,867 |   |  | $                              | 0.74 |                           | $ | 649,000  
|                                            |  |           |   |  |                                |      |                           |   |          
|Weighted-average remaining contractual life |  | 7.9 Years |   |  |                                |      |                           |   |          
|                                            |  |           |   |  |                                |      |                           |   |          



The weighted average grant date fair
value of options granted during the quarter ended December 31, 2005 was $1.08 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 December 31, 2005 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           |  | 635,331            |  | $                                                  | 0.20 |                                                               | 6.4 years |                    | 502,831   |                                                    | $ | 0.21                                                          |  | 6.0 years
|0.35  0.91             |  | 1,083,000          |  |                                                    | 0.62 |                                                               | 8.6 years |                    | 619,329   |                                                    |   | 0.64                                                          |  | 8.4 years
|1.05  63.33            |  | 201,537            |  |                                                    | 2.74 |                                                               | 9.0 years |                    | 33,707    |                                                    |   | 10.85                                                         |  | 5.2 years
|                        |  |                    |  |                                                    |      |                                                               |           |                    |           |                                                    |   |                                                               |  |          
|                        |  | 1,919,868          |  |                                                    |      |                                                               |           |                    | 1,155,867 |                                                    |   |                                                               |  |          
|                        |  |                    |  |                                                    |      |                                                               |           |                    |           |                                                    |   |                                                               |  |          



Assuming that no additional
share-based payments are granted after December 31, 2005, unamortized stock compensation expense of $367,000 will be recognized in the statement of operations over a weighted average period of 2.9 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 December 31, 2005) 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.



11



---

##### 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 December 31, 2005) and were secured by the assets of the Company and
the guarantee of the Chairman of the Board of Directors. In December 2005, the Company determined that it no longer needed this facility and elected to let it expire at its December 31, 2005 maturity date.



The aggregate outstanding borrowings from the bank under its credit line were $1,295,000 and
$3,198,000 at December 31, 2005 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 approximately $233,000. The balance of this loan was $1,273,000 and $1,456,000 at December 31, 2005 and June 30, 2005,
respectively.



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 $102,000 as of
December 31, 2005.



|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 (Loss) Per Share
|-- | -------------------------



Basic earnings (loss) per common share is computed as net earnings (loss) available to common stockholders divided by the weighted-average number of common shares
outstanding for the period. Diluted earnings (loss) 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.
Basic and diluted loss per common share are equal for the three and six months ended December 31, 2004 because the assumed exercise of options and warrants and the conversion of preferred stocks is antidilutive. As of December 31, 2005,
6,755,193 shares of common stock were issuable upon the conversion or exercise of options, warrants and preferred stock.



12



---

##### Table of Contents

The following summarizes the computations of basic and diluted earnings (loss) per common share for the three and six
months ended December 31, 2005:



|                                                   |  |                                 |            |   |      |   |            |  
|-------------------------------------------------- |  | ------------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                   |  | Three Months Ended December 31, |           
|                                                   |  | 2005                            |            |   | 2004 |  
|Numerator:                                         |  |                                 |            |   |      |   |            |  
|Net income                                         |  | $                               | 805,000    |   |      | $ | 9,000      |  
|Less: preferred stock dividends                    |  |                                 | (50,000    | ) |      |   | (19,000    | )
|                                                   |  |                                 |            |   |      |   |            |  
|Net income (loss) available to common stockholders |  | $                               | 755,000    |   |      | $ | (10,000    | )
|                                                   |  |                                 |            |   |      |   |            |  
|Denominator:                                       |  |                                 |            |   |      |   |            |  
|Weighted average shares outstanding - basic        |  |                                 | 11,231,627 |   |      |   | 10,124,694 |  
|Assumed conversion of preferred stock              |  |                                 | 4,382,843  |   |      |   |           |  
|Effect of outstanding stock options                |  |                                 | 1,105,407  |   |      |   |           |  
|Effect of outstanding stock warrants               |  |                                 | 331,621    |   |      |   |           |  
|                                                   |  |                                 |            |   |      |   |            |  
|                                                   |  |                                 | 17,051,497 |   |      |   | 10,124,694 |  
|                                                   |  |                                 |            |   |      |   |            |  
|Earnings (loss) per common share, basic            |  | $                               | 0.07       |   |      | $ | (0.00      | )
|                                                   |  |                                 |            |   |      |   |            |  
|Earnings (loss) per common share, diluted          |  | $                               | 0.05       |   |      | $ | (0.00      | )
|                                                   |  |                                 |            |   |      |   |            |  
|                                                   | 
|                                                   |  | Six Months Ended December 31,   |           
|                                                   |  | 2005                            |            |   | 2004 |  
|Numerator:                                         |  |                                 |            |   |      |   |            |  
|Net income                                         |  | $                               | 1,010,000  |   |      | $ | (804,000   | )
|Less: preferred stock dividends                    |  |                                 | (89,000    | ) |      |   | (39,000    | )
|                                                   |  |                                 |            |   |      |   |            |  
|Net income (loss) available to common stockholders |  | $                               | 921,000    |   |      | $ | (843,000   | )
|                                                   |  |                                 |            |   |      |   |            |  
|Denominator:                                       |  |                                 |            |   |      |   |            |  
|Weighted average shares outstanding - basic        |  |                                 | 11,058,411 |   |      |   | 9,862,176  |  
|Assumed conversion of preferred stock              |  |                                 | 4,382,843  |   |      |   |           |  
|Effect of outstanding stock options                |  |                                 | 878,979    |   |      |   |           |  
|Effect of outstanding stock warrants               |  |                                 | 219,524    |   |      |   |           |  
|                                                   |  |                                 |            |   |      |   |            |  
|                                                   |  |                                 | 16,539,757 |   |      |   | 9,862,176  |  
|                                                   |  |                                 |            |   |      |   |            |  
|Earnings (loss) per common share, basic            |  | $                               | 0.08       |   |      | $ | (0.09      | )
|                                                   |  |                                 |            |   |      |   |            |  
|Earnings (loss) per common share, diluted          |  | $                               | 0.06       |   |      | $ | (0.09      | )
|                                                   |  |                                 |            |   |      |   |            |  



|7. | Liquidity and Capital Resources
|-- | -------------------------------



The Company incurred significant operating losses in past years that depleted its capital resources. However, operating results have improved and the Company reported net
income of $1,934,000 for the year ended June 30, 2005 and $1,010,000 for the six months ended December 31, 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 with the proceeds utilized for working capital purposes. In addition, 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 for the next twelve months.



13



---

##### 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.



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 various customers, a number of 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.



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.



14



---

##### Table of Contents

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 December 31, 2005 Compared to the Three Months Ended December 31, 2004



The following tables set forth a comparison of the three month period ended December 31, 2005 to the three month period ended December 31, 2004.
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 December 31, |          
|                   |  | 2005                            |           | 2004 |   | %         | 
|Revenues:          |  |                                 |           |      |   |           |  |      |  
|Product sales      |  | $                               | 5,734,000 |      | $ | 5,152,000 |  | 11.3 | %
|Service revenue    |  |                                 | 1,864,000 |      |   | 1,434,000 |  | 30.0 | %
|Commission revenue |  |                                 | 1,853,000 |      |   | 1,600,000 |  | 15.8 | %
|                   |  |                                 |           |      |   |           |  |      |  
|Total revenues     |  | $                               | 9,451,000 |      | $ | 8,186,000 |  | 15.5 | %
|                   |  |                                 |           |      |   |           |  |      |  



Revenues. Total
revenues increased $1,265,000, or 15.5%, between periods and all three categories of revenues showed significant increases.



Product sales increased to $5,734,000 for the quarter, an increase of $582,000 from the quarter ended December 31, 2004, or 11.3%. During fiscal
2005, the Company acquired the operations of Comtrex Corporation, an authorized Autodesk reseller with offices in Greensboro, Charlotte, and Morrisville, North Carolina thereby increasing its geographic reach and increasing its sales volume. The
increase in product sales attributable to this acquisition for the quarter ended December 31, 2005 was approximately $682,000.



Service revenues increased $430,000, or 30.0%, for the three months ended December 31, 2005 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 $253,000 or 15.8% for the three months ended December 31, 2005, compared to the same period in the prior fiscal year.
The increase in commission revenues was a result of a significant industry-wide increase in sales volume and a continued focus by the Company to increase this



15



---

##### Table of Contents

category of business. During the quarter ended December 31, 2005 the Company had one large commission sale which yielded commission revenues of
approximately $260,000.



Cost of Revenues and Gross Margin



|                        |  |                                 |           |      |   |           |  |      |   
|----------------------- |  | ------------------------------- | --------- | ---- | - | --------- |  | ---- | --
|                        |  | Three Months Ended December 31, |          
|                        |  | 2005                            |           | 2004 |   | %         | 
|Cost of revenue:        |  |                                 |           |      |   |           |  |      |   
|Cost of product sales   |  | $                               | 3,382,000 |      | $ | 3,485,000 |  | (3.0 | )%
|Cost of service revenue |  |                                 | 1,171,000 |      |   | 1,161,000 |  | 0.9  | % 
|                        |  |                                 |           |      |   |           |  |      |   
|Total cost of revenue   |  | $                               | 4,553,000 |      | $ | 4,646,000 |  | (2.0 | )%
|                        |  |                                 |           |      |   |           |  |      |   
|Gross margin            |  | $                               | 4,898,000 |      | $ | 3,540,000 |  |      |   
|                        |  |                                 |           |      |   |           |  |      |   



Costs of
revenue. Total cost of revenue decreased $103,000, or 2.0%, for the three months ended December 31, 2005 as compared to the same period in the prior fiscal year.



Cost of product sales decreased $103,000, or 3.0%, despite an increase of 11.3% in product revenues between periods. The
cost of product sales as a percentage of related revenue for the three months ended December 31, 2005 was 58.9%, compared to 67.6% in the same period in 2004. 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; 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 quarter ended December 31, 2004.



Cost of service revenue increased only $10,000, or .9%, for the three months
ended December 31, 2005 compared to the same period in the prior fiscal year while service revenues increased 30.0%. Cost of service revenue as a percentage of related revenue for the three months ended December 31, 2005 decreased to 62.8%
from 80.9% 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 increased significantly from 43.2% for the three months ended December 31, 2004 to 51.8% 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, volume discounts and service utilization improvements and higher commission revenue as a percentage of total revenue.



Other Operating Expenses



|                                    |  |                                 |           |      |   |           |  |      |  
|----------------------------------- |  | ------------------------------- | --------- | ---- | - | --------- |  | ---- | -
|                                    |  | Three Months Ended December 31, |          
|                                    |  | 2005                            |           | 2004 |   | %         | 
|Other operating expenses:           |  |                                 |           |      |   |           |  |      |  
|Selling, general and administrative |  | $                               | 3,860,000 |      | $ | 3,307,000 |  | 16.7 | %
|Depreciation and amortization       |  |                                 | 99,000    |      |   | 73,000    |  | 35.6 | %
|                                    |  |                                 |           |      |   |           |  |      |  
|Total other operating expenses      |  | $                               | 3,959,000 |      | $ | 3,380,000 |  | 17.1 | %
|                                    |  |                                 |           |      |   |           |  |      |  



Selling, General
and Administrative Expense. Selling, general and administrative expenses increased $553,000, or 16.7%, for the three months ended December 31, 2005 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 40.8% for the three months ended
December 31, 2005 up slightly from 40.4% for the same period in the prior fiscal year.



16



---

##### Table of Contents

Depreciation and Amortization. Depreciation and amortization expenses increased $26,000, or 35.6%,
for the three months ended December 31, 2005 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 computers
for new personnel that were hired during the quarter 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)



|                             |  |                                 |          |   |      |   |          |   |  |       |   
|---------------------------- |  | ------------------------------- | -------- | - | ---- | - | -------- | - |  | ----- | --
|                             |  | Three Months Ended December 31, |         
|                             |  | 2005                            |          |   | 2004 |   |          | % | 
|Other income (expense):      |  |                                 |          |   |      |   |          |   |  |       |   
|Minority interest            |  | $                               |         |   |      | $ | (21,000  | ) |  | 100.0 | % 
|Interest and other income    |  |                                 | 2,000    |   |      |   | (9,000   | ) |  | 122.0 | % 
|Interest expense             |  |                                 | (124,000 | ) |      |   | (114,000 | ) |  | 8.8   | % 
|                             |  |                                 |          |   |      |   |          |   |  |       |   
|Total other income (expense) |  | $                               | (122,000 | ) |      | $ | (144,000 | ) |  | (15.3 | )%
|                             |  |                                 |          |   |      |   |          |   |  |       |   



Other Income
(Expense). Other income (expense) decreased $22,000, or 15.3%, for the three months ended December 31, 2005 compared to the same period in the prior fiscal year. 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. Interest expense increased as a result of higher interest rates on the Companys lines of credit as well as the amortization of
financing costs incurred in the prior fiscal year.



Income tax expense



|                   |  |                                 |        |      |   |       |  |      |  
|------------------ |  | ------------------------------- | ------ | ---- | - | ----- |  | ---- | -
|                   |  | Three Months Ended December 31, |       
|                   |  | 2005                            |        | 2004 |   | %     | 
|Income tax expense |  | $                               | 12,000 |      | $ | 7,000 |  | 71.4 | %
|                   |  |                                 |        |      |   |       |  |      |  



Income Tax
Expense. Income tax expense increased $5,000 for the three months ended December 31, 2005 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.



Six Months Ended December 31, 2005 Compared to the Six Months Ended December 31, 2004



The following tables set forth a comparison of the six month period ended December 31, 2005 to the six month period ended December 31, 2004. The
amounts are derived from selected items reflected in our unaudited Consolidated Statements of Operations included elsewhere in this report. The six months financial results are not necessarily indicative of future results.



Revenues



|                   |  |                               |            |      |   |            |  |      |  
|------------------ |  | ----------------------------- | ---------- | ---- | - | ---------- |  | ---- | -
|                   |  | Six Months Ended December 31, |           
|                   |  | 2005                          |            | 2004 |   | %          | 
|Revenues:          |  |                               |            |      |   |            |  |      |  
|Product sales      |  | $                             | 11,945,000 |      | $ | 9,632,000  |  | 24.0 | %
|Service revenue    |  |                               | 3,727,000  |      |   | 2,739,000  |  | 36.1 | %
|Commission revenue |  |                               | 3,007,000  |      |   | 2,568,000  |  | 17.1 | %
|                   |  |                               |            |      |   |            |  |      |  
|Total revenues     |  | $                             | 18,679,000 |      | $ | 14,939,000 |  | 25.0 | %
|                   |  |                               |            |      |   |            |  |      |  



17



---

##### Table of Contents

Revenues. The Company realized significant revenue growth over the same period in the prior fiscal
year. Total revenues increased $3,740,000, or 25.0%, between periods and all three categories of revenues showed large increases.



Product sales increased to $11,945,000 for the six months ended December 31, 2005, an increase of $2,313,000 from the same period in 2004, or 24.0%.
The increase is due to continued economic improvement in the Companys market, aggressive promotional campaigns initiated by Autodesk resulting in an increased demand for their products and improved execution and performance of the Company. In
April 2005, the Company acquired the operations of Comtrex Corporation, an authorized Autodesk reseller with offices in Greensboro, Charlotte, and Morrisville, North Carolina thereby increasing its geographic reach and increasing its sales volume.
The increase in product sales attributable to this acquisition for the quarter ended December 31, 2005 was approximately $1,232,000.



Service revenues increased $988,000, or 36.1%, for the six months ended December 31, 2005 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 $439,000 or 17.1% for the six months ended December 31, 2005, compared to the same period in the prior fiscal year. The
increase in commission revenues was a result of a significant industry-wide increase in sales volume and a continued focus by the Company to increase this category of business.



Cost of Revenues and Gross Margin



|                        |  |                               |           |      |   |           |  |      |  
|----------------------- |  | ----------------------------- | --------- | ---- | - | --------- |  | ---- | -
|                        |  | Six Months Ended December 31, |          
|                        |  | 2005                          |           | 2004 |   | %         | 
|Cost of revenue:        |  |                               |           |      |   |           |  |      |  
|Cost of product sales   |  | $                             | 7,202,000 |      | $ | 6,605,000 |  | 9.0  | %
|Cost of service revenue |  |                               | 2,398,000 |      |   | 2,131,000 |  | 12.5 | %
|                        |  |                               |           |      |   |           |  |      |  
|Total cost of revenue   |  | $                             | 9,600,000 |      | $ | 8,736,000 |  | 9.9  | %
|                        |  |                               |           |      |   |           |  |      |  
|Gross margin            |  | $                             | 9,079,000 |      | $ | 6,203,000 |  |      |  
|                        |  |                               |           |      |   |           |  |      |  



Costs of
revenue. Total cost of revenue increased $864,000, or 9.9%, for the six months ended December 31, 2005 as compared to the same period in the prior fiscal year.



Cost of product sales increased $597,000, or 9.0%, despite a 24.0% increase in product revenues. The cost of product sales
as a percentage of related revenue for the six months ended December 31, 2005 was 60.3%, compared to 68.6% in the same period in 2004. 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 six months ended December 31, 2004.



Cost of service revenue increased $267,000, or 12.5%, for the six months
ended December 31, 2005 compared to the same period in the prior fiscal year, but service revenues increased by 36.1%. As a result, cost of service revenue as a percentage of related revenue for the six months ended December 31, 2005
decreased to 64.3% from 77.8% in the same period in the prior fiscal year. This decrease was due to a significant increase in billable time, resulting in more effective utilization of the Companys services personnel.



18



---

##### Table of Contents

Gross margin. Overall, the Companys gross margin percentage increased significantly from
41.5% for the six months ended December 31, 2004 to 48.6% for the same period in the current fiscal year.



Other Operating Expenses



|                                    |  |                               |           |      |   |           |  |      |  
|----------------------------------- |  | ----------------------------- | --------- | ---- | - | --------- |  | ---- | -
|                                    |  | Six Months Ended December 31, |          
|                                    |  | 2005                          |           | 2004 |   | %         | 
|Other operating expenses:           |  |                               |           |      |   |           |  |      |  
|Selling, general and administrative |  | $                             | 7,588,000 |      | $ | 6,584,000 |  | 15.2 | %
|Depreciation and amortization       |  |                               | 193,000   |      |   | 134,000   |  | 44.0 | %
|                                    |  |                               |           |      |   |           |  |      |  
|Total other operating expenses      |  | $                             | 7,781,000 |      | $ | 6,718,000 |  | 15.8 | %
|                                    |  |                               |           |      |   |           |  |      |  



Selling, General
and Administrative Expense. Selling, general and administrative expenses increased $1,004,000, or 15.2%, for the six months ended December 31, 2005 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 40.6% for the six months ended December 31, 2005, down significantly from 44.1% for the same
period in the prior fiscal year. 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 $59,000, or 44.0%, for the six months ended December 31, 2005
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)



|                             |  |                               |          |   |      |   |          |   |  |        |   
|---------------------------- |  | ----------------------------- | -------- | - | ---- | - | -------- | - |  | ------ | --
|                             |  | Six Months Ended December 31, |         
|                             |  | 2005                          |          |   | 2004 |   |          | % | 
|Other income (expense):      |  |                               |          |   |      |   |          |   |  |        |   
|Minority interest            |  | $                             |         |   |      | $ | (59,000  | ) |  | (100.0 | )%
|Interest and other income    |  |                               | 7,000    |   |      |   | 4,000    |   |  | 75.0   | % 
|Interest expense             |  |                               | (263,000 | ) |      |   | (218,000 | ) |  | 20.6   | % 
|                             |  |                               |          |   |      |   |          |   |  |        |   
|Total other income (expense) |  | $                             | (256,000 | ) |      | $ | (273,000 | ) |  | (6.2   | )%
|                             |  |                               |          |   |      |   |          |   |  |        |   



Other Income
(Expense). Other income (expense) decreased $17,000 for the six months ended December 31, 2005 compared to the same period in the prior fiscal year. 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. Interest expense increased as a result of higher interest rates on the Companys lines of credit as well as the amortization of financing
costs incurred in the prior fiscal year.



Income tax expense



|                   |  |                               |        |      |   |        |  |       |  
|------------------ |  | ----------------------------- | ------ | ---- | - | ------ |  | ----- | -
|                   |  | Six Months Ended December 31, |       
|                   |  | 2005                          |        | 2004 |   | %      | 
|Income tax expense |  | $                             | 32,000 |      | $ | 15,000 |  | 113.3 | %
|                   |  |                               |        |      |   |        |  |       |  



19



---

##### Table of Contents

Income Tax Expense. Income tax expense increased $17,000 for the six months ended
December 31, 2005 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.



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 six months ended December 31, 2005 were approximately $112,000, compared to $261,000 for the same period in 2004.



For the six months ended December 31, 2005 net cash provided by operating activities was $1,289,000, a betterment of
$3,232,000 over the same period in 2004. The major difference between the periods was that the Company earned $1,010,000 net income in 2005 as compared to a net loss of $804,000 in 2004, a difference of $1,814,000. In addition, accounts and other
receivables decreased by $254,000 for the six months ended December 31, 2005 but increased by $464,000 during the same period in 2004, a difference of $718,000.



For the six months ended December 31, 2005 the Company used $1,171,000 of its cash in financing activities compared
with providing cash of $1,593,000 for the same period in 2004. The main reason for this difference is that during 2005 the Company paid down both its long-term debt and borrowings under its lines of credit from the cash provided by its operating
activities as well as from proceeds from the sale of $1,191,000 of preferred stock.



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 December 31, 2005) 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



20



---

##### Table of Contents

credit facility bore interest at the greater of 7.5%, or the prime rate plus 2.0% (9.25% at December, 2005) and were secured by the assets of the Company and
the guarantee of the Chairman of the Board of Directors. In December 2005, the Company determined that it no longer needed this facility and elected to let it expire at its December 31, 2005 maturity date.



The total borrowings from the bank under the $3.0 million line and the
$700,000 line were approximately $1.3 million and $3.2 million as of December 31, 2005 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 $3.7 million at December 31, 2005, and the Company had a deficiency of working capital of approximately $329,000. The working capital deficit was in large part caused by the classification of the
lines of credit as current liabilities due to their demand provisions. 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.



Below is a summary of the Companys contractual obligations and commitments at December 31, 2005:



|                                                            |  |       |           |                 |   |             |  |             |           |                  |   |         |  |   |        
|----------------------------------------------------------- |  | ----- | --------- | --------------- | - | ----------- |  | ----------- | --------- | ---------------- | - | ------- |  | - | -------
|                                                            |  | Total |           | Less than 1year |   | 1  3 years |  | 3  5 years |           | More than 5years
|Contractual Obligations                                     |  |       |           |                 |   |             |  |             |           |                  |   |         |  |   |        
|Lines of credit *                                           |  | $     | 1,295,000 |                 | $ | 1,295,000   |  | $           |          |                  | $ |        |  | $ |       
|Long-term obligations **                                    |  |       | 1,375,000 |                 |   | 416,000     |  |             | 959,000   |                  |   |        |  |   |       
|Interest on fixed rate obligations                          |  |       | 232,000   |                 |   | 194,000     |  |             | 38,000    |                  |   |        |  |   |       
|Operating leases                                            |  |       | 3,980,000 |                 |   | 1,103,000   |  |             | 1,853,000 |                  |   | 801,000 |  |   | 223,000
|Note payable to related party and capital lease obligations |  |       | 1,065,000 |                 |   | 996,000     |  |             | 69,000    |                  |   |        |  |   |       
|                                                            |  |       |           |                 |   |             |  |             |           |                  |   |         |  |   |        
|Total obligations                                           |  | $     | 7,947,000 |                 | $ | 4,004,000   |  | $           | 2,919,000 |                  | $ | 801,000 |  | $ | 223,000
|                                                            |  |       |           |                 |   |             |  |             |           |                  |   |         |  |   |        



|* | 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.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------



|** | On January 27, 2006, the Company prepaid its long-term obligation to a vendor, therefore the only remaining long-term obligation after that date is the acquisition loans
described in Note 4 which total $102,000 as of December 31, 2005.
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



21



---

##### Table of Contents

|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 December 31, 2005, 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 six months ended December 31, 2005. 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.



22



---

##### Table of Contents

PART II. OTHER INFORMATION



|ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
|------- | ---------------------------------------------------



The Annual Meeting of Shareholders was held on November 10, 2005. Of the 15,338,485 shares entitled to vote at the meeting, 9,359,881 voted. The
following matters were voted on at the meeting:



|                                                                     |  |                 |  |         |  |          
|-------------------------------------------------------------------- |  | --------------- |  | ------- |  | ---------
|                                                                     |  | Number of Votes
|Proposal                                                             |  | In Favor        |  | Against |  | Abstain  
|To elect the following persons to the Board of Directors:            |  |                 |  |         |  |          
|Edgar D. Aronson                                                     |  | 7,026,339       |  | 793,043 |  | 1,540,498
|Garnett Y. Clark                                                     |  | 9,354,257       |  | 5,624   |  | 0        
|George W. Cox                                                        |  | 9,352,946       |  | 6,935   |  | 0        
|Eugene J. Fischer                                                    |  | 9,351,485       |  | 8,396   |  | 0        
|W. James Hindman                                                     |  | 9,274,542       |  | 85,339  |  | 0        
|Robert J. Post                                                       |  | 9,354,422       |  | 5,459   |  | 0        
|Donald R. Walsh                                                      |  | 9,285,359       |  | 74,522  |  | 0        
|To ratify the amendment to the companys Restricted Stock Award Plan |  | 8,785,014       |  | 179,625 |  | 395,242  



|ITEM 6. | EXHIBITS
|------- | --------



|           |  |                                                                                                                                                                          
|---------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNo. |  | Description of Exhibit                                                                                                                                                   
|           | 
|10.1       |  | Loan and Security Agreement between Avatech Solutions, Inc. and Avatech Solutions, Subsidiary Inc. and Mercantile-Safe Deposit and Trust Company dated January 27, 2006 *
|           | 
|10.2       |  | Discharge and Satisfaction of Indebtedness Agreement between Avatech Solutions, Inc. and Avatech Solutions, Subsidiary Inc. Dassault Systèmes dated January 23, 2006 *   
|           | 
|10.3       |  | Autodesk Authorized Channel Partner Agreement with Avatech Solutions, Inc. dated February 1, 2006a                                                                       
|           | 
|10.4       |  | Restricted Stock Award Plan, as amendedb                                                                                                                                 
|           | 
|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
|- | --------------



|a. | Incorporated by reference to our Current Report on form 8-K filed on February 9, 2007,
File No. 001-31265
|-- | ---------------------------------------------------------------------------------------------------------



|b. | Incorporated by reference to our Quarterly Report on form 10-Q filed on November 14,
2005 File No. 001-31265
|-- | ------------------------------------------------------------------------------------------------------------



23



---

##### Table of Contents

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: February 14, 2006 |  |  |  | By                                       |  | /s/ Donald R. Walsh 
|                        |  |  |  |                                          |  |                      |  | Donald R. Walsh                                                                        
|                        |  |  |  |                                          |  |                      |  | Chief Executive Officer                                                                
|                        |  |  | 
|Date: February 14, 2006 |  |  |  | By                                       |  | /s/ Lawrence Rychlak
|                        |  |  |  |                                          |  |                      |  | Lawrence Rychlak                                                                       
|                        |  |  |  |                                          |  |                      |  | Vice President and Chief Financial Officer (Principal financial and accounting officer)



24